SUBJECT NAME: ECONOMICAL ANALYSIS FOR BUSINESS

CODE: 10488MB103
STAFF NAME: JAYA SURIYAA.K, NPRCET102
DEPARTMENT: MBA

UNIT I INTRODUCTION
The themes of economics scarcity and efficiency three fundamental
economic problems societys capability Production possibility fronties
(PPF) Productive efficiency Vs economic efficiency economic growth &
stability Micro economies and Macro economies the role of markets and
government Positive Vs negative externalities.

UNIT II CONSUMER AND PRODUCER BEHAVIOUR

Market Demand and Supply Determinants Market equilibrium
elasticity of demand and supply consumer behaviour consumer
equilibrium Approaches to consumer behaviour Production Short-run
and long-run Production Function Returns to scale economies Vs
diseconomies of scale Analysis of cost Short-run and long-run cost
function Relation between Production and cost function.

UNIT III PRODUCT AND FACTOR MARKET

Product market perfect and imperfect market different market structures
Firms equilibrium and supply Market efficiency Economic costs of
imperfect competition factor market Land, Labour and capital Demand
and supply determination of factor price Interaction of product and factor
market General equilibrium and efficiency of competitive markets.

UNIT IV PERFORMANCE OF AN ECONOMY MACRO ECONOMICS

Macro-economic aggregates circular flow of macroeconomic activity
National income determination Aggregate demand and supply
Macroeconomic equilibrium Components of aggregate demand and national
income multiplier effect Demand side management Fiscal policy in
theory.

UNIT V AGGREGATE SUPPLY AND THE ROLE OF MONEY

Short-run and Long-run supply curve Unemployment and its impact
Okuns law Inflation and the impact reasons for inflation Demand Vs
Supply factors Inflation Vs Unemployement tradeoff Phillips curve shortrun and long-run Supply side Policy and management- Money marketDemand and supply of money money-market equilibrium and national
income the role of monetary policy.

TOTAL: 60 PERIODS

TEXT BOOKS
1. Paul A. Samuelson and William D. Nordhaus, Economics, 18th edition,
Tata McGraw Hill, 2005.

References
1. William Boyes and Michael Melvin, Textbook of economics, Biztantra,
2005.
2. N. Gregory Mankiw, Principles of Economics, 3rd edition, Thomson
learning, New Delhi, 2007.
3. Richard Lipsey and Alee Charystal, Economics, 11th edition, Oxford
University Press, New
Delhi, 2008.
4. Karl E. Case and Ray C. fair, Principles of Economics, 6th edition, Pearson
Education Asia, New
Delhi, 2002.

UNIT I INTRODUCTION
The themes of economics scarcity and efficiency three fundamental
economic problems societys capability Production possibility fronties
(PPF) Productive efficiency Vs economic efficiency economic growth &
stability Micro economies and Macro economies the role of markets and
government Positive Vs negative externalities.
ECONOMICS
Economics is the study of how economic agents or societies choose to use scarce
productive resources that have alternative uses to satisfy wants which are unlimited and
of varying degrees of importance.
The main concern of economics is economic problem: its identification, description,
explanation and solution, if possible. The source of any economic problem is scarcity.
Scarcity of resources forces economic agents to choose among alternatives. Therefore,
economic problem can be said to be a problem of choice and valuation of alternatives.
The problem of choice arises because limited resources with alternative uses are to be
utilized to satisfy unlimited wants, which are of varying degrees of importance. Had the
resources like human, natural, capital, etc. not been scarce, there would have been no
problem of choice and hence no economic problem at all. Therefore, the root cause of
all economic problems is scarcity.
Scarcity is a relative concept. It can be defined as excess demand i.e., demand more
than the supply. For example, unemployment is essentially the scarcity of jobs.
Inflation is essentially scarcity of goods.
The job of any manager is of economic one. Decision-making is the main job of
management. Decision-making involves evaluating various alternatives and
choosing the best among them. Consider a manager in any function at any level in
an organization: he exercises choice in the name of decision-making. A finance
manager is expected to mobilize resources from various sources so as to minimize
the cost of funds and deploy these resources so as to maximize the return on
investment. A marketing manager is to allocate his advertising budget among
various media in such a way so as to maximize the reach.
The nature of an economic system depends on how the above questions are resolved
and who co-ordinates the decisions of millions of economic agents. At the two extremes
are the Market and Command Economies. In between lies the widely prevalent Mixed
Economy, which is a mix of command and market economies.

In a Market Economy, market mechanism co-ordinates on the economic Decisionmaking of various economic agents. It helps the economic system decide what to
produce, how to produce and for whom. Consumer demand determines what to produce,
competition forces the firms to decide how to produce most economically and factor
ownership and factor prices determine the purchasing power of individuals i.e., for whom
to produce.
Market Economy
In a market economy, demand determines what goods and services are to be
produced and how much of each good and service to be produced. Consumers are
assumed to act in a rational manner so as to maximize their economic welfare. They
spend their income on various products in such a way so as to maximize their
economic welfare.
Given the demand, firms decide how to produce the required goods and services in a
most efficient manner so as to maximize their profits. This results in optimum
allocation of scarce resources. The last question i.e., how the goods and services are
distributed is resolved by the ownership pattern of factor inputs and factor prices.
In the market economy described above, prices assume significance in allocation of
resources and determining factor prices.
Suppose consumer tastes change in favor of product A. In maximizing their welfare
consumer demand for product A goes up. Given the supply, this results in an
increased price for product A. This induces the firms to produce more of product A
so as to maximize their profits. To increase the supply of product A more factor
inputs are required for producing product A i.e., increase in demand for factor inputs

used for producing product A. Hence prices of factor inputs used for producing A also
increase. This causes the redistribution of income in favor of the factor inputs used
for producing product A. This way price assumes significance by providing signals
and incentives to the economic agents and co-ordinates their decisions in a market
economy.
Adam Smith proclaimed that through the functioning of the invisible hand, those
who pursue their own self-interest in a competitive economy would most effectively
promote the public interest. The tendency of the market prices to direct individuals
pursuing their own interests into productive activities that also promote the
economic well being of the society, is referred to as the invisible hand principle. It
has been proved that under restrictive assumptions, a perfectly competitive economy
is efficient. It should be noted that an economy is said to be producing efficiently
when it cannot increase the economic welfare of anyone without making someone
else worse off. According to Adam Smith, under perfect competition and with no
market failures, markets will squeeze as many useful goods and services out of the
available resources as possible. However, where monopolies or other sorts of market
imperfections or market failures become pervasive, the remarkable efficiency
properties of the invisible hand may be destroyed.
Command Economy
Rationale
A command mechanism is a method of determining what, how, when, where and for
whom goods and services are produced, using a hierarchical organization structure in
which people carry out the instructions given to them. The best example of a
hierarchical organization structure is the military. Commanders make decisions
requiring actions that are passed down a chain of command. Soldiers and mariners on
the front line take the actions they are ordered.
The economic system that prevailed in the former Soviet Union and the former
communist nations of Eastern Europe was called a command economy because under
that system central planning authorities determined resource allocation, production
goals, and prices. A command economy differs from a market economy in two
important ways:
firstly, in a command economy the state owns all the productive resources, like
land, factories, financial institutions, retail stores, and the bulk of the housing
stock. Government enterprise and government ownership of resources are the
rule rather than the exception in a command economy.
secondly, in a command economy, authoritarian methods are used to determine
resource use and prices.
A centrally planned economy is one in which politically appointed committees plan
production by setting target outputs for factory and enterprise managers and in general
manager the economy to achieve political objectives.
Mixed Economy

An economy that uses a market co-ordinating mechanism is called a market economy.

However, most of the real world economies use both markets and commands to coordinate economic activity. An economy that relies on both markets and command
mechanism is called a mixed economy.
In most modern nations, governments control many resources, and criteria other than
personal gain and business profit are used to decide how resources will be employed.
Most of modern nations have a mixed economy, where governments as well as business
firms provide goods and services. In such economies government supplies roads,
defense, pensions, and sometimes even schooling directly to the citizens. In modern
economies, governments also commonly intervene in the markets to control prices and
correct the shortcomings of a system in which prices and the pursuit of personal gain
influence resource use and incomes.

ECONOMIC ROLE OF THE GOVERNMENT

In figure 1.2 we see how the government fits into the circular flow of expenditure and
income. Governments participate in input markets by purchasing labor services and
other productive resources.
Government borrows funds from credit markets when their expenditures exceed their
tax revenues. Governments also participate in product markets to purchase the output of
business firms. They purchase such goods as paper, aircraft, and machinery, and they
contract with construction firms to build roads and structures.
The vertical arrows in figure 1.2 show how governments participate in markets and
provide income to workers, resource owners, and business firms. The horizontal arrows
show how governments tax households and businesses to obtain the funds necessary to
purchase products and hire input services. The inputs and products are used to provide
government goods and services that benefit both households and business firms.
Governments provide national defense, education, police and fire protection, and a host
of other services to the public at no direct charge. Most government goods and services
are not sold by the unit in the markets. Instead, governments make their goods and
services available freely as public goods or establish criteria for the eligibility of
individuals to obtain certain services.
By bidding for resources, providing income support to the elderly, the poor, and
veterans, subsidizing certain activities, and taxing business and households,
governments influence market demand and affect prices. Thus, in the mixed economy
governments, as well as households and business firms, influence resource allocation.
Figure 1.2: Government and the Economy

In a mixed economy governments compete in input markets and product markets to

obtain the resources and products they need to supply goods and services. Governments
obtain funds to finance their operations by taxing households and business firms and by
borrowing in credit markets. Governments use some of their revenues to provide income
support to the elderly, the poor and other groups and also to subsidize some business
firms. Apart from these general Government functions, government also participates in
the production process along with business firms and in both product and input markets
in the form of Public Sector Enterprises.
OPPORTUNITY COST
Economics deals with choosing one alternative among various alternatives. Before
choosing a particular alternative you rank all the alternatives based on their priority and
then choose the alternative, which is on the top of the priority list. This choice implies
sacrificing the other alternatives. The cost of this choice can be evaluated in terms of the

sacrificed alternatives. If this alternative was not chosen then you could have chosen the
alternative, which is second on the priority list. Therefore, the cost of this particular
choice is the benefit of the next best alternative foregone. This is called Opportunity Cost.
Therefore, opportunity cost is the highest valued benefit that must be sacrificed as a result
of choosing an alternative.
Suppose a machine can produce either X or Y. The opportunity cost of producing a
given quantity of X is the quantity of Y, which the resource would have produced. If that
machine can produce 10 units of X or 20 units of Y, then the opportunity cost of 1X is
2Y. Suppose we have no information about quantities produced, but have information
about their prices. Then the opportunity cost is the ratio of their respective prices.
However, partial equilibrium analysis is not useful and relevant to apply when there is
interrelationship between commodities or between factors. Thus when markets for
various commodities and factors are interdependent, that is, when changes in the price
of a commodity or a factor have important repercussions on the demand for other
commodities or factors, partial equilibrium analysis would not yield correct results. In
such cases, when there is significant interrelationship between various markets or that
the changes in one market would significantly affect the others, we should employ
general equilibrium analysis, which considers simultaneous equilibrium of all the
markets taking into account all effects of changes in price in one market over others.
It may be mentioned that both types of equilibrium analysis are useful, each being
valuable in its own way. Partial equilibrium analysis is useful when the changes in
conditions in one market have negligible repercussions on the other markets. When the
changes in conditions in one market have significant effect on the other markets,
general equilibrium analysis should be used.
When we look at the economic system as a whole, there is a greater deal of
interrelationship and interdependence among various markets for commodities and
factors and there are a large number of Decision-making agents consumers, producers,
workers and other resource owners. All these agents are self-interested and would
behave to maximize their goals; consumers would maximize their utility, and producers
would maximize their profits. The general equilibrium would occur when markets for
all commodities and factors and all Decision-making agents consumers, producers,
resource owners are simultaneously in equilibrium.
To sum up, partial equilibrium analysis focuses on explaining the determination of price
and quantity in a given product or factor market when one market is viewed as
independent of other markets. On the other hand, general equilibrium analysis deals
with explaining simultaneous equilibrium in all markets when prices and quantities of
all products and factors are considered as variables. Thus in general equilibrium
analysis, inter-relationship among markets of all products and factors are explicitly
taken into account.
Figure 1.3 depicts the general structure of a general equilibrium. The outer loop
shows the demands and supplies of all goods and factors. Here, we speak of not a
single good or factor but of all different products which are made of a vast array of
factors of production.

