Basic Concepts of Economics

1. Micro and Macro Economics

Economics is the study of economies, the study of how human beings coordinate
their wants, given the institutional structures of the society. I t i s t h e s t u d y o f
consumption, production, exchange and distribution of goods
a n d s e r v i c e s . In the study of economics, coordination refers to how the three central
problems facing any economy are solved. These central problems are: what and how
much to produce; how to produce; and for whom to produce.

Economics is divided into two different branches: Micro & Macro economics.
Microeconomics studies how the forces of supply and demand allocate scarce resources in
the economy. It examines the behavior of firms, consumers and the role of government.
Microeconomics studies the behavior of discrete parts of the economy—the
individual, the household, the company. It looks at how prices are determined, and how
prices then determine production, distribution, and use of goods and services. It is the study
of decisions that people and businesses make regarding the allocation of resources and
prices of goods and services. For example, consumers decide how much of various goods to
purchase, workers decide what job to take and business people decide how many workers
to hire and how much output to produce.) As prices have important effects on the
individuals’ decisions, the microeconomics is frequently called "price theory". The
major scope of microeconomics is supply and demand and other forces that determine price.

Macroeconomics is the field of economics that studies the behavior of the economy
as a whole. It examines whole economic systems and how different sectors interact. It looks
at economy-wide phenomena such as changes in unemployment, national income, rate of
growth, and price levels. For example, macroeconomics would look at the factors that
determine your average living costs. National economic policies and complexities of
industrial production are also studied. It deals primarily with aggregates (total amount of
goods & services produced by society) and general level of prices. It addresses issues such
as level of growth of national output (GNP & GDP), interests rates, unemployment, and
inflation.
Micro and macroeconomics are intertwined, so as economists gain understanding of
certain phenomena, they can help nations and individuals make more-informed decisions
when allocating resources. The systems by which nations allocate their resources can be
placed on a spectrum where the command economy is on the one end and market economy
is on the other. The market economy advocates forces within a competitive market, which
constitute the “invisible hand,” to determine how resources should be allocated. The
command economic system relies on the government to decide how the country's resources
would best be allocated. In both systems, however, scarcity and unlimited wants force
governments and individuals to decide how best to manage resources and allocate them in
the most efficient way possible. However, there are always limits to what the economy and
government can do.
Utility
Utility is defined as the power in an article or service to satisfy a want. The concept of

utility is subjective and depends on the intensity of want to an individual. It hardly indicates the
actual usefulness or worth of goods or service. So utility is not intrinsic in the commodity. It is
also devoid of any moral or ethical significance. The utility declines as we get more units of a
commodity.
Total utility: total amount of pleasure or satisfaction that is derived from having, owning or
consuming a given amount of a good or service at a point of time.
Average Utility: total amount of pleasure or satisfaction divided by total units of a commodity
consumed by a consumer at a point of time.
Marginal Utility: it refers to the additional pleasure or satisfaction that is derived from
consuming the last unit of a good or service.

Equilibrium
Equilibrium is the most fundamental concept in economics. The word “equilibrium” is
derived from Latin words “acquus’, which means “equal”, and “libra’ which means “balance”. In
economics, equilibrium can be defined as a situation in which economic forces, as they exist at
the time, have no tendency to change. It is the position towards which an economic
phenomenon—price, quantity, income etc.—tends to move and once it reaches the point of
equilibrium, the movement stops. It is a state of balance in such a way that the opposite forces
mutually cancel each other so that the object on which these forces exert their pressure is not
subject to any disturbance. There are economic activities present in a state of equilibrium—in
equilibrium a firm produces, sells and earns profit and different firms in the industry carry on
their productive activities smoothly.

Static and Dynamic Economics

The meaning of the two terms in economics is different from the meaning given to them
in physical sciences.
The term ‘static’ in physical sciences is indicative of a position of rest, of absence of any
movement whatsoever. In economics, however, the term ‘static’ does not indicate a motionless
economy. There is movement in the economy but this movement is constant, regular, smooth and
certain, devoid of certain jerks and shocks. Uncertainty does not creep in. Thus the chief features
of static state in economies are the absence of uncertainty and the existence of constant
movement through time. This is not a state of idleness but one where work proceeds smoothly at
a steady pace, day in and day out, and year after year in the economy. Pigou remarks, “just as the
drops of water that form a stream, are always changing but its form remains the same, in a static
state, the factors change but they are not of any consequence”. According to Hicks, “we should
call economic static those parts of economic theory where we do not trouble about dating”. In
static economics, various economic phenomena and their effects are analysed without reference
to time. For instance, when we say that if price is lowered by 5 %, demand rises by 3%, we are in
the field of static analysis.
The word “dynamics’ means causing to move. In economics it refers to the study of
economic change. In economic static, the relations between the relevant variables refer to the
same point or period of time. In economic dynamic, the relations between relevant variables refer
to different point of time. It is, thus, a process of change through time. Since dynamic is that
which changes and static which does not involve change, it is pertinent to ask what is that
change? An economic unit may undergo a change with respect to itself at a different place or a
different time. We can therefore say that the change may occur with respect to matter, space or
time. For instance, in the process of manufacturing goods, the matter may undergo change or in
the process of transportation space undergoes a change. Similarly, in the process of hoarding
time undergoes a change.
While the economy is in the process of change through time, economic variables may
change in two ways: one way is that, though the time element has undergone a change, the
economy may not change its pattern and thus the values of the economic variables remain the
same. The second way is that the economy may evolve through time and change its pattern so
that the economic variables are non-stationary through time. The former way of happening of the
change relates to static state, while the latter type relates to economic dynamics.
Ragnar Frisch has broadened the vistas of economic dynamics by including in it not only
continuing changes but also the process of change. According to him “ dynamic analysis is one
in which we consider the magnitudes of certain variables on different points of time and we
introduce certain equations which embrace at the same time several of those magnitudes at
different instants” Economic dynamic thus should embody functional relationships of variables
with different dates appended to them. For instance:

Ct = f (Yt-1)
Where: C is consumption, Y is income and T is time.

