Economics for 2 nd PUC

Transcription

1 Economics for 2 nd PUC By Professor Vipin This module is designed from the exam point of view. The quality of the content in this is the BEST you will come across. P a g e 1 105

2 1 Introduction to Microeconomics Introduction Economics is the social science that describes the factors that determine the production, distribution and consumption of goods and services. Scottish philosopher Adam Smith (1776) defined what was then called political economy as "an inquiry into the nature and causes of the wealth of nations", in particular as: A branch of the science of a statesman or legislator [with the twofold objectives of providing] a plentiful revenue or subsistence for the people... [and] to supply the state or commonwealt h with a revenue for the public services. Economy An economy is a system which tries to balance the available resources of a country (land, labor, capital and enterprise) against the wants and needs of consumers. The basic functions of an economy are production, consumption, distribution and exchange. Basic Problems of an Economy The problem of scarcity of resources which arises before an individual consumer also arises collectively before an economy. On account of this problem and economy has to choose between the following: 1. Which goods should be produced and in how much quantity? 2. What technique should be adopted for production? 3. For whom goods should be produced? These three problems are known as the central problems or the basic problems of an economy. This is so because all other economic problems cluster around these problems. These problems arise in all economics whether it is a socialist economy like that of North Korea or a capitalist economy like that of America or a mixed economy like that of India. Similarly, they arise in developed and under- developed economics alike. What to produce? There are two aspects of this problem firstly, which goods should be produced, and secondly, what should be the quantities of the goods that are to be produced. The first problem relates to the goods which are to be produced. In other words, what goods should be produced? An economy wants many things but all these cannot be produced with the available resources. Therefore, an economy has to choose what goods should be produced and what goods should not be. In other words, whether consumer goods should be produced or producer goods or whether general goods P a g e 2 105

3 should be produced or capital goods or whether civil goods should be produced or defense goods? The second problem is what should be the quantities of the goods that are to be produced. Production of goods depends upon the use of resources. Hence, this problem is the problem of allocation of resources. If we allocate more resources for the production of one commodity, the resources for the production of other commodities would be less. How to produce? The second basic problem is which technique should be used for the production of given commodities. This problem arises because there are various techniques available for the production of a commodity such as, for the production of wheat, we may use either more of labor and less of capital or less of labor or more of capital. With the help of both these techniques, we can produce equal amount of wheat. Such possibilities exist relating to the production of other commodities also. Therefore, every economy faces the problem as to how resources should be combined for the production of a given commodity. The goods would be produced employing those methods and techniques, whereby the output may be the maximum and cost of production be the minimum. Organization of Economic Activities Choice is an important tool in the organization of economic activities. Just like an individual, a nation also has limited resources. Therefore it must decide what to produce, how to produce and for whom to produce. The way a nation solves this problem is by way of an Economic System. There are 3 types of Economic Systems Centrally Planned Economy A planned economy is an economic system in which inputs are based on direct allocation. Economic planning may be carried out in a decentralized, distributed or centralized manner depending on the specific organization of economic institutions. An economy based on economic planning (either through the state, an association of worker cooperatives or another economic entity that has jurisdiction over the means of production) appropriates its resources as needed, so that allocation comes in the form of internal transfers involving the purchasing of assets by one government agency or firm by another. In a traditional model of planning, decision-making would be carried out by workers and consumers on the enterprise-level. Less extensive forms of planned economies include those that use indicative planning as components of a market-based or mixed economy, in which the state employs "influence, subsidies, grants, and taxes, but does not compel." This latter is sometimes referred to as a "planned market economy". In some instances, P a g e 3 105

4 the term planned economy has been used to refer to national economic development plans and statedirected investment in market economies. Countries like China, Russia and North Korea are examples of centrally planned economies. Capitalist Economy or Market Economy Capitalism is an economic system based on private ownership of the means of production and the creation of goods and services for profit. Central characteristics of capitalism include private property, capital accumulation, wage labor and competitive markets. In a capitalist market economy, investments are determined by private decision and the parties to a transaction typically determine the prices at which they exchange assets, goods, and services. The degree of competition in markets, the role of intervention and regulation, and the scope of state ownership vary across different models of capitalism. Economists, political economists, and historians have adopted different perspectives in their analyses of capitalism and have recognized various forms of it in practice. These include laissez-faire or free market capitalism, welfare capitalism and state capitalism. Each model has employed varying degrees of dependency on free markets, public ownership, obstacles to free competition, and inclusion of statesanctioned social policies. Countries like America and Great Britain follow capitalism. Mixed Economy A mixed economy is variously defined as an economic system consisting of a mixture of either markets and economic planning, public ownership and private ownership, or free markets and economic interventionism. However, in most cases, "mixed economy" refers to market economies with strong regulatory oversight and governmental provision of public goods, although some mixed economies also feature a number of state-run enterprises. In general the mixed economy is characterized by the private ownership of the means of production, the dominance of markets for economic coordination, with profit-seeking enterprise and the accumulation of capital remaining the fundamental driving force behind economic activity. But unlike a free-market economy, the government would wield indirect macroeconomic influence over the economy through fiscal and monetary policies designed to counteract economic downturns and capitalism's tendency toward financial crises and unemployment, along with playing a role in interventions that promote social welfare. Subsequently, some mixed economies have expanded in scope to include a role for indicative economic planning and/or large public enterprise sectors. Countries like India, Germany and France follow mixed economy system. Positive and Normative Economics Positive Economics P a g e 4 105

5 Positive economics is a branch of economics that focuses on the description and explanation of phenomena, as well as their casual relationships. It focuses primarily on facts and cause-and-effect behavioral relationships, including developing and testing economic theories. As a science, positive economics focuses on analyzing economic behavior. It avoids economic value judgments. For example, positive economic theory would describe how money supply growth impacts inflation, but it does not provide any guidance on what policy should be followed. "The unemployment rate in France is higher than that in the United States" is a positive economic statement. It gives an overview of an economic situation without providing any guidance for necessary actions to address the issue. Normative Economics Normative economics is a branch of economics that expresses value or normative judgments about economic fairness. It focuses on what the outcome of the economy or goals of public policy should be. Many normative judgments are conditional. They are given up if facts or knowledge of facts change. In this instance, a change in values is seen as being purely scientific. Welfare economist Amartya Sen explained that basic (normative) judgments rely on knowledge of facts. An example of a normative economic statement is "The price of milk should be $6 a gallon to give dairy farmers a higher living standard and to save the family farm." It is a normative statement because it reflects value judgments. It states facts, but also explains what should be done. Normative economics has subfields that provide further scientific study including social choice theory, cooperative game theory, and mechanism design. Microeconomics Microeconomics (from Greek prefix mikro- meaning "small" and economics) is a branch of economics that studies the behavior of individuals and small impacting players in making decisions on the allocation of limited resources. Macroeconomics Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets. This includes national, regional, and global economies. With microeconomics, macroeconomics is one of the two most general fields in economics. These two terms were first coined and used by Prof Ragner Frisch, the first Nobel Laureate in Economics in Uses of Micro Economics 1. Individual Behavior Analysis: Micro economics studies behavior of individual consumer or producer in a particular situation. 2. Resource Allocation: Resources are already scare i.e. less in quantity. Micro economics helps in proper allocation and utilization of resources to produce various types of goods and services. P a g e 5 105

6 3. Price Mechanization: Micro economics decides prices of various goods and services on the basis of 'Demand-Supply Analysis'. 4. Economic Policy: Micro economics helps in formulating various economic policies and economic plans to promote all round economic development. 5. Free Enterprise Economy: Micro economics explain operating of a free enterprise economy where individual has freedom to take his own economic decisions. 6. Public Finance: It helps the government in fixing the tax rate and the type of tax as well as the amount of tax to be charged to the buyer and the seller. 7. Foreign Trade: It helps in explaining and fixing international trade and tariff rules, causes of disequilibrium in BOP, effects of factors deciding exchange rate, etc. 8. Social Welfare: It not only analyze economic conditions but also studies the social needs under different market conditions like monopoly, oligopoly, etc. P a g e 6 105

7 2 Theory of Consumer Behavior There are two theories that explain consumer behavior, they are; Utility Theory and the Indifference Preference Theory. Utility Analysis Eminent economists such as Jevons, Walras and Menger developed the utility analysis during the 19 th century. The real credit for its present development goes to Alfred Marshall and Pigou. The term utility should not be confused with satisfaction. A consumer gets satisfaction only after consumption. But utility is calculation of want-satisfying power of a particular commodity before consumption. Utility refers to expected satisfaction whereas satisfaction denotes realized satisfaction. Measurement of Utility Utility is a subjective concept. According to Alfred Marshall, it can be measured objectively in terms of price. The price a person is willing to pay shows the utility for the consumer. Cardinal and Ordinal Measures of Utility Cardinal Measure of Utility a. One util equals one unit of money b. Utility of money remains constant However, over a passage of time, it has been felt by economists that the exact or absolute measurement of utility is not possible. There are a number of difficulties involved in the measurement of utility. This is because of the fact that the utility derived by a consumer from a good depends on various factors, such as changes in consumer s moods, tastes, and preferences. These factors are not possible to determine and measure. Therefore, no such technique has been devised by economists to measure utility. Utility; thus, is not measureable in cardinal terms. However, the cardinal utility concept has a prime importance in consumer behavior analysis. Ordinal Utility Concept Cardinal utility approach is based on the fact that the exact or absolute measurement of utility is not possible. However, modern economists rejected the cardinal utility approach and introduced the concept of ordinal utility for the analysis of consumer behavior. P a g e 7 105

8 According to them, it may not be possible to measure exact utility, but it can be expressed in terms of less or more useful good. For instance, a consumer consumes coconut oil and mustard oil. In such a case, the consumer cannot say that coconut oil gives 10 utils and mustard oil gives 20 utils. Instead he/she can say that mustard oil gives more utility to him/her than coconut oil. In such a case, mustard oil would be given rank 1 and coconut oil would be given rank 2 by the consumer. This assumption lays the foundation for the ordinal theory of consumer behavior. Concepts of Utility Initial Utility It is the utility derived from consumption of the first unit of a commodity. For example having the first glass of water to quench your thirst. Total Utility This is the total utility derived from consuming a given amount of goods and services over a period of time. If a person consumes five units of a commodity and derives U1, U2, U3, U4, and U5 utlity from the units of a commodity then the total utility is TU = U 1 + U 2 + U 3 + U 4 + U 5 This can also be the sum of marginal utility of each successive unity of consumption. TU x = MU x Marginal Utility The utility derived from the consumption of additional unit of commodity is known as marginal utility. In other words, the change in total utility due to the change in consumption of commodity is known as marginal utility. Mathematically it can be expressed as: TU is the change in total utility. MU = TU Q Q is the change in consuming additional unit of a good. It can also be expressed as MU n = TU n TU n 1 P a g e 8 105

9 MU n is the marginal utility of n units TU n is the total utility of n units TU n-1 is the total utility of n-1 units Law of Diminishing Marginal Utility A German economist Gossen explained this law. Therefore it is also known as Gossen s First Law. Alfred Marshall, the founder of the neo-classical school popularized it. The law of diminishing marginal utility is one of the important laws of utility analysis. Statement of the Law As consumer increases the consumption of any one commodity keeping constant consumption of all the other commodities, the marginal utility of the variable commodity must eventually decline. In other words, as a consumer consumes more of any commodity, the total utility increases but the increase in total utility is not proportionate to the increase in units of consumption. Assumptions of the Law 1. All the units of the given commodity are homogenous i.e. identical in size shape, quality, quantity etc. 2. The units of consumption are of reasonable size. The consumption is normal. 3. The consumption is continuous. There is no unduly long time interval between the consumption of the successive units. 4. The law assumes that only one type of commodity is used for consumption at a time. 5. Though it is psychological concept, the law assumes that the utility can be measured cardinally i.e. it can be expressed numerically. 6. The consumer is rational human being and he aims at maximum of satisfaction. Glass of Water Total Utility Marginal Utility Explanation of the Law As more and more quantity of a commodity is consumed, the intensity if desire decreases and also the utility derived from the additional unit. Suppose a person drinks water and 1st glass of water gives him maximum satisfaction. When he will drink 2nd glass of water, his total satisfaction would increase. But the utility added by 2nd glass of water (MU) is less than the 1st glass of water. His Total utility and marginal utility can be put in the form of a following schedule. P a g e 9 105

10 Exceptions of the Law 1. The law does not hold well in the rare collections. For example, collection of ancient coins, stamps etc. 2. The law is not fully applicable to money. The marginal utility of money declines with richness but never falls to zero. 3. It does not apply to the knowledge, art and innovations. 4. The law is not applicable for precious goods such as jewelry or gems. 5. Law does not operate if consumer behaves in irrational manner. For example, drunkard is said to enjoy each successive peg more than the previous one. 6. Man is fond of beauty and decoration. He gets more satisfaction by getting the above merits of the commodities. 7. If a dress comes into fashion or a trend, its utility goes up. On the other hand its utility goes down if it goes out of fashion. Importance of the Law of Diminishing Marginal Utility 1. Basis of Economic Laws: The Law of Diminishing Marginal Utility is the basic law of con sumption. The Law of Demand, the Law of Equi-marginal Utility, and the Concept of Consumer s Surplus are based on it. 2. Diversification in Consumption and Production: The changes in design, pattern and pack ing of commodities very often brought about by producers are in keeping with this law. We know that the use of the same good makes us feel bored; its utility diminishes in our estimation. We want variety in soaps, toothpastes, pens, etc. Thus, this law helps in bringing variety in consumption and production. 3. Value Theory: The law helps to explain the phenomenon in value theory that the price of a commodity falls when its supply increases. It is because with the increase in the stock of a commodity, its marginal utility diminishes. 4. Diamond-Water Paradox: The famous diamond-water paradox of Smith can be explained with the help of this law. Because of their relative scarcity, diamonds possess high marginal utility and so a high price. Since water is relatively abundant, it possesses low marginal utility and hence low price even though its total utility is high. That is why water has low price as compared to a diamond though it is more useful than the latter. 5. Progressive Taxation: The principle of progression in taxation is also based on this law. As a person s income increases, the rate of tax rises because the marginal utility of money to him falls with the rise in his income. 6. Basis of Socialism: I his law underlie the socialist plea for an equitable distribution of wealth. The marginal utility of money to the rich is low. It is, therefore, advisable that their surplus wealth be acquired by the state and distributed to the poor who possess high marginal utility for money. 7. For Producer: This law helps the producer in increasing sales. The producer reduces the price of the product for the purpose of increasing sales. The consumers purchase more quantity of that product to obtain maximum satisfaction given their income. As they buy more quantities the marginal utility of the last rupee diminishes. Thus, the sale of the product increases. P a g e

11 Concept of Consumer Behavior Consumer behavior is the study of individuals, groups, or organizations and the processes they use to select, secure, and dispose of products, services, experiences, or ideas to satisfy needs and the impacts that these processes have on the consumer and society. Budget Line Consumer Budget states the real income or purchasing power of the consumer from which he can purchase certain quantitative bundles of two goods at given price. It means, a consumer can purchase only those combinations (bundles) of goods, which cost less than or equal to his income. Budget line is a graphical representation of all possible combinations of two goods which can be purchased with given income and prices, such that the cost of each of these combinations is equal to the money income of the consumer. Alternately, Budget Line is locus of different combinations of the two goods which the consumer consumes and which cost exactly his income. Let us understand the concept of Budget line with the help of an example: Suppose, a consumer has an income of Rs. 20. He wants to spend it on two commodities: X and Y and both are priced at Rs. 10 each. Now, the consumer has three options to spend his entire income: (i) Buy 2 units of X; (ii) Buy 2 units of Y; or (iii) Buy 1 unit of X and 1 unit of Y. It means, possible bundles can be: (2, 0); (0, 2) or (1, 1). When all these three bundles are represented graphically, we get a downward sloping straight line, known as Budget Line. It is also known as price line. Budget Set Budget set is the set of all possible combinations of the two goods which a consumer can afford, given his income and prices in the market. In addition to the three options, there are some more options available to the consumer within his income, even if entire income is not spent. Budget set includes all the bundles with the total income of Rs. 20, i.e. possible bundles or Consumer s bundles are: (0, 0); (0, 1); (0, 2); (1, 0); (2, 0); (1,1). Consumer s Bundle is a quantitative combination of two goods which can be purchased by a consumer from his given income. P a g e

12 Suppose, a consumer has a budget of Rs. 20 to be spent on two commodities: apples (A) and bananas (B). If apple is priced at Rs. 4 each and banana at Rs. 2 each, then the consumer can determine the various combinations (bundles), which form the budget line. The possible options of spending income of Rs. 20 are given in the table. In the figure, number of apples is taken on the X-axis and bananas on the Y-axis. At one extreme (Point E ), consumer can buy 5 apples by spending his entire income of Rs. 20 only on apples. The other extreme (Point j ), shows that the entire income is spent only on bananas. Between E and J, there are other combinations like F, G, H and I. By joining all these points, we get a straight line AB known as the Budget Line or Price line. Every point on this budget line indicates those bundles of apples and bananas, which the consumer can purchase by spending his entire income of 20 at the given prices of goods. Important Points about Budget Line 1. Budget line AB slopes downwards as more of one good can be bought by decreasing some units of the other good. 2. Bundles which cost exactly equal to consumer s money income (like combinations E to J) lie on the budget line. 3. Bundles which cost less than consumer s money income (like combination D) shows under spending. They lie inside the budget line. 4. Bundles which cost more than consumer s money income (like combination C) are not available to the consumer. They lie outside the budget line. P a g e

13 Slope of Budget Line We know, the slope of a curve is calculated as a change in variable on the vertical or Y-axis divided by change in variable on the horizontal or X-axis. In the example of apples and bananas, slope of the budget line will be number of units of bananas, that the consumer is willing to sacrifice for an additional unit of apple. Slope of Budget Line = Units of Bananas (B) willing to Sacrifice/ Units of Apples (A) willing to Gain Slope = P B P A As seen in the figure, bananas need to be sacrificed each time to gain 1 apple. So, Slope of Budget Line = -2/1 = **2/1 = 2 Numerator will always have negative value as it shows number of units to be sacrificed. However, for analysis, absolute value is always considered. This slope of budget line is equal to Price Ratio of two goods. What is Price Ratio? Price Ratio is the price of the good on the horizontal or X-axis divided by the price of the good on the vertical or Y-axis. For instance, If good X is plotted on the horizontal axis and good Y on the vertical axis, then: Price Ratio = Price of X (PX)/Price of Y(PY) = PX /P Effect of change in the relative Prices (Apples and Bananas) If there is any change in prices of the two commodities, assuming no change in the money income of consumer, then budget line will change. It will change the slope of budget line, as price ratio will change, with change in prices. (i) Change in the price of commodity on X-axis (Apples): When the price of apples falls, then new budget line is represented by a shift in budget line to the right from AB to A 1 B. The new budget line meets the Y-axis at the same point B, because the price of bananas has not changed. But it will touch the X-axis to the right of A at point A 1, because the consumer can now purchase more apples, with the same income level. Similarly, a rise in the price of apples will shift the budget line towards left from AB to A 2 B. P a g e