Figure 1.3

Inputs, Production, Outputs, and Consumption Form the Circular Flow of Economic
Life
The general equilibrium of an economy links together the supplies and demands of a
vast number of factors and products. Observe how profit-maximizing firms and utilitymaximizing households interact in product markets at A and in factor markets at E.
Also, note that the flow of money inside the circular flow moves in the opposite
direction from the flow of goods and factors.
Each good or factor is exchanged in a market, and the equilibrium of supply and
demand determines the price and quantity of the item. Note that the upper loop carries
the supplies and demands for products, while the lower loop matches it with the
supplies and demands for factors of production. Households buy their consumption
goods with the incomes they earn from the factors they supply. Similarly, businesses
buy factors and supply products, paying out factor incomes and profits with the
revenues from the products that businesses sell.
Three fundamental economic problems:
the fundamental economic problem is how to allocate scare resources amoung unlimited
wants, there are three questions that we have to answer they are
What to produce? - this refers to the types of goods & services should be produced &
their
quantities
How to produce?
- this refers to the method of production

whom to produce? - this refers to the national problem of how the national output
should be distributed amoung the population
Production-possibility frontier
In economics, a production-possibility frontier (PPF), sometimes called a productionpossibility curve or product transformation curve, is a graph that shows the different rates
of production of two goods and/or services that an economy can produce efficiently
during a specified period of time with a limited quantity of productive resources, or
factors of production. The PPF shows the maximum amount of one commodity that can
be obtained for any specified production level of the other commodity (or composite of
all other commodities), given the society's technology and the amount of factors of
production available.
Though they are normally drawn as concave (bulging out) from the origin, PPFs can also
be represented as linear (straight) or bulging in toward the origin, depending on a number
of factors. A PPF can be used to represent a number of economic concepts, such as
scarcity of resources (i.e., the fundamental economic problem all societies face),
opportunity cost (or marginal rate of transformation), productive efficiency, allocative
efficiency, and economies of scale. In addition, an outward shift of the PPF results from
growth of the availability of inputs such as physical capital or labor, or technological
progress in our knowledge of how to transform inputs into outputs. Such a shift allows
economic growth of an economy already operating at full capacity (on the PPF), which
means that more of both outputs can be produced during the specified period of time
without reducing the output of either good. Conversely, the PPF will shift inward if the
labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases
the stock of physical capital. However, most economic contractions reflect not that less
can be produced, but that the economy has started operating below the frontiertypically
both labor and physical capital are underemployed. The combination represented by the
point on the PPF where an economy operates shows the priorities or choices of the
economy, such as the choice between producing more capital goods and fewer consumer
goods, or vice versa.
Efficiency

An example PPF with illustrative points marked

Main articles: Productive efficiency and Allocative efficiency
A PPF shows all possible combinations of two goods that can be produced
simultaneously during a given period of time, ceteris paribus. Commonly, it takes the
form of the curve on the right. For an economy to increase the quantity of one good
produced, production of the other good must be sacrificed. Here, butter production must
be sacrificed in order to produce more guns. PPFs represent how much of the latter must
be sacrificed for a given increase in production of the former.[1]
Such a two-good world is a theoretical simplification, necessary for graphical analysis. If
one good is of primary interest, all others can be represented as a composite good.[2][3] In
addition, the model can be generalised to the n-good case using mathematics.[4]
Assuming that the supply of the economy's factors of production does not increase,
making more butter requires that resources be redirected from making "guns" to making
"butter". If production is efficient, the economy can choose between combinations (i.e.
points) on the PPF: B if guns are to be prioritised, C if more butter is needed, D if an
intermediate mix is required, and so forth.[1]
Hence, all points on the curve are points of maximum productive efficiency (i.e., no more
output can be achieved from the given inputs); all points inside the frontier (such as A)
are feasible but productively inefficient; all points outside the curve (such as X) are
unfeasible with the given resources and thus unattainable in the short run. [5] A point on
the curve satisfies allocative efficiency, also called Pareto efficiency, if, for given
preferences and distribution of income, no movement along the curve or redistribution of
income there could raise utility of someone without lowering the utility of someone
else.[6]
Efficiency

An example PPF with illustrative points marked

Main articles: Productive efficiency and Allocative efficiency

A PPF shows all possible combinations of two goods that can be produced
simultaneously during a given period of time, ceteris paribus. Commonly, it takes the
form of the curve on the right. For an economy to increase the quantity of one good
produced, production of the other good must be sacrificed. Here, butter production must
be sacrificed in order to produce more guns. PPFs represent how much of the latter must
be sacrificed for a given increase in production of the former.[1]
Such a two-good world is a theoretical simplification, necessary for graphical analysis. If
one good is of primary interest, all others can be represented as a composite good.[2][3] In
addition, the model can be generalised to the n-good case using mathematics.[4]
Assuming that the supply of the economy's factors of production does not increase,
making more butter requires that resources be redirected from making "guns" to making
"butter". If production is efficient, the economy can choose between combinations (i.e.
points) on the PPF: B if guns are to be prioritised, C if more butter is needed, D if an
intermediate mix is required, and so forth.[1]
Hence, all points on the curve are points of maximum productive efficiency (i.e., no more
output can be achieved from the given inputs); all points inside the frontier (such as A)
are feasible but productively inefficient; all points outside the curve (such as X) are
unfeasible with the given resources and thus unattainable in the short run. [5] A point on
the curve satisfies allocative efficiency, also called Pareto efficiency, if, for given
preferences and distribution of income, no movement along the curve or redistribution of
income there could raise utility of someone without lowering the utility of someone
else.[6]
Opportunity cost

Increasing butter from A to B carries little opportunity cost, but for C to D the cost is
great.
Main article: Opportunity cost
If there is no increase in productive resources, increasing production of a first good
entails decreasing production of a second, because resources must be transferred to the

first and away from the second. Points along the curve describe the trade-off between the
goods. The sacrifice in the production of the second good is called the opportunity cost
(because increasing production of the first good entails losing the opportunity to produce
some amount of the second). Opportunity cost is measured in the number of units of the
second good forgone for one or more units of the first good.[1]
In the context of a PPF, opportunity cost is directly related to the shape of the curve (see
below). Unless a straight-line PPF is used, opportunity cost will vary depending on the
start and end point. In the diagram on the right, producing 10 more packets of butter, at a
low level of butter production, costs the opportunity of 5 guns (as with a movement from
A to B). At point C, the economy is already close to its maximum potential butter output.
To produce 10 more packets of butter, 50 guns must be sacrificed (as with a movement
from C to D). The ratio of opportunity costs is determined by the marginal rate of
transformation.
Marginal rate of transformation

Marginal rate of transformation increases when the transition is made from AA to BB.
The slope of the production-possibility frontier (PPF) at any given point is called the
marginal rate of transformation (MRT). It describes numerically the rate at which output
of one good can be transformed (by re-allocation of production resources) into output of
the other. It is also called the (marginal) "opportunity cost" of a commodity, that is, it is
the opportunity cost of X in terms of Y at the margin. It measures how much of good Y is
given up for one more unit of good X or vice versa. The shape of a PPF is commonly
drawn as concave from the origin to represent increasing opportunity cost with increased
output of a good. Thus, MRT increases in absolute size as one moves from the top left of
the PPF to the bottom right of the PPF.[7]
The marginal rate of transformation can be expressed in terms of either commodity. The
marginal opportunity costs of guns in terms of butter is simply the reciprocal of the
marginal opportunity cost of butter in terms of guns. If, for example, the (absolute) slope
at point BB in the diagram is equal to 2, then, in order to produce one more packet of
butter, the production of 2 guns must be sacrificed. If at AA, the marginal opportunity

cost of butter in terms of guns is equal to 0.25, then, the sacrifice of one gun could
produce four packets of butter, and the opportunity cost of guns in terms of butter is 4.
Shape
The production-possibility frontier can be constructed from the contract curve in an
Edgeworth production box diagram of factor intensity.[8] The example used above (which
demonstrates increasing opportunity costs, with a curve concave from the origin) is the
most common form of PPF.[9] It represents a disparity in the factor intensities and
technologies of the two production sectors. That is, as an economy specializes more and
more into one product (e.g., moving from point B to point D), the opportunity cost of
producing that product increases, because we are using more and more resources that are
less efficient in producing it. With increasing production of butter, workers from the gun
industry will move to it. At first, the least qualified (or most general) gun workers will be
transferred into making more butter, and moving these workers has little impact on the
opportunity cost of increasing butter production: the loss in gun production will be small.
But the cost of producing successive units of butter will increase as resources that are
more and more specialized in gun production are moved into the butter industry.[10]
If opportunity costs are constant, a straight-line (linear) PPF is produced.[11] This case
reflects a situation where resources are not specialized and can be substituted for each
other with no added cost.[10] Products requiring similar resources (bread and pastry, for
instance) will have an almost straight PPF, hence almost constant opportunity costs.[10]
More specifically, with constant returns to scale, there are two opportunities for a linear
PPF: firstly, if there was only one factor of production to consider, or secondly, if the
factor intensity ratios in the two sectors were constant at all points on the productionpossibilities curve. With varying returns to scale, however, it may not be entirely linear in
either case.[12]
With economies of scale, the PPF would appear bowed in ("inverted") toward the origin,
with opportunity costs falling as more is produced of each respective product. Here
greater specialization in producing successive units of a good drives down its opportunity
cost (say from mass production methods or specialization of labor).[13]

A common PPF:
opportunity cost

increasing A straight line PPF: constant An inverted PPF:

opportunity cost
opportunity cost

Position

An unbiased expansion in a PPF

The two main determinants of the position of the PPF at any given time are the state of
technology and management expertise (which are reflected in the available production
functions) and the available quantities and productivity of factors of production. Only
points on or within a PPF are actually possible to achieve in the short run. In the long run,
if technology improves or if the productivity or supply of factors of production increases,
the economy's capacity to produce both goods increases, i.e., economic growth occurs.
This increase is shown by a shift of the production-possibility frontier to the right
(outward). Conversely, a natural, military or ecological disaster might move the PPF to
the left (inward), reflecting a reduction in an economy's total productive capacity.[1] Thus
all points on or within the curve are part of the production set, i.e., combinations of goods
that the economy could potentially produce.

decrea

If the two production goods depicted are capital investment (to increase future production
possibilities) or current consumption goods, the PPF can represent, how the higher
investment this year, the more the PPF would shift out in following years.[14] It can also
represent how a technological progress that more favors production possibilities of one
good, say Guns, shifts the PPF outwards more along the Gun axis, "biasing" production
possibilities in that direction. Similarly, if one good makes more use of say capital and if
capital grows faster than other factors, growth possibilities might be biased in favor of the
capital-intensive good.