1. National Income Concepts

i. Gross National Product (GNP)

GNP stands for the monetary value of all goods and services that are (i) currently
produced, (ii) sold through the official market, (iii) not resold or used in further production, (iv)
produced by the nationally owned resources (factors of production), and (v) valued at the market
prices (current or constant).
GNP is a flow concept and includes only those items that are produced during the period
of time for which the GNP stands. GNP accounts for only those goods and services, which are
traded through the official market. Thus, it ignores the ‘do it yourself’ activities as well as the
un/under reported productions. For instance, housewives’ activities, social services and other
unpaid works are excluded. Similarly, unreported production triggered by the desire to avoid
excise duties or for other reasons is not included in GNP. This gives rise to black or parallel
economy, which has two components: legal but un/under reported and illegal like gambling,
prostitution, narcotics, smuggling, etc. However, self-consumption of production by the producer
and rent on owner-living houses are included in GNP.
Intermediate goods are not included in GNP, for avoiding double counting. Therefore,
only the value of final goods or alternatively values added at each stage of production are
included in it.
It excluded non-productive transactions such as purely financial transactions and second
hand sales. The former are of three types: public transfer payments, private transfer payments
and buying and selling of securities (shares or bonds).
GNP belongs to the nation, and thus, it must be produced by its owned factors of
production only. Since some factors like labour, entrepreneur and capital are globally mobile and
MNCs are operating in many countries including India, a part of this GNP is produced abroad
and a part of foreign GNP is produced under a national territory. Thus, if an Indian professor
takes up a four month Visiting Professorship in a US University, his income in USA is the part
of India’s GNP and similarly the profit that a MNC makes in India, is not a part of India’s GNP.
GNP at market price is inclusive of the indirect taxes (Ti), net of subsidies (S) as it values
the goods at the prices paid by the end users. To get GNP at factor cost (GNPF), one must deduct
net indirect taxes from GNPM:

GNPF = GNPM - Ti +S

ii. Gross Domestic Product (GDP)

It refers to the value of the goods and services produced within the nation’s geographical
territory, irrespective of the ownership of the resources. Therefore, salary of an Indian visiting
professor in USA is the GDP of USA and the dividend earned by a foreign company in India
constitutes GDP of India. In view of this, while GNP consists of income produced by the
nation’s owned resources irrespective of the place of production, GDP refers to income produced
within the nation’s territory irrespective of the ownership of the resources that produced it. The
difference between the two concepts is accounted for by the net factor income earned abroad
(NIA). Thus,
GDPF = GNPF -NIA
From the point of view of the employment generation at home, GDP is more relevant than GNP,
and hence, the former often receives a greater attention than the latter.

iii. NNP:
GNP minus Depreciation.

NNP is measured at factor cost and market prices.

NNPFC = NNPMP - indirect taxes + subsidies
NNPFC is globally known as national income.

iv. NDP
GDP minus Depreciation.

v. Personal Income: It is the sum of all incomes actually received by all individuals or
household during a given period.

PI = NI – social security contributions –corporate income tax – undistributed

corporate profits + transfer payments

vi. Disposable income

DI = PI – personal taxes

vii. Gross Domestic Capital Formation

This consists of that part of GDP, which is used to create productive assets such as
constriction of building schools, roads, procurement of machine and equipments.
viii. Gross Domestic Savings
Gross domestic savings have three components: household sector savings,
government sector savings and corporate sector savings. Household sector constitutes the
largest share, followed by corporate sector. Government sector savings are negative.

Other Economic Terms

1. Budget
It is the master financial plan of a government. It brings together estimates of anticipated
revenues and proposed expenditure for the budget period. The term is derived from the old
English word Bougette, the sack or pouch from which the Chancellor of the Exchequer
extracted his papers presenting to parliament the government's financial programmes for the
ensuing fiscal year. In India, the budget is divided into (1) Revenue budget and (2) Capital
budget. The former includes revenue receipts and revenue disbursements while the latter
contains capital receipts and capital disbursements.

2. Economic Growth
Growth of the aggregate quantity of goods and services (GNP) produced annually. It
is generally percentage change in output of goods and services over the preceding year.

3. Investment
The purchase of the means of production such as plant equipments over a given period.

4. Wealth
A stock of assets (physical and financial) accumulated from flows of savings.

5. Crowding out effect

Refers to any reduction in private sector spending as a result of a deficit-financed increase in
the government sector's spending.

6. Deficit Financing
Refers to the various methods the government has at its disposal to finance a given level of
deficit spending.

7. Budget deficit
Total receipts (Revenue and capital) minus total expenditure (Revenue and capital).

8. Revenue deficit
Total revenue receipts minus total revenue expenditure.

9. Fiscal deficit
Total Public Revenue receipts minus total Public Expenditure. It is the sum of overall
budgetary deficit and borrowings and others liabilities.

10. Primary deficit

Fiscal deficit minus interest payment.
11. Inflation
Steady and sustained rise in the general level of prices.

12. Recession
A moderate decline in economic activities, which lasts from 6 to 18 months.

13. Monetary Policy

The policy of a Central bank in exercising its limited power of control over the money
supply, the level of interest rates, credit conditions and the stability of financial markets.

14. Fiscal policy

Government tax policy and spending priorities and decisions. It is the type of government
economic activity that affects the level of national income through changes in government
spending on goods and services, transfer payments, and taxes. The role of fiscal policy is
important in stabilizing the economy and achieving low levels of unemployment and
inflation.

15. Transfer Payments

Payments such as social security, welfare and unemployment payments that are made by the
government to an individual and that do not arise out of current productive activities.

16. Subsidy
Subsidies are used by the government to promote social objectives. It is a direct or indirect
payment by a government to households or firms and may also includes grants or other aids
from a central government to local governments.

17. Direct and Indirect Tax

Taxes can be on income received or expenditure incurred. Those taxes, which are imposed on
the receipt of income, are called direct, while those, which are imposed on expenditure, are
regarded as indirect taxes. Income tax, profit tax, property tax, capital gain tax etc., are direct
tax while excise duties, custom duties, sale tax, trade tax etc are indirect taxes.

26. Corporate Income Tax

It is a tax levied on the income of corporations.

27. Excise Duty

A tax imposed on production of goods.

28. Sale Tax

A tax imposed on the sale of consumer goods.

29. Value Added Tax

A tax levied on a firm, based on the difference between the firm's sales and the firm's
purchases from other firms.
30. Capital receipts
The main items of capital receipts are loans raised by the Government from public,
borrowings by the government from RBI and from other parties through sale of treasury bills,
loans receipts from foreign institutions and governments and recoveries of loans granted by
the central government to State and Union Territory governments.

31. Capital Payments

These payments consist of capital expenditure on acquisition of assets like land, buildings,
machinery and equipment, as also investments in shares and loans and advances given to
State and Union Territory governments etc.

32. Non-plan Expenditure

Total budget expenditure is divided into Non-plan and Plan expenditure. Non-plan
expenditure is further divided in to revenue and capital non-plan expenditure.

Non-plan revenue expenditure includes: interest payment, defence revenue expenditure,

subsidies, debt relief to farmers, postal deficit, police pensions, other general services, social
services, economic services, communication, science and technology and grants to states and
UTs and grants to foreign government.

Capital non-plan expenditure includes: defence capital expenditure, loans to public

enterprises, loans to states and UTs and loans to foreign governments.