14 (ii) Change in the price of commodity on Y-axis (Bananas): With a fall in the price of bananas, the new budget line will shift to the right from AB to A 2 B. The new budget line meets the X-axis at the same point A, due to no change in the price of apples. But it will touch the Y-axis to the right of B at point B 1, because the consumer can now purchase more bananas, with the same income level. Similarly, a rise in the price of bananas will shift the budget line towards left from AB to A 2 B. Indifference Curve Analysis Meaning When a consumer consumes various goods and services, then there are some combinations, which give him exactly the same total satisfaction. The graphical representation of such combinations is termed as indifference curve. Indifference curve refers to the graphical representation of various alternative combinations of bundles of two goods among which the consumer is indifferent. Alternately, indifference curve is a locus of points that show such combinations of two commodities which give the consumer same satisfaction. Let us understand this with the help of following indifference schedule, which shows all the combinations giving equal satisfaction to the consumer. As seen in the schedule, consumer is indifferent between five combinations of apple and banana. Combination P (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on. When these combinations are represented graphically and joined together, we get an indifference curve IC1 as shown in the diagram In the diagram, apples are measured along the X-axis and bananas on the Y-axis. All points (P, Q, R, S and T) on the curve show different combinations of apples and bananas. These points are joined with the help of a smooth curve, known as indifference curve (IC1). An indifference curve is the locus of all the points, representing different combinations, that are equally satisfactory to the consumer. Every point on IC1, represents an equal amount of satisfaction to the consumer. So, the consumer is said to be indifferent between the combinations located on Indifference Curve IC1. The combinations P, Q, R, S and T give equal satisfaction to the consumer and therefore he is indifferent among them. These combinations are together known as Indifference Set. P a g e

15 Indifference Map Indifference Map refers to the family of indifference curves that represent consumer preferences over all the bundles of the two goods. An indifference curve represents all the combinations, which provide same level of satisfaction. However, every higher or lower level of satisfaction can be shown on different indifference curves. It means, infinite number of indifference curves can be drawn. Properties of Indifference Curve 1. Indifference curves are always convex to the origin: An indifference curve is convex to the origin because of diminishing MRS. MRS declines continuously because of the law of diminishing marginal utility. As seen in the table, when the consumer consumes more and more of apples, his marginal utility from apples keeps on declining and he is willing to give up less and less of bananas for each apple. Therefore, indifference curves are convex to the origin. It must be noted that MRS indicates the slope of indifference curve. 2. Indifference curve slope downwards: It implies that as a consumer consumes more of one good, he must consume less of the other good. It happens because if the consumer decides to have more units of one good (say apples), he will have to reduce the number of units of another good (say bananas), so that total utility remains the same. 3. Higher Indifference curves represent higher levels of satisfaction: Higher indifference curve represents large bundle of goods, which means more utility because of monotonic preference. Consider point A on ICX and point B on IC2 in the diagram. At A, consumer gets the combination (OR, OP) of the two commodities X and Y. At B, consumer gets the combination (OS, OP). As OS > OR, the consumer gets more satisfaction at IC2. 4. Indifference curves can never intersect each other: As two indifference curves cannot represent the same level of satisfaction, they cannot intersect each other. It means, only one indifference curve will pass through a given point on an indifference map. In the figure below, satisfaction from point A and from B on IC1 will be the same. Similarly, points A and C on IC2 also give the same level of satisfaction. It means, points B and C should also give the same level of satisfaction. However, this is not possible, as B and C lie on two different indifference curves, IC1 and IC2 respectively and represent different levels of satisfaction. Therefore, two indifference curves cannot intersect each other. P a g e

16 Marginal Rate of Substitution (MRS) Marginal Rate of Substitution (MRS): MRS refers to the rate at which the commodities can be substituted with each other, so that total satisfaction of the consumer remains the same. For example, in the example of apples (A) and bananas (B), MRS of A for B, will be number of units of B, that the consumer is willing to sacrifice for an additional unit of A, so as to maintain the same level of satisfaction. MRS AB = Units of Bananas (B) willing to Sacrifice / Units of Apples (A) willing to Gain MRS AB = B/ A MRS AB is the rate at which a consumer is willing to give up Bananas for one more unit of Apple. It means, MRS measures the slope of indifference curve. It must be noted that in mathematical terms, MRS should always be negative as numerator (units to be sacrificed) will always have negative value. However, for analysis, absolute value of MRS is always considered. MRS between Apple and Banana: Combination Apples Banana MRS AB (A) (B) P 1 15 Q B:1 A R 3 6 4B:1A S 4 3 3B:1A T 5 1 2B:1 A P a g e

17 As seen in the given schedule and diagram, when consumer moves from P to Q, he sacrifices 5 bananas for 1 apple. Thus, MRS AB comes out to be 5:1. Similarly, from Q to R, MRS AB is 4:1. In combination T, the sacrifice falls to 2 bananas for 1 apple. In other words, the MRS of apples for bananas is diminishing. Why MRS diminishes? MRS falls because of the law of diminishing marginal utility. In the given example of apples and bananas, Combination P has only 1 apple and, therefore, apple is relatively more important than bananas. Due to this, the consumer is willing to give up more bananas for an additional apple. But as he consumes more and more of apples, his marginal utility from apples keeps on declining. As a result, he is willing to give up less and less of bananas for each apple. Assumptions Optimal Choice of Consumer (Utility Maximization or Consumer Equilibrium) The various assumptions of indifference curve are: 1. Two commodities: It is assumed that the consumer has a fixed amount of money, whole of which is to be spent on the two goods, given constant prices of both the goods. 2. Non Satiety: It is assumed that the consumer has not reached the point of saturation. Consumer always prefer more of both commodities, i.e. he always tries to move to a higher indifference curve to get higher and higher satisfaction. 3. Ordinal Utility: Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods. 4. Diminishing marginal rate of substitution: Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this assumption, an indifference curve is convex to the origin. 5. Rational Consumer: The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total satisfaction. Conditions of Consumer s Equilibrium: The consumer s equilibrium under the indifference curve theory must meet the following two conditions: 1. MRS XY = Ratio of prices or P X /P Y Let the two goods be X and Y. The first condition for consumer s equilibrium is that MRS XY = P X /P Y P a g e

18 a. If MRS XY > P X /P Y, it means that the consumer is willing to pay more for X than the price prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of prices and the equilibrium is established. b. If MRS XY < P X /P Y, it means that the consumer is willing to pay less for X than the price prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to the ratio of prices and the equilibrium is established. 2. MRS continuously falls: The second condition for consumer s equilibrium is that MRS must be diminishing at the point of equilibrium, i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously falls, the equilibrium cannot be established. Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium. IC 1, IC 2 and IC 3 are the three indifference curves and AB is the budget line. With the constraint of budget line, the highest indifference curve, which a consumer can reach, is IC 2. The budget line is tangent to indifference curve IC 2 at point E. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity X and ON quantity of commodity Y. All other points on the budget line to the left or right of point E will lie on lower indifference curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and only one indifference curve, consumer maximizes his satisfaction at point E, when both the conditions of consumer s equilibrium are satisfied: a. MRS = Ratio of prices or P X /P Y : At tangency point E, the absolute value of the slope of the indifference curve (MRS between X and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at any other point as MRS XY > P X /P Y at all points to the left of point E and MRS XY < P X /P Y at all points to the right of point E. So, equilibrium is established at point E, when MRS XY = P X /P Y. b. MRS continuously falls: The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC 2 is convex to the origin at point E. P a g e

19 3 Demand Analysis Meaning of Demand Demand is an economic principle that describes a consumer's desire and willingness to pay a price for a specific good or service. Holding all other factors constant, the price of a good or service increases as its demand increases and vice versa. Determinants of Demand The five determinants of demand are: 1. Price of the good or service. 2. Prices of related goods or services. These are either complementary, which are things that are usually bought along with the product in demand. They could also be substitutes for the product in demand. 3. Income of those with the demand. 4. Tastes or preferences of those with the demand. 5. Expectations. These are usually about whether the price will go up. Demand Function The demand function shows the relationship between quantity demanded and its determinants. It is expressed as: P Price Pr Prices of Related Goods Y Income T Tastes and Preferences Qd = f(p, PR, Y, T ) Example: If the demand equation Qd = 20 2p represents the market situation for a good. If the price of tomato per kg at different points of time is Rs. 4, Rs, 5, Rs. 6, Rs. 7 and Rs. 8 then calculate the quantity of good demanded by a consumer in the market at different prices and prepare an individual demand schedule. Solution: Linear demand equation is Qd = 20-2p When p is 4; Qd = 20-2(4) = 12 When p is 5; Qd = 20-2(5) = 10 When p is 6; Qd = 20 2(6) = 8 When Qd = 20 2(7) = 6 P a g e

20 When Qd = 20 2(8) = 4 Individual Demand Schedule Price (in Rs.) Demand (in kg) Statement Law of Demand In economics, the law states that, all else being equal, as the price of a product increases, quantity demanded falls; likewise, as the price of a product decreases, quantity demanded increases. In other words, the law of demand states that the quantity demanded and the price of a commodity are inversely related, other things remaining constant. If the income of the consumer, prices of the related goods, and preferences of the consumer remain unchanged, then the change in quantity of good demanded by the consumer will be negatively correlated to the change in the price of the good. There are, however, some possible exceptions to this rule. Demand Schedule Price in Rupees Demand in Kg The table shows the demand of all the consumers in a market. When the price decreases there is increase in demand for goods and vice versa. When price is Rs. 5 demand is 100 kilograms. When the price is Rs. 4 demand is 200 kilograms. Thus the table shows the total amount demanded by all consumers various price levels. There is same price in the market. All consumers purchase commodity according to their needs. The market demand P a g e

21 curve is the total amount demanded by all consumers at different prices. The market demand curve slopes from left down to the right. Assumptions There should not be any change in income of consumer a) There should not be any change in Taste, preferences, habits and fashion of consumers b) There should not be any change in Price of the related commodity c) Population should be constant d) Should not anticipate any price change in the future e) The seasons and climate should not change f) No change in government policy g) Commodity should be normal one h) There should be no change in the population size i) Distribution of income and wealth should be equal j) There should be continuous demand k) There should be perfect competition in the market Exception to the Law a) Giffen goods: Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties of this category like bajra, cheaper vegetable like potato come under this category. Sir Robert Giffen or Ireland first observed that people used to spend more their income on inferior goods like potato and less of their income on meat. But potatoes constitute their staple food. When the price of potato increased, after purchasing potato they did not have so many surpluses to buy meat. So the rise in price of potato compelled people to buy more potato and thus raised the demand for potato. This is against the law of demand. This is also known as Giffen paradox. b) Conspicuous Consumption: This exception to the law of demand is associated with the doctrine propounded by Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy sections of the society. The prices of these goods are so high that they are beyond the reach of the common man. The higher the price of the diamond the higher the prestige value of it. So when price of these goods falls, the consumers think that the prestige value of these goods comes down. So quantity demanded of these goods falls with fall in their price. So the law of demand does not hold good here. c) Conspicuous necessities: Certain things become the necessities of modern life. So we have to purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has not gone down in spite of the increase in their price. These things have become the symbol of status. So they are purchased despite their rising price. These can be termed as U sector goods. d) Ignorance: A consumer s ignorance is another factor that at times induces him to purchase more of the commodity at a higher price. This is especially so when the consumer is haunted by the phobia that a high-priced commodity is better in quality than a low-priced one. P a g e

22 e) Emergencies: Emergencies like war, famine etc. negate the operation of the law of demand. At such times, households behave in an abnormal way. Households accentuate scarcities and induce further price rises by making increased purchases even at higher prices during such periods. During depression, on the other hand, no fall in price is a sufficient inducement for consumers to demand more. f) Future changes in prices: Households also act speculators. When the prices are rising households tend to purchase large quantities of the commodity out of the apprehension that prices may still go up. When prices are expected to fall further, they wait to buy goods in future at still lower prices. So quantity demanded falls when prices are falling. g) Change in fashion: A change in fashion and tastes affects the market for a commodity. When a broad toe shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the stocks. Broad toe on the other hand, will have more customers even though its price may be going up. The law of demand becomes ineffective. Why Demand Curve Slopes Downwards Marginal utility decreases: When a consumer buys more units of a commodity, the marginal utility of such commodity continue to decline. The consumer can buy more units of commodity when its price falls and vice versa. The demand curve falls because demand is more at lower price. Price effect: When there is increase in price of commodity, the consumers reduce the consumption of such commodity. The result is that there is decrease in demand for that commodity. The consumers consume mo0re or less of a commodity due to price effect. The demand curve slopes downward. Income effect: Real income of consumer rises due to fall in prices. The consumer can buy more quantity of same commodity. When there is increase in price, real income of consumer falls. This is income effect that the consumer can spend increased income on other commodities. The demand curve slopes downward due to positive income effect. Same price of substitutes: When the price of a commodity falls, the prices of substitutes remaining the same, consumer can buy more of the commodity and vice versa. The demand curve slopes downward due to substitution effect. Demand of poor people: The income of people is not the same. The rich people have money to buy same commodity at high prices. Large majority of people are poor. They buy more when price fall and vice versa. The demand curve slopes due to poor people. Different uses of goods: There are different uses of many goods. When prices of such goods increase these goods are put into uses that are more important and their demand falls. The demand curve slopes downward due to such goods. Normal and Inferior Goods In economics, an inferior good is a good that decreases in demand when consumer income rises (or rises in demand when consumer income decreases), unlike normal goods, for which the opposite is observed. Normal goods are those for which consumers' demand increases when their income increases. P a g e

23 Substitutes and Complimentary Goods A complementary good is a good whose use is related to the use of an associated or paired good. Two goods (A and B) are complementary if using more of good A requires the use of more of good B. For example, the demand for one good (printers) generates demand for the other (ink cartridges). If the price of one good falls and people buy more of it, they will usually buy more of the complementary good also, whether or not its price also falls. Similarly, if the price of one good rises and reduces its demand, it may reduce the demand for the paired or complementary good as well. In economics, you may often hear about substitute goods. These are the opposite of complementary goods and are a whole other topic by themselves. For instance, Microsoft Windows-based personal computers and Apple Macs are substitutes. If you buy one, you probably don't buy the other. Sprite and 7- UP are another example of substitute goods. Shifts in Demand Curve i. Increase in Demand is shown by rightward shift in demand curve from DD to D1D1. Demand rises from OQ to OQ1 due to favourable change in other factors at the same price OP ii. Decrease in Demand is shown by leftward shift in demand curve from DD to D2D2. Demand falls from OQ to OQ2 due to unfavourable change in other factors at the same price OP Increase in Demand refers to a rise in the demand of a commodity caused due to any factor other than the own price of the commodity. In this case, demand rises at the same price or demand remains same even at higher price. For example, suppose a research reveals that people who regularly eat green vegetables live longer. This will raise the demand for green vegetables even at the same price and it will shift the demand curve of vegetables towards right. P a g e

24 Decrease in Demand refers to a fall in the demand of a commodity caused due to any factor other than the own price of the commodity. In this case, demand falls at the same price or demand remains same even at lower price. It leads to a leftward shift in the demand curve Market Demand Schedule Market demand schedule refers to a tabular statement showing various quantities of a commodity that all the consumers are willing to buy at various levels of price, during a given period of time. It is the sum of all individual demand schedules at each and every price. Where Dm is the market demand and DA + DB +. are the individual demands of Household A, Household B and so on. Let us assume that A and B are two consumers for commodity x in the market. Table below shows that market demand schedule is obtained by horizontally summing the individual demands: As seen in the table, market demand is obtained by adding demand of households A and B at different prices. At Rs. 5 per unit, market demand is 3 units. When price falls to Rs. 4, market demand rises to 5 units. So, market demand schedule also shows the inverse relationship between price and quantity demanded. P a g e

25 Elasticity of Demand Income Elasticity of Demand The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumer s income. The formula for the Income Elasticity of Demand (IEoD) is given by: % Change in Quantity Demanded IEoD = ( ) %Change in Income a) A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. b) A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. c) A zero income elasticity of demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods. Price Elasticity of Demand Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income). Types of Price Elasticity The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price differs from commodity to commodity. Demand for some commodities is more elastic while that for certain others are less elastic. Using the formula of elasticity, it possible to mention following different types of price elasticity: a) Perfectly inelastic demand (ep = 0) b) Inelastic (less elastic) demand (e < 1) c) Unitary elasticity (e = 1) d) Elastic (more elastic) demand (e > 1) e) Perfectly elastic demand (e = ) Factors Determining Price Elasticity of Demand 1. The number of close substitutes the more close substitutes there are in the market, the more elastic is demand P a g e

26 because consumers find it easy to switch. E.g. Air travel and train travel are weak substitutes for inter-continental flights but closer substitutes for journeys of around km e.g. between major cities in a large country. 2. The cost of switching between products there may be costs involved in switching. In this case, demand tends to be inelastic. For example, mobile phone service providers may insist on a12 month contract which has the effect of locking-in some consumers once a choice has been made 3. The degree of necessity or whether the good is a luxury necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. An example of a necessity is rare-earth metals which are an essential raw material in the manufacture of solar cells, batteries. China produces 97% of total output of rare-earth metals giving them monopoly power in this market 4. The proportion of a consumer's income allocated to spending on the good products that take up a high % of income will have a more elastic demand 5. The time period allowed following a price change demand is more price elastic, the longer that consumers have to respond to a price change. They have more time to search for cheaper substitutes and switch their spending. 6. Whether the good is subject to habitual consumption consumers become less sensitive to the price of the good of they buy something out of habit (it has become the default choice). 7. Peak and off-peak demand - demand is price inelastic at peak times and more elastic at offpeak times this is particularly the case for transport services. 8. The breadth of definition of a good or service if a good is broadly defined, i.e. the demand for petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be more elastic following a price change. Cross Elasticity of Demand In economics, the cross elasticity of demand or cross-price elasticity of demand measures the responsiveness of the demand for a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be: Measuring Cross Elasticity E A,B = 20% 10% = 2% %Change in quantity demanded of product A %Change in price of product B In the example above, the two goods, fuel and cars (consists of fuel consumption), are complements; that is, one is used with the other. In these cases the cross elasticity of demand will be negative, as shown by P a g e

27 the decrease in demand for cars when the price for fuel will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to positive infinity (at the point when both goods can be consumed). Where the two goods are independent, or, as described in consumer theory, if a good is independent in demand then the demand of that good is independent of the quantity consumed of all other goods available to the consumer, the cross elasticity of demand will be zero: as the price of one good changes, there will be no change in demand for the other good P a g e