2 MARKS:
1. What is economics?
2. What is scarcity?
3. What is efficiency?
4. Define PPF.
5. What is productive efficiency?
6. What is economic efficiency?
7. Write a note on economic growth and stability.
8. Define Micro economics.
9. Define macro economics.
10. What is called a efficient market.
15 MARKS:
1.
2.
3.
4.
5.

State and explain the three fundamental economic problems.

Explain the societys technological possibilities.
Explain the role of government in economy.
Explain about the +ve and -ve externalities.
Explain the various types of economic systems.

UNIT II CONSUMER AND PRODUCER BEHAVIOUR

Market Demand and Supply Determinants Market equilibrium
elasticity of demand and supply consumer behaviour consumer
equilibrium Approaches to consumer behaviour Production Short-run
and long-run Production Function Returns to scale economies Vs
diseconomies of scale Analysis of cost Short-run and long-run cost
function Relation between Production and cost function.
Supply and Demand Analysis
ANALYSIS OF DEMAND
The amount of a good that a consumer is willing to buy and able to purchase over a
period of time, at a certain price is known as the quantity demanded of that good. The
quantity desired to be purchased may be different from the quantity of good actually
bought by the consumer. As quantity demanded is a flow concept, the relevant time
dimension has to be mentioned which will indicate the quantity demanded per unit of
time. Demand is a relationship between the price and the quantity demanded, other
things remaining constant. Here the other things imply, the factors which influence the
decision of the consumer to buy.
If X1 denotes the quantity demanded and P1 its price per unit of the good, then other
things remaining constant the demand function will be given as
X1 = f(P1)
The function shows that quantity demanded depends on the price. This means that any
change in price will result in a corresponding change in the quantity demanded.
The Demand Schedule and the Demand Curve
The demand schedule is generally represented by a table which shows how the quantity
demanded of a good varies with price, other things remaining constant. Table 2.1 shows
a hypothetical demand schedule for jackets sold per month at Guwahati.
Table 2.1

500

Quantity demanded
(in numbers)
10 lakhs

450

11 lakhs

400

12 lakhs

350

13 lakhs

300

14 lakhs

250

15 lakhs

Price (in rupees)

200

16 lakhs

150

17 lakhs

Table 2.1 is constructed, based on the implicit assumption that the number of jackets
demanded solely depends on their respective prices. Plotting the above figures in a
graph, we can derive the demand curve. The graphical representation of the demand
schedule is the demand curve, as shown in figure 2.1.
Figure 2.1

The graph shows that the demand curve is downward sloping. A change in the quantity
demanded is a movement along the demand curve caused by a change in the price of the
good. A decrease in the price is reflected by a corresponding increase in the amount of
quantity demanded. This inverse relationship between price and the quantity demanded
is depicted in the shape of the demand curve. The downward slope of the demand curve
reflects the law of demand, which states that other things remaining the same, if the
price of any good decreases its quantity demanded increases and vice versa.
There are however some instances where the law of demand does not hold good. These
are given below:
Firstly, if the concerned good is a Giffen good the rational consumer will go on
decreasing his consumption of the good as the price falls. This is because a Giffen good
is such that the consumer purchases less and less of the good as its price falls and vice
versa. It was noticed by Giffen that when the prices of bread increased, consumers
curtailed their consumption of meat and other expensive items and consumed more of
bread.
Secondly, a consumer may judge a good by its price. This behavior of the consumer is
known as Veblen effect due to a change in price. Thus, when a price hike takes place for
a good the consumer may be misguided to think that a quality improvement has taken
place and he consumes more of the product.

Thirdly, sometimes it so happens that when the price of a good is on a rise the consumer
expects it to rise further. In such a case he may purchase more and more units of a good
as its price goes on increasing.
Fourthly, in the share market it is noted that when the price of a particular share rises its
demand also increases to some people and vice versa.
In all the above cases it should be noted that the demand curve is upward rising instead
of being downward sloping. This implies that, due to one unit increase in the price, the
quantity demanded also increases by some amount, and vice versa.
Factors Influencing the Demand Curve
Apart from its own price, there are several other factors that determine the nature of
the demand curve for a good. We briefly discuss those.
a. Price of close substitutes and complements: Given other things, if the price
of a substitute falls, then the consumer will shift his preference in favor of the
substitute, thereby creating a fall in the demand for the concerned good. Tea
and coffee are close substitutes. If the price of coffee suddenly falls, price of
tea remaining the same, the level of consumption of tea may show a fall. This
is because, consumers who could not afford coffee previously may now shift to
it, thereby decreasing their consumption of tea.
Again for some people it is seen that due to a price rise in butter, their
consumption of butter not only declines, but a sharp reduction in the
quantity demanded also takes place in the case of bread. This is because
bread and butter are complementary items to some people and they cannot
take one without the other.
b. The income of the consumer: As the income of the consumer rises, his
buying potential tends to rise. So with a similar price structure, the consumer is
now in a position to buy more of the same good. This results in an upward shift
of the demand curve. Discussion about movement along a demand curve and
shift of a demand curve is dealt later.
c. Existing wealth of the consumer: Income is not the only decisive factor for a
shift in the demand curve. If the existing wealth of the consumer, e.g. holding
of stocks, bonds, real estate, business property, etc. permits him to make a
purchase, the demand curve may shift rightward.
d. Changes in tastes and preferences of the consumer: If the tastes and
preferences of the consumer no more permits him to continue with the same
good, given other things, the consumer may switch over to some other good.
This may cause the demand curve to shift leftward.
e. Expectations regarding future price changes: If the consumer expects a price
fall in the near future he may curtail his present purchase to purchase in the
future. This depends very much on the nature of the good. If the good is an
essential one or is of a perishable nature, predictions regarding future price
changes may not be of any use to the consumer.

f. Special influences: Sometimes there exist factors which are applicable only to a
particular good in question. For example, demand for woolen garments rise in
the winter season; if the traffic rules are made more strict, you will find the sale
of helmets rising, etc.
g. Population: At a given price, how much of a good will be purchased depends
much on the size of the market. For a large market, the level of purchase of a good
or a service will be more and vice versa. For example, if the population of a city
increases its demand for housing will also increase.
A Change in Quantity Demanded or Change in Demand
Changes in Quantity Demanded
In general, the demand curve is downward sloping. The negative slope reflects
the inverse relationship between price and quantity demanded according to the
law of demand. Along the demand curve, quantity demanded increases as the
price of the good decreases. A change in the quantity demanded is a change in
the amount of a good buyers are willing and able to buy in response to a
change in the price of the good. A change in the quantity demanded is
represented by a movement along a given demand curve caused by an increase
or decrease in the price of the good. For example, for the demand curve
depicted in figure 2.2, a decrease in the price from p1 to p2 would result in an
increase in the quantity demanded from q1 to q2. The (q2 q1) increase in the
quantity, buyers are willing to purchase as the price decreases is called an
increase in quantity demanded.

Changes in Demand
As we have seen earlier, the relationship between the price of a good and the quantity of

the good demanded over a given period also depends on such influences as income
available for spending, wealth, prices of related goods, expectations regarding future
prices, consumer preferences, and the number of buyers in the market. The quantity of a
good that consumers are willing and able to buy at any given price changes if any one of
these influences change. A change in demand is a change in the relationship between the
price of a good and the quantity demanded caused by a change in something other than the
price of the good.
A change in demand implies a movement of an entire demand curve for a good. In
this case, a new demand schedule must be drawn up, because the quantity demanded
by consumers at each price changes. Figure 2.3 shows not only the old demand curve
but also the new demand curve resulting from an increase in demand. It is to be
noticed that the quantity demanded in the new demand curve D 2 i.e. q2 is greater
than the quantity demanded in the old demand curve D 1 at each possible price p 1.
The increase in the demand is represented by a shift outward of the demand curve
D1.

ELASTICITY OF DEMAND
By now we have already come to know from the law of demand that, when the price
of a good increases, the quantity demanded falls, other things remaining the same.
But, this information is not of much practical use since we know only the direction of
change in the demand for a given change in the price. If we know the magnitude of
this change, it will help a lot in our decision making. In this chapter we will make an
effort to understand the extent to which the quantity demanded will rise (fall) due to a
fall (rise) in the price of the same good or a related good or due to the rise (fall) in the
income of the consumer. This involves an analysis of demand sensitivity with respect
to prices of goods and income which helps the business to forecast market trends for
the future.
Price Elasticity
of Demand

To know the responsiveness of the quantity demanded to change in

the price, we measure the price elasticity of demand. As all goods are
not equally responsive to price changes, price elasticities for different
goods are different. Price elasticity of demand is defined as the
percentage change in quantity demanded resulting from one percent
change in the price of the good, other things remaining constant. It
can also be denoted as
ep

It can be observed that the quantity demanded decreases when the price increases and
this ratio is negative. However, the absolute value is usually taken and hence Price
Elasticity of demand is shown as a positive number. Suppose that the Railway fares
are increased by 6% and the demand for rail travel decreases by 2%. The price
elasticity of demand for rail travel is:

= 0.33. As the elasticity measure is a

proportion of two percentages, it is unit-free.