Plan Expenditure
The plan expenditure includes expenditure on central plans such as agriculture, rural
development, irrigation, flood control, energy, industry, mineral, transport, communication,
science and technology, environment, social services and others.

33. Capital Gain Tax

It refer to a tax on the increased value of an asset or security; it is a tax on the increment in
the value of an assets held by a person.

34. Countervailing Duty

A duty imposed on imported goods to control unfair trade practices by other countries.

35. Financial Bill

The proposals of the Government for levy of new taxes, modification of the existing tax
structure or continuance of existing tax structure beyond the period approved by the
Parliament are submitted to Parliament through this bill.
Concept of Economic Planning
Economic planning has become a craze in modern times in developing countries.
It acquired a tremendous support after the end of World War II when advanced but
disrupted economies had to be rehabilitated and the under-developed economies were
fired with the ambition of rapid economic development. Planning has become popular
due to basic defects of capitalism and free enterprises and owing to the realization that,
unless a free enterprise economy is regulated and controlled, it would not ensure stable
growth or maximise social welfare. For the developing countries like India, economic
planning is a sine qua non for acceleration of growth, alleviation of regional and sectoral
disparities and mobilisation of public and private resources in desired channels. Although
both the advanced and the under developing countries follow economic planning, but
planning in advanced countries is corrective in nature made to ensure economic stability
while in developing countries, it is developmental planning made to ensure rapid growth.

Meaning of planning
Planning may be defined as the conscious and deliberate choice of economic
priorities by some public authority. It is the making of major economic decisions—what
and how much is to be produced, and to whom it is to be allocated by the conscious
decision of a determinate authority, on the basis of a comprehensive survey of economic
system as a whole. Planning is a mechanism for coordinating economic decisions. In the
word of the Second Five -Year Plan of India, economic planning is “essentially a way of
organising and utilising resources to maximise advantage in terms of defined social ends.
The two main constituents of the concept of planning are: a system of ends to be pursued
and knowledge as to the available resources and their optimum allocations.”
Thus, planning, in short, may be defined as conceiving, initiating, regulating
and controlling economic activity by the State according to set priorities with a
view to achieving well-defined objectives within a given time.
The main steps of planning are:
1. formulation of objectives or goals;
2. fixing targets to be achieved and priorities of production of each sector of the
economy;
3. mobilisation of the financial and other resources required for the execution of
the plan;
4. creation of the necessary organisation or agency for execution of the plan; and
5. creating assessment machinery for assessing the progress made.

Forms of Planning

1. Authoritarian and Democratic Planning

In authoritarian planning, government is the sole centralised agency, which draws
the plan and implement it. It is more comprehensive, systematic, rigid and efficient. In
democratic planning, the plan is prepared by an expert body called planning
commission which is outside the government or the executive and is finally approved
by legislature which represents the people. It is based on the system of free
enterprise, but economic
activity outside the public sector is sought to be regulated and guided indirectly by
providing incentives for investment through fiscal and monetary policies.

2. Planning by Inducement and Planning by Direction

Planning by inducement is often referred to indicative planning. In this type of
planning, the planner either subsidises production or control prices, if it is intended to
increase the consumption of a commodity. The first acts on the supply side and the latter
on the demand side. Cheaper price is an inducement for the consumer and subsidy is an
inducement to the producer. This is planning through the market mechanism. The basic
idea is that the market controls the entrepreneur and the state can control the entrepreneur
by controlling the market. The state tries to manipulate the market by means of incentives
and inducements through price fixation, taxation and subsidies. The government seeks to
influence economic and investment decisions by offering incentives to entrepreneurs via
fiscal and monetary policies but does not control or regulate directly the functioning of
the economy. Thus, it is planning by persuasion rather than compulsion. There is
freedom of enterprise, freedom of production and consumption subject to some
regulation or control. However, there are writers who are not ready to consider the
indicative planning as planning in true sense as there can be no planning without direct
order or directions.
Planning by direction is very comprehensive. It covers the entire economy. There
is complete concentration of economic authority in the state. There is one authority,
which is in sole charge of planning, directing, and execution of the plan in accordance
with the pre-determined targets and priorities. Only planning by direction can guarantee
the success of the plan, otherwise the target would turn out to be mere pious wishes.
Planning by direction implies detailed instructions being given both to producers and
consumers. A list of all commodities to be produced with the quantity of each has to be
prepared.

3. Centralised and Decentralised Planning

Centralised planning is done from the top. Each citizen, producer or consumer has
simply to carry out the instructions or the job or duty assigned to him. The apex planning
body makes centralized plan. In India centralized plans are prepared by the Planning
Commission and approved by the parliament. Central authority executes the plan through
its subordinate staff. In case of decentralized planning, plan is prepared from the
grassroots level. For instance, each village panchayat may be asked to prepare a plan for
the economic development of the village and each industry may be asked to prepare its
own plan. Out of these plans, an integrated plan may then be evolved. Under Centralised
planning, the higher authority delegates the power to the lower governments or
lower bureaucracy to execute and implement plans at state, district or block level, while
under decentralized planning, power to make plan is devolved to lower level
government. The lower government works as a coordinate not subordinate to
higher government in decentralized planning.

4. Physical and Financial Planning

In physical planning, the planning authority has to work out how much land,
materials, capital equipment will be required to implement the plan and achieve the
targets set out for it. As stated in the Second Five-Year Plan, physical planning “is an
attempt to work out the implication of the development effort in terms of factor
allocation and product yields so as to maximise income and employment.’ It is
an input-output analysis. In physical planning, the planners have to determine not
only the amount of investment but also work out its composition in terms of the
various goods and services required to obtain a certain increase of output of product.
Thus in physical planning, we make an overall assessment of the available real resources
like raw materials, manpower, and capital equipment and devise ways and means to
mobilise them for achieving the targeted output. These targets are laid in physical
terms e.g. so many tons of steel, food grains, coal, etc.
In case of financial planning, the planners determine how much money will have
to be invested in order to achieve the pre-determined objectives or targets. Total outlay is
fixed in terms of money on the basis of growth rate to be achieved, the various targets of
production, estimates of the required quantity of consumer goods and the various
services, expenditure on the necessary infrastructure, etc., as well as revenue from
taxation, borrowings and savings. This money is then used to mobilise the required
resources. There has, thus, to be integration between physical and financial planning.