28 4 Production and Cost Production function explains the relationship between factor input and output of a given technology. Accoriding to Watson, Production function is a relationship between physical inputs and physical outputs of a firm. It is written as Y - Output R Land L Labor K Capital O Organization Isoquants Y = f(r, L, K, O ) An isoquant is a curve on which the various combinations of labour and capital show the same output. An isoproduct curve is a curve along which the maximum achievable rate of production is constant. It is also known as a production indifference curve or a constant product curve. A number of isoquants representing different amounts of output are known as an isoquant map. In Figure 1, curves IQ, IO1 and IQ2 show an isoquant Units of Labour map. Starting from the curve IQ which yields 100 units Fig. 1. Of product, the curve IQ1 shows 200 units and the IQ2 curve 300 units of the product which can be produced with altogether different combinations of the two factors. Marginal Rate of Technical Substitution The principle of marginal rate of technical substitution (MRTS or MRS) is based on the produc tion function where two factors can be substituted in variable proportions in such a way as to produce a constant level of output. The marginal rate of technical substitution between two factors К (capital) and L (labor), MRTSIK is the rate at which L can be substituted for К in the production of good X without changing the quantity of P a g e

29 output. As we move along an isoquant downward to the right, each point on it represents the substitution of labor for capital. MRTS LC = K L Where K is the change in units of capital used and L is the change in units of labor used. Total Product (TP) Total Product, Average Product and Marginal Product Average Product (AP) Total product of a factor is the amount of total output produced by a given amount of the factor, other factors held constant. As the amount of a factor increases, the total output increases. It will be seen from the table that when with a fixed quantity of capital (K), more units of labour are employed total product is increasing in the beginning. TP = Margnal Product Average product of a factor is the total output produced per unit of the factor employed. Thus, Average Product = Total Product No of units of Variable Factor Marginal Product (MP) Marginal product of a factor is the addition to the total production by the employment of an extra unit of a factor. Suppose when two workers are employed to produce wheat in an agricultural farm and they produce 170 quintals of wheat per year. Now, if instead of two workers, three workers are employed and as a result total product increases to 270 quintals, then the third worker has added 100 quintals of wheat to the total production. Thus 100 quintals is the marginal product of the third worker. TP n is the total product of n units TP n-1 is the total product of n-1 units MP = TP n TP n 1 P a g e

30 Short Run Analysis of Production / Law of Variable Proportions The short run is a time period where at least one factor of production is in fixed supply. A business has chosen its scale of production and must stick with this in the short run We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labor, raw materials and energy. Law of variable proportions occupies an important place in economic theory. This law examines the production function with one factor variable, keeping the quantities of other factors fixed. In other words, it refers to the input-output relation when output is increased by varying the quantity of one input. When the quantity of one factor is varied, keeping the quantity of other factors con stant, the proportion between the variable factor and the fixed factor is altered; the ratio of employ ment of the variable factor to that of the fixed factor goes on increasing as the quantity of the variable factor is increased. Assumptions of the Law 1. First, the state of technology is assumed to be given and unchanged. If there is improvement in the technology, then marginal and average products may rise instead of diminishing. 2. Secondly, there must be some inputs whose quantity is kept fixed. This is one of the ways by which we can alter the factor proportions and know its effect on output. This law does not apply in case all factors are proportionately varied. Behavior of output as a result of the variation in all inputs is discussed under returns to scale. 3. Thirdly the law is based upon the possibility of varying the proportions in which the various factors can be combined to produce a product. The law does not apply to those cases where the factors must be used in fixed proportions to yield a product. P a g e

31 Three Stages of the Law The behavior of these total, average and marginal products of the variable factor as a result of the increase in its amount is generally divided into three stages which are explained below: Stage 1: Law of Increasing Returns In this stage, total product curve TP increases at an increasing rate up to a point. In the figure. from the origin to the point F, slope of the total product curve TP is increasing, that is, up to the point F, the total product increases at an increasing rate (the total product curve TP is concave upward upto the point F), which means that the marginal product MP of the variable factor is rising. Stage 2: Law of Diminishing Returns In stage 2, the total product continues to increase at a diminishing rate until it reaches its maximum point H where the second stage ends. In this stage both the marginal product and the average product of the variable factor are diminishing but remain positive. At the end of the second stage, that is, at point M marginal product of the variable factor is zero (corresponding to the highest point H of the total product curve TP). Stage 2 is very crucial and important because as will be explained below the firm will seek to produce in its range. Stage 3: Law of Negative Returns: In stage 3 with the increase in the variable factor the total product declines and therefore the total product curve TP slopes downward. As a result, marginal product of the variable factor is negative and the marginal product curve MP goes below the X-axis. In this stage the variable factor is too much relative to the fixed factor. This stage is called the stage of negative returns, since the marginal product of the variable factor is negative during this stage. It may be noted that stage 1 and stage 3 are completely symmetrical. In stage 1 the fixed factor is too much relative to the variable factor. Therefore, in stage 1, marginal product of the fixed factor is negative. On the other hand, in stage 3 the variable factor is too much relative to the fixed factor. Therefore, in stage 3, the marginal product of the variable factor is negative. P a g e

32 Long Run Production Analysis Returns to Scale The laws of returns to scale are often confused with returns to scale. By returns to scale is meant the behavior of production or returns when all productive factors are increased or decreased simultaneously and in the same ratio. When all inputs are changed in the same proportion, we call this as a change in scale of production. The way total output changes due to change in the scale of production is known as returns to scale. Thus, whereas in the short-run change in output is associated with the change in factor proportions, and change in output in the long-run is associated with change in the scale of production. Thus returns to scale is the long-run concept. Increasing returns to Scale This situation occurs if a percentage increases in all inputs results in a greater percentage change in output. For e.g. a 10 % increase in all inputs causes a 20% increase in output. By increasing its scale, the firm may be able to use new production methods that were infeasible at the smaller scale. For instance, the firm may utilize sophisticated, highly efficient, large-scale factories. It also may find it advantageous to exploit specialization of labour at the large scale. This is shown in the following example. Inputs (Units) Output (Units) 2 capital + 2 Labour Capital + 4 Labour 500 The table shows that the input is increasing by 100%, on the other hand the output is increased by 150%. This shows the increasing returns to scale. As changes in the output is more than the change in input. Constant returns to Scale It occurs if a given percentage change in all inputs results in an equal percentage in output. For instance, if all inputs are doubled, output also doubles; a 10% increase in inputs would imply a 10% increase in output; and so on. Under constant returns, the firm s input are equally productive whether or smaller or larger levels of output are produced. A common example of constant returns to scale occurs when a firm can easily replicate its production process. For, instance a manufacturer of electrical company finds that it can double its output by replicating its current plant and labour force, that is, by building an identical palnt beside the old one. P a g e

33 Inputs (Units) Output (Units) 2 capital + 2 Labour Capital + 4 Labour 400 The above example shows that as the inputs (i.e. labour and capital) increased to 100%, output also increased to 100%. Decreasing Returns to scale It occurs if a given percentage increase in all inputs results in a smaller percentage increase in output. The most common explanation for decreasing Returns involves organization factors in very large firms. As the scale of firms increases, the difficulties in Coordinating and monitoring the many management functions. Coordinating production and distribution of 12 products manufactured in four separate plants typically means incurring additional costs tor management and information systems that would be unnecessary in a firm one-quarter size. As a result, proportional increases in output require more than proportional increases in inputs. The following example will explain decreasing returns to scale. Inputs (Units) Output (Units) 2 capital + 2 Labour capital + 4 Labour 300 The above shows, that inputs ate increases to 100% but the increase output is 50%, which shows that there is decreasing returns to scale. P a g e

34 Cost In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this case, money is the input that is gone in order to acquire the thing. Fixed costs Short Run Costs Fixed costs do not change with output, firms must pay these even if they shut down Examples include the rental costs of buildings; the costs of leasing or purchasing capital equipment; the annual business rate charged by local authorities; the costs of employing full-time contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance. Fixed costs are the overhead costs of a business. Total fixed costs (TFC) Average Fixed Cost Average fixed cost (AFC) = TFC / output Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production. A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs. Variable Costs Variable costs vary directly with output when output is zero, variable costs will be zero but as production increases, total variable costs will rise. Examples of variable costs include the costs of raw materials and components, packaging and distribution costs, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear Average variable cost (AVC) = total variable costs (TVC) /output (Q) Total Cost (TC) Total cost = fixed costs + variable costs Average Total Cost (ATC or AC) P a g e

35 Average total cost is the cost per unit produced Average total cost (ATC) = total cost (TC) / output (Q) Marginal Cost Marginal cost is the change in total costs from increasing output by one extra unit The marginal cost of supplying extra units of output is linked with the marginal productivity of labor. The law of diminishing returns implies that marginal cost will eventually rise as output increases. At some point, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases. MC = TC n TC n 1 Long Run Costs In the short run, some factors of production are fixed. Corresponding to each different level of fixed factors, there will be a different short run average total cost curve (SATC). The average total cost curve is just one of many SATCs that can be obtained by varying the amount of the fixed factor, in this case, the amount of capital. Long run average total cost curve. In the long run, all factors of production are variable, and hence, all costs are variable. The long run average total cost curve (LATC) is found by varying the amount of all factors of production. However, because each SATC corresponds to a different level of the fixed factors of production, the LATC can be constructed by taking the lower envelope of all the SATCs, as is illustrated in Figure The LATC is shown to be tangent to each of five different SATCs, labeled SATC 1 through SATC 5. In general, there will be a large number of SATCs, each of which corresponds to a different level of the fixed factors the firm can employ in the short run. Because there is such a large number of SATCs more than just the five illustrated in Figure the lower envelope of all the SATCs, which makes up the LATC, can be approximated by a smooth, U shaped curve. P a g e

36 Economies of scale The U shape of the LATC, depicted in Figure, reflects the changing costs of production that the firm faces in the long run as it varies the level of its factors of production and hence the level of its output. At low levels of output, a firm can usually increase its output at a rate that exceeds the rate at which it increases its factor inputs. When this situation occurs, the firm's average total costs are falling, and the firm is said to be experiencing economies of scale. At higher levels of output, the firm may find that its output increases at the same rate at which it increases its factor inputs. In this case, the firm's average total costs remain constant, and the firm is said to experience constant returns to scale. At even higher output levels, the firm's output will tend to increase at a rate that is below the rate at which it increases its factor inputs. In this situation, average total costs are rising, and the firm is said to experience diseconomies of scale. The firm's minimum efficient scale is the level of output at which economies of scale end and constant returns to scale begin. The minimum efficient scale is indicated in Figure. Opportunity Costs Opportunity Cost Opportunity cost is concerned with the cost of forgone opportunities/alternatives. In other words, it is the return from the second best use of the firms resources which the firms forgoes in order to avail of the return from the best use of the resources. Sunk Cost Sunk costs are those do not alter by varying the nature or level of business activity. Sunk costs are generally not taken into consideration in decision making as they do not vary with the changes in the future. Sunk costs are a part of the outlay/actual costs. Real Cost It was introduced by Alfred Marshall. It refers to all efforts, services and sacrifices made in production of a commodity. Private Cost A producer's or supplier's cost of providing goods or services. It includes internal costs incurred for inputs, labor, rent, and depreciation but excludes external costs incurred as environmental damage (unless the producer or supplier is liable to pay for them). Social Cost It is the expense to an entire society resulting from a news event, an activity or a change in policy. When assessing the overall impact of its commercial actions in terms of social costs, a socially responsible business operator should take into account its own production expenses, as well as any indirect expenses or damages borne by others. P a g e

37 5 The Theory of Firm and Perfect Competition Meaning of Market In mainstream economics, the concept of a market is any structure that allows buyers and sellers to exchange any type of goods, services and information. The exchange of goods or services for money is a transaction. There are 4 conditions to be met for the existence of a market: 1. Commodity which is traded 2. Existence of buyers and sellers 3. Price 4. A location for the exchange to take place; virtual or physical. Difference between Firm and Industry Firm Is a business within an industry Existence of one firm is case of monopoly is called industry A sub sector of a type of a business No separate rules and regulations are formulated for a firm. Industry Group of firms dealing in same business There can be many firms in an industry A sub sector of an economy Rules and regulations are made for an industry. Market Structure Meaning Economists assume that there are a number of different buyers and sellers in the marketplace. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price. P a g e

38 Perfectly Competitive Market A purely competitive (price taker) market exists when the following conditions occur: 1. Low entry and exit barriers - there are no restraints on firms entering or exiting the market 2. Homogeneity of products - buyers can purchase the good from any seller and receive the same good. 3. Perfect knowledge about product quality, price, and cost 4. No single buyer or seller is large enough to influence the market price 5. There is absence of transport costs 6. There is free mobility for the factors of production Sellers must take the existing market price; if they set a price above the market price, no one will buy their product because potential buyers simply will go to other suppliers. Setting a price below the market price does not make any sense because the firm can sell as much as it wants to at the market price; selling below the market price will just reduce profits. Because sellers must take the current market price a purely competitive market is also called a "price takers" market. Revenue Total Revenue Total revenue is the total sale proceeds of a firm by selling a commodity at a given price. If a firm sells 2 units of a commodity at Rs. 18, total revenue is 2 x 18 = Rs. 36. Thus total revenue is price per unit multiplied by the number of units sold, i.e., R = P Q, where R is the total revenue, P the price and Q the quantity. Average Revenue TR = p q Average Revenue (AR or A) is the average receipts from the sale of certain units of the commod ity. It is found out by dividing the total revenue by the number of units sold. In our above example, average revenue is 36 / 2 = Rs.18. The average revenue of a firm is, in fact, the price of the commodity at each level of output. Since = P Q Thus the functional relationship P = f (Q) is the average revenue curve which reflects price as a function of quantity demanded. It is also the demand curve. Marginal Revenue Marginal revenue (MR or M) is the addition to total revenue as a result of a small increase in the sale of a firm. Algebraically, M is the addition to R by selling n + 1 units instead of n units. M = dr/do, where d represents a change. Since we are concerned mainly with the relationship between average revenue and marginal revenue, we ignore total revenue in our discussion. P a g e

39 MR = TR Q Relationship Between TR, AR and MR under Perfect Competiton Under pure (or perfect) competition, a very large number of firms are assumed to be present. The supply of each seller is just like a drop of water in a mighty ocean so that any increase or decrease in production by any one firm exerts no perceptible influence on the total supply and on the price in the market. The collective forces of demand and supply determine the price in the market so that only one price tends to prevail for the whole industry. Each firm has to take the market price as given and sell its quantity at the ruling market price. In simple terms, the firm is a price-taker and the firm s demand curve is infinitely elastic. As the firm sells more and more at the given price, its total revenue will increase but the rate of increase in the total revenue will be constant, since AR = MR. In the figure, OX axis represents the number of units sold and OY axis represents the price per unit. The price of the unit remains constant at P 1. Consequently AR and MR curves coincide with each other. P a g e

40 Supply In economics, supply refers to the amount of a product that producers and firms are willing to sell at a given price when all other factors being held constant. Usually, supply is plotted as a supply curve showing the relationship of price to the amount of product businesses are willing to sell. Short Run Supply Curve To illustrate, consider the production and supply decision made by Raj the rice grower, a hypothetical firm. Because Raj is one of many of rice producers, each producing identical products and each with a relatively small part of the overall market, he has no market control. This graph displays Raj's U-shaped cost curves representing his rice production. Note that all three curves (average total cost, average variable cost, and marginal cost) are U-shaped. The marginal cost curve is U-shaped as a direct consequence of increasing, then decreasing marginal returns. As a profit-maximizing rice producer, Raj produces the quantity of rice that equates the going market price with marginal cost. Raj's supply response to changing prices can be observed by... well... by changing prices then noting Raj's supply response. One place to begin is with a price of say Rs. 4. The quantity supplied by Raj at a $4 price is thus 7kg rice. This price/quantity supplied combination is one point on Raj's rice supply curve. What might Raj do if he faces different prices? Consider a higher price. This higher price induces Raj to increase his quantity supplied from 7 to almost 8. How about a Rs. 8 price? Once again, a higher price motivates Raj to increase his quantity supplied. Bumping the price up to Rs. 10, results in an even greater quantity supplied 9kg of rice. Does Raj reduce the quantity supplied if the price declines? Up to a point. That point being the minimum of the average variable cost curve, about Rs If the price falls below this level, then Raj shuts down production in the short run, incurring a lost equal to total fixed cost. The conclusion from this analysis is that the marginal cost curve that lies above the average variable cost is Raj's short-run supply curve. A click of the [Short-Run Supply] button highlights Raj's rice supply curve. Here all 3 conditions of short run equilibrium must be fulfilled: 1. P = SMC 2. SMC is not decreasing P a g e

41 3. P > SAVC Long Run Supply Curve The long-run adjustment undertaken by a perfect competitive industry in response to demand shocks can result in increasing, decreasing, and constant costs, which then trace out long-run industry supply curves that are positively-sloped, negative-sloped, or horizontal, respectively. The path taken by an industry depends on underlying changes in resource prices and production cost. If the expansion of an industry causes higher resource prices and production cost, then the result is an increasing-cost industry. If expansion causes lower resource prices and production cost, then the result is a decreasing-cost industry. If expansion has no affect on resource prices and production cost, then the result is a constant-cost industry. The three alternatives are: Increasing-Cost Industry (shut down point): An industry with a positivelysloped long-run industry supply curve that results because expansion of the industry causes higher production cost and resource prices. An increasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average supply curve of each firm to shift upward, which increases the minimum efficient scale of production Decreasing-Cost Industry (Normal profit): An industry with a negatively-sloped long-run industry supply curve that results because expansion of the industry causes lower production cost and resource prices. A decreasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift downward, which decreases the minimum efficient scale of production. Constant-Cost Industry (Break Even Point): An industry with a horizontal long-run industry supply curve that results because expansion of the industry causes no change in production cost or resource prices. A constant-cost industry occurs because the entry of new firms, prompted by an increase in demand, does not affect the long-run average cost curve of individual firms, which means the minimum efficient scale of production does not change P a g e

42 Determinants of Supply 1. Resource Prices: The prices paid for the use of labor, capital, land, and entrepreneurship affect production cost and the ability to supply a good. 2. Production Technology: The information available concerning production techniques affects the ability to supply a good. Technology is what producers know about the ways to combine inputs into the production of outputs. 3. Other Prices: The supply for one good is based on the prices paid for other goods that use the same resources for production. A change in the price of a substitute good (or substitute -in- production) induces sellers to alter the mix of goods purchased. 4. Sellers' Expectations: The decision to sell a good today depends on expectations of future prices. Sellers seek to sell the good at the highest possible price. If sellers expect the price to decline in the future, they are inclined to sell more now. 5. Number of Sellers: The number of sellers willing and able to sell a good affects the overall supply. With more sellers, there is more supply. With fewer sellers, there is less supply. Meaning Law of Supply The law of supply describes the practical interaction between the price of a commodity and the quantity offered by producers for sale. The law of supply is a hypothesis, which claims that at higher prices the willingness of sellers to make a product available for sale is more while other things being equal. When the price of a product is high, more producers are interested in producing the products. Supply Schedule Supply schedule represents the relationship between prices and the quantities that the firms are willing to produce and supply. In other words, at what price, how much quantity a firm wants to produce and supply. Assuming a firm wants to supply oranges. The supply curve is a graphical representation of the law of supply. The supply curve has a positive slope, and it moves upwards to the right. This curve shows that at the price of $6, six dozens will be supplied and at the higher price $12, a larger quantity of 13 dozens will be supplies P a g e