Let us suppose that you are a wholesale seller of bulbs. You know that the price
elasticity of demand remains unchanged and is equal to 1.5. And the price has increased
by 20%. To know the amount of decrease of quantity demanded that will be due to the
increase in price we can use the above formula as follows:
= 1.5
or, percentage change in quantity demanded

= 1.5 x 20%
= 30%

So, in this way, we can predict the expected change in quantity demanded due to price
changes if we can estimate the price elasticity of demand. Similarly we can also forecast
the required change in price, when we want to realize a targetted change in quantity
demanded and know the price elasticity of demand.
Extending the calculation of price elasticity of demand (ep) we have
% change
demanded

in

quantity

and, % change in price

=
=

Combining the above two, we have

x 100
x 100

In notational form it can be represented as

follows:
where,
= Infinitesimal change in quantity
= Infinitesimal change in price
P = Original price of the good
Q = Original quantity demanded of the good
However, without taking the help of calculus also we can derive the price elasticity of
demand. Let the initial amounts of quantity demanded and price be Q1 and P1,
respectively. Due to a change in the price to P2, let us assume that the quantity
demanded changes to Q2 (in opposite direction). Then the price elasticity of demand
will be given by
ep

Here it should be noted that the sign of ep will be negative as quantity changes in the
opposite direction in which price changes.
Let us consider an example. When the price of an item ABC is Rs.5 per unit, the
quantity demanded is 20 units. When the price of ABC rises by Rs.5 per unit to Rs.10
per unit, the quantity demanded falls to 10 units.
What is the price elasticity of demand?
We see, P1 = Rs.5, P2 = Rs.10, Q1 = 20 units and
Q2 = 10 units.
So, ep=

= 0.5

Generally price elasticity of demand is classified into the following categories:

i. Perfectly elastic demand: Here no reduction (increase) in the price is required
to cause an increase (reduction) in the quantity demanded. This implies that a
very small amount of change in the price will result in a change in the quantity
demanded to the extent of infinity. The point A denotes such a situation where
elasticity is equal to BA/0, which is equal to infinity.

ii. Perfectly inelastic demand: In this case a change in price, however large it may
be, causes no change in quantity demanded. This situation is depicted by the
point B in figure 2.6, where elasticity is equal to 0/AB = 0.
iii. Unit elasticity of demand: Where a given change in the price causes an equally
proportionate change in the quantity demanded, the value of price elasticity of
demand is unitary. In figure 2.6 above unitary elasticity is represented by the
point R where elasticity is measured as BR/RA = 1 (R is the mid-point of AB).
iv. Relatively elastic demand: Here a change in the price results in more than
proportionate change in the quantity demanded. Any point on the line AB
which lies between A and R represents a relatively elastic demand. At a point
between A and R, such as , the value of elasticity will be
/
, which is
greater than unity.
v. Relatively inelastic demand: In this case a change in the price results is less
than proportionate change in the quantity demanded. Consider a point
between R and B, the value of elasticity in this case is given by
which, obviously, is less than unity.
=%
Unitary Elastic %
e =1
Relatively
Elastic
Perfectly
Elastic

>%

e>1

=0

e=

Relatively
Inelastic

<%

e<1

Perfectly
Inelastic

=0

e=0

Price Elasticity, Total Revenue and Total Expenditure

Total Expenditure and Total Revenue: What is total revenue to the seller is total
expenditure to the buyer. Price elasticity of demand is a vital factor when businessmen
estimate the total revenue they can expect to make. All sellers are interested in the
amounts consumers will spend on an item because consumer expenditure is an
important determinant of their profits. Expenditures by consumers represent the total
revenue sellers take in from selling their products.
Total expenditure by consumers over any given period is the number of units of a
product purchased over that period, Q, multiplied by the price of the product, P.
Total Expenditure = P.Q = Total Revenue.
This equation shows that PQ, price times quantity, over any period equals both the total
expenditure on that product by consumers and the total revenue sellers receive from
selling the product.
For example, if the price of wheat averaged Rs.10 per kilogram and 80 million
kilograms were sold last month, total expenditure on wheat was Rs.800 million. This

sum also equals the total revenue received that month by the sellers in the market.
Figure 2.10 shows the demand for and supply of wheat assuming Rs.10 per kilogram
equilibrium price and an equilibrium quantity of 80 million kilograms per month.

The market equilibrium price of wheat is Rs.10 per kg. At that price, 80 million kg. are
sold each month. The total expenditure on wheat is represented by the area OAEQ. This
area also measures the total revenue sellers receive from the sale of wheat that month.
Consumers total expenditure can be represented as the rectangular area OAEQ in the
figure. The width of the rectangle is Rs.10, price per kilogram represented by the
distance OA on the vertical axis. The length of the rectangle is the 80 million kilograms
sold per month, represented by the distance OQ on the horizontal axis. Multiplying the
length by the width, give the rectangle OAEQ, which represents Rs.800 million per
month. This area represents both the total expenditure by consumers and the total
revenue to the sellers.
Predicting Changes in Total Expenditure and Revenue in Response to Price
Increases: Suppose there is a decrease in the supply of wheat. Figure 2.11 shows how
such a decrease in supply affects the price of wheat and the quantity demanded. As a
result of the decrease in the supply, the market equilibrium price of wheat increases
from Rs.10 per kg to P2. The increase in price causes the quantity demanded per month
to decline to Q2. What effect will the increase in the price has on consumer expenditure
on wheat and on the total revenue of sellers?
There is no clear-cut answer to the question. The increase in the price of wheat acts to
increase total consumer expenditure by increasing the P component of PQ. However,
the law of demand indicates that as price goes up the quantity of wheat demanded will
come down. The Q component of PQ thus will decrease whenever price goes up. There
are therefore two forces that influence PQ when price goes up, and they are opposite in
direction. If we know the price elasticity of demand for wheat, however, we can forecast
the change in PQ. This is because we can use price elasticity of demand to predict the
relative magnitudes of the upward and the downward forces influencing expenditure

and revenue. Thus sellers can use price elasticity of demand to predict changes in their
total revenue when prices change.
Suppose the demand for wheat is inelastic. This means that the percentage reduction in
quantity demanded caused by the price increase will be smaller (ignoring the direction
of change) than the percentage increase in price that caused it. Under such
circumstances, the upward influence on the price increase on revenue is stronger than
the depressing effect of the reduction in quantity demanded on revenue. For example, if
a 10 percent increase in the price results in only a 5 percent decline in the quantity
demanded, as would be the case if the elasticity of demand for wheat were 0.5, total
revenue will increase as a result of the price increase. An inelastic demand therefore
implies that total revenue and total expenditure on a good will increase when price rises.
Figure 2.11

In figure 2.11 the gain in revenue as a result of the price increase is represented by the
area ABFH. This represents the increase in revenue from Q2 kg of wheat sold at a
higher price. The loss of revenue from the reduction in the quantity demanded is
represented by the area GHEQ. This represents revenue that the sellers would have
enjoyed by selling more units had the price remained at Rs.10 per kg. When demand is
inelastic, the gain in revenue from the price increase will exceed the loss in revenue
from the decline in sales volume. At the extreme, suppose the price elasticity of demand
for a good were 0. This implies that an increase in the price would have no effect on the
quantity demanded. If this were the case, the total revenue taken in by the sellers would
increase by the percentage increase in price.
Cross Price Elasticity of Demand
Cross price elasticity of demand is defined as the percentage change in the quantity
demanded of a good due to a change in the price of another good, other things

remaining constant. Let two goods, Q1 and Q2 be available to the consumer with P1 and
P2 as their respective prices. Then the cross price elasticity of demand of Q1 is the
percentage change in the quantity demanded of Q1 due to one percent change in P2. In
general, if Qi and Qj are the two goods with respective prices as Pi and Pj then the cross
price elasticity of demand of Qi is defined as the percentage change in the quantity
demanded of Qi due to one percent change in Pj. In mathematical notation it is denoted
as
follows:
ecij

=
=

As price and quantity values cannot be in negative terms, the sign of the cross price
elasticity is determined by the sign of the derivative
. If the value of the
derivative is positive then will be positive and it will be negative, if the value of
derivative is negative, other things remaining unchanged. When two goods are
substitutes (i.e., both serve the same purpose and one can be used in the place of the
other) then the increase in the price of one good decreases its own demand and increases
the quantity demanded of the other good. In this case the cross price elasticity of
demand is positive, the value of the derivative being positive. On the contrary, in the
case of complementary goods, (i.e. goods which are used jointly) the increase in the
price of one good decreases the quantity demanded of both the goods. Here the value of
the derivative,
is negative which in turn makes the value of ec also negative.
Consider three goods tea, coffee and sugar, where tea and coffee are substitutes and the
combinations tea and sugar or coffee and sugar are complementary goods. If the price of
coffee increases then consumers will shift their preferences from coffee to tea thereby
increasing the consumption of tea. In this case the value of the derivative,
is
positive. On the other hand, considering the combination tea and sugar, if the price of
tea increases then consumers will consume less amounts of both tea and sugar. So in the
case of complementary goods the value of the derivative,
as well as the cross
price elasticity of demand ec become negative.
Income
Elastici
ty
of
Deman
d
The income elasticity of demand is defined, as the rate of change in the
quantity demanded of a good due to change in the income of the consumer. As
we have seen in Demand Analysis and Consumer Behavior, income is one
of the determinants of the quantity demanded. In functional form it can be
represented as follows:
Q =

f(Y)

where Q is the amount of quantity demanded and Y the income of the

consumer. In this context it should be noted that the curve which captures the
changes in the quantity demanded due to change in the income of the consumer
is known as the "Engel Curve". The income elasticity of demand of the consumer
is given by
ey

It is clear that the sign of the elasticity depends on the sign of the derivative
as
both of the expressions Q and Y are positive, i.e. Q > 0 and Y > 0. If the amount of
good demanded rises as the income of the consumer increases, then the value of the
income elasticity is positive. When the demand for a particular good increases due to an
increase in the level of income of the consumer, then such a good is called a normal
good. The income effect of a normal good is always positive. For some goods it is seen
that due to an increase in the income of the consumer the demand for the good falls.
Such a good is known as an inferior good and the income effect of such a good is
negative. The underlying reason for the income effect being negative is that the
derivative
for such a good is negative. Similarly it can be inferred that if the
income effect of the good is zero then the income elasticity of demand will also become
equal to zero. So we see that the concept of income elasticity of demand can be utilized
for the classification of goods into normal and inferior goods. Goods with positive
income elasticity of demand are called normal goods and goods with negative income
elasticity of demand are called inferior goods.
Income elasticity of demand can be used to classify goods into luxuries or necessities. If
the income elasticity of a good is greater than one, it is called a luxury. If the income
elasticity of a good is less than one, it is called a necessity. If it is equal to one it can be
called a semi-luxury good.
Difference between Income Elasticity of Demand and Income Sensitivity of
demand:
The concept of income sensitivity of demand is very similar to the concept of income
elasticity of demand. While income elasticity of demand deals with the changes in the
physical units purchased due to change in the income level, the income sensitivity deals
with the changes in the rupee expenditure due to change in incomes. Income sensitivity
of a good during a period of time is defined as a ratio of percentage change in rupee
expenditure to percentage change in disposable income during that period.
Symbolically, coefficient of income sensitivity during a period t
=
However, it needs to be noted that the coefficient is only a rough estimate as no
method to disentangle the effects of changes in income from those of changes in the
prices and tastes has yet been developed.

Promotional (or, Advertising) Elasticity of Demand

Advertising occupies an important place in the present market economy. The
advertising elasticity of demand measures the extent to which the demand of a product
will be influenced by advertisement and other promotional activities. It has been seen
that some goods are more responsive to advertising, e.g. cosmetics than others.
Advertising elasticity of demand measures the response of quantity demanded to change
in the expenditure on advertising and other sales promotion activities. The point formula
for advertising elasticity of demand is
eA =

where, Q =
A=

quantity of goods sold, and

units of advertising expenditure on the good

The arc elasticity formula in this case can be written as

eA =
where the subscript 1 denotes the initial values and the subscript 2 denotes the end
values.
The Determinants of Elasticity of Demand
THE PRICE ELASTICITY OF DEMAND DEPENDS ON FOUR MAIN
FACTORS
i.