Objectives of Planning

♦ Achieving full employment

♦ Maximisation of National income and raising standard of living of common masses
♦ Rural industrialisation
♦ Self-sufficiency in food and raw materials
♦ Reduction of inequalities
♦ Reduction of regional imbalances

Concept of Stock and Flow

A measurement of quantity of any commodity or money or assets at a point of
time is called stock, while a measurement of quantity over a specific period of time is
called flow. Unlike stock that is not a function of time, a flow measures quantity passing
per minute, hour, day or whatever. A common analogy is to a reservoir. The water
entering and leaving the reservoir is a flow, but that water actually in the reservoir at any
one point of time is a stock. For example, income is a flow and wealth is a stock.
 Demand Analysis
Introduction:
Demand is one of the most critical economic decision variables. It reflects the size
and pattern of market. Business activity is always market-driven. The manufacturers’
inducement to invest in a given line of production depends on the size of market. In the
process of production, inputs are transformed into flows of output. Output, when sold in
the market, yields revenue. Inputs, to be obtained for the productive process, involve
costs. Profit is the difference between revenues and cost and it is influenced by the
demand-supply conditions for output and input. The demand for output and inputs, the
demand for firm and the industry, the demand by the consumer and the stockiest, and the
similar becomes therefore relevant for managerial decision making.

Concept of Demand
The demand for anything, at a given price, is the amount of it, which a person
desires to buy per unit of time at a given place. Demand, thus, has three important
elements. First, it is a desired quantity and the phrase quantity demanded is used for it.
Second, demand must be backed with enough money. So demand in economics is
effective demand. Thirdly, quantity demanded is a flow and not a stock.
The demand for a product implies (i) desire to acquire it, (ii) willingness to
pay for it and, (iii) ability to pay for it. All the three must be checked to identify and
establish demand. A beggar’s desire to stay in a five-star hotel and his willingness to
pay the bill is not demand because he lacks necessary money to pay the bill of the hotel.
It is merely his wishful thinking. Similarly, a miser’s desire for and ability to pay for a car
is not demand, as he does not have necessary willingness to par for a car. One may
come across a well- established person who possesses both the willingness and
ability to pay for higher education. But he has really no desire to have it; he pays the
fee for a regular course, and eventually does not attend his classes. Thus, in economic
sense, he does not have a demand for higher education (degree/diploma)
To sum up, the demand for a product is the desire for that product backed by
willingness as well as ability to pay for it. It is always defined with reference to a
particular time, place, price, and given values of other variables on which it depends.

Determinants of Demand

♦ Price of the product

♦ Price of other related goods
♦ Consumer income and wealth
♦ Distribution of income and wealth
♦ Size of population
♦ Taste, preferences and fashion
♦ Demonstration effect
♦ Advertisement expenditure
♦ Price expectation of the consumer
♦ Availability of credit facility to consumer
Thus demand of a commodity, say X, may be the function of the following variables:

Dx = f (Px, Py, Pz, Y, W, De, Di, A, E, T, P, C, µ)

Where:
Px = price of x commodity, Py = price of Y commodity (a substitutive commodity),
Pz, = price of z commodity (a complementary commodity), Y = Income of the consumer,
W = wealth of the consumer, De = demonstration effect, Di = distribution of income and
wealth in the society, A = advertisement expenditure, E = price expectation of the
consumer, T = taste, preferences and fashion, P = size of population, C = credit facility
available to consumer, and µ = disturbance term or error term

Demand Function
Demand, as a function of the above variables, becomes a very complicated
relationship. It would be difficult to formulate any demand theory. Therefore, we
presume that all variables, except the price of a commodity, which we are considering,
remain constant. Now we can state the relationship between the quantity demanded of
a commodity and its price.

Dx = f (Px)
In the slope and intercept form, the demand function may be stated as;

Dx = a - b Px

Law of Demand
The law of demand states: if other things remain the same, price of a
commodity and its demand have inverse relationship. If the price increases, its
demand decreases and vice versa.
When the demand-price relation is shown in the form of a table, it is called
demand schedule and when it is plotted on a graph, it is called demand curve. The
demand curve is downward slopping indicating the inverse relationship between the price
of the product and its demand.

A demand schedule for Sugar

Price per kg Quantity

(Rs.) demanded
(kg)
2 10
3 8
4 6
5 4
6 2
 In the above table, a hypothetical demand schedule, showing the range of prices
and the corresponding different quantities of the commodity a buyer will buy, is given.
The table shows inverse relationship between the price and quantity demanded.

Why does demand curve slope downward?

A demand curve normally slopes downward from northwest to southeast. There
are various reasons for it. First, when the price is reduced, new buyers of the commodity
enter the market. Second, when the price falls, the old consumers buy more of it because
of income and substitution effects. Third, the principle of different uses is also
responsible for the downward slope of demand curve. When the commodity is costly, it is
used only in more important uses but when the price falls, the commodity is also
demanded for less important uses. Lastly, the law of demand operates because of the
principles of different desires. People in a society are of different taste, habits, liking etc.
Some have stronger desires and others may have weak desire. When the price is higher
only those consumers who are of strong desires buy that commodity. When the price
falls, people with less strong desires also start buying the commodity.

Change in Demand and Change in Quantity Demanded

It is important to draw simple distinction between change in demand and change
in quantity demanded. The law of demand has reference to extension or contraction of
demand (change in quantity demanded) but the change in demand (increase or decrease
in demand) is associated with the change in other variable that affect the demand. When
there is a movement on the same demand curve due to change in the price of the product,
the quantity demanded of the product changes, which is called change in quantity
demanded. The movement of consumer from one demand curve to another due to
change in all other variables, except the price of the product, is known as change in
demand.

Exception of Law of Demand

1. Giffen Paradox
The law of demand is not applicable to Giffen goods i.e., inferior goods. All Giffen
goods are inferior goods but all inferior goods are not Giffen goods. In case of giffen
goods, when price of such good, say X, falls, the negative income effect is so
powerful to out-weight the positive substitution effect. When the price falls, a
consumer demands less. Therefore, the law of demand does not hold true in case of
these goods.
2. Conspicuous consumption
There are some goods, which are demanded by rich people only when they are
expensive. Rare paintings, diamond jewellery etc., fall in this category. The
consumption of these goods is known as conspicuous consumption.
3. Fear of future rise in prices
If it is believed that the price of a commodity is likely to be higher in the future than
at present, then even though the price has already risen, more quantity of the
commodity may be bought at the higher price by the consumer.
Types of Demand

1. Direct and Derived Demand

Direct demand refers to demand for goods meant for final consumption. It is the
demand for consumer goods. By contrast, derived demand refers to the demand for
goods which are needed for further production. Thus, demand for an input is a
derived demand.
2. Domestic and Industrial Demand
In case of certain industrial raw materials, which are also used for domestic purpose,
this distinction is very meaningful. The example of the refrigerator can be given to
distinguish between the demand for domestic consumption and demand for industrial
use.
3. Autonomous and Induced Demand
When the demand for a product is tied to the purchase of some parent product, its
demand is called induced demand. For example, demand for cement is induced by the
demand for housing. Thus, demand for all producers’ goods is induced demand. In
addition, even in the realm of consumer goods, we may think of induced demand.
Like complementary goods, bread and butter. Autonomous demand on the other hand
is not induced. Unless a product is totally independent of the use of other products, it
is difficult to talk about autonomous demand. In present world of dependence, there is
hardly any autonomous demand. No body consumes just a single commodity but a
bundle of commodities. Even then all direct demands may loosely be called
autonomous. In context of econometric estimates of demand, this distinction is used
to identify the determinants of demands. For example in Dx = a-bPx, “a” represents
the autonomous part which captures the effect of all non-price factors, whereas “b”
represents the induced part as Dx is induced by Px, given the size of “b”.