43 Market Supply Curve The summation of supply curves of all the firms in the industry gives us the market supply curve. The upward sloping function is given as QS = a + bp a is the maximum limit of the function b is the slope of function. Exceptions The law of supply states that other things being equal; the supply of a commodity extends with a rise in price and contracts with a fall in price. There are however a few exceptions to the law of supply. 1. Exceptions of a fall in price: If the firms anticipate that the price of the product will fall further in future, in order to clear their stocks they may dispose it off at a price that is even lower than the current market price. 2. Sellers who are in need of cash: If the seller is in need of hard cash, he may sell his product at a price which may even be below the market price. 3. When leaving the industry: If the firms want to shut down or close down their business, they may sell their products at a price below their average cost of production. 4. Agricultural output: In agricultural production, natural and seasonal factors play a dominant role. Due to the influence of these constraints supply may not be responsive to price changes. 5. Backward sloping supply curve of labor: The rise in the price of a good or service sometimes leads to a fall in its supply. The best example is the supply of labor. A higher wage rate enables the worker to maintain his existing material standard of living with less work, and he may prefer extra leisure to more wages. The supply curve in such a situation will be backward sloping SS1 as illustrated. P a g e

44 Elasticity of Supply Completely (Perfectly) Inelastic supply: In this case the quantity supplied does not react to the changes in the price. The increase or decrease in the price does not change the quantity supplied. The diagram below shows us the completely inelastic supply: As seen in the diagram, the supply curve S1S1 is parallel to Y axis and is a vertical line. The diagram below shows that even when the price rises there is no change in the quantity supplied. When price rises from P1 to P2 the quantity supplied still remains the same. Completely (Perfectly) Elastic supply: When a minuscule change in price results in infinite change in the quantity supplied then it is a case of completely elastic supply. For instance when there is marginal rise in the price, then the quantity supplied rises infinitely. The following diagram shows us the completely elastic supply curve represented with a horizontal line. We can see that the supply curve S1S1 is parallel to the X axis. Here PEs will be equal to infinity. Even the smallest price change in this case will change the quantity by infinity. The value of price elasticity of supply here will be infinity ( ) Unitary Elastic supply: When the proportionate change in quantity supplied is equal to the proportionate change in the price of the commodity then we call it as unitary or unit elasticity of supply. Here PEs will be 1 at all the points Here we can see that when price rises from 20 rupees to 40 rupees, the quantity supplied also rises from 20 lakhs to 40 lakhs. So when we compute the Price elasticity of supply we have : % change in quantity supplied/% change in price Which I (40-20)/20 Which gives us 1 as the answer. P a g e

45 % change in quantity supplied/% change in price Which is (12-8)/8 = Which gives us 0.5 as the answer. Relatively Inelastic supply: When the percentage change in quantity supplied is less than the proportionate change in price than it is a case of relatively inelastic supply. Let us see this kind of supply by putting the values for price and quantity. In this case PEs will be less than 1. Here when the price increases from rupees 20 to rupees 40, the quantity supplied rises from 8 lakhs to 12 lakhs. So if we compute the PEs as per the percentage formula then we have Relatively Elastic supply: When the percentage change in quantity supplied is more than the percentage change in the price then we can say that it is relatively elastic supply. It can be seen in the diagram: For such relatively elastic supply PEs will be more then 1. In the diagram above when price rises from 20 rupees to 40 rupees, the quantity supplied rises from 2 lakhs to 6 lakhs. Applying the percentage formula we have: Which gives us 2 as the answer. (6-2)/2 (40-20)/20 Thus it can be seen that the responsiveness of the quantity to price when measured gives us different values and when these values are put in various ranges then we have the various degrees of elasticity P a g e

46 Equilibrium under Perfect Competition We know that under perfect completion both buyers and sellers are price takers. Neither of them can influence the price level. The price of a product is determined by its supply and demand forces. This process of determination of price by supply and demand is called Price Mechanism Adam Smith calls price mechanism as an invisible hand. Accoding to Adam Smith invisible hand is always at work. Equilibrium means a state of rest. It is a position from which there will be no intention to move in either direction. It is a point where buyers and sellers obejctives are satisfied. Market Equilibrium Market equilibrium is a market state where the supply in the market is equal to the demand in the market. The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in the market. If a market is at equilibrium, the price will not change unless an external factor changes the supply or demand, which results in a disruption of the equilibrium. Supply, Demand & Equilibrium If a market is not at equilibrium, market forces tend to move it to equilibrium. Let's break this concept down. If the market price is above the equilibrium value, there is an excess supply in the market (a surplus), which means there is more supply than demand. In this situation, sellers will tend to reduce the price of their good or service to clear their inventories. They probably will also slow down their production or stop ordering new inventory. The lower price entices more people to buy, which will reduce the supply further. This process will result in demand increasing and supply decreasing until the market price equals the equilibrium price. If the market price is below the equilibrium value, then there is excess in demand (supply shortage). In this case, buyers will bid up the price of the good or service in order to obtain the good or service in short supply. As the price goes up, some buyers will quit trying because they don't want to, or can't, pay the higher price. Additionally, sellers, more than happy to see the demand, will start to supply more of it. Eventually, the upward pressure on price and supply will stabilize at market equilibrium. P a g e

47 6 Imperfect Competitive Markets Monopoly Monopoly is the least competitive market structure of all. A pure monopoly is a market with only one producer who produces 100% of the output. In a pure monopoly the HHI is 10,000, the highest HHI possible. Consumers have the least choice in a monopoly market buy from the monopolist or don t buy. AOTE, we would expect a monopoly market to have the highest price and the lowest total production of any market structure. Features of Monopoly 1. One seller: The classic monopoly has only one seller by definition. In actuality, we also use the market structure to analyze industries that have essentially one producer controlling almost all the output. 2. Unique product: Since there is only one producer, or effectively one producer, the productthey make cannot be compared to alternatives. It is unique. This is important in understanding why a company like Pepsi is not a monopoly even though it is the only company that can produce its version. The product is not unique. 3. Good or poor information is largely irrelevant: Whether the information is good or bad is essentially irrelevant since there is no other product to compare this one to. 4. Barriers to Entry: As in oligopoly, firms are not able to move resources in, and out of this market relatively easily with little expense. The barriers to entry are higher in monopoly and also include the same two types. 5. Artificial barriers: artificial barriers to entry keep new firms from entering even if they wish to. These are generally structural features that make entry difficult or impossible. Artificial barriers to entry include patents, government licenses, control of a raw material, network advantage and high start-up costs 6. Natural barrier: there is one natural barrier large economies of scale that discourages new producers from even trying to enter. There is such a cost advantage to being big that the industry has ended up with only one producer. A new producer is reluctant to enter because they can t produce for as low a cost.

48 Market Demand Curve of Monopoly Firm Single-seller status for Ranbaxy Pharmaceutical means that it faces a negatively-sloped demand curve, such as the one displayed in the exhibit to the right. The demand curve facing any monopoly is the market demand curve for the product. The top curve in the exhibit is the demand curve (D) for Coflex. This demand curve is also theaverage revenue curve for Coflex. It shows the per unit revenue received by Ranbaxy Pharmaceutical for the sale of Coflex. For reference purposes, the lower curve is the marginal revenue curve (MR). This curve displays the extra revenue received by Ranbaxy Pharmaceutical for each extra ounce of Coflex sold. Because a monopoly is a price maker with extensive market control, it faces a negatively-sloped demand curve. To sell a larger quantity of output, it must lower the price. For example, the Ranbaxy Pharmaceutical can sell 1 ounce of Coflex for Rs. 10. However, if it wants to sell 2 ounces, then it must lower the price to Rs If it seeks to sell 3 ounces, then the price must be lowered to Rs. 9. Larger quantities are only sold it the price is less. For this reason, the marginal revenue generated from selling extra output is less than price. While the price of the second ounce sold of Coflex is Rs. 9.50, the marginal revenue generated by selling the second ounce is only Rs. 9. While the Rs price means the monopoly gains Rs from selling the second ounce, it loses Rs due to the lower price on the first ounce (Rs. 10 to Rs.9.50). The net gain in revenue, that is marginal revenue, is thus only Rs. 9 (= Rs Rs. 0.50). By similar reasoning, the marginal revenue generated by the third ounce of Coflex is only Rs. 8, even though the price is Rs. 9. On the plus side, Ranbaxy Pharmaceutical receives Rs. 9 from selling the third ounce. However, to sell the third ounce, it must lower the price on the first two ounces from Rs to Rs. 9. It loses Rs on each of these two ounces, or a total loss of Rs. 1. As such, the net gain in revenue, marginal revenue, is only Rs. 8 (= Rs. 9 - Rs. 1) Short Run Equilibrium under Monopoly (TR, TC approach) The short-run production decision for a monopoly can be graphically illustrated using total revenue and total cost curves, such as those displayed in the exhibit to the right. These total curves represent the total revenue and cost of Coflex production by Ranbaxy Pharmaceutical the Coflex grower. Total Revenue: The line (TR) depicts the total revenue Ranbaxy Pharmaceutical

49 receives from Coflex production. The line is hump-shaped because Ranbaxy Pharmaceutical must lower the price to sell a larger quantity. Total Cost: The line (TC) depicts the total cost Ranbaxy Pharmaceutical incurs in the production of Coflex. The shape is based on increasing, then decreasing marginal returns. Profit: The vertical difference between these two lines is economic profit. If the total revenue line is above the total cost line, economic profit is positive. If the total revenue line is below the total cost line at the far right and far left, economic profit is negative. The key for Ranbaxy Pharmaceutical is to identify the production level that gives the greatest vertical distance between the total revenue and total cost curves in the middle of the diagram. This might not be evident by just looking at the exhibit. The output quantity identified is, once again, 6 ounces of Coflex. Short Run Equilibrium (MC, MR Approach) increasing, then decreasing marginal returns. Perhaps the most common method of identifying the profit-maximizing level of production for a monopoly is using marginal revenue and marginal cost curves, such as those displayed in this exhibit. Marginal Revenue: The negatively-sloped line, labeled MR, is the marginal revenue Ranbaxy Pharmaceutical receives for each extra ounce of Coflex sold. Marginal Cost: The U-shaped curve, labeled MC, is the marginal cost Ranbaxy Pharmaceutical incurs in the production of Coflex. The shape is based on Average Revenue: The negatively-sloped light green line (AR) is the average revenue Ranbaxy Pharmaceutical receives from selling Coflex, which is also the demand curve. Average Cost: Two additional U-shaped curves included in the diagram (just for good measure) are average total cost (ATC) and average variable cost (AVC). These curves are helpful when identifying the level of economic profit or loss and the firm's short-run supply curve. In this analysis, Ranbaxy Pharmaceutical needs to identify the quantity of output that achieves equality between marginal revenue and marginal cost. The highlighted quantity is once again 6 ounces of Coflex. The price charged by Ranbaxy Pharmaceutical to sell this quantity is Rs

50 Long Run Equilibrium of Monopoly In the long run monopolist would make adjustment in the size of his plant. The long-run average cost curve and its corresponding longrun marginal cost curve portray the alternative plants, i.e., various plant sizes from which the firm has to choose for operation in the longrun. The monopolist would choose that plant size which is most appropriate for a particular level of demand. In the short run the monopolist adjusts the level of output while working with a given existing plant. His profit- maximizing output in the short run will be where only the short-run marginal cost curve (i.e., marginal cost curve with the existing plant) is equal to marginal revenue. But in the long run he can further increase his profits by adjusting the size of the plant. So in the long run he will be in equilibrium at the level of output where given marginal revenue curve cuts the long run marginal cost curve. Fixing output level at which marginal revenue is equal to long-run marginal cost shows that the size of the plant has also been adjusted. That is, a plant size has been chosen which is most optimal for a given demand for the product. It should be carefully noted that, in the long run, marginal revenue is also equal to short-run marginal cost. But this short-run marginal cost is of the plant which has been selected in the long run keeping in view the given demand for the product. Thus while, in the short run, marginal revenue is equal only to the short-run marginal cost of the given existing plant, in the long run marginal revenue is equal to the long-run marginal cost as well as to the short-run marginal cost of that plant which is appropriate for a given demand for the product in the long run. In the long- run equilibrium, therefore, both the long-run marginal cost curve and short-run marginal cost curve of the relevant plant intersect the marginal revenue curve at the same point. Further, it is important to note that, in the long run, the firm will operate at a point on the long- run average cost curve (LAC) at which the short-run average cost is tangent to it. This is because it is only at such tangency point that short-run marginal cost (SMC) of a plant equals the long-run marginal cost (LMC). It therefore follows that for the monopolist to maximise profits in the long run, the following conditions must be fulfilled: 1. MR = LMC = SMC 2. SAC = LAC 3. P LAC

51 Monopolistic Competition Meaning Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes. Features 1. A large number of firms: The first important feature of monopolistic competition is that under it there are a relatively large number of firms each satisfying a small share of the market demand for the product. Because there are a large number of firms under monopolistic competition, there exists stiff competition between them. Unlike perfect competition these large number of firms do not produce identical products. 2. Product differentiation: The second important feature of monopolistic competition is that the products produced by various firms are not identical but are slightly different from each other. Though different firms make their products slightly different from others, they remain close substitutes of each other. 3. Some influence over the price: Each firm under monopolistic competition produces a product variety which is close substitute of others. Therefore, if a firm lowers the price of its product variety, some customers of other product varieties will switch over to it. This means as it lowers the price of its product variety; quantity demanded of it will increase. On the other hand, if it raises the price of its product, some of its customers will leave it and buy the similar products from its competing firms. 4. Non-price competition: Expenditure on advertisement and other selling costs: An important feature of monopolistic competition is that firms incur a considerable expenditure on advertisements and other selling costs to promote the sales of their products. Promoting sales of their products through advertisement is an important example of non-price competition 5. Product variation: Another form of non-price competition which a firm under monopolistic competition has to face is the variation in products by various firms. A firm, under perfect competition, does not confront this problem, for the product is homogeneous under perfect competition. 6. Freedom of entry and exit: This is another important feature of monopolistic competition. In a monopolistically competitive industry it is easy for the new firms to enter and the existing firms to leave it. Free entry means that when in the industry existing firms are making supernormal profits, the new firms enter the industry which leads to the expansion of output.

52 Short Run Equilibrium of Monopolistic Firm Assuming the conditions with respect to all substitutes such as their nature and prices being constant, the demand curve for the product of a firm will be given. We further suppose that the product of the firm is held constant, only variables are price and output in respect of which equilibrium adjustment is to be made. The individual equilibrium under monopolistic competition is graphically shown DD is the demand curve for the product of an individual firm, the nature and prices of all substitutes being given. This demand curve DD is also the average revenue (AR) curve of the firm. AC represents the average cost curve of the firm, while MC is the marginal cost curve corresponding to it. It may be recalled that average cost curve first falls due to internal economies and then rises due to internal diseconomies. Given these demand and cost conditions a firm will adjust his price and output at the level which gives it maximum total profits. Theory of value under monopolistic competition is also based upon the profit maximization principle, as is the theory of value under perfect competition. Thus a firm in order to maximize profits will equate marginal cost with marginal revenue. In Fig. 28.3, the firm will fix its level of output at OM, for at OM output marginal cost is equal to marginal revenue. The demand curve DD facing the firm in question indicates that output OM can be sold at price MQ OP. Therefore, the determined price will evidently be MQ or OP. In this equilibrium position, by fixing its price at OP and output at OM, the firm is making profits equal to the area RSQP which is maximum. It may be recalled that profits RSQP are in excess of normal profits because the normal profits which represent the minimum profits necessary to secure the entrepreneur s services are included in average cost curve AC. Thus, the area RSQP indicates the amount of supernormal or economic profits made by the firm. In the short-run, the firm, in equilibrium, may make supernormal profits, as shown above, but it may make losses too if the demand conditions for its product are not so favorable relative to cost conditions. The above diagram depicts the case of a firm whose demand or average revenue curve DD for the product lies below the average cost curve throughout indicating thereby that no output of the product can be produced at positive profits.

53 However, the firm is in equilibrium at output ON and setting price NK or OT, for by adjusting price at OT and output at ON, it is rendering the losses to the minimum. In such an unfavorable situation there is no alternative for the firm except to make the best of the bad bargain. We thus see that a firm in equilibrium under monopolistic competition, as under pure or perfect competition, may be making supernormal profits or losses depending upon the position of the demand curve relative to the position of the average cost curve. Further, a firm may be making only normal profits even in the short run if the demand curve happens to be tangent to the average cost curve. Meaning Oligopoly Oligopoly is an important form of imperfect competition. Oligopoly is said to prevail when there are few firms or sellers in the market producing or selling a product. In other words, when there are two or more than two, but not many, producers or sellers of a product, oligopoly is said to exist. Oligopoly is also often referred to as Competition among the Few. Features of Oligopoly 1. Interdependence: The most important feature of oligopoly is the interdependence in decision -making of the few firms which comprise the industry. This is because when the number of competitors is few, any change in price, output, product etc. by a firm will have a direct effect on the fortune of its rivals, which will then retaliate in changing their own prices, output or products as the case may be. 2. Importance of advertising and selling costs: A direct effect of interdependence of oligopolists is that the various firms have to employ various aggressive and defensive marketing weapons to gain a greater share in the market or to prevent a fall in their market share. For this various firms have to incur a good deal of costs on advertising and on other measures of sales promotion. 3. Group behavior: Further, another important feature of oligopoly is that for the proper solution to the problem of determination of price and output under, it analysis of group behavior is important. Theories of perfect competition, monopoly and monopolistic competition present no difficult problem of making suitable assumption about human behavior. 4. Indeterminateness of demand curve facing an oligopolist: Another important feature is the indeterminateness of the demand curve facing an oligopolist. The demand curve shows what amounts of its product a firm will be able to sell at various prices. Now, under perfect competition, an indi vidual firm s demand curve is given and definite.

54 Meaning Duopoly Duopoly is a limiting case of oligopoly, in the sense that it has all the characteristics of oligopoly except the number of sellers which are only two increase of duopoly as against a few in oligopoly. The main distinguishing feature of duopoly (and also of oligopoly) from other market situating is that the sellers decisions are not independent of each other. Duopoly Equilibrium Conditions 1. MR = MC 2. At the last stage, supply of both firms must be equal 3. Supply of each firm at zero price should be 1/3 rd of market demand Behavior of Firms in Oligopoly 1. Collusive Oligopoly: If firms in oligopoly collude and form a cartel, then they will try and fix the price at the level which maximizes profits for the industry. They will then set quotas to keep output at the profit maximizing level. 2. Non Collusive Oligopoly: Where each firm aims at maximizing its own profits and how much quantity to produce assuming that the other firms would not change their quantity supplied.