The closeness of substitutes

ii.

The proportion of income spent on the good

iii.

The time elapsed since a price change

iv.

Nature of the good.

i.

The closeness of substitutes: The closer the substitutes for a good or service, the
more elastic is the demand for it. For example, salt is hardly having any
substitutes in our life, whereas different brands of soaps are good substitutes, so
that
the
demand
for
these
goods
is
elastic.
In everyday language, we call some goods, such as food and housing necessities
and the other goods, such as exotic vacations, luxuries. Necessities are goods that
have poor substitutes and that are crucial for our well-being, so generally they
have inelastic demand. Luxuries are goods that usually have many substitutes and
so have elastic demands.

The degree of substitutability between two goods also depend on how narrowly
(or broadly) we define them. For example, even though oil does not have a close
substitute, different types of oil are close substitutes of each other. Saudi Arabian
Light, a particular type of oil is a close substitute for Alascan North Slope,
another particular type of oil. If you happen to be economic adviser to Saudi
Arabia, you will not contemplate a unilateral price increase. Even though Saudi
Arabian Light has some unique characteristics, other oils can easily substitute for
it, and most buyers will be sensitive to its price relative to the prices of other
types of oil. So the demand for Saudi Arabian Light is highly elastic.
This example, which distinguishes between oil in general and different types of
oil, applies to many other goods and services. The closeness of the substitutes for
a good also depends on some other factors discussed below.
Proportion of income spent on the good: Other things remaining the same, the
higher the proportion of income spent on a good, the more elastic is the demand
for it. If only a small fraction of income is spent on a good, then a change in its
price has little impact on the consumers overall budget. In contrast even a small
rise in the price of a good that commands a large part of the consumers budget
induces the consumer to make a radical reappraisal of expenditures.
To appreciate the importance of the proportion of income spent on a good,
consider your own elasticity of demand for textbooks and potato chips. If the
price of textbooks doubles (i.e. it increases 100 percent), there will be a big
decrease in the quantity of textbooks bought. There will be an increase in sharing
and illegal photocopying. If the price of a packet of potato chips doubles also a
100 percent increase, there will be almost no change in the quantity of packets
demanded. Let us discuss the reason for this difference. Textbooks take a large
proportion of your budget while potato chips occupy a tiny portion. None of us
will like the increase in the price of either of the two, but you will hardly notice
the effects of the increased price of potato chips, while the increased price of the
textbooks puts your budget under severe strain.

Time elapsed since price change: The greater the time lapse since a price change, the
more elastic is the demand. When a price changes, consumers often continue to buy
similar quantities of a good for a while. But given enough time, they find acceptable and
less costly substitutes. As this process of substitution occurs, the quantity purchased of
an item that has become more expensive gradually declines. That is, given more time, it
is possible to find more effective substitutes for a good or service whose price has
increased. It is also possible to find more uses for a good whose price has decreased.
To describe the effect of time on demand, we distinguish between two time-frames:
i.

Short run demand

ii.

Long run demand

To describe the effect of time on demand, we distinguish between two time-frames:

i.

Short run demand

ii.

Long run demand

Short run demand describes the response of buyers to a change in the price of a good
before sufficient time has elapsed for all possible substitutions to be made. Long run
demand describes the response of buyers to a change in the price after sufficient time
has elapsed for all the possible substitutions to be made.
For example, within a period of a month or two there may be little that we as drivers
can do to react to an increase in the oil prices. However, over several years we can
seek out more fuel-efficient vehicles and buy them to replace our older ones. We can
also move closer to our place of work. Also over a period of several years more
substitutes are developed for goods whose prices go up. For example, a sharp
permanent increase in the price of petrol might lead to the development of substitute
fuel.
iv.

Nature of the good: In general, it is seen that luxury items are price elastic
whereas necessary items are price inelastic. This is because, changes in the
price level affects the necessary goods comparatively less to the luxury goods.

The main determinants of income elasticity of demand are as follows

i.

Nature of the need the good covers: It is seen that the percentage of income
spent on food declines as the level of income increases. This is known as Engel's
law.
It is noticed that for a normal good, increase in income, other things remaining
the same, is associated with increase in the quantity of goods purchased. A good
whose income elasticity is greater than one is called a luxury good. Foreign
travel, in fact, has an estimated elasticity of about 3, indicating that it can be
considered as a luxury good. Goods with income elasticities between zero and
one are considered necessities. On the other hand, a negative elasticity of
demand implies an inverse relationship between income and the amounts of
goods purchased. Goods with negative income elasticities are those that
consumers will eventually stop buying as their income increases.

ii.

The initial level of income of a country: This means to say that depending on
the level of development of a country different goods are categorized into luxury
or necessary items. E.g., a TV set is a luxury item in an underdeveloped country
whereas it is a necessity in a country with high per capita income.

Time period: Consumption patterns generally adjust with a time-lag to changes in

income. It is seen that consumers adjust to rising income at a faster rate than to falling
incomes,
with
respect
to
their
consumption
practices.
It is seen that once a consumer is associated to a high MPC (marginal propensity to
consume) it becomes very difficult for him/her to decrease the same overnight, due to

falling incomes. However, the case is just the opposite when an increase in the income
takes place. In this case, the consumer can increase his MPC even without any lag of
time. This implies to say that, it is always difficult for the consumer to adjust
himself/herself to falling incomes than to rising incomes.
The determinants of cross-price elasticity of demand
The main determinants of cross-elasticity is the nature of the goods relative to their
uses. If two goods can satisfy equally well the same need, the cross elasticity is high and
vice versa.
Slope and Elasticity
It can also be proved algebraically that the price elasticity of demand does not depend
on the slope of the demand curve. Consider a straight line demand curve of the form P =
a + bQ, where, P and Q are the price and quantity demanded, a the intercept term and b
the slope coefficient. Here a and b are assumed to be constant and b < 0. The slope of
the demand curve is given by
=

(a + bQ) = b, which implies,

So the price elasticity will be given as

ep =

, where, Q =

or, ep = P/(P a). So, we find that the slope of the demand curve is b whereas the
absolute value of the elasticity of demand is given by P(P a), which proves the fact
that the value of the slope of a demand curve is independent of the value of its elasticity.
ANALYSIS OF SUPPLY
Supply of a good refers to the various quantities of the good which a seller is willing
and able to sell at different prices in a given market, at a particular point of time, other
things remaining the same. An aspect of supply which needs attention is that supply is
related to scarcity. It is only the scarce goods which have a supply price. On the
contrary, goods which are available freely have no supply price, e.g. air is available
freely and hence does not have supply price.
The Supply Schedule
The supply side of a market typically involves the terms on which businesses produce
and sell their products. The supply schedule relates the quantity supplied of a good to its
market price, other things remaining the same, e.g. cost of production, the prices of
related goods, government policies, etc.
The supply schedule (and the supply curve) for a good shows the relationship between
its market price and the amount of that good that producers are willing to produce and
sell, other things remaining the same. Or in other words, it is a tabular representation of
data on the quantity supplied and price of the good. Let us consider an example. The

table below shows, for each price, the quantity of cornflakes that cornflake makers want
to produce and sell.
Supply Schedule of Cornflakes
Price
supplied
box)

Quantity
(millions
of
(Rs. per
boxes per year)

A 50

18

B 40

16

C 30

12

D 20

07

E 10

00

The supply schedule for cornflakes indicates that when the price per box is Rs.10
no one is willing to produce and sell cornflakes, hence the quantity supplied is
zero. When price increases the producers are willing to produce and supply more
and more of cornflakes.
The Supply Curve
Table 2.4 shows a hypothetical supply schedule for cornflakes. When we represent the
supply schedule in the form of a graph we get the supply curve. In figure 2.13 we plot
the data given in table 2.4 in the form of a supply curve. It shows the typical case of
an upward-sloping supply curve. At a very low price, breakfast cereal manufacturers
might want to devote their factories for producing other types of cereal, like bran
flakes, that earn them more profit than cornflakes. As the price of cornflakes
increases, ever more cornflakes will be produced. At ever-higher cornflake prices,
cereal makers will find it profitable to add more workers, more machines to make the
cornflakes and then stuff them into boxes, and even more cornflake factories. As a
result, we see that the higher the price of cornflakes the more the amount of
cornflakes supplied. The supply curve in figure 2.13 is represented by a smooth
upward-rising curve passing through the points as depicted in the supply schedule.
Supply curve for cornflakes

Behind the Supply Curve

In examining the forces determining the supply curve, we need to analyze the factors
upon which the supply of a particular good depends. These can be stated in the form of a
supply function:
SX = f(PX, PY, PZ, ...., Pf, T)
where,
SX =
Amount of supply of the good X;
PX = Price of the good X;
PY, PZ...
= Prices of other goods in the market;
Pf = Prices of the factors of production required to produce the good
X;
T = State of technology used by the producer to produce
the good X.
Let us discuss all these factors given above, in detail.
A. Price of the good: Since higher money income is required to induce the producer
to produce more, the amount supplied, therefore, increases when producers get a
higher price for their products. The higher the price of the good, the more is the
incentive of the producer to produce more.
a. Prices of other goods: Any change in the price of other goods in the market also
has influence on the supply of a good. For example, if the price of ceiling fans
rises, compared to pedestal fans, the producers of the latter will start considering
switching their production to ceiling fans as it has become more attractive to
produce ceiling fans compared to pedestal fans. In this context it should be noted

that the prices of only related goods, either substitutes or complements, influence
the supply of the said good. The prices of goods excluding these have either no
impact or a negligible impact on the supply of the concerned good.
b. Prices of the factors of production: We know that the production of different
goods require different factors of production in different proportions. An increase
in the price of a factor of production, say labor, may lead to a larger increase in
the costs of making those goods that are labor-intensive. However, if the good
produced is comparatively less labor-intensive the increase in the cost of
production will be negligible. In this way the prices of the factors of production
will lead to changes in the relative profitability of different goods and thus their
amounts supplied.
c. State of technology: When the firm changes its production technology it may
result in lower costs, greater capacity of production, etc. Technological advances
consist of changes that lower the amount of inputs needed to produce the same
quantity of output. That covers everything from actual scientific breakthroughs to
better application of existing technologies to simple reorganization of the flow of
work. For example, manufacturers have become much more efficient over the last
decade or so. It takes very few hours of labor today to manufacture an
automobile.
There are some other minor influences which affect supply. Among them government
policies have an important bearing on the supply curve. Environmental and health
considerations determine what technologies can be used, while taxes and minimum
wage laws can significantly raise input prices. There are also some special influences
which affect the supply curve. The weather exerts an important influence on farming.
The computer industry has been marked by a keen spirit of innovation, which has led to
a continuous flow of new products. Market structure will affect supply, and expectations
about future prices often have an important impact upon supply decisions.
The Law of Supply
As discussed earlier, the quantity supplied depends upon a number of factors. The law of
supply takes into account only the most important determinant of supply, viz., the price
of the good. The supply function is thus represented as follows:
SX

f(PX), other things remaining constant

where,
Sx

Amount of good X supplied; and

PX

Price of the good X.