4. Perishable and Durable Goods Demand

Both consumers’ goods and producers’ goods are further classified into perishable/
non-durable/single use goods and durable/non-perishable/repeated use goods. The
former refers to final output like bread or raw material like cement which can be used
only once. The latter refers to items like shirt, car or machines which can be used
repeatedly.

5. New and Replacement Demand

If the purchase or acquisition of an item is meant as an addition to stock, it is
new demand. It the purchase of an item is meant for maintaining the old stock of
capital/ asset intact, it is replacement demand.

6. Final and Intermediate Demand

The demand for semi-finished products, industrial raw materials and similar
intermediate goods are all intermediate demands. The demand for goods that is made
by consumer for final consumption is final demand. Like demand for car is a final
demand while demand for steel by car industry is an intermediate demand.
 7. Individual and Market Demand
This distinction is often employed by the economist to study the size of buyers’
demand, individual as well as collective. A market is visited by different consumers,
consumer differences depending upon factors like income, sex etc. they all react
differently to the prevailing market price of a commodity. For example, when the
price is very high, a low -income buyer may not buy anything though a high-income
buyer may buy something. In case we distinguish between demand of an individual
buyer and that of market, which is the aggregate of individual demands.

8. Company (Firm) and Industry Demand

An industry is the aggregate of firms (companies). Thus, the company’s demand is
similar to an individual demand, whereas the industry’s demand is similar to the
aggregate total demand. Demand for engineers by automobile industry is an industry
demand, while demand for engineers by Hero Honda is company demand.
--------------------------------------------------------------------ts1-----------------------------------------------------------
Elasticity of Demand
Economists and businessmen often concerned with the responsiveness of one
variable to change in some other variable. The law of demand states that a change in
the price of a commodity causes a change in the quantity demanded. The change is in
the reverse direction. This inverse relationship indicated by the law of demand is a
qualitative one as it only indicates the direction in which the change would take place.
It does not provide us the precise information about the degree of change. The
concept of elasticity of demand explains degree of change in quantity demanded due
to change in price.
The concept of elasticity in economics is borrowed from physics. In physics, it is
supposed to show the reaction of one variable with respect to change in other
variables on which it is dependent. The elasticity may be defined as the percentage
change in some dependent variable given a one per cent change in independent
variables, ceteris paribus. There are as many elasticities of demand as its
determinants. The most important of these elasticities are: (1) price elasticity, (2)
income elasticity, and (3) cross elasticity.

Price Elasticity
It is a measure of the responsiveness of demand to changes in the commodity’s
own price. If the change in the price is very small, we use as a measure of the
responsiveness of the demand the point elasticity of demand. If the changes in the
price are not small we use the arc elasticity of demand as the relevant measure.

Ep = proportional change in demand / proportional change in price

Ep = - ∆Q/∆P. P/Q

Where:
Ep = price elasticity, p = initial price, Q = initial quantity demanded, and ∆ = change.

Three points must be noted at this stage:

 1. Price elasticity is a ratio of marginal demand (∆Q/∆P) to average demand (Q/P).
2. Elasticity is a unitless or dimensionless concept. It is just a pure number. Consider
the relative variation of the quantity ∆Q/Q. we can not alter the ratio simply by
changing the unit of measure as both the numerator and denominator are
expressed in the same unit. The same is true to ∆P/P.
3. The coefficient of elasticity is ordered according to absolute value as opposed to
algebraic value. Hence, an elasticity of –2 is greater than an elasticity of –1 even
though algebraically the opposite would be true.

Thus, ep = - ∆Q/∆P. P/Q

If demand curve is linear, then Q = a - bP

Its lope is ∆Q/∆P = -b, substituting it in the formula of elasticity, we get
ep = -b. P/Q, which implies that elasticity changes at the various points of demand
curve. Graphically, the point elasticity of linear demand curve is shown by the ratio of
the segment of the line to the right and to the left of the particular point.
Thus, ep = lower segment/ upper segment.
This formula is used when ep is measured at a particular point. When ep is measured
on an arc, the following formula would be used-

Ep = - ∆Q/∆P. (P1 + P2) / (Q1+Q2)

Where, P1 is initial price and P2 is new price and Q1 is initial quantity and Q2 is new
quantity.

Degrees of Price Elasticity of Demand

Following are the degrees of price elasticity of demand:

1. Perfectly elastic demand (ep = ∞)

2. Perfectly inelastic demand (ep = 0)
3. Highly elastic demand (ep > 1)
4. Unitary elastic demand (ep = 1)
5. Less elastic or inelastic demand (ep < 1)
A good or service is considered to be highly elastic if a slight change in price
leads to a sharp change in the quantity demanded. Usually these kinds of products are
readily available in the market and a person may not necessarily need them in his or her
daily life. On the other hand, an inelastic good or service is one whose changes in price
witness only modest changes in the quantity demanded, if any at all. These goods tend to
be things that are more of a necessity to the consumer in his or her daily life.
Interpretation of Elasticity Coefficients
The sign of the coefficient shows the directional change. The negative sign shows
inverse relationship between the price and the quantity demanded. As already stated, for
interpretation point of view, coefficient value is considered in absolute figure. The
interpretation of ep = -1.5 would be that a 1 percent increase in price would lead to a
1.5% decline in quantity demanded. Or if the price falls by 1 percent, quantity demanded
would increase by 1.5%. If the elasticity coefficient is less than one, the demand is less
elastic or inelastic. If it is equal to one, demand is unitary elastic. If ep > one, the demand
is more elastic. On the basis of estimated coefficient of price elasticity, nature of a
commodity or a service can be identified. For instance, if a commodity is price-inelastic,
it would be an essential commodity. For luxury products, ep would be greater than one.
Measurement of Price Elasticity of Demand

1. Total Outlay Method

This method to measure the elasticity of demand was used by Marshall. In this
method we compare the change in the total expenditure incurred by a consumer before
and after the variation in price. The elasticity of demand is expressed in ways: (i) unity;
(ii) greater than unity; and (iii) less than unity. Elasticity is considered unity when the
total expenditure remains the same even after a change in price. Elasticity of demand is
said to be greater than unity when with the fall in price the expenditure increases or as the
price increases, the expenditure falls. Elasticity is considered to be less than unity when
the amount spent increases with the rise in price and decreases with the fall in price.
These three categories of elasticity have been shown in the following table.