55

56 Macro Economics

57 7 Introduction to Macro Economics Concept of Macro Economics Macroeconomics is the branch of economics that studies the behavior and performance of an economy as a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate, gross domestic product and inflation. Macroeconomics analyzes all aggregate indicators and the microeconomic factors that influence the economy. Government and corporations use macroeconomic models to help in formulating of economic policies and strategies. Emergence of Macro Economics Macroeconomics, as a separate branch of economics, emerged after the British economist John Maynard Keynes published his celebrated book, The General Theory of Employment, Interest and Money in The dominant thinking in economics before Keynes was that all the labourers who are ready to work will find employment and all the factories will be working at their full capacity. This school of thought is known as the classical tradition. However, the Great Depression of 1929 and the subsequent years saw the output and employment levels in the countries of Europe and North America fall by huge amounts. It affected other countries of the world as well. Demand for goods in the market was low, many factories were lying idle, workers were thrown out of jobs. In USA, from 1929 to 1933, unemployment rate rose from 3 per cent to 25 per cent (unemployment rate may be defined as the number of people who are not working and are looking for jobs divided by the total number of people who are working or looking for jobs). Over the same period aggregate output in USA fell by about 33 per cent. These events made economists think about the functioning of the economy in a new way. The fact that the economy may have long lasting unemployment had to be theorized about and explained. Keynes book was an attempt in this direction. Unlike his predecessors, his approach was to examine the working of the economy in its entirety and examine the interdependence of the different sectors. The subject of macroeconomics was born. Nature and Scope of Macro Economics Nature of Macro Economics Macroeconomics is the study of aggregates or averages covering the entire economy, such as total employment, national income, national output, total investment, total consumption, total savings, aggregate supply, aggregate demand, and general price level, wage level, and cost structure. In other words, it is aggregative economics which examines the interrelations among the various aggregates, their determination and causes of fluctuations in them. Thus in the words of Professor Ackley, Macroeconomics deals with economic affairs in the large, it concerns the overall dimensions of economic life. It looks at the total size and shape and functioning of the elephant of economic experience, rather than working of articulation or dimensions of the individual parts. It studies the character of the forest, independently of the trees which compose it.

58 Macroeconomics is also known as the theory of income and employment, or simply income analysis. It is concerned with the problems of unemployment, economic fluctuations, inflation or deflation, international trade and economic growth. It is the study of the causes of unemployment, and the various determinants of employment. In the field of business cycles, it concerns itself with the effect of investment on total output, total income, and aggregate employment. In the monetary sphere, it studies the effect of the total quantity of money on the general price level. In international trade, the problems of balance of payments and foreign aid fall within the purview of macroeconomic analysis. Above all, macroeconomic theory discusses the problems of determination of the total income of a country and causes of its fluctuations. Finally, it studies the factors that retard growth and those which bring the economy on the path of economic development. The obverse of macroeconomics is microeconomics. Microeconomics is the study of the economic actions of individuals and small groups of individuals. The study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities. But macroeconomics deals with aggregates of these quantities; not with individual incomes but with the national income, not with individual prices but with the price levels, not with individual output but with the national output. Microeconomics, according to Ackley, deals with the division of total output among industries, products, and firms, and the allocation of resources among competing uses. It considers problems of income distribution. Its interest is in relative prices of particular goods and services. Macroeconomics, on the other hand, concerns itself with such variables as the aggregate volume of the output of an economy, with the extent to which its resources are employed, with the size of the national income, with the general price level. Both microeconomics and macroeconomics involve the study of aggregates. But aggregation in microeconomics is different from that in macroeconomics. In microeconomics the interrelationships of individual households, individual firms and individual industries to each other deal with aggregation. The concept of industry, for example, aggregates numerous firms or even products. Consumer demand for shoes is an aggregate of the demands of many households, and the supply of shoes is an aggregate of the production of many firms. The demand and supply of labour in a locality are clearly aggregate concepts. However, the aggregates of microeconomic theory, according to Professor Bilas, do not deal with the behaviour of the billions of dollars of consumer expenditures, business investments, and government expenditures. These are in the realm of microeconomics. Thus the scope of microeconomics to aggregates relates to the economy as a whole, together with subaggregates which (a) cross product and industry lines (such as the total production of consumer goods, or total production of capital goods), and which (b) add up to an aggregate for the whole economy (as total production of consumer goods and of capital goods add up to total production of the economy; or as total wage income and property income add up to national income). Thus microeconomics uses aggregates relating to individual households, firms and industries, while macroeconomics uses aggregates which relate them to the economy wide total.

59 Scope of Macro Economics 1. To Understand the Working of the Economy: The study of macroeconomic variables is indispensable for understanding the working of the economy. Our main economic problems are related to the behaviour of total income, output, employment and the general price level in the economy. These variables are statistically measurable, thereby facilitating the possibilities of analysing the effects on the functioning of the economy. As Tinbergen observes, macroeconomic concepts help in making the elimination process understandable and transparent. For instance, one may not agree on the best method of measuring different prices, but the general price level is helpful in understanding the nature of the economy. 2. In Economic Policies: Macroeconomics is extremely useful from the point of view of economic policy. Modern governments, especially of the underdeveloped economies, are confronted with innumerable national problems. They are the problems of overpopulation, inflation, balance of payments, general underproduction, etc. I. In General Unemployment: The Keynesian theory of employment is an exercise in macroeconomics. The general level of employment in an economy depends upon effective demand which in turn depends on aggregate demand and aggregate supply functions. Unemployment is thus caused by deficiency of effective demand. In order to eliminate it, effective demand should be raised by increasing total investment, total output, total income and total consumption. Thus, macroeconomics has special significance in studying the causes, effects and remedies of general unemployment. II. In National Income: The study of macroeconomics is very important for evaluating the overall performance of the economy in terms of national income. With the advent of the Great Depression of the 1930s, it became necessary to analyse the causes of general overproduction and general unemployment. III. In Economic Growth: The economics of growth is also a study in macroeconomics. It is on the basis of macroeconomics that the resources and capabilities of an economy are evaluated. Plans for the overall increase in national income, output, and employment are framed and implemented so as to raise the level of economic development of the economy as a whole. IV. In Monetary Problems: It is in terms of macroeconomics that monetary problems can be analysed and understood properly. Frequent changes in the value of money, inflation or deflation, affect the economy adversely. They can be counteracted by adopting monetary, fiscal and direct control measures for the economy as a whole. V. In Business Cycles: Further macroeconomics as an approach to economic problems started after the Great Depression. Thus its importance lies in analysing the causes of economic fluctuations and in providing remedies. 3. For Understanding the Behaviour of Individual Units: For understanding the behaviour of individual units, the study of macroeconomics is imperative. Demand for individual products depends upon aggregate demand in the economy. Unless the causes of deficiency in aggregate demand are analysed, it is not possible to understand fully the reasons for a fall in the demand of individual products. The reasons for increase in costs of a particular firm or industry cannot be analysed without knowing the average cost conditions of the whole economy. Thus, the study of individual units is not possible without macroeconomics.

60 Limitations of Macro Economics 1. Fallacy of Composition: In Macroeconomic analysis the fallacy of composition is involved, i.e., aggregate economic behaviour is the sum total of individual activities. But what is true of individuals is not necessarily true of the economy as a whole. For instance, savings are a private virtue but a public vice. If total savings in the economy increase, they may initiate a depression unless they are invested. Again, if an individual depositor withdraws his money from the bank there is no ganger. But if all depositors do this simultaneously, there will be a run on the banks and the banking system will be adversely affected. 2. To Regard the Aggregates as Homogeneous: The main defect in macro analysis is that it regards the aggregates as homogeneous without caring about their internal composition and structure. The average wage in a country is the sum total of wages in all occupations, i.e., wages of clerks, typists, teachers, nurses, etc. 3. But the volume of aggregate employment depends on the relative structure of wages rather than on the average wage. If, for instance, wages of nurses increase but of typists fall, the average may remain unchanged. But if the employment of nurses falls a little and of typists rises much, aggregate employment would increase. 4. Aggregate Variables may not be Important Necessarily: The aggregate variables which form the economic system may not be of much significance. For instance, the national income of a country is the total of all individual incomes. A rise in national income does not mean that individual incomes have risen. The increase in national income might be the result of the increase in the incomes of a few rich people in the country. Thus a rise in the national income of this type has little significance from the point of view of the community. 5. Indiscriminate Use of Macroeconomics Misleading: An indiscriminate and uncritical use of macroeconomics in analyzing the problems of the real world can often be misleading. For instance, if the policy measures needed to achieve and maintain full employment in the economy are applied to structural unemployment in individual firms and industries, they become irrelevant. Similarly, measures aimed at controlling general prices cannot be applied with much advantage for controlling prices of individual products. 6. Statistical and Conceptual Difficulties: The measurement of macroeconomic concepts involves a number of statistical and conceptual difficulties. These problems relate to the aggregation of microeconomic variables. If individual units are almost similar, aggregation does not present much difficulty. But if microeconomic variables relate to dissimilar individual units, their aggregation into one macroeconomic variable may be wrong and dangerous.

61 Difference between Micro and Macro Economics Parameter Micro Economics Macro Economics Scope Study of individual economic units such as firm, industry or consumer. Study of large segments of economy such as aggregate demand and supply. Method of study Intensive study Brief study Different Economic Agents Equilibrium Analysis Domain Economic agent thinks about its own interest and welfare. Consumers get maximum satisfaction by combination of optimum goods and services at lower prices. Producers get maximum profit at minimum cost of production. Studies partial equilibrium in the economy such as consumer equilibrium, producer equilibrium etc Comprises of theories on consumer behavior, production and cost etc Economic agents are different from individual economic agents and their aim is to get maximum welfare of a country. Studies general equilibrium in the economy such as price levels, market equilibrium etc Comprises of

62 8 National Income Accounting Introduction National income accounting provides economists and statisticians with detailed information that can be used to track the health of an economy and to forecast future growth and development. Although national income accounting is not an exact science, it provides useful insight into how well an economy is functioning, and where monies are being generated and spent. Some of the metrics calculated by using national income accounting include gross domestic product (GDP), gross national product (GNP) and gross national income (GNI). Basic Concepts of National Income 1. Consumption Goods: These are goods which are also known as consumer goods. These include, food, clothing, services such as transport and recreation. 2. Capital Goods: These are goods used in production by the producer. These include factories, raw materials, machinery. 3. Intermediate Goods: These are goods which are produced by one producer and used by some other producer as material input. These include petroleum and its byproducts. 4. Final Goods: These are goods purchased for final use. These include electronic gadgets, automobiles and textiles. 5. Stock and Flow: Economics, business, accounting, and related fields often distinguish between quantities that are stocks and those that are flows. These differ in their units of measurement. A stock variable is measured at one specific time, and represents a quantity existing at that point in time (say, December 31, 2004), which may have accumulated in the past. A flow variable is measured over an interval of time. Therefore a flow would be measured per unit of time (say a year). Flow is roughly analogous to rate or speed in this sense. 6. Depreciation Cost: The depreciated cost method of asset valuation is an accounting tool used by both corporations and individuals. It allows for the books to always be carrying an asset at its current worth, and allows cash flows based on that asset to be measured in proportion to the value of the asset itself. It also allows for even tax treatment of large capital assets like homes, factories and equipment.

63 Circular Flow of Income National income, output, and expenditure are generated by the activities of the two most vital parts of an economy, its households and firms, as they engage in mutually beneficial exchange. Households The primary economic function of households is to supply domestic firms with needed factors of production - land, human capital, real capital and enterprise. The factors are supplied by factor owners in return for a reward. Land is supplied by landowners, human capital by labour, real capital by capital owners (capitalists) and enterprise is provided by entrepreneurs. Entrepreneurs combine the other three factors, and bear the risks associated with production. Firms The function of firms is to supply private goods and services to domestic households and firms, and to households and firms abroad. To do this they use factors and pay for their services. Factor incomes Factors of production earn an income which contributes to national income. Land receives rent, human capital receives a wage, real capital receives a rate of return, and enterprise receives a profit. Members of households pay for goods and services they consume with the income they receive from selling their factor in the relevant market. Production function The simple production function states that output (Q) is a function (f) of: (is determined by) the factor inputs, land (L), labour (La), and capital (K), i.e. Q = f (L, La, K) The Circular flow of income Income (Y) in an economy flows from one part to another whenever a transaction takes place. New spending (C) generates new income (Y), which generates further new spending (C), and further new income (Y), and so on. Spending and income continue to circulate around the macro economy in what is referred to as thecircular flow of income. The circular flow of income forms the basis for all models of the macro-economy, and understanding the circular flow process is key to explaining how national income, output and expenditure is created over time.

64 Injections and withdrawals The circular flow will adjust following new injections into it or new withdrawals from it. An injection of new spending will increase the flow. A net injection relates to the overall effect of injections in relation to withdrawals following a change in an economic variable. Savings and investment The simple circular flow is, therefore, adjusted to take into account withdrawals and injections. Households may choose to save (S) some of their income (Y) rather than spend it (C), and this reduces the circular flow of income. Marginal decisions to save reduce the flow of income in the economy because saving is a withdrawal out of the circular flow. However, firms also purchase capital goods, such as machinery, from other firms, and this spending is an injection into the circular flow. This process, called investment (I), occurs because existing machinery wears out and because firms may wish to increase their capacity to produce The public sector In a mixed economy with a government, the simple model must be adjusted to include the public sector. Therefore, as well as save, households are also likely to pay taxes (T) to the government (G), and further income is withdrawn out of the circular flow of income. Including international trade Government injects income back into the economy by spending (G) on public andmerit goods like defence and policing, education, and healthcare, and also on support for the poor and those unable to work. Finally, the model must be adjusted to include international trade. Countries which trade are called open economies, the households of an open economy will spend some of their income on goods from abroad, called imports (M), and this is withdrawn from the circular flow. Foreign consumers and firms will, however, also wish to buy domestic products, called exports (X), and this is an injection into the circular flow.

65 Macro Economic Identities GDP The most important concept of national income is Gross Domestic Product. Gross domestic product is the money value of all final goods and services produced within the domestic territory of a country during a year. Algebraic expression under product method is, GDP=(P*Q) where, GDP=Gross Domestic Product P=Price of goods and service Q=Quantity of goods and service denotes the summation of all values. According to expenditure approach, GDP is the sum of consumption, investment, government expenditure, net foreign exports of a country during a year. Algebraic expression under expenditure approach is, GDP=C+I+G+(X-M) Where, C=Consumption I=Investment G=Government expenditure (X-M)=Export minus import GDP includes the following types of final goods and services. They are: Consumer goods and services. Gross private domestic investment in capital goods. Government expenditure. Exports and imports. Gross National Product (GNP) Gross National Product is the total market value of all final goods and services produced annually in a country plus net factor income from abroad. Thus, GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country including net factor income from abroad. The GNP can be expressed as the following equation: GNP=GDP+NFIA (Net Factor Income from Abroad) or, GNP=C+I+G+(X-M)+NFIA

66 Net National Product (NNP) Net National Product is the market value of all final goods and services after allowing for depreciation. It is also called National Income at market price. When charges for depreciation are deducted from the gross national product, we get it. Thus, NNP=GNP-Depreciation or, NNP=C+I+G+(X-M)+NFIA-Depreciation National Income (NI) National Income is also known as National Income at factor cost. National income at factor cost means the sum of all incomes earned by resources suppliers for their contribution of land, labor, capital and organizational ability which go into the years net production. Hence, the sum of the income received by factors of production in the form of rent, wages, interest and profit is called National Income. Symbolically, NI=NNP+Subsidies-Interest Taxes or, GNP-Depreciation+Subsidies-Indirect Taxes or,ni=c+g+i+(x-m)+nfia- Depreciation-Indirect Taxes+Subsidies Personal Income (PI) Personal Income is the total money income received by individuals and households of a country from all possible sources before direct taxes. Therefore, personal income can be expressed as follows: PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-Social Security Contribution+Transfer Payments Disposable Income (DI) The income left after the payment of direct taxes from personal income is called Disposable Income. Disposable income means actual income which can be spent on consumption by individuals and families. Thus, it can be expressed as: DI=PI-Direct Taxes From consumption approach, DI=Consumption Expenditure+Savings Per Capita Income (PCI) Per Capita Income of a country is derived by dividing the national income of the country by the total population of a country. Thus, PCI=Total National Income/Total National Population

67 Product Method Measurement of National Income In this method, national income is measured as a flow of goods and services. We calculate money value of all final goods and services produced in an economy during a year. Final goods here refer to those goods which are directly consumed and not used in further production process. In this method, the national income is estimated by aggregating the value of all final goods and services produced in a country during one year. Income Method Under this method, national income is measured as a flow of factor incomes. There are generally four factors of production labour, capital, land and entrepreneurship. Labour gets wages and salaries, capital gets interest, land gets rent and entrepreneurship gets profit as their remuneration. This is calculated using: GDP = w + r + i + π w is wages r is rent i is rent and pi is profit Expenditure Method In this method, national income is measured as a flow of expenditure. GDP is sum-total of private consumption expenditure. Government consumption expenditure, gross capital formation (Government and private) and net exports (Export-Import). This is calculated using: GDP = C + I + G + net X C is private final expenditure on goods and services I is gross domestic private investment G is governments final consumption and investment expenditure. Net X is net value of exports. Value Added Method There are three main wealth-generating sectors of the economy manufacturing and construction, primary (including oil& gas, farming, forestry & fishing) and a wide range of service-sector industries. This measure of GDP adds together the value of output produced by each of the productive sectors in the economy using the concept of value added. Value added is the increase in the value of goods or services as a result of the production process Value added = value of production - value of intermediate goods

68 Difficulties in Measuring National Income 1. Non Monetary Transactions: The first problem in National Income accounting relates to the treatment of non-monetary transactions such as the services of housewives to the members of the families. For example, if a man employees a maid servant for household work, payment to her will appear as a positive item in the national income. But, if the man were to marry to the maid servant, she would performing the same job as before but without any extra payments. In this case, the national income will decrease as her services performed remains the same as before. 2. Problem of Double Counting: Only final goods and services should be included in the national income accounting. But, it is very difficult to distinguish between final goods and intermediate goods and services. An intermediate goods and service used for final consumption. The difference between final goods and services and intermediate goods and services depends on the use of those goods and services so there are possibilities of double counting. 3. The Underground Economy: The underground economy consists of illegal and uncleared transactions where the goods and services are themselves illegal such as drugs, gambling, smuggling, and prostitution. Since, these incomes are not included in the national income, the national income seems to be less than the actual amount as they are not included in the accounting. 4. Petty Production: There are large numbers of petty producers and it is difficult to include their production in national income because they do not maintain any account. 5. Public Services: Another problem is whether the public services like general administration, police, army services, should be included in national income or not. It is very difficult to evaluate such services. 6. Transfer Payments: Individual get pension, unemployment allowance and interest on public loans, but these payments creates difficulty in the measurement of national income. These earnings are a part of individual income and they are also a part of government expenditures. 7. Capital Gains or Loss: When the market prices of capital assets change the owners make capital gains or loss such gains or losses are not included in national income. 8. Price Changes: National income is the money value of goods and services. Money value depends on market price, which often changes. The problem of changing prices is one of the major problems of national income accounting. Due to price rises the value of national income for particular year appends to increase even when the production is decreasing. 9. Wages and Salaries paid in Kind: Additional payments made in kind may not be included in national income. But, the facilities given in kind are calculated as the supplements of wages and salaries on the income side. 10. Illiteracy and Ignorance: The main problem is whether to include the income generated within the country or even generated abroad in national income and which method should be used in the measurement of national income.