The law of supply states that other things remaining constant, more of a good is supplied
at a higher price and less of it is supplied at a lower price. This proposition follows
naturally if we assume that producers are interested in money incomes. Higher revenue
from sales is necessary to induce producers to increase the supply of the good. The
element other things remaining constant means that determinants other than price of
good X remain unchanged.

Shifts in Supply
Shift in supply means increase or decrease in the quantity supplied at the given price.
Supply changes when any influence other than the goods own price changes. In terms of
a supply curve, we say that supply increases (decreases) when the amount supplied
increases (decreases) at each market price. In figure 2.14 at the same price level an
increase in supply is shown by a shift in the supply curve to the right from S0S0 to S1S1,
while a decrease in supply by a shift of the supply curve to the left from S 0S0 to S2S2.
For example, at price P0, OQ0 quantity is supplied when the supply curve is S0S0. On the
other hand, QQ0 and
quantities are supplied when supply curves are S1S1 and
S2S2, respectively.
Change in supply is, in fact, the extension or contraction of supply. When more units of
the good are supplied at higher price (OQ1 at price P1), it is called the extension of the
supply, and when less units of the good are supplied at a lower price (OQ2 at price P2) it
is called contraction of supply. In other words, a movement upwards on a supply curve
indicates extension in supply and a movement downwards on a supply curve shows
contraction in supply. These are shown with the help of arrows along with the supply
curve S0S0 in figure 2.14.

Figure 2.14: Shift in the supply curve caused by factors other than price of good X
So, it should be remembered that when the supply of a particular good goes up
(down) in response to a price rise (fall), it is a movement along the supply curve.
When the supply of a good goes up (down) because of one or more factors affecting
the supply, it is a shift of the supply curve. The factors that cause a shift in the
Supply Curve are the same as explained above under Behind the Supply Curve.

Kinds of Supply Elasticity: Let us illustrate the different types of elasticities with the
help of the following table:
When elasticity of supply is
Equal to infinity
More than one but less than infinity
Equal to one
Less than one but more than zero
Equal to zero

It is called
Perfectly elastic supply
Relatively elastic supply
Unitary elastic supply
Relatively
inelastic
supply
Perfectly inelastic supply

EQUILIBRIUM OF SUPPLY AND DEMAND

We have seen that demand for any good primarily depends on the price of that good.
We have also seen that the supply of any good also depends on the price of that good.
Let us now see how the equilibrium price is determined by demand and supply. The
equilibrium price is that price at which total demand for any good in the market is equal
to the total supply of that good in the market. How the equilibrium price is determined
can be explained as follows.
Before starting the analysis let us assume that there exists perfect competition in the
goods market. This means that there are large number of buyers and sellers in the
market. Each buyer takes the price as given and decides to demand certain units of the
good at that price. In this way each individual has his own demand curve. By summing
up all such demand curves we can derive the market demand curve. From the market
demand curve we can know the total quantity demanded by all buyers in the market at
different price levels. In the same way, each seller takes the price as given and decides
to offer a certain quantity for sale in the market. Thus each seller has an individual
supply curve and by summing up the individual supply curves of all the sellers in the
market, we get the market supply curve. From the market supply curve we can know the
total supply by all sellers at different prices.
Let us now have a diagrammatic representation of the market demand and supply
curves. In figure 2.16, we plot price along the vertical axis and market demand and
market supply along the horizontal axis. Let DD represent the market demand curve and
SS represent the market supply curve. The market demand curve is downward sloping
whereas the market supply curve is upward rising. The demand and the supply curves
intersect at the point E where the price is equal to OP. The equilibrium price comes at
the intersection point of the supply and the demand curves. At this price the total amount
of demand equals total supply and is equal to PE.
Hence OP represents the price at which total demand equals total supply, and is the
equilibrium price in the market. Now if the price in the market is greater than OP or less
than OP total demand will not be equal to total supply. For example, if the price is OP1,
then total demand is P1D1 and total supply is equal to P1S1. Hence

total supply is greater than total demand and D1S1 is the amount of excess supply. Again
at the price OP2 total demand is equal to P2D2 and total supply is equal to P2S2. In this case
total demand exceeds total supply and excess demand is equal to S2D2.
Figure 2.16

Thus it is seen that if the price is OP total demand is equal to total supply and
equilibrium is reached. But if the price is greater than or less than OP, total demand
will not be equal to total supply and equilibrium will not be reached. There will
either be excess demand or excess supply. If we assume that in the case of excess
demand there will be competition among the buyers which will bid up the price and
in the case of excess supply there will be competition among the sellers which will
lower the price, then it can be seen that even if price is greater than or less than OP, it
will gradually move towards OP. Let us suppose that in the initial situation the price
in the market is OP1. At this price buyers want to purchase P1D1 units but the sellers
want to sell P1S1 units. Since P1S1 is greater than P1D1 units, all the sellers will not be
able to sell their output. In order to dispose of the excess supply the sellers will
reduce the price. As price falls the quantity demanded increases and the quantity
supplied decreases. This process continues until the price OP is reached. Similarly, if
the initial price is OP2 in the market, then S2D2 will be the excess demand. When
excess demand remains, all the consumers will not be able to fulfill their demands.
There will be competition among the buyers and the price will increase. As the price
increases total demand will fall and total supply will increase. This process will
continue until the price OP is reached. In this way equality between total demand and
total supply is reached through the variations in the price level.
The determination of equilibrium price can also be explained in an alternative
manner. We know that we can get a demand function where the quantity demanded

is a function of the price level. We can also get a supply function where quantity
supplied is a function of price. Let D represent total demand, S represent total supply
and P represent the price level. Then the demand function can be written as
D = f(P)

....eqn. (1)

Similarly the supply curve can be written as

S = g(P)

...eqn. (2)

Here f and g are notations for the functions. For equilibrium total demand should be
equal to total supply. This means
D = S ...eqn. (3)
So, we get three equations with three unknowns: D, S and P. Hence solving these
three equations we can get the values of the three unknowns. In this way the
equilibrium price and the equilibrium quantities of demand and supply are
simultaneously determined in the goods market.
Simultaneous Shifts of Supply and Demand
It is often seen that the real-world economic issues are complicated, and several forces
simultaneously act on supply and demand situations, thereby making the analysis more
complex.
In such situations the demand and supply curves may change their positions at the same
time. In that case the new equilibrium price and the new equilibrium quantity may be
greater than, equal to or even less than the initial equilibrium levels. It depends on the
magnitude and the direction of the shifts of the two curves. For example, if both the
demand and supply curves shift to the right by the same amount the equilibrium point
shifts to the right by the same amount and the equilibrium price remains unaffected.
This is shown in figure 2.20(a). Here we see that the initial price level remains static at
the level P0, due to the simultaneous shift in the demand and supply curves, though the
equilibrium position shifts from E0 to E1. Secondly, if the shift of the demand curve is
greater than the shift of the supply curve, the equilibrium price will increase. In figure
2.20(b) we see that the amount of shift of the demand curve is more than the shift of the
supply curve. As a result, the equilibrium position has changed from E0 to E2, the
corresponding changes in price and quantity being P0P1 and Q0Q1, respectively.
Similarly, if the demand curve shifts to the right and the supply curve shifts to the left,
the equilibrium price will increase. This increase in the price can either be with or
without any corresponding change in the quantity. When the amounts of changes of
demand and supply are equal there will not be any change in the price. However, if the
shift in the demand curve is more than the shift in the supply curve then the equilibrium
quantity will also increase but it depends on the direction. Therefore, we see that with
the help of the demand and supply curves we can determine not only the equilibrium

price and the equilibrium quantity but also the change in the price or the change in
quantity in the event of a shift of the demand and the supply curves.
Figure 2.20(a)

Figure 2.21: Price Ceiling

The sellers may dispose it on first come first served basis. They may also hoard it
under the counter and distribute it to the buyers on the basis of their personal feelings.
The sellers may also distribute it on the basis of customers previous purchases. But it is
not better to leave it to the sellers. For social justice the government should introduce
rationing by prices. The government may issue to each consumer ration coupons in such
a manner that the total quantity Q0 is distributed among the consumers on the basis of
governments allotments.
Figure 2.22: Floor Price

Consider another type of rationing where the fixed price is higher than the equilibrium
price. This is shown with the help of figure 2.22. Suppose that DD is the initial demand
curve, SS is the initial supply curve and P0 is the equilibrium price. Suppose also that
this is not socially or politically desirable and the government fixes the minimum price
at P1 which is higher than P0. At P1, planned demand is OQ1, but planned supply is OQ2.
Here the firms will accumulate stocks at the rate Q1Q2 per period. To avoid this, firms
will try to sell more by lowering prices. But this is not permissible. Here the price can
be fixed at P1 by directing the firms to restrict production at OQ1. It can be also done if
the government purchases the surplus stock Q1Q2 at the legal minimum price OP1. The
government may destroy it or may store it in the hope of releasing the stocks when demand
increases in future.
In any case when there are price controls and when the price is fixed either below the
equilibrium level or above the equilibrium level the market forces are not permitted to
operate freely. The market forces cannot allocate the resources and the allocation is
done by the administrative decisions of the government.
Significance of Demand Analysis

Demand is one of the crucial requirements for the functioning of any business enterprise,
its survival and growth. Information on the size and type of demand helps the
management in planning its requirements of men, materials, machines and money. For
example, if the demand for a product is subject to temporary business recession, the firm
may plan to pile up the stock of unsold products. If the demand for a product shows a
trend towards a substantial and sustained increase in the long run, the firm may plan to
install additional plant and equipment to meet the demand on a permanent basis. If the
demand for a firms product is falling, while its rivals sale is increasing, the firm needs
to plan to undertake some sales promotion activity like advertisement. If the firms
supply of the product is unable to meet the existing demand, the firm may be required to
revise its production plan and schedule; or the firm may have to review its purchase plan for
inputs and the suppliers response to input requirements by the firm. In the same way, larger
the demand for the firms product, the higher is the price the firm can charge. The common
theme underlying these examples is that the whole range of planning, cost budgeting,
purchase plan, market research, pricing decision, advertisement budget, profit planning, etc.
call for an analysis of demand. In fact, demand analysis is one area of economics that has
been used most extensively by business. The decision which management makes with
respect to any functional area, always hinges on an analysis of demand.
CHOICE AND UTILITY THEORY
Whenever a set of alternatives are open to us at the same point of time, we often
make choices. Provided we are all rational beings, it can be said that, behind all
activities, our basic motive is to maximize the total level of satisfaction. Whatever
we choose in our daily life, depends on the way we value it. For example, if you are
given with alternatives, either to study Economics or to practice Mathematics, you
will choose the alternative that gives you more satisfaction. Again, when the number
of available alternatives are more than two we may choose a combination.
Here we have to understand the difference between preferences and choices. From a
bunch of goods available to the consumer, there may exist a difference in his
preference and choice. This is because, while we make preferences we only express
our likes and dislikes. On the contrary, we choose something from the preferred
alternatives that suits our budget best.
The concept of utility has been developed by economists to explain the basic
principles of consumer choice and behavior. By utility we mean the extent of
satisfaction obtained from the consumption of the goods and services preferred by
consumers. Given the available resources, the level of income, and market prices of
various goods, the rational consumer allocates his spending in such a way that the
preferred combination gives him the highest utility.
To compare the various goods available to the consumer, two basic approaches are
followed: the cardinalist approach and the ordinalist approach. According to the
cardinalist approach, utility can be measured in subjective units. Whereas, the
ordinalists opine that utility cannot be measured, but can only be ranked in order of
preference. For example, let us consider that there are five goods, X1, X2, X3, X4 and
X5, from which the consumer has to choose only one.