Case Price Demand Total Outlay Elasticity

No. (Px in Rs.) (Qx in Unit) (Px.Qx in Rs.) (ep)

1 10 4 40 ep > 1
5 12 60
2 10 4 40 ep = 1
5 8 40
3 10 4 40 ep < 1
5 6 30

2. Geometrical Method
When elasticity is measured at a point on a demand curve, it is called point
elasticity. It is measured at the point by the ratio of the lower part of the linear
demand curve to the upper part. If demand curve is non-linear, a tangent is to be
drawn at the point on demand curve where elasticity is to be measured. Then, Ep is
measured by dividing the lower segment of the tangent line from its upper segment.

3. Percentage Method
When calculating elasticity of demand with the help of percentage method, we
compare percentage change in quantity to the percentage change in price. The
elasticity, according to this method, is the percentage change in the quantity
demanded to the percentage change in the price changed. Thus, the price
elasticity becomes ratio of a relative change in the quantity to a relative change in
price.

Ep = -∆Q/∆P. P/Q
4. Arc Method
The measurement of price elasticity of demand between any two points on a
demand curve is known as arc elasticity. When elasticity is to be measured not on a
point but on an arc, instead of initial price and initial quantity, average of both the
prices and both the quantities is considered.

Ep = -∆Q/∆P. (P1 + P2) / (Q1+Q2)

Determinants of Price Elasticity

1. Availability of substitutes
If the commodity has many close substitutes, its demand will be highly price-
elastic. The reason is that if the price of such a commodity goes up, consumers will
start consuming other substitutable goods.

2. Nature of Goods
Ep also depends on the nature of goods. Essential goods have inelastic or
relatively less elastic demand, while luxury products have relatively more elastic
demand.

3. Position of a commodity in the budget

Budget position means the fraction of total expenditure devoted to a single
commodity. The elasticity of a commodity on which a small percentage of income is
spent is relatively lower.

4. Number of uses of a commodity

The more uses a commodity can be put to, the more elastic its demand would be.
If the price of such a commodity increases, consumers will use it only in a few
applications.
5. Postponement of Use
The goods the purchase and use of which can be deferred have a high elastic
demand. When price has risen and demand cannot be postpone, that will make
demand less responsive to price rise than when demand can be postpone.

6. Price expectation of Buyers

When the price of a product has fallen and the buyers expect it to fall further, then
they will postpone buying the good and this will make demand less responsive.

7. Time factor in adjustment of consumption pattern

In short run, it is difficult to change habits. Hence, the short run demand is less
responsive to price change. The longer the time allowed for making adjustment in
consumption pattern, the greater will be the elasticity.
 Income Elasticity of Demand
Income elasticity of demand measures the degree of responsiveness of quantity
demanded of a commodity with respect to the change in the level of income of a
consumer, other things remaining constant.

Ei = ∆Q/∆Y. Y/Q

Where:
Ei = income elasticity, Y =initial income, Q = initial quantity demanded, and ∆ =
change.

If income elasticity is to be measured on an arc, average of both incomes and both

the quantities will be considered in place of initial income and initial quantity.

Ei = ∆Q/∆Y. Y1+Y2/Q1+Q2

Unlike Ep which is always negative, Ei is generally positive. However, in case of

inferior and Giffen goods, it is negative. The reason is that when income increases,
consumers switch over to the consumption of superior substitutes. For all normal goods,
Ei is positive though the degree of elasticity varies in accordance with the nature of
commodities. Consumer goods of three categories, viz., necessities, comforts and luxury
have Ei less than one, equal to one, and more than one, respectively. The income
elasticity of demand for different categories of goods may, however, vary from household
to household and from time to time, depending upon the choice and preference of the
consumers, level of consumption and income, and their susceptibility to demonstration
effect.
Understanding of Income elasticity of demand is significant in production
planning and management in the long run. It is useful in demand forecasting. It is
generally believed that the demand for goods and services increases with the increase in
GNP depending on the marginal propensity to consume. This may be true in the context
of aggregate demand, but not necessary for a particular product. It is quite likely that
increase in GNP flows to a section of consumers who do not, or are not in a position to
consume the product in which a businessman is interested. For instance, if the major
proportion of increased GNP goes to those who can afford a car, the growth rate of GNP
can not be used to calculate income elasticity of demand for motorcycles.

Cross Elasticity of Demand

The cross elasticity is the measure of responsiveness of demand for a commodity
to the changes in the price of its substitutes or complementary goods.

Ec = ∆Qx /∆Py. Py/Qx

Where:
Ec = cross elasticity, Qx = initial quantity of x commodity, Py = initial price of y
commodity, ∆ = change.
If Ec is to be measured on an arc, above formula is modified as:
 Ec = ∆Qx /∆Py . Py1+ Py2 / Qx1+Qx2

Sign of Ec will be negative in case of complementary goods and positive in case of

substitutive goods. An important use of Ec is to identify the extent of substitutability
between the two goods. Its coefficient helps the businessman in fixing the price of its
product. If Ec of a product is greater than 1, it would not be advisable to increase the price;
rather reducing the price may prove beneficial. In case of complementary goods, demand
projection can be made by calculating the Ec. For instance, if elasticity of demand for car
with respect to price of petrol is greater than one, it would suggest that the company has to
invest more on R&D to make the car model more fuel-efficient to enhancing the demand.

Practical Uses of Elasticity

The concept is useful to both business as well as government managers. It helps
the sales manager in fixing the price of his product. The concept is also important to the
economic planners of the country. In trying to fix the production targets for various goods
in a plan, a planner must estimate the likely demand for goods at the end of the plan. This
requires the understanding of income elasticity of demand.
The price elasticity of demand as well as cross elasticity of demand would
determine the substitution between goods and hence useful in fixing the output-mix. The
concept is also useful to policy makers in particular determining taxation policy, minimum
wage policy, stabilization programmes for agriculture and price policy for various other
goods where administered prices are used. The main uses of the concept are:

1. In taxation
2. In Monopoly Price
3. In International trade
4. In Production
5. In Distribution
 Production

Production in economics is generally understood as the transformation of inputs into

outputs. The inputs are what a firm buys (i.e, productive resources) and outputs (i.e,
goods and services produced) what it sells. Apart from physical changes of the matter,
production also includes services like buying and selling, transporting and financing. But
in economic analysis, we restrict the use of term ‘production’ to the production of goods
only because in the production of goods we can precisely specify the inputs and also
identify the quantity and quality of outputs.