69 National Income and Welfare People get economic welfare through the consumption of goods and services. That means the greater is the volume of consumption of goods & services, the higher is their economic welfare. The total consumption of goods and services by the people depends on the National income of the country. That means, the level of economic welfare of the community depends on the national income of the country & improvement in N.I. means more goods & services and consumption of more goods & services leads to greater economic welfare of the people of the country. However some of the economist who differ from the opinion of economists, Alfred Marshall, A.C. Pigue, J.R. Hicks and other. The citizens express diverse opinion about the relationship between N.I. & economic welfare. They make a distinction between economic welfare & non-economic welfare. Economic welfare can be measured, but non-economic welfare cannot be measured. They do not consider N.I. as the barometer as economic welfare. To sum up we can say that the economic welfare of the community depends upon N.I. However, N.I. is not a reliable index of economic welfare for certain reasons. Limitations of National Income as a measure of National Welfare 1. National Income estimate considers only those transactions which are carried through money. It does not take into A/c the portion of output especially the farm output. If the portion of output kept for self-consumption is also brought to the market, the national Income will increase, though the total output in the country has not really increased. So, increase in income does not result in increase in economic welfare. 2. The N.I. at current prices cannot be a proper indicator of the economic welfare of the community. This is because if the prices changes, the N.I. also charges. But the actual production of the economy does not change. So, if the income alone increases without an increase in production, economic welfare cannot increase. 3. The per capita Income is a better index that the N.I. to measure economic welfare of a country. 4. The per capita Income also is not a foolproof index of economic welfare. This is because, if the growth of population in the country is at a higher rating than the increase it the real national income of the country, the per capita income and the economic welfare of the people will decrease.

70 9 Money and Banking Introduction Money is the most important invention of modern times. It has undergone a long process of historical evolution. In the absence of money when goods were exchanged for goods it was called barter exchange. The inconveniences of barter, led to the invention of a medium of exchange i.e. money. Earlier commodity money in form of shells, utensils, animal skins, etc. was prevalent. This gave way to metallic money (gold, silver, alloy metals), then came paper money, Bank money and plastic money. Definition According to Crowther, "Anything that is generally acceptable as a means of exchange and which at the same time acts as a measure and store of value." Functions of Money Various functions of money can be classified into three broad groups: (a) Primary functions, which include the medium of exchange and the measure of value; (b) Secondary junctions which include standard of deferred payments, store of value and transfer of value; and (c) Contingent functions which include distribution of national income, maximization of satisfaction, basis of credit system, etc. These functions have been explained below: 1. Medium of Exchange: The most important function of money is to serve as a medium of exchange or as a means of payment. To be a successful medium of exchange, money must be commonly accepted by people in exchange for goods and services. While functioning as a medium of exchange, money benefits the society in a number of ways: (a) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through money. (b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of goods and services with minimum effort and time, (c) It promotes allocation efficiency by facilitating specialization in production and trade, (d) It allows freedom of choice in the sense that a person can use his money to buy the things he wants most, from the people who offer the best bargain and at a time he considers the most advantageous. 2. Measure of Value: Money serves as a common measure of value in terms of which the value of all goods and services is measured and expressed. By acting as a common denominator or numeraire, money has provided a language of economic communication. It has made transactions easy and simplified the problem of measuring and comparing the prices of goods and services in the market. Prices are but values expressed in terms of money.

71 Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting system because the values of a variety of goods and services which are physically measured in different units (e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss of a firm, etc. To be satisfactory measure of value, the monetary units must be invariable. In other words, it must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods of falling prices and falls during periods of rising prices. 3. Standard of Deferred Payments: When money is generally accepted as a medium of exchange and a unit of value, it naturally becomes the unit in terms of which deferred or future payments are stated. Thus, money not only helps current transactions though functions as a medium of exchange, but facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standard of deferred payments. But, to become a satisfactory standard of deferred payments, money must maintain a constant value through time ; if its value increases through time (i.e., during the period of falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of creditors. 4. Store of Value: Money, being a unit of value and a generally acceptable means of payment, provides a liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value, money provides security to the individuals to meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance that attractive future buying opportunities can be exploited. Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was Keynes who first fully realized the liquid store value of money function and regarded money as a link between the present and the future. This, however, does not mean that money is the most satisfactory liquid store of value. To become a satisfactory store of value, money must have a stable value. 5. Transfer of Value: Money also functions as a means of transferring value. Through money, value can be easily and quickly transferred from one place to another because money is acceptable everywhere and to all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat. 6. Distribution of National Income: Money facilitates the division of national income between people. Total output of the country is jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution of national product through the system of wage, rent, interest and profit. 7. Maximization of Satisfaction: Money helps consumers and producers to maximize their benefits. A consumer maximizes his satisfaction by equating the prices of each commodity (expressed in terms of money) with its marginal utility. Similarly, a producer maximizes his profit by equating the marginal productivity of a factor unit to its price. 8. Basis of Credit System: Credit plays an important role in the modern economic system and money constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.

72 9. Liquidity to Wealth: Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money. Demand for Money The demand for money is affected by several factors, including the level of income, interest rates, and inflation as well as uncertainty about the future. The way in which these factors affect money demand is usually explained in terms of the three motives for demanding money: the transactions, the precautionary, and the speculative motives. Supply of Money There are four measures of money supply in India which are denoted by M 1, M 2, M 3 and M 4. This classification was introduced by the Reserve Bank of India (RBI) in April Prior to this till March 1968, the RBI published only one measure of the money supply, M or defined as currency and demand deposits with the public. This was in keeping with the traditional and Keynesian views of the narrow measure of the money supply. M 1. The first measure of money supply, M 1 consists of: (i) Currency with the public which includes notes and coins of all denominations in circulation excluding cash on hand with banks: (ii) Demand deposits with commercial and cooperative banks, excluding inter-bank deposits; and (iii) Other deposits with RBI which include current deposits of foreign central banks, financial institutions and quasi-financial institutions such as IDBI, IFCI, etc., other than of banks, IMF, IBRD, etc. The RBI characterizes as narrow money. M 2. The second measure of money supply is M 2 which consists of M 1 plus post office savings bank deposits. Since savings bank deposits of commercial and cooperative banks are included in the money supply, it is essential to include post office savings bank deposits. The majority of people in rural and urban India have preference for post office deposits from the safety viewpoint than bank deposits. M 3. The third measure of money supply in India is M 3, which consists of M 1, plus time deposits with commercial and cooperative banks, excluding interbank time deposits. The RBI calls M 3 as broad money. M 4. The fourth measure of money supply is M 4 which consists of M 3 plus total post office deposits comprising time deposits and demand deposits as well. This is the broadest measure of money supply. Of the four inter-related measures of money supply for which the RBI publishes data, it is M 3 which is of special significance. It is M 3 which is taken into account in formulating macroeconomic objectives of the economy every year. Since M 1 is narrow money and includes only demand deposits of banks along-with currency held by the public, it overlooks the importance of time deposits in policy making. That is why, the RBI prefers M 3 which includes total deposits of banks and currency with the public in credit budgeting for its credit policy. It is on the estimates of increase in M 3 that the effects of money supply on prices and growth of national income are estimated. In fact is an empirical measure of money supply in India, as is the practice in developed countries. The Chakravarty Committee also recommended the use of M 3 for monetary targeting without any reason.

73 New Definition of Money Supply At present there are only 3 monetary aggregates: NM 1 = Currency with public + demand deposits in banking system + other deposits with RBI NM 2 = NM 1 + short term deposits of residents (including and up to the contractual maturity of 1year) NM 3 = NM 2 + long term deposits of residents + call / term funding from financial institutions Narrow Money and Broad Money The narrow definition of money can be given as: Mn = C + DD + OD C is the currency held by public DD is the demand deposit held in banks OD is the other deposits in RBI Broad money can be represented as: MB = C + DD + SD + TD C is the currency held by public DD is the demand deposit held in banks SD represents savings deposits in post offices TD represents time deposits with banks

74 Commercial Banks Meaning A commercial bank is a type of bank that provides services such as accepting deposits, making business loans, and offering basic investment products. Commercial bank can also refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses, as opposed to individual members of the public (retail banking). Functions of Commercial Banks Primary Functions The primary functions of the commercial banks include the following: A. Acceptance of Deposits 1. Time Deposits: These are deposits repayable after a certain fixed period. These deposits are not withdrawn able by cheque, draft or by other means. It includes the following. (a) Fixed Deposits: The deposits can be withdrawn only after expiry of certain period say 3 years, 5 years or 10 years. The banker allows a higher rate of interest depending upon the amount and period of time. Previously the rates of interest payable on fixed deposits were determined by Reserve Bank. Presently banks are permitted to offer interest as deter mined by each bank. However, banks are not permitted to offer different interest rates to different customers for deposits of same maturity period, except in the case of deposits of Rs. 15 lakhs and above. These days the banks accept deposits even for 15 days or one month etc. In times of urgent need for money, the bank allows premature closure of fixed deposits by paying interest at reduced rate. Depositors can also avail of loans against Fixed Depos its. The Fixed Deposit Receipt cannot be transferred to other persons. (b) Recurring Deposits: In recurring deposit, the customer opens an account and de posit a certain sum of money every month. After a certain period, say 1 year or 3 years or 5 years, the accumulated amount along with interest is paid to the customer. It is very helpful to the middle and poor sections of the people. The interest paid on such deposits is gener ally on cumulative basis. This deposit system is a useful mechanism for regular savers of money. (c) Cash Certificates: Cash certificates are issued to the public for a longer period of time. It attracts the people because its maturity value is in multiples of the sum invested. It is an attractive and high yielding investment for those who can keep the funds for a long time. It is a very useful account for meeting future financial requirements at the occasion of marriage, education of children etc. Cash certificates are generally issued at discount to face value. It means a cash certificate of Rs. 1, 00,000 payable after 10 years can be pur chased now, say for Rs. 20, Demand Deposits: These are the deposits which may be withdrawn by the deposi tor at any time without previous notice. It is withdraw able by cheque/draft. It includes the following: (a) Savings Deposits: The savings deposit promotes thrift among people. The savings deposits can only be held by individuals and non-profit institutions. The rate of interest paid on savings deposits is lower than that of time deposits. The savings account holder gets the advantage of liquidity (as in current a/c) and small income in the form of interests. But there are some restrictions on withdrawals. Corporate bodies and business firms are not allowed to open SB Accounts. Presently interest on SB Accounts is determined

75 by RBI. It is 4.5 per cent per annum. Co-operative banks are allowed to pay an extra 0.5 per cent on its savings bank deposits. (b) Current Account Deposits: These accounts are maintained by the people who need to have a liquid balance. Current account offers high liquidity. No interest is paid on cur rent deposits and there are no restrictions on withdrawals from the current account. These accounts are generally in the case of business firms, institutions and co-operative bodies. Nowadays, banks are designing and offering various investment schemes for deposit of money. These schemes vary from bank to bank. It may be stated that the banks are currently working out with different innovative schemes for deposits. Such deposit accounts offer better interest rate and at the same time withdraw able facility also. These schemes are mostly offered by foreign banks. In USA, Current Accounts are known as 'Checking Accounts' as a cheque is equivalent to check in America. B. Advancing of Loans: The commercial banks provide loans and advances in various forms. They are given below: 1. Overdraft: This facility is given to holders of current accounts only. This is an ar rangement with the bankers thereby the customer is allowed to draw money over and above the balance in his/her account. This facility of overdrawing his account is generally pre-arranged with the bank up to a certain limit. It is a short-term temporary fund facility from bank and the bank will charge interest over the amount overdrawn. This facility is generally available to business firms and companies. 2. Cash Credit: Cash credit is a form of working capital credit given to the business firms. Under this arrangement, the customer opens an account and the sanctioned amount is credited with that account. The customer can operate that account within the sanctioned limit as and when required. It is made against security of goods, personal security etc. 3. Discounting of Bills: Discounting of Bills may be another form of bank credit. The bank may purchase inland and foreign bills before these are due for payment by the drawer debtors, at discounted values, i.e., values a little lower than the face values. The Banker's discount is generally the interest on the full amount for the unexpired period of the bill. The banks reserve the right of debiting the accounts of the customers in case the bills are ulti mately not paid, i.e., dishonored. 4. Loans and Advances: It includes both demand and term loans, direct loans and advances given to all type of customers mainly to businessmen and investors against per sonal security or goods of movable or immovable in nature. The loan amount is paid in cash or by credit to customer account which the customer can draw at any time. 5. Housing Finance: Nowadays the commercial banks are competing among them selves in providing housing finance facilities to their customers. It is mainly to increase the housing facilities in the country. State Bank of India, Indian Bank, Canara Bank, Punjab National Bank, has formed housing subsidiaries to provide housing finance. 6. Educational Loan Scheme: The Reserve Bank of India, from August, 1999 intro duced a new Educational Loan Scheme for students of full time graduate/post-graduate professional courses in private professional colleges. 7. Loans against Shares/Securities: Commercial banks provide loans against the se curity of shares/debentures of reputed companies. Loans are usually given only up to 50% value (Market Value) of

76 the shares subject to a maximum amount permissible as per RBI directives. Presently one can obtain a loan up to Rs.10 lakhs against the physical shares and up to Rs. 20 lakhs against dematerialized shares. 8. Loans against Savings Certificates: Banks are also providing loans up to certain value of savings certificates like National Savings Certificate, Fixed Deposit Receipt, Indira Vikas Patra, etc. The loan may be obtained for personal or business purposes. 9. Consumer Loans and Advances: One of the important areas for bank financing in recent years is towards purchase of consumer durables like TV sets, Washing Machines, Micro Oven, etc. Banks also provide liberal Car finance. 10. Securitization of Loans: Banks are recently trying to securities a part of their part of loan portfolio and sell it to another investor. Under this method, banks will convert their business loans into a security or a document and sell it to some Investment or Fund Manager for cash to enhance their liquidity position. Secondary Functions The secondary functions of the banks consist of agency functions and general utility functions. A. Agency Functions Agency functions include the following: (i) Collection of cheques, dividends, and interests: As an agent the bank collects cheques, drafts, promissory notes, interest, dividends etc., on behalf of its customers and credit the amounts to their accounts. (ii) Payment of rent, insurance premiums: The bank makes the payments such as rent, insurance premiums, subscriptions, on standing instructions until further notice. Till the order is revoked, the bank will continue to make such payments regularly by debiting the customer's account. (iii) Dealing in foreign exchange: As an agent the commercial banks purchase and sell foreign exchange as well for customers as per RBI Exchange Control Regulations. (iv) Purchase and sale of securities: Commercial banks undertake the purchase and sale of different securities such as shares, debentures, bonds etc., on behalf of their customers. They run a separate 'Portfolio Management Scheme' for their big customers. (v) Act as trustee, executor, attorney, etc: The banks act as executors of Will, trustees and attorneys. It is safe to appoint a bank as a trustee than to appoint an individual. Acting as attorneys of their customers, they receive payments and sign transfer deeds of the properties of their customers. (vi) Act as correspondent: The commercial banks act as a correspondent of their customers. Small banks even get travel tickets, book vehicles; receive letters etc. on behalf of the custom ers. (vii) Preparations of Income-Tax returns: They prepare income-tax returns and provide advices on tax matters for their customers. For this purpose, they employ tax experts and make their services, available to their customers.

77 B. General Utility Services The General utility services include the following: (i) Safety Locker facility: Safekeeping of important documents, valuables like jewels are one of the oldest services provided by commercial banks. 'Lockers' are small receptacles which are fitted in steel racks and kept inside strong rooms known as vaults. These lockers are available on half-yearly or annual rental basis. (ii) Payment Mechanism or Money Transfer: Transfer of funds is one of the important functions performed by commercial banks. Cheques and credit cards are two important payment mechanisms through banks. Despite an increase in financial transactions, banks are managing the transfer of funds process very efficiently. (iii) Travelers' cheques: Travelers Cheques are used by domestic travelers as well as by international travelers. However the use of traveler's cheques is more common by interna tional travelers because of their safety and convenience. These can be also termed as a modi fied form of traveler's letter of credit. (iv) Circular Notes or Circular Letters of Credit: Under Circular Letters of Credit, the cus tomer/traveller negotiates the drafts with any of the various branches to which they are addressed. Thus the traveller can obtain funds from many of the branches of banks instead only from a particular branch. Circular Letters of Credit are therefore a more useful method for obtaining funds while travelling to many countries. (v) Issue "Travellers Cheques": Banks issue travellers cheques to help carry money safely while travelling within India or abroad. Thus, the customers can travel without fear, theft or loss of money. (vi) Letters of Credit: Letter of Credit is a payment document provided by the buyer's banker in favour of seller. This document guarantees payment to the seller upon production of document mentioned in the Letter of Credit evidencing dispatch of goods to the buyer. (vii) Acting as Referees: The banks act as referees and supply information about the business transactions and financial standing of their customers on enquiries made by third parties. This is done on the acceptance of the customers and help to increase the business activity in general. (viii) Provides Trade Information: The commercial banks collect information on business and financial conditions etc., and make it available to their customers to help plan their strategy. Trade information service is very useful for those customers going for cross-border business. It will help traders to know the exact business conditions, payment rules and buyers' financial status in other countries. (ix) ATM facilities: The banks today have ATM facilities. Under this system the custom ers can withdraw their money easily and quickly and 24 hours a day. This is also known as 'Any Time Money'. Customers under this system can withdraw funds i.e., currency notes with a help of certain magnetic card issued by the bank and similarly deposit cash/cheque for credit to account. (x) Credit cards: Banks have introduced credit card system. Credit cards enable a cus tomer to purchase goods and services from certain specified retail and service establishments up to a limit without making immediate payment. In other words, purchases can be made on credit basis on the strength of the credit card. (xi) Gift Cheques: The commercial banks offer Gift cheque facilities to the general public. These cheques received a wider acceptance in India. Under this system by paying equivalent amount one can buy gift cheque for presentation on occasions like Wedding, Birthday.