Total Utility
The total utility received from a good is measured as the total satisfaction enjoyed from
the consumption of that good. The more the units of a particular good a consumer
consumes, greater will be his total utility or satisfaction from it up to a certain point. As
the consumer keeps on increasing the consumption of the good, he eventually reaches a
point of saturation represented by the maximum level of total utility. However, as the
concept of total utility is subjective, it is very difficult to measure. Only the person
concerned can, to a certain extent, make a reasonable estimate of the amount of total
utility obtained.
Marginal Utility and the Law of Diminishing Marginal Utility
The extra satisfaction a consumer can receive by consuming an extra unit of a good is
marginal utility. In other words, marginal utility is the rate of change in total utility
per unit change in the quantity of the good consumed. Mathematically, it can be
represented as
=

(also represented as is (Q)) Where,

U is the total utility to a consumer, and
Q is the quantity consumed to get U level of total utility
As it is noted that due to a one unit increase in consumption a corresponding
increase in total utility takes place, we can say that marginal utility (MU) is positive,
i.e. MU > 0.
Again the marginal utility received from a good is likely to decline as we consume
more and more units of it. For example, if someone provides you with a bottle of
soft drink you will enjoy it and acquire the maximum possible satisfaction from it. If
another bottle of the same drink is provided you may still enjoy it, with a reduced
level of satisfaction. However, if a third bottle is provided you may be reluctant to
accept it. This implies that the marginal utility obtained from the bottles gradually
diminish. The law of diminishing marginal utility (DMU) states that the marginal
utility of any good tends to decline as more of the good is consumed over a definite
period of time.
An interesting point to be noted here is that the operation of the law of diminishing
marginal utility is only valid subject to a particular period of time. This implies that,
if the second bottle of drink is provided on the next day, then the amount of utility
obtained from it may not have decreased. So, we may say that the law of
diminishing marginal utility operates only when the effect of the total utility
obtained from the consumption of the particular good prevails, without any
distortion.

SUBSTITUTES AND COMPLEMENTARY GOODS

Substitute goods are those that serve a similar purpose to the consumer. When we go to
the market to buy an item, it is not only the price of that item that influences our
purchase, but we are also influenced by the prices of the substitutes. This is because,
when we intend to buy an item we have a definite preference ordering in our mind. In
the case of substitutes, the ranking of the preferences is very close or sometimes
negligible. So, whenever the price of an item varies from its substitute, the rational
consumer will shift his preference in favor of the latter. For example, a significant price
hike of mustard oil has increased the demand of sunflower oil to a great extent.
Complementary goods are those, whose demand patterns are so related to each other that an
increase in the price of the first good will cause a decrease in the demand for the other
goodi.e., less of the second good will now be demanded. Similarly, a decrease in the price
of the first good will result in an increase in the demand for the other good, i.e., more of the
second good will now be demanded. For example, a constant price rise of petrol is likely to
cause a decline in the demand of two-wheelers.
An Alternative Approach: Substitution Effect and Income Effect
We have seen in our earlier discussion that the marginal utility approach is used to
derive the demand curve. An alternative approach, known as the indifference curve
approach can also be used to explain consumer behavior and the basic relation between
price and quantity demanded.
Substitution effect: Whenever the price of a good rises, consumers tend to substitute
other goods to satisfy their needs. Substitution effect deals with the change in the
quantity demanded of one good when the price of the other good changes, other things
remaining constant.
Income effect: Whenever an increase in the real income of the consumer occurs, he will
be in a position to buy more units of the goods which he was buying previously, prices
of the goods and other things remaining the same.
It should be noted that real income and money income are not the same thing. Money
income does not consider price changes of the different goods available in the market. Real
income tells us about the actual purchasing power of the consumer with his given money
income. So in case of a price rise the real income of the consumer will fall, the money
income remaining constant. This will result in a downward shift of the demand curve and is
known as the income effect due to a rise in the price.
THE PARADOX OF VALUE
It is seen that items of great value e.g., water, air, etc. are often sold at negligible
prices or are costless, whereas items like jewelry with very little use to mankind, are
sold at exorbitant prices. The paradox of value deals basically with the reason why
consumers pay zero or very less amounts of money for certain items with very high
benefits.
Adam Smith, in his highly celebrated book, "The Wealth of Nations" discussed 'the
diamond-water paradox'. How is it so that the demand for water being so high its
price is very low and the demand for diamond in spite of being very low faces such

high prices? The relative abundance of water in most places brings its marginal
utility very close to zero. On the contrary, due to the scarcity of diamonds all over
the world its marginal utility is always maintained at a very high level. So, the
willingness of a consumer to sacrifice more units of money in the case of diamond is
solely contributed to its availability constraint which is manifested through higher
marginal utility. This can be explained with the help of a graphical representation:
Figure 3.5

Figure 3.6

In the graphs given above (figures 3.5 and 3.6) the availability of water and diamond are
represented by vertical lines and drawn parallel to the vertical axis along which we
measure price and marginal utility. Along the horizontal axis we measure the
availability of water and diamond respectively. In the first figure we see that the
marginal utility curve of water intersects at a very low level. Whereas, in the second
figure we see that the marginal utility curve of diamond intersects at a very high level.
Prices and marginal utilities being proportional to each other, the relative price of
diamond is much higher compared to water, as the marginal utility of water is very low.

THE CONSUMER SURPLUS

The concept of consumer surplus was first introduced by Marshall. Consumer
surplus measures the difference between what a person is prepared to pay for a
commodity and the amount that he actually is required to pay. We enjoy consumer
surplus if we pay the same amount of money for each and every unit of good
bought. The amount that the consumer is willing to pay for the first unit of good he
buys is termed as consumers marginal value. The marginal value decreases as more
and more units are bought. A consumer who maximizes marginal value will buy to
that extent where marginal value equals price. The figure 3.7 explains the concept.
Figure 3.7

Suppose a consumer faces the demand curve, AB, in figure 3.7. He will be willing
to pay a price of q1p1 for q1 units of the good. For q2 units of the good he will be
willing to pay q2p2. And for Q, he will be willing to pay QN and so on. Now
suppose the market price is OP, i.e. at the going price of OP, the consumer can
decide about the quantity of the good he would like to demand. With the demand
curve AB, he will demand OQ.
Consumer Surplus is defined as the difference between the amount we are willing to
pay and what we actually pay. In figure 3.7 the consumer actually pays OP per unit
of the good, but he was willing to pay more than OP for any unit to the left of Q.
Take the case of q1. The consumer is willing to pay q1p1, but he actually pays q1r1.
Hence, the consumer surplus in (q1p1 q1r1) = r1p1. In the same way for q2, the
consumer surplus is r2p2 and for Q, it is zero. If the quantities are finely divisible,
the total amount that the consumer is willing to pay is the area OANQ, whereas
what he actually pays is represented by the area OPNQ. The difference between

these two areas, i.e. the area APN is the consumers surplus.

Income and Substitution Effect

INCOME EFFECT
Income effect is the change in the consumption of a good arising out of the change in
the purchasing power of money, which occurs due to a price change. In this situation
while the price remains constant, utility changes. In such a situation the consumer will
be in a position to buy more (less) of both the goods with his increased (decreased)
purchasing power. This is the income effect of a fall (rise) in prices.
THE SUBSTITUTION EFFECT
The substitution effect measures the change in the purchase of a good, which
arises out of the change in its relative price alone. It is to be noted that the utility
(satisfaction) remains constant while the price changes. Let us at first explain the
meaning of the terms relative price and real income remaining the same. The
relative price of a commodity is the amount of the other commodity that can be
obtained in lieu of one unit of this commodity. It is the price of one commodity in
terms of the other commodity, represented by the price-ratio of the two
commodities. This is the slope of the budget line. Thus, when the budget line is so
shifted that its slope changes then the relative price also changes. On the other
hand, when the budget line shift is parallel, the slope remains the same and
therefore no change in the relative price takes place. The phrase real income
remaining the same, here means that the money income and the money prices are
so changed that the consumer can purchase the previous combination if he likes
so. This concept is utilized in the Slutsky measure of substitution effect.
SUMMARY
Indifference curve is a curve that shows different combinations of two
goods that yields exactly the same level of satisfaction to a given
consumer. In other words, indifference curve is a line that shows all
combinations of two goods between which the consumer is indifferent.
The indifference curve slopes down in accordance with the law of
diminishing marginal utilities. Indifference curves of an individual do
not intercept each other and higher the indifference curve, higher is the
utility level.
When a consumer has a fixed income, he spends all of his income and is
confronted with market prices of two commodities; he has to move
along with a straight line known as budget line. The slope of the budget
line depends on the ratio of the prices of the two commodities.
Whenever there is a change in his income the budget line shifts to right
or left.

In order to get maximum satisfaction, a consumer moves along his

budget line until he reaches the highest attainable indifference curve.
The budget line, at this point, touches the indifference curve but does
not intercept the indifference curve. Thus, at equilibrium, the budget
line is tangent to the indifference curve.
Price effect is equal to the sum of income effect and substitution effect.
The substitution effect measures the effect of change in relative price of
any commodity, the real income remaining the same. The income effect
measures the change in the quantity demanded of a good for a change in
the real income resulting from a change in the price of the good.
THE PRODUCTION FUNCTION
The production function is a purely technical relation, which relates factor inputs
and outputs. It describes the law of proportion, that is, the transformation of factor
inputs into products (outputs) at any particular time period. The production
function represents the technology of a firm or an industry, or of the economy as
a whole. It gives us the maximum amount of output that can be obtained by
employing different inputs.
A method of production (process or activity) is a combination of the factor inputs
required for the production of one unit of output. Usually a good may be
produced by various methods of production. For example, a unit of good X may
be produced by any of the following processes:
Process 1
Units of labor required 10
Units of capital required 15

Process 2

Process 3

15
15

05
20

A process of production is technically efficient if it uses less of at least one factor

and no more from the other factors, compared to any other process of production.
In our above example we see that the process 2 is technically inefficient
compared to the process 1.
Let us consider a single production process in which an entrepreneur utilizes two
variable inputs, labor (L) and capital (K) and one or more fixed inputs in order to
produce a single output, Q. His production function states the quantity of his
output Q as a function of the quantities of his variable inputs L and K:
Q = f(L, K)
The production function is constructed based on the assumption that the state of
the technology is given and output can be increased by increasing inputs. When
the technology changes, the production function itself changes. Further, it is
assumed that the inputs are utilized in the best possible way, i.e. optimum
utilization of inputs. The best utilization of any particular input combination is a
technical, not an economic problem. Selection of the best input combination for
the production of a particular output level depends upon input and output prices

and is the subject of economic analysis.