Production is sometimes defined as creation of utility or the creation of want-satisfying

goods. It is said that just as man cannot destroy matter, he cannot create matter, what he
can do is to give it utility. Consumption means extracting utility from the matter,
production means putting utility into it. But this is not a scientifically correct definition.
To produce a thing which has utility but not value is not production in economic sense.
Production, therefore, should be defined, not as creation of utility but creation or
addition of value.
The utility and value can be created by changing: (i) the form of matter, (ii) place of
matter, (iii) and the time of matter.

Production Function

Production function may be defined as the functional relationship between physical

inputs and physical outputs. It describes technology, not economic behavior. It refers to a
flow of inputs resulting into a flow of outputs over a period of time, leaving prices aside.
The production function shows the maximum quantity of output that can be produced
from a given set of inputs in the existing state of technology. A production function for a
good y can be shown in the general form as:

y = ƒ(x1, x2, ..., xm)

Which relates a single output y to a series of factors of production x1, x2, ..., xm. Note that
in writing production functions in this form, we are excluding joint production, i.e. that a
particular process of production yields more than one output (e.g. the production of wheat
grain often yields a co-product, straw.

For understanding the nature of production function, the following points may be
considered:

1. The production function represents purely a technical relationship between

physical quantities of inputs and outputs.
2. The output is the result of a joint use of factors of production. It is obvious that
the physical production of one factor can be measured only in context of this
factor being used in conjunction with other factors.
 3. The nature or the quantity of the various factors and the manner in which they are
combined will depend upon the state of technological knowledge. For example,
labour productivity will depend on the quantity of labour as determined by their
education and training. Similarly, the productivity of machines will be determined
by the technical advances embodied in them. Thus, the state of technology is
treated as given for specifying the production function. A change in technology
will mean a shift to another production function. Improvement in technology will
result in a larger output from a given combination of factors of production.
4. In specifying the production function of a firm, we have to take into account the
variability of the factors and also whether they are divisible or indivisible. These
features of the factors determine their physical productivities and hence the nature
of the production.
5. The production function may be short run and long run according to the time
period. In the short run, all the factors cannot be raised in the same proportion
because in the short run, some of inputs may be fixed in supply. Their supply
cannot be enhanced. So when, we study the short run production function, we
have to keep some of the inputs constant and some variable. Hence, when
quantity of a factor of production is augmented, keeping the quantity of other
factors constant, we get the laws of returns. In the long run, quantity of all the
factors of production can be increased in the same proportion or in a different
proportion. In the long run, study laws of returns to scale.

Law of Variable Proportions

There are three laws of returns known to economists, the law of increasing,
constant and decreasing returns. There is said to be increasing, decreasing or constant
returns according as the marginal return rises, falls or remains unchanged as the quantity
of a factor of production is increased. In terms of cost, an industry is subject to
increasing, decreasing or constant returns according as the marginal cost of production
falls, rises or remains the same with the increase in the quantity of a variable factor.
Modern economists consider these three laws only the three stages of one law,
i.e., law of variable proportion.
The law of variable proportion occupies a very important place in economic
theory. It describes the production function with one variable factor while quantities of
other factors are held constant. It describes the input-output relation in a situation when
output is increased by increasing the quantity of one factor, keeping the quantity of other
inputs constant. When the quantity of one factor is increased, keeping the quantities of
other factors constant, naturally the proportion between the variable factor and fixed
factors altered, i.e., the ratio of the variable factor to that of fixed factors goes on
increasing with the successive increase in the quantity of variable factor.

According to Stigler, “ As equal increments of one input are added, the inputs of other
productive services being held constant, beyond a certain point the result in increment of
product will decrease, i.e., the marginal product will diminish”.
According to Benham, “As the proportion of one factor in the combination of factors is
increased, after a point, first the marginal and then the average product of that factor
will diminish”.

Assumptions of the Law

1. State of technology is assumed to be constant.
2. Some inputs are held constant.
3. Proportion of inputs is assumed changeable.

In order to study the law, three terms must be properly understood. They are:

Total Product: The total quantity produced during some period of time by all the factors
of production that the firm uses. If the inputs of all but one factor are held constant, the
total output (TP) will change as more or less of the variable factor is used. This variation
is shown in the table.

Average Product: It is merely the total product per unit of variable factor, which is
labour in the present case.

APL = TP / L

Marginal Product: It is the change in total product resulting from the use of one more
(or one less) unit of the variable factor. MP refers to the rate at which output is tending to
vary as input varies at a particular output. It is the partial derivative of the TP with respect
to variable factor.

MPL = ∆TP /∆L (in case of discrete variable) and MPL = ∂TP/∂L (In case of continuous
variable).

Statement of Law

The law can be explained with the help of following table

Labour TP (Unit) APL (Unit) MPL (Unit)

Unit
0 0 0 0
1 14 14 14
2 52 26 38
3 108 36 56
4 176 44 68
5 250 50 74
6 324 54 74
7 392 56 68
8 448 56 56
9 486 54 68
10 500 50 14
 11 484 44 -16
12 432 36 -52
13 338 26 -94
14 196 14 -142

First stage is up to 8th unit of labour; second stage starts from the point where average
product is equal to marginal products and ends when marginal products becomes zero (8-
10 unit of labour); and third stage is the stage of negative marginal product (after 10th unit
of labour).

Figure 1 – Law of variable proportion

This graph shows three stages of production—increasing AP; decreasing AP while MP is

positive; and negative MP. Stage first is inefficient because the addition of an extra unit
of labour results in an increase in the AP of all labour units employed. A DMU should
never produce where APL is rising since this implies that it could increase APL by
employing more labour. It should produce somewhere in the second stage.

Uses of the Law

Besides agriculture, the law also applies to other fields of economic activities such as
manufacturing.

Reasons for application of the Law

1. Wrong combinations
2. Scarcity of factors
3. Imperfect substitutes of factors

RETURNS TO SCALE (RTS)

The law of variable proportion states that as more and more of the variable input is added
to the fixed factor base, the increment to the total output after some point will decline
progressively with each additional unit of variable factor. This law is applicable in the
short run. Under returns to scale, the behaviour of output is studied when all factors of
production are changed in the same direction and in the same proportion. RTS is a long
run concept. In the long run, output may be increased by changing all the factors by the
same proportion or by different proportion. Traditional theory of production concentrates
on the first case and assumes the homogeneity of production function.

Suppose we start from an initial level of inputs and output

Q0 = f (L, K) and we increase both the inputs by the same proportion λ, we will
obtain a new level of output Q1 higher than the original level Q0 .