78 (xii) Accepting Bills: On behalf of their customers, the banks accept bills drawn by third parties on its customers. This resembles the letter of credit. While banks accept bills, they provide a better security for payment to seller of goods or drawer of bills. (xiii) Merchant Banking: The commercial banks provide valuable services through their merchant banking divisions or through their subsidiaries to the traders. This is the function of underwriting of securities. They underwrite a portion of the Public issue of shares, Deben tures and Bonds of Joint Stock Companies. (xiv) Advice on Financial Matters: The commercial banks also give advice to their custom ers on financial matters particularly on investment decisions such as expansion, diversifica tion, new ventures, rising of funds etc. (xv) Factoring Service: Today the commercial banks provide factoring service to their customers. It is very much helpful in the development of trade and industry as immediate cash flow and administration of debtors' accounts are taken care of by factors. This service is again provided only by a separate subsidiary as per RBI regulations. Meaning RBI and its Functions The Reserve Bank of India is India's Central Banking Institution, which controls the Monetary Policy of the Indian Rupee. It commenced its operations on 1 April 1935 during the British Rule in accordance with the provisions of the Reserve Bank of India Act, The original share capital was divided into shares of 100 each fully paid, which were initially owned entirely by private shareholders. Following India's independence on 15 - August , the RBI was nationalized in the year of Functions of RBI Traditional Functions of RBI: 1. Issue of Currency Notes: The RBI has the sole right or authority or monopoly of issuing currency notes except one rupee note and coins of smaller denomination. These currency notes are legal tender issued by the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100, 500, and 1,000. The RBI has powers not only to issue and withdraw but even to exchange these currency notes for other denominations. It issues these notes against the security of gold bullion, foreign securities, rupee coins, exchange bills and promissory notes and government of India bonds. 2. Banker to other Banks: The RBI being an apex monitory institution has obligatory powers to guide, help and direct other commercial banks in the country. The RBI can control the volumes of banks reserves and allow other banks to create credit in that proportion. Every commercial bank has to maintain a part of their reserves with its parent's viz. the RBI. Similarly in need or in urgency these banks approach the RBI for fund. Thus it is called as the lender of the last resort. 3. Banker to the Government: The RBI being the apex monitory body has to work as an agent of the central and state governments. It performs various banking function such as to accept deposits, taxes and make payments on behalf of the government. It works as a representative of the government even at the international level. It maintains government accounts, provides financial advice to the government. It manages government public debts and maintains foreign exchange

79 reserves on behalf of the government. It provides overdraft facility to the government when it faces financial crunch. 4. Exchange Rate Management: It is an essential function of the RBI. In order to maintain stability in the external value of rupee, it has to prepare domestic policies in that direction. Also it needs to prepare and implement the foreign exchange rate policy which will help in attaining the exchange rate stability. In order to maintain the exchange rate stability it has to bring demand and supply of the foreign currency (U.S Dollar) close to each other. 5. Credit Control Function: Commercial bank in the country creates credit according to the demand in the economy. But if this credit creation is unchecked or unregulated then it leads the economy into inflationary cycles. On the other credit creation is below the required limit then it harms the growth of the economy. As a central bank of the nation the RBI has to look for growth with price stability. Thus it regulates the credit creation capacity of commercial banks by using various credit control tools. 6. Supervisory Function: The RBI has been endowed with vast powers for supervising the banking system in the country. It has powers to issue license for setting up new banks, to open new branches, to decide minimum reserves, to inspect functioning of commercial banks in India and abroad, and to guide and direct the commercial banks in India. It can have periodical inspections an audit of the commercial banks in India. Development Functions 1. Development of the Financial System: The financial system comprises the financial institutions, financial markets and financial instruments. The sound and efficient financial system is a precondition of the rapid economic development of the nation. The RBI has encouraged establishment of main banking and non-banking institutions to cater to the credit requirements of diverse sectors of the economy. 2. Development of Agriculture: In an agrarian economy like ours, the RBI has to provide special attention for the credit need of agriculture and allied activities. It has successfully rendered service in this direction by increasing the flow of credit to this sector. It has earlier the Agriculture Refinance and Development Corporation (ARDC) to look after the credit, National Bank for Agriculture and Rural Development (NABARD) and Regional Rural Banks (RRBs). 3. Provision of Industrial Finance: Rapid industrial growth is the key to faster economic development. In this regard, the adequate and timely availability of credit to small, medium and large industry is very significant. In this regard the RBI has always been instrumental in setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and EXIM BANK etc. 4. Provisions of Training: The RBI has always tried to provide essential training to the staff of the banking industry. The RBI has set up the bankers' training colleges at several places. National Institute of Bank Management i.e. NIBM, Bankers Staff College i.e. BSC and College of Agriculture Banking i.e. CAB is few to mention. 5. Collection of Data: Being the apex monetary authority of the country, the RBI collects process and disseminates statistical data on several topics. It includes interest rate, inflation, savings and investments etc. This data proves to be quite useful for researchers and policy makers. 6. Publication of the Reports: The Reserve Bank has its separate publication division. This division collects and publishes data on several sectors of the economy. The reports and bulletins are

80 regularly published by the RBI. It includes RBI weekly reports, RBI Annual Report, Report on Trend and Progress of Commercial Banks India., etc. This information is made available to the public also at cheaper rates. 7. Promotion of Banking Habits: As an apex organization, the RBI always tries to promote the banking habits in the country. It institutionalizes savings and takes measures for an expansion of the banking network. It has set up many institutions such as the Deposit Insurance Corporation- 1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These organizations develop and promote banking habits among the people. During economic reforms it has taken many initiatives for encouraging and promoting banking in India. 8. Promotion of Export through Refinance: The RBI always tries to encourage the facilities for providing finance for foreign trade especially exports from India. The Export-Import Bank of India (EXIM Bank India) and the Export Credit Guarantee Corporation of India (ECGC) are supported by refinancing their lending for export purpose. Supervisory Functions of RBI 1. Granting license to banks: The RBI grants license to banks for carrying its business. License is also given for opening extension counters, new branches, even to close down existing branches. 2. Bank Inspection: The RBI grants license to banks working as per the directives and in a prudent manner without undue risk. In addition to this it can ask for periodical information from banks on various components of assets and liabilities. 3. Control over NBFIs: The Non-Bank Financial Institutions are not influenced by the working of a monitory policy. However RBI has a right to issue directives to the NBFIs from time to time regarding their functioning. Through periodic inspection, it can control the NBFIs. 4. Implementation of the Deposit Insurance Scheme: The RBI has set up the Deposit Insurance Guarantee Corporation in order to protect the deposits of small depositors. All bank deposits below Rs. One lakh are insured with this corporation. The RBI work to implement the Deposit Insurance Scheme in case of a bank failure. Meaning Monetary Policy of RBI The term monetary policy is also known as the 'credit policy' or called 'RBI's money management policy' in India. How much should be the supply of money in the economy? How much should be the ratio of interest? How much should be the viability of money? etc. Such questions are considered in the monetary policy. From the name itself it is understood that it is related to the demand and the supply of money. Objectives of Monetary Policy 1. Rapid Economic Growth: It is the most important objective of a monetary policy. The monetary policy can influence economic growth by controlling real interest rate and its resultant impact on the investment. If the RBI opts for a cheap or easy credit policy by reducing interest rates, the investment level in the economy can be encouraged.

81 2. Price Stability: All the economics suffer from inflation and deflation. It can also be called as Price Instability. Both inflation and deflation are harmful to the economy. Thus, the monetary policy having an objective of price stability tries to keep the value of money stable. 3. Exchange Rate Stability: Exchange rate is the price of a home currency expressed in terms of any foreign currency. If this exchange rate is very volatile leading to frequent ups and downs in the exchange rate, the international community might lose confidence in our economy. The monetary policy aims at maintaining the relative stability in the exchange rate. The RBI by altering the foreign exchange reserves tries to influence the demand for foreign exchange and tries to maintain the exchange rate stability. 4. Balance of Payments (BOP) Equilibrium: Many developing countries like India suffer from the Disequilibrium in the BOP. The Reserve Bank of India through its monetary policy tries to maintain equilibrium in the balance of payments. 5. Full Employment: The concept of full employment was much discussed after Keynes's publication of the "General Theory" in It refers to absence of involuntary unemployment. In simple words 'Full Employment' stands for a situation in which everybody who wants jobs get jobs. However it does not mean that there is Zero unemployment. 6. Neutrality of Money: Economist such as Wicksted, Robertson has always considered money as a passive factor. According to them, money should play only a role of medium of exchange and not more than that. Therefore, the monetary policy should regulate the supply of money. The change in money supply creates monetary disequilibrium. 7. Equal Income Distribution: Many economists used to justify the role of the fiscal policy are maintaining economic equality. However in recent years economists have given the opinion that the monetary policy can help and play a supplementary role in attainting an economic equality. Instruments of Monetary Policy Quantitative Instruments or General Tools The Quantitative Instruments are also known as the General Tools of monetary policy. These tools are related to the Quantity or Volume of the money. The Quantitative Tools of credit control are also called as General Tools for credit control. 1. Bank Rate Policy (BRP): The Bank Rate Policy (BRP) is a very important technique used in the monetary policy for influencing the volume or the quantity of the credit in a country. The bank rate refers to rate at which the central bank (i.e. RBI) rediscounts bills and prepares of commercial banks or provides advance to commercial banks against approved securities. 2. Open Market Operation (OMO): The open market operation refers to the purchase and/or sale of short term and long term securities by the RBI in the open market. This is very effective and popular instrument of the monetary policy. The OMO is used to wipe out shortage of money in the money market, to influence the term and structure of the interest rate and to stabilize the market for government securities, etc. It is important to understand the working of the OMO. If the RBI sells securities in an open market, commercial banks and private individuals buy it.

82 This reduces the existing money supply as money gets transferred from commercial banks to the RBI. Contrary to this when the RBI buys the securities from commercial banks in the open market, commercial banks sell it and gets back the money they had invested in them. 3. Variation in the Reserve Ratios (VRR): The Commercial Banks have to keep a certain proportion of their total assets in the form of Cash Reserves. Some part of these cash reserves are their total assets in the form of cash. Apart of these cash reserves are also to be kept with the RBI for the purpose of maintaining liquidity and controlling credit in an economy. These reserve ratios are named as Cash Reserve Ratio (CRR) and a Statutory Liquidity Ratio (SLR). The CRR refers to some percentage of commercial bank's net demand and time liabilities which commercial banks have to maintain with the central bank and SLR refers to some percent of reserves to be maintained in the form of gold or foreign securities. In India the CRR by law remains in between 3-15 percent while the SLR remains in between percent of bank reserves. Any change in the VRR (i.e. CRR + SLR) brings out a change in commercial banks reserves positions. Qualitative Instruments or Selective Tools The Qualitative Instruments are also known as the Selective Tools of monetary policy. These tools are not directed towards the quality of credit or the use of the credit. 1. Fixing Margin Requirements: The margin refers to the "proportion of the loan amount which is not financed by the bank". Or in other words, it is that part of a loan which a borrower has to raise in order to get finance for his purpose. 2. Consumer Credit Regulation: Under this method, consumer credit supply is regulated through hirepurchase and installment sale of consumer goods. Under this method the down payment, installment amount, loan duration, etc is fixed in advance. This can help in checking the credit use and then inflation in a country. 3. Publicity: This is yet another method of selective credit control. Through it Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. This published information can help commercial banks to direct credit supply in the desired sectors. Through its weekly and monthly bulletins, the information is made public and banks can use it for attaining goals of monetary policy. 4. Credit Rationing: Central Bank fixes credit amount to be granted. Credit is rationed by limiting the amount available for each commercial bank. This method controls even bill rediscounting. 5. Moral Suasion: It implies to pressure exerted by the RBI on the Indian banking system without any strict action for compliance of the rules. It is a suggestion to banks. It helps in restraining credit during inflationary periods. Commercial banks are informed about the expectations of the central bank through a monetary policy 6. Control through Directives: Under this method the central bank issue frequent directives to commercial banks. These directives guide commercial banks in framing their lending policy. Through a directive the central bank can influence credit structures, supply of credit to certain limit for a specific purpose. The RBI issues directives to commercial banks for not lending loans to speculative sector such as securities, etc beyond a certain limit. 7. Direct Action: Under this method the RBI can impose an action against a bank. If certain banks are not adhering to the RBI's directives, the RBI may refuse to rediscount their bills and securities.

83 Credit Creation by Commercial Banks To explain the process of credit creation, we make the following assumptions: 1. There are many banks, say А, В, C, etc., in the banking system. 2. Each bank has to keep 10 percent of its deposits in reserves. In other word 10 per cent is the required ratio fixed by law. 3. The first bank has Rs as deposits. 4. The loan amount drawn by the customer of one bank is deposited in full in the second bank, and that of the second bank into the third bank, and so on. 5. Each bank starts with the initial deposit which is deposited by the debtor of the other bank. Given these assumptions suppose that Bank A receives cash deposits of Rs to begin with. This is the cash in hand with the bank which is its asset and this amount is also the liability of the bank by way of deposits it holds. Given the reserve ratio of 10 per cent, the bank keeps Rs. 100 in reserves and lends Rs 900 to one of its customers who, in turn, give a cheque to some person from whom he borrows or buys something. The net changes in Bank A is balance sheet are +Rs 100 in reserves and +Rs 900 in loans on the assets side and Rs 1000 in demand deposits on the liabilities side as shown in Table Before these changes Bank A had zero excess reserves. This loan of Rs. 900 is deposited by the customer in Bank B whose balance sheet is shown in Table Bank B starts with a deposit of Rs. 900, Keeps 10 per cent of it or Rs. 90 as cash in reserve. Bank B has Rs 810 as excess reserves which it lends thereby creating new deposits.

84 This loan of Rs. 810 is deposited by the customer of Bank B into Bank C. The balance sheet of Bank C is shown in Table Bank C keeps Rs 81 or 10 per cent of Rs 810 in cash reserves and lends Rs This Process goes on to other banks. Each bank in the sequence gets excess reserves, lends and creates new demand deposits equal to 90% of the preceding bank s. In this way, new deposits are created to the tune of Rs in the banking system, as shown in Table The multiple credit creation shown in the last column of the above Table can also be worked out algebraically as: Rs 1000[1+ (9/10)+(9/10)2+(9/10)3+ +(9/10) ] =Rs 1000(1/1-9/10) = Rs 1000(1/1/10)= Rs = Rs

85 10 Consumption and Investment Function Concepts of Consumption, Income, Savings and Investment 1. Consumption is a major concept in economics and is also studied by many other social sciences. Economists are particularly interested in the relationship between consumption and income, and therefore in economics the consumption function plays a major role Different schools of economists define production and consumption differently. According to mainstream economists, only the final purchase of goods and services by individuals constitutes consumption, while other types of expenditure in particular, fixed investment, intermediate consumption, and government spending are placed in separate categories. Other economists define consumption much more broadly, as the aggregate of all economic activity that does not entail the design, production and marketing of goods and services. C refers to consumption f is the functional relationship Y is income C = f(y) 2. Income is the consumption and savings opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings received... in a given period of time." In the field of public economics, the term may refer to the accumulation of both monetary and non-monetary consumption ability, with the former (monetary) being used as a proxy for total income. I is the investment expenditure Y = C + I 3. Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in, for example, a deposit account, a pension account, an investment fund, or as cash. Saving also involves reducing expenditures, such as recurring costs. In terms of personal finance, saving generally specifies low-risk preservation of money, as in a deposit account, versus investment, wherein risk is higher; in economics more broadly, it refers to any income not used for immediate consumption.

86 "Saving" differs from "savings." The former refers to an increase in one's assets, an increase in net worth, whereas the latter refers to one part of one's assets, usually deposits in savings accounts, or to all of one's assets. Saving refers to an activity occurring over time, a flow variable, whereas savings refers to something that exists at any one time, a stock variable. S refers to saving Y = C + S 4. In economics, investment is the accumulation of newly produced physical entities, such as factories, machinery, houses, and goods inventories. In finance, investment is putting money into an asset with the expectation of capital appreciation, dividends, and/or interest earnings. This may or may not be backed by research and analysis. Most or all forms of investment involve some form of risk, such as investment in equities, property, and even fixed interest securities which are subject, among other things, to inflation risk. It is indispensable for project investors to identify and manage the risks related to the investment. Equality between Savings and Investment Y = C + I A variation of the Keynesian injections-leakages model includes the two private sectors, the household sector and the business sector. This variation, more formally termed the two-sector injections-leakages model, captures the interaction between induced saving (and indirectly induced consumption expenditures) and autonomous investment expenditures. This model provides an alternative to the twosector aggregate expenditures (Keynesian cross) analysis of the macro economy, including equilibrium, disequilibrium, and the multiplier. Equilibrium is identified as the intersection between the saving line and the investment line. Two related variations are the three-sector injections-leakages model and the four-sector injections-leakages model. The saving-investment model provides an alternative to the more common two-sector Keynesian model; the Keynesian cross, aggregate expenditures-aggregate production model of the macro economy. Both models provide essentially the same analysis and are essentially "two sides of the same coin." The key difference between the two models is that consumption is explicitly eliminated from the injectionsleakages variation. Whereas the Keynesian cross builds on the consumption function, the injectionsleakages model builds on the saving function.

87 Consumption Function Keynes Consumption Function In economics, the consumption function, or better, the consumption expenditure function, is a single mathematical function used to express consumer spending. It was first mentioned by John Maynard Keynes who tried to detail it in his most famous book The General Theory of Employment, Interest, and Money. The function is used to calculate the amount of total consumption in an economy. Due to the lack of mathematic tools when it was first draft, a very simplistic presentation was created. It was made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy s income level. C is total consumption c 0 is autonomous consumption c 1 is the marginal propensity to consume Y d is disposable income Properties of Consumption Function C = c 0 + c 1 Y d 1. Average Propensity to Consume (APC): The average propensity to consume (APC) indicates what the household sector does with income. The APC indicates the portion of income that is used for consumption expenditures. If, for example, the APC is 0.9, then 90 percent of income goes for consumption. The standard formula for calculating average propensity to consume (APC) is APC = consumption Income 2. The marginal propensity to consume (MPC) indicates what the household sector does with extra income. The MPC indicates the portion of additional income that is used for consumption expenditures. If, for example, the MPC is 0.75, then 75 percent of extra income goes for consumption MPC = Change in consumption Change in income

88 Importance of Consumption Function We briefly discuss below the importance of consumption from various points of view: 1. Consumption function depends on income. As income rises, consumption increases but less than the rise in income. It is essential to increase investment. 2. There may be general over production which may force the government to intervene in the economy through public policy. 3. It explains the turning point of trade cycles. 4. Explains the danger of over saving. 5. It brings out the unique feature of income generation. 6. There may be existence of under employment equilibrium. 7. It explains the declining marginal efficiency of capital. Determinants of Consumption Function 1. Psychological characteristics of human nature: The subjective factors affecting propensity to consume are internal to the economic system. The subjective factors include characteristics of human nature, social practices which lead households to refrain or activate to spending out of their incomes. For example, religious belief of the people towards spending, their foresight, attitude towards life, level of education, etc. Etc., directly affect propensity to consume or determine the slope and position of the consumptions curve. The subjective factors do not undergo a material change over a short period of time. These remain constant in the short run. 2. Objective Factors: The objective factors are external to economic system. They undergo rapid changes and bring market shifts in the consumption function. Investment Function Investment is the second component of aggregate expenditure. Investment function plays an important role in the determination of equilibrium level of national income and corresponding level of employment. Types of Investment 1. Planned Investment: Planned Investment can also be called as Intended Investment because an investor while making investment make a concrete plan of his investment. 2. Gross Investment: Gross Investment means the total amount of money spent for creation of new capital assets like Plant and Machinery, Factory Building, etc. It is the total expenditure made on new capital assets in a period. 3. Induced Investment: Induced Investment is positively related to the income level. That is, at high levels of income entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption expenditure increases this leads to an increase in investment of capital goods, in order to produce more consumer goods. 4. Net Investment: Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a period of time, usually a year. It must be noted that a part of the investment is meant for depreciation of the capital asset or for replacing a worn-out capital asset. Hence it must be deducted to arrive at net investment.

89 Determinants of Investment The marginal efficiency of capital displays the expected rate of return from investment, at a particular given time. The marginal efficiency of capital is compared to the rate of interest. Keynes described the marginal efficiency of capital as: The marginal efficiency of capital is equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital asset during its life just equal to its supply price. J.M.Keynes, General Theory, Chapter 11 This theory suggests investment will be influenced by: 1. The marginal efficiency of capital 2. The interest rates Generally, a lower interest rate makes investment relatively more attractive. If interest rates, were 3%, then firms would need an expected rate of return of at least 3% from their investment to justify investment. If the marginal efficiency of capital was lower than the interest rate, the firm would be better off not investing, but saving the money. Multiplier The concept of Investment Multiplier is an important contribution of Prof. J.M. Keynes. Keynes believed that an initial increment in investment increases the final income by many times. Multiplier expresses the relationship between an initial increment in investment and the resulting increase in aggregate income. In practice, it is observed that when investment is increased by a certain amount, then the change in income is not restricted to the extent of the initial investment, but it changes several times the change in investment. In other words, change in income is a multiple of the change in investment. Multiplier explains how many times the income increases as a result of an increase in the investment. Multiplier (k) is the ratio of increase in national income ( Y) due to an increase in investment ( I). K= Y/ I Suppose an additional investment ( I) of RS 4,000 crores in an economy generates an additional income ( Y) of Rs 16,000 crores. The value of multiplier (k), in this case will be: k =16,000/4,000 = 4 It means, income increased 4 times with a single increase in investment.

90 Marginal Propensity to Consume / Save MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents K = 1 1 MPC The marginal propensity to save (MPS) is the fraction of an increase in income that is not spent on an increase in consumption. That is, the marginal propensity to save is the proportion of each additional dollar of household income that is used for saving. Working of Multiplier K = 1 MPS Let us understand this with the help of an example. 1. Suppose, an additional investment of Rs 100 crores (AI) is made to construct a flyover. This extra investment will generate an extra income of Rs100 crores in the first round. But this is not the end of the story 2. If MPC is assumed to be 0.90, then recipients of this additional income will spend 90% of Rs 100 crores, i.e. Rs 90 crores as consumption expenditure and the remaining amount will be saved. It will increase the income by Rs 90 crores in the second round. 3. In the next round, 90% of the additional income of Rs 90 crores, i.e. Rs 81 crores will be spent on consumption and the remaining amount will be saved. 4. This multiplier process will go on and the consumption expenditure in every round will be 0.90 times of the additional income received from the previous round. The multiplier process is shown in Table 8.4. Thus, an initial investment of Rs 100 crores leads to a total increase of Rs 1,000 crores in the income. As a result, Multiplier (K) = Y/ I= 1,000/100 = 10

91 Diagrammatic Presentation of Multiplier: The multiplier can also be shown graphically using the AD and AS approach. In Fig. 8.7, income is taken on the X-axis and aggregate demand on the Y-axis. Suppose, the initial equilibrium is determined at point E where AD curve intersects the AS curve. The equilibrium level of income is OY. Now, suppose that the investment increases by I / so that the new aggregate demand curve (AD 1 ) intersects the aggregate supply curve (AS) at point F. Thus, the new equilibrium level of income is OY 1. The income rises from OY to OY 1, in response to an initial increase in investment ( I ). It is clear from the figure that the increase in income (YY 1 or Y) is greater than increase in investment ( I ). The value of multiplier is given by K= Y/ I

92 11 Government Budget and Economy Budget A budget is a quantitative expression of a plan for a defined period of time. It may include planned sales volumes and revenues, resource quantities, costs and expenses, assets, liabilities and cash flows. It expresses strategic plans of business units, organizations, activities or events in measurable terms. Balanced Budget Types of Budget Balanced budget is a situation, in which estimated revenue of the government during the year is equal to its anticipated expenditure. Government's estimated Revenue = Government's proposed Expenditure. For individuals and families, it is always advisable to have a balanced budget. Most of the classical economists advocated balanced budget, which was based on the policy of 'Live within means'. According to them, government's revenue should not fall short of expenditure. They also favoured balanced budget because they believed that government should not interfere in economic activities and should just concentrate on the maintenance of internal and external security and provision of basic economic and social overheads. To achieve this, government has to have enough fiscal discipline so that its expenditures are equal to revenue. Unbalanced Budget The budget in which income & expenditure are not equal to each other is known as Unbalanced Budget. Unbalanced budget is of two types :- 1. Surplus Budget The budget is a surplus budget when the estimated revenues of the year are greater than anticipated expenditures. Government expected revenue > Government proposed Expenditure. Surplus budget shows the financial soundness of the government. When there is too much inflation, the government can adopt the policy of surplus budget as it will reduce aggregate demand. 2. Deficit Budget: Deficit budget is one where the estimated government expenditure is more than expected revenue. Government's estimated Revenue < Government's proposed Expenditure. Such deficit amount is generally covered through public borrowings or withdrawing resources from the accumulated reserve surplus. In a way a deficit budget is a liability of the government as it creates a burden of debt or it reduces the stock of reserves of the government.

93 In developing countries like India, where huge resources are needed for the purpose of economic growth & development it is not possible to raise such resources through taxation, deficit budgeting is the only optio Components of Budget Revenue Account This financial statement includes the revenue receipts of the government i.e. revenue collected by way of taxes & other receipts. It also contains the items of expenditure met from such revenue. a) Revenue Receipts: These are the incomes which are received by the government from all sources in its ordinary course of governance. These receipts do not create a liability or lead to a reduction in assets. Revenue receipts are further classified as tax revenue and non-tax revenue. I. Tax Revenue: Tax revenue consists of the income received from different taxes and other duties levied by the government. It is a major source of public revenue. Every citizen, by law is bound to pay them and non-payment is punishable. Taxes are of two types, viz., Direct Taxes and Indirect Taxes. Direct taxes are those taxes which have to be paid by the person on whom they are levied. Its burden cannot be shifted to someone else. E.g. Income tax, property tax, corporation tax, estate duty, etc. are direct taxes. There is no direct benefit to the tax payer. Direct taxes are progressive which means the amount increases with respect to increase in income. Indirect taxes are those taxes which are levied on commodities and services and affect the income of a person through their consumption expenditure. Here the burden can be shifted to some other person. E.g. Custom duties, sales tax, services tax, excise duties, etc. are indirect taxes.

94 II. Non-Tax Revenue: Apart from taxes, governments also receive revenue from other nontax sources. These include revenue from public sector companies, fines, grants from foreign aid and interest receipts. b) Revenue Expenditure: Revenue expenditure is the expenditure incurred for the routine, usual and normal day to day running of government departments and provision of various services to citizens. It includes both development and non-development expenditure of the Central government. Usually expenditures that do not result in the creations of assets are considered revenue expenditure. I. In general revenue expenditure includes following :- II. Expenditure by the government on consumption of goods and services. III. Expenditure on agricultural and industrial development, scientific research, education, health and social services. IV. Expenditure on defence and civil administration. V. Expenditure on exports and external affairs. VI. Grants given to State governments even if some of them may be used for creation of assets. VII. Payment of interest on loans taken in the previous year. VIII. Expenditure on subsidies. Capital Account This part of the budget includes receipts & expenditure on capital account projected for the next financial year. Capital budget consists of capital receipts & Capital expenditure. a) Capital Receipts: Receipts which create a liability or result in a reduction in assets are called capital receipts. They are obtained by the government by raising funds through borrowings, recovery of loans and disposing of assets. Items included in Capital Receipts are I. Loans raised by the government from the public through the sale of bonds and securities. They are called market loans. II. Borrowings by government from RBI and other financial institutions through the sale of Treasury bills. III. Loans and aids received from foreign countries and other international Organisations like International Monetary Fund (IMF), World Bank, etc. IV. Receipts from small saving schemes like the National saving scheme, Provident fund, etc. V. Recoveries of loans granted to state and union territory governments and other parties. b) Capital Expenditure: Any projected expenditure which is incurred for creating asset with a long life is capital expenditure. Thus, expenditure on land, machines, equipment, irrigation projects, oil exploration and expenditure by way of investment in long term physical or financial assets are capital expenditure. Planned and Unplanned Capital Expenditure

95 India has adopted economic planning as a strategy for economic development. For stepping up the rate of economic development five-year plans have been formulated. So far ten five-year plans have been completed. The expenditure incurred on the items relating to five year plans is termed as plan expenditure. Such expen diture is incurred by the Central Government. A provision is made for such expenditure in the budget of the Central Government. Assistance given by the Central Government to the State Governments and Union Territories for plan purposes also forms part of the plan expenditure. Plan expenditure is sub divided into Revenue Expenditure and Capital Expenditure. The expenditure provided in the budget for routine normal activities of the government is called non-plan expenditure. Its examples are expenditure incurred on administrative services, salaries and pension etc. There is no provision in the plan for such expenditure. Non-plan expenditure is also sub-divided into revenue expenditure and capital expenditure. Fiscal Policy Arthur Smithies defines fiscal policy as a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment. Objectives of Fiscal Policy 1. Development by effective Mobilisation of Resources: The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources. 2. Efficient allocation of Financial Resources: The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc. 3. Reduction in inequalities of Income and Wealth: Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper middle class and the upper class. 4. Price Stability and Control of Inflation: One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc. 5. Employment Generation: The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generate more employment.

96 6. Balanced Regional Development: Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc. 7. Reducing the Deficit in the Balance of Payment: Fiscal policy attempts to encourage more exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. 8. Capital Formation: The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. 9. Increasing National Income: The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country. 10. Development of Infrastructure: Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost. 11. Foreign Exchange Earnings: Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. Instruments of Fiscal Policy The instruments of fiscal policy are: Public Expenditure This is the expenditure incurred by the government for promotion of social and economic welfare of the people. This has a significant effect on income, output and employment. Hence it can have a big impact on the growth of the country. Deflationary gap is the excess of output over planned expenditure at base price. The government restores full employment when there is less investment by the private sector. According to Wagner s law of increasing state activities there exists a causal relationship between government expenditure and economic development. He said that there is a tendency of increasing public expenditure in India due to: 1. Participation in material production 2. Provision of social services. 3. Maintenance and enforcement of law and order.

97 Public Revenue This is the revenue made from tax and non tax sources. A suitable tax policy results in economic stability. Changes in the rates of taxes will cause changes in level of income and consumption of people. In India tax revenue comes from income tax, service tax, customs duties etc. Non tax revenue comprises of interest receipts obtained by the government for loans and advances from local governments and public sector undertakings. The tax system in India is an important instrument in fiscal policy. It is used for: 1. To mobilize revenue and check for unwanted expenditure. 2. To affect changes in the pattern of distribution of income and wealth. 3. To use a weapon to control inflation and deflation. Progressive direct tax system affects the income of people and changes their purchasing power which regulates inflation and deflation. Public Debt Public debt refers to the borrowings of the government to meet the budget deficits. It is used to control inflation and deflation. It is often argued that internal or market debt does not matter much because we owe money to ourselves. This is because transfer of money happens between people, purchasing power remains within the country. External debt on the other hand is to be taken seriously because purchasing power is transferred from one country to another through debt repayment and interest payments. Prof Raja Chellaiah has suggested following techniques to reduce debt: a) Accounts of RBI should be integrated with those of the government b) A substantial part of gold reserves created by gold seized from smuggling and other illegal activities must be auctioned. c) Utilization of resources generated through disinvestment. d) Utilization of resources generated through sale of a part of vast real estate. Deficit Financing Fiscal deficit presents a more comprehensive view of budgetary imbalances. It is widely used as a budgetary tool for explaining and understanding the budgetary developments in India. Fiscal deficit refers to the excess of total expenditure over total receipts (excluding borrowings) during the given fiscal year. Deficit financing refers to the borrowing undertaken by the government to make up for the revenue shortfall. It is the best stimulant for the economy in short term. However, in the long term it becomes a drag on the economy and becomes the reason for rise in interest rate. There is no precise definition of the term deficit financing. Deficit financing is an important source of capital formation in the developed and under developed countries of the world. In advanced countries, the newly created money is used to finance public investments which increase economic growth.

98 Budget Deficits When the government expenditure exceeds revenues, the government is having a budget deficit. Thus the budget deficit is the excess of government expenditures over government receipts (income). When the government is running a deficit, it is spending more than it's receipts. The government finances its deficit mainly by borrowing from the public, through selling bonds; it is also financed by borrowing from the Central Bank. Revenue Deficit Revenue Deficit takes place when the revenue expenditure is more than revenue receipts. The revenue receipts come from direct & indirect taxes and also by way of non-tax revenue. Revenue Deficit = Revenue Expenditure Revenue Receipts Fiscal Deficit Fiscal Deficit is a difference between total expenditure (both revenue and capital) and revenue receipts plus certain non-debt capital receipts like recovery of loans, proceeds from disinvestment. In other words, fiscal deficit is equal to budgetary deficit plus governments market borrowings and liabilities. Fiscal Deficit = Total Expenditure Revenue Receipts + Non Debt Receipts Primary Deficit The fiscal deficit may be decomposed into primary deficit and interest payment. The primary deficit is obtained by deducting interest payments from the fiscal deficit. Thus, primary deficit is equal to fiscal deficit less interest payments. It indicates the real position of the government finances as it excludes the interest burden of the loans taken in the past. Primary Deficit = Fiscal Deficit Interest Payments

99 12 Open Economy Meaning of Open Economy An open economy is an economy in which there are economic activities between the domestic community and outside (people, and even businesses, can trade in goods and services with other people and businesses in the international community, and funds can flow as investments across the border). Trade can take the form of managerial exchange, of technology transfers, and of all kinds of goods and services. Linkage of Open Economy 1. Product Market Linkage: Consumers and firms can buy both domestic and foregn goods. This is called product market linkage which can occur through foreign trade. 2. Financial Market Linkage: Investors can choose to invest in domestic and foregin assets. This is financial market linkage. 3. Factor Market Linkage: It involves free movement of factors of production. Firms can choose where to produce and workers can choose where to work. Closed Economy Autarky is the quality of being self-sufficient. Usually the term is applied to political states or their economic systems. Autarky exists whenever an entity can survive or continue its activities without external assistance or international trade. If a self-sufficient economy also refuses all trade with the outside world then it is called a closed economy Difference Between Closed and Open Economy Open Economy An open economy is one, which is not only involved in the process of production within its domestic territory but also can participate in production anywhere in the rest of the world. It buys shares, debentures, bonds etc. from foreign countries and sells shares, debentures, bonds etc. to foreign countries. It borrows from foreign countries and lends to foreign countries. It can send gifts and remittances to foreigners and can receive the same from them. Normal residents of an open economy can move or be employed and are allowed to work in the domestic territory of other economies. Closed Economy Closed economy is an economy, which does not have any sort of economic relation with rest of the world but is confined to itself only. It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares, debentures, bonds etc. to foreign countries. It neither borrows from the foreign countries nor lends to the foreign countries. It neither receives gifts from foreigners nor sends gifts to foreigners. Normal residents of a closed economy cannot go to other countries to work in their domestic territory. No foreigner is allowed to work in the domestic territory of a closed economy.

100 Domestic Trade Basic Concepts of Trade The trade conducted within the national boundaries of a country is known as internal trade. Internal trade can also be termed as Home trade or Domestic trade. Foreign Trade 1. Unilateral Trade: A trade agreement joins two or more states in a joint commitment to expand their trade. Normally, this includes domestic structural reforms such as lowering tariffs and reducing bureaucratic regulations. A unilateral trade agreement is technically not an agreement, but the actions of one country to expand its market and reform its economy. 2. Bilateral Trade: Bilateral trade or clearing trade is trade exclusively between two states, particularly, barter trade based on bilateral deals between governments, and without using hard currency for payment. Bilateral trade agreements often aim to keep trade deficits at minimum by keeping a clearing account where deficit would accumulate. 3. Multilateral Trade: Multilateral trade agreements are between many nations at one time. This makes them extremely complicated to negotiate, but very powerful once all parties sign. Balance of Trade Balance of Trade and Balance of Payments Balance of payments should be distinguished from balance of trade. Balance of trade refers to the export and import of visible items, i.e., material goods. It is the difference between the value of visible exports and imports. Visible items are those items which are recorded in the customs returns; for example, material goods exported and imported. If the value of visible exports is greater than that of visible imports, the balance of trade is favourable. If the value of visible imports is greater than that of visible exports the balance of trade is unfavourable; if the value of visible exports is equal to that of visible imports, the balance of trade is in equilibrium. Balance of trade is also known as merchandise account of exports and imports. Balance of Payments Balance of payments, on the other hand, is a more comprehensive concept because it covers (a) visible items (i.e., balance of trade or merchandise account) and (b) invisible items. Invisible items are those items which are not recorded in the customs returns; for example, services (such as transpiration, banking, insurance, etc.), capital flows, purchase and sale of gold, etc. Thus, balance of payments is a broader term than balance of trade; balance of payments includes both visible as well as invisible items, whereas balance of trade includes only visible items.

101 Structure of Balance of Payments The balance of payments account of a country is constructed on the principle of double-entry bookkeeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business accounting in one respect. These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official reserve assets account. Current Account The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance, income and payments of foreign investments, etc. Transfer payments relate to gifts, foreign aid, pensions, private remittances, charitable donations, etc. received from foreign individuals and governments to foreigners. In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On the other side, imports are shown as a negative item and are calculated c.i.f. (costs, insurance and freight) and included. The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable. It is, however, services and transfer payments or invisible items of the current account that reflect the true picture of the balance of payments account. The balance of exports and imports of services and transfer payments is called the balance of invisible trade. The invisible items along with the visible items determine the actual current account position. If ex ports of goods and services exceed imports of goods and services, the balance of payments is said to be favourable. In the opposite case, it is unfavourable. In the current account, the exports of goods and services arid the receipts of transfer payments (unrequited receipts) are entered as credits (+) because they represent receipts from foreigners. On the other hand, the imports of goods and services and grant of transfer payments to foreigners are entered as debits (-) because they represent payments to foreigners. The net value of these visible and invisible trade balances is the balance on current account.