Q1 = f (λL, λK)

If Q1 increases by the same proportion λ as the inputs, we say that there are constant
returns to scale (CRTS). If Q1 increases less than proportionally with the increase in the
inputs, we have decreasing returns to scale (DRTS). If Q1 increases more than
proportionally with the increase in the inputs, we have increasing returns to scale (IRTS).

RTS are measured mathematically by the coefficients of the production function. For
example, above simple function can be converted into mathematical as:

Q0 = a Lb1 K b2

Let L and K be increased λ time. The new level of output is

Q1 = a (λL)b1 (λK) b2

Q1 = (a Lb1 K b2) λb1+b2

 Q1 =λb1+b2Y0
If b1+b2 = v, then

Q1 =λvY0

If v = 1, Constant RTS, v> 1, Increasing RTS; and v< 1, Decreasing RTS.

Here v is total elasticity of production, indicating how much output is responsive to

change in the total inputs.

From Q = a Lb1 K b2 , Isoquants (Equal product curve) can be drawn. If Q = a Lb1

b2
K is written in terms of L with Q held constant, combinations of L and K producing
that level of Q can be derived.

L = (a-1QK-b2)1/b1

Thus, given level of Q can be produced by using different combination of L and

K. A family of isoquants can be derived by specifying alternative, constant levels of Q
and solving for the value of L, consistent with each value of K. These isoquants are
shown in the figure below.

A map of isoquants

Figure-2

The slope at each point on an isoquant represents the rate at which L must be
substituted for K to maintain output at the constant level. The slope of isoquant is known
as the marginal rate of technical substitution (MRTS). It reflects the rate at which
labour can be substituted for capital, while holding output constant. It is equal to the ratio
of marginal product of labour to the marginal product of capital. MRTSLK declines as
more labour is substituted for capital.

MRTSLK = (∂Q/∂L) / (∂Q/∂K) = (b1/b2). (K/L)

Where ∂Q/∂L is the marginal product of labour and ∂Q/∂K is the marginal product
of capital.

Level of Optimum Input-use

Optimum combination of labour and capital to produce a given level of output
will be at the point where the isoquant is tangent to the factor price line. It means that the
slope of isoquant should be equal to the slope of factor price line. That is:

MRTSLK = (∂Q/∂L) / (∂Q/∂K = PL / P K

Point a, b and c in the graph below show the optimum combination of L and K under
different investment constraints. Line from the origin going through these equilibrium
points is known as expansion path or scale line or production line. This line is a
straight line, indicating that production function is homogeneous. The product lines
describe the technically possible alternative paths of expanding output. What path will be
chosen by a firm,
will depend on the
prices of labour
and capital.

Optimum
combinations of
Labour and
Capital
The above stated returns to scale can be described by isoquants and factor price lines.

Increasing returns to scale

If the output more than doubles when inputs are doubled, there are increasing returns to
scale. The prospect of increasing returns to scale is an important issue from a public
policy perspective. If there are IRTS, then it is economically advantageous to have one
large firm producing (at relatively low cost) rather than to have many small firms (at
relatively high
cost). Because this
large firm can
control price that
it sets, it may need
to be regulated.

Capital

labour

Increasing Returns to Scale

Constant returns to scale

A second possibility with respect to scale of production is that output may double when

inputs are doubled. In this case we say there are CRTS. With CRTS, the size of the firm’s
operation does not affect the productivity of its factors—one plant using a particular
production process can easily be replicated, so that two plants produce twice as much
output.

Constant Returns to Scale

Decreasing returns to scale

Finally output may less than doubles when all inputs double. The case of DRTS applies
to some firms with large-scale operations. Eventually, difficulties in organizing and
running at large-scale operations may lead to decreased productivity of both labour and
capital. Thus, the DRTS case is likely to be associated with the problems of coordinating
tasks and maintain a useful line of communication between management and workers.
 Decreasing returns to
Scale

Causes of increasing returns to scale

The IRTS are due to technical and/ or managerial indivisibilities. Usually most processes
can be duplicated but it may not be possible to halve them. One of the basic
characteristics of advanced industrial technology is the existence of mass production
methods over large sections of manufacturing industry. ‘Mass Production methods, such
as the assembly line in the car industry, are processes are available only when the level of
output is large. They are more efficient than the best available process for producing
small levels of output. Assume that we have three processes:

Labour (L) capital (K)

output (Q)

A. Small Scale process

01
01
01

B. Medium Scale
Process 50
50
100

C. Large Scale Process

100
100
400
The K/L ratio is the same for all the processes and each process can be duplicated (but
not halve). The large scale processes are technically more productive than small scale
process. The indivisibility will tend to lead to IRTS.

Thus, specialization, division of labour, and some physical laws are the major factors in
explaining the IRTS.

Causes of decreasing returns to scale

The most common causes are ‘diminishing returns to management. As size of operation
increased, top management eventually becomes overburdened and less efficient in its role
as coordinator and ultimate decision-maker. Another cause for DRTS may be found in
exhaustible natural resources. For example, doubling the fishing fleet may not lead to a
doubling of the catch of fishes as fishes may exhaust in the sea or pond area.
 Inflation

Inflation means a steady and sustained rise in the general level of price. There are as
many prices as the number of goods and services. All these individual prices are
combined into one, which is called general (macro) price that is the price of a unit of all
goods and services. This general price is obtained as a weighted average of individual
goods prices.

Pt = Σ wi pit
Where Pi = general price in period t, Pit = price of good I in period t, wi = weight of good
i, n = number of goods and services in the economy.

wi >= 0 and Σwi = 1

The weight for the various component items are determined by the relative significance
of that item in all the items during the base period.

wi = Qi0Pi0 / ΣQi0Pi0
Where Qi0 & Pi0 are the quality and price of the good I in the base period.

Sector Weight, wi in base year 1981-82 Weight, wi in base year 1993-94

Primary 32.295 22.025
Food 17.385 15.402
Energy 10.663 14.226
Manufacturing 57.042 63.749

PIt = Σ wi (Pit/Pi0)

PIt = Σ (Qi0Pi0 / ΣQi0Pi0) (Pit/Pi0)

Now, inflation means the rate of change in this index experienced in percentages. Thus
inflation rate in the period t (Pt) over the previous period is given by

Rate of inflation = (PIt - PI(t-1)) X 100

There are 5 price index series in India.
1. GDP deflator: This includes only the final goods
2. WPI: This has a flaw as it does not includes the price of services
3. CPI for industrial workers
4. CPI for urban non-manual employees
5. CPI for agricultural labourer
In CPI we exclude price of capital and intermediate goods and include price of services
WPI is used to measure the official rate of inflation in the country. It is also used for the
indexation of the capital gains for the purpose of computing the tax liability on the capital
gains.