Graphically, the production function is usually presented as a curve where the
changes of the relevant variables are shown either by movements along the
curve or by shifts of the curve. For example, while representing the production
function graphically we refer to the total productivity of labor in the production
of Q that can be secured from the input L, if capital is assigned a fixed value K 0
or, Q = f (L, K0).
RETURNS TO SCALE
The law of production describes the technically possible ways of increasing
the level of output by changing all the factors of production, which is possible
only in the long run. This is because in the long run all the factors of
production are variable. The law of returns to scale refer to the long run
analysis of production. The laws of returns to scale refer to the effects of scale
relationships which implies that in the long run output can be increased by
changing all factors by the same proportion, or by different proportions.
Let us start with an initial level of production function given by the equation
Q0 = f(K, L)
and we increase all the factors of production by the same proportion p. We will
clearly obtain a new level of output Q*, higher than the original level Q0,
Q* = f(p.K, P.L)
If Q* increases in the same proportion as the inputs, p, we say that there are
constant returns to scale (CRS).
If Q* increases less than proportionately with an increase in the factor inputs, we
have decreasing returns to scale (DRS).
If Q* increases more than proportionately with an increase in the factor inputs,
we have increasing returns to scale (IRS).
So we see that as the scale of production changes the level of production also
changes, thereby indicating that Q* is a function of p.
Or, Q* = (p). Here p is called the size of the scale of production process.
Change in p means change in the scale of production process.
Mathematically, there will be constant returns to scale if the return to scale
function is a straight line. Under CRS, Q*/ p is constant. Under IRS, Q*/ p
increases as p increases. Under DRS, Q*/ p decreases as p increases. In the
case of IRS the returns to scale function is convex from below while under DRS
the returns to scale function is concave from below. This is shown in figure 4.4.
Returns to Scale

2 MARKS:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
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16.
17.

What is demand, supply?

What is called demand schedule?
What are the elasticities of demand?
What is price elasticity of demand?
What is cross price elasticity?
What is called income elasticity of demand?
What is market equilibrium?
What is elasticity of supply?
Define fixed cost, variable cost, fixed resources, and variable resources.
What is short run, long run?
What is called marginal utility?
What is consumer equilibrium?
What is called returns to scale?
What are its categories?
What is economies of scale?
What is diseconomies of scale?
Differentiate between economies and diseconomies of scale.

15 MARKS:
1. Explain the determinants of elasticity of supply.
2. Explain the determinants of elasticity of demand.
3. Write an essay on consumer behavior (or) approaches to consumer behavior (or) Consumer
utility.
4. Explain about returns to scale and its categories.
5. Explain about the economies of scale.

UNIT III PRODUCT AND FACTOR MARKET

Product market perfect and imperfect market different market structures
Firm s equilibrium and supply Market efficiency Economic costs of
imperfect competition factor market Land, Labour and capital Demand
and supply determination of factor price Interaction of product and factor
market General equilibrium and efficiency of competitive markets.
Perfect Competition
A perfectly competitive market model is based on the following assumptions:
1. There are a large number of buyers and sellers in the industry/market, so that
no individual buyer or seller, however large, can influence the price by
changing the purchase or output. This means the individual buyer or seller is
an insignificant player in the market.
2. All firms in the industry produce a homogeneous product. The technical
characteristics of the product as well as the services associated with its sale
and delivery are identical. There is no way in which a buyer could
differentiate among products of different firms.
3. Entry and exit of firms is free for the industry. That is, there are no barriers to
entry or exit from the industry. Entry or exit may take time, but firms have
freedom of movement in and out of the industry.
The assumption of large number of sellers and of product homogeneity imply that
the individual firm in perfect competition is a price taker: its demand curve is
infinitely elastic, indicating that the firm can sell any amount of output at the
prevailing market price. In figure 6.1, the demand curve of a firm in the perfectly
competitive market is horizontal at the market price P. The level of market price is
determined in the market by the supply and demand forces. For the firm, P = AR =
MR, since the price is constant.

Perfect competition among sellers prevails if an individual seller has only an

imperceptible influence on the market price and on the actions of others. Each seller
acts as if he had no influence. Analogous conditions must hold for perfect competition
among buyers. A market is perfectly competitive if perfect competition prevails on both
the sellers' and the buyers' sides of the market. The market price which was considered
as a parameter in the previous chapters is now a variable, and its magnitude is
determined jointly by the actions of buyers and the sellers.
SHORT RUN AND LONG RUN EQUILIBRIUM OF THE COMPETITIVE
FIRM
Let us consider a firm producing a single product under conditions of perfect
competition. Under perfect competition, the firm takes the market price as given and
adjusts the level of output to maximize the level of profit. Output is a parameter of
action. Under conditions of perfect competition, any single firm produces a very small
part of the total output in the market. It is not capable of influencing the market price
through its own behavior. It is assumed that all firms produce a homogeneous product.
Moreover, there is free entry and free exit of firms. The buyers and sellers have
complete knowledge of the conditions of the market. The objective of the firm is to
maximize profit. The firm adjusts its output level so as to maximize profit. The cost
functions of the firm are assumed to be regularly shaped.
Let us now consider the equilibrium of such a firm under conditions of perfect
competition.
For a firm, profit function is given by

=
=
=

where,

RC
Profit
Total Revenue, f1(Q), a function of quantity
Total Cost, f2(Q), a function of output

EFFICIENCY OF COMPETITIVE MARKETS

Evaluating the Market Mechanism
The Concept of Efficiency: Allocative efficiency is a condition achieved when
resources are allocated in ways allowing the maximum possible net benefit from their
use. Three properties are observed in a freely competitive market mechanism to fulfill
the marginal conditions of allocative efficiency:
a. Efficient allocation of resources among firms (equilibrium of production).
b. Efficient distribution of goods produced between consumers (equilibrium of
consumption).
c. Efficient combination of products (simultaneous equilibrium of production and
consumption).

Pareto efficiency is a situation wherein there is no other allocation in which some other
individual is better off and no individual is worse off. Effectively, it becomes
impossible to make anyone better off without making someone worse-off. When an
efficient allocation of resources have been attained, it is not possible to make any person
in the society better-off without making someone else worse-off. No changes in the
productive methods or further exchange of goods and services can result in additional
net gains if resources are efficiently allocated.
Long run competitive equilibrium and allocative efficiency: It is easy to show
that a system of competitive markets has the potential to achieve allocative
efficiency. Concentrate on the single competitive industry that produces bread. A
net gain is possible if the maximum price someone is willing to pay for more bread
exceeds the minimum price a seller is willing to accept to make that bread available.
Efficient output of a good: The efficient output of bread per day corresponds to
point E, at which the marginal benefit of bread just equals the marginal cost.
The maximum price a buyer will pay for another unit of a good is called the
marginal benefit of the good. The minimum price a seller will accept for making
another unit available is its marginal cost. The marginal cost represents the value of
the resources necessary to make one more unit of a good available.
Figure 6.10

SUMMARY
Perfect competition is a market structure where no participant can influence
prices. Perfect competition is a market structure characterized by a complete
absence of rivalry among the individual firms. A perfectly competitive
market model is constructed assuming that there are large number of buyers
and sellers in the industry/market, so that no individual buyer or seller,
however large, can influence the price by changing the purchase or output; all
firms in the industry produce a homogenous product; entry and exit of firms

is free for the industry. In perfect competition, an individual firm is a price

taker.
Under perfect competition, the firm takes the market price as given and
adjusts the level of output to maximize the level of profit. The objective of
the competitive firm is to maximize profits. In order to maximize profit, the
firm adjusts its output level at which price equals the marginal cost of
production, that is, P = MC. Diagrammatically, the firm reaches equilibrium,
when the upward rising MC curve intercepts its horizontal demand curve. In
perfect competition, the condition for the short run equilibrium of a firm is P
= MR = AR = MC.
To determine a firm's shutdown point in the short run, variable costs must be
taken into consideration. When market price equals minimum possible
average variable cost, losses at the output for which price equals marginal
cost are the same as fixed cost. If price falls below minimum possible
average variable cost, the firm shuts down because operating losses would
then exceed fixed cost.
In a perfect competition, no firm will earn abnormal profits. A firm in the
long run operates at a point where its average cost is minimum. Average cost
will be minimum when it is equal to marginal cost, MC = AC. Since in the
long run no firm is earning abnormal profits, the revenue must be equal to its
cost. In other words, Total Revenue = Total Cost (or) price is equal to cost.
Thus, the long run zero-economic-profit condition requires price = MC =
Minimum long run AC.
The short run supply curve of the industry is obtained from the horizontal
summation of the short run supply curves of the individual firms. The short
run supply curve of the firm is again the upward rising portion of the
marginal cost curve which lies above the AVC curve. However, in the long
run, the MC curve is not the supply curve of the firm because in the long run,
only one point of the MC curve can be the equilibrium point where the firm
earns only normal profit. If the existing firms earn excess profits new firms
enter into the industry and excess profit will soon be eliminated.
The supply curve of a firm in the long run depends on the cost curves. If the
industry is a constant cost industry, the long run supply curve will be a
horizontal straight line. If the industry is an increasing (decreasing) cost
industry, the long run supply curve will be upward rising (downward
sloping).
Allocative efficiency, Pareto efficiency or simply efficiency is a condition
achieved when resources are allocated in ways allowing the maximum
possible net benefit from their use. An allocation is known as Pareto
efficiency or allocative efficiency if the only way to make one individual
better off is to make another worse off. Under ideal conditions, an economy
attains allocative efficiency when all the firms operating in the industry are

perfect competitors and there are no externalities.

IMPERFECT COMPETITION
Thus far, conditions of perfect competition have been assumed to prevail in all the
markets. A perfectly competitive industry contains a large number of firms selling a
homogeneous product. Input and the output prices are unaffected by the actions of any
individual firm. Each firm faces a horizontal demand curve and maximizes profit by
selecting an output level at which marginal cost equals market price.
A market is imperfectly competitive if some individual sellers have some degree of
control over price of the output. This broad definition of imperfect competition
encompasses markets of many different types, which can be distinguished by further
classification. Product and input markets are frequently classified according to the
number of sellers and buyers, which they contain. Product markets can be further
classified with regard to differentiation. However, there may be industries in which the
products of the different firms are close substitutes but differentiated in the eyes of the
buyers. This gives rise to product differentiation.
Traditionally markets are classified on the basis of the number of sellers and buyers and
the nature of the product being sold in the market. The following market forms are
distinguished:
Monopoly: In monopoly there is only one seller producing and selling a product which
has no close substitutes. The monopolist firm is the industry and the demand of the
monopolist coincides with the industry demand. The monopolist can change both price
and quantity. The price elasticity of demand faced by the monopolist is finite. Finally,
since there is only one firm, entry is totally blockaded.
Monopolistic Competition: It exists when many sellers compete to sell a differentiated
product in a market into which the entry of new sellers is possible. In a monopolistically
competitive market the product of each is a close substitute of the products of the
others.
Oligopoly: In an oligopoly market there are few sellers so that there is interdependence
among the sellers and the sellers are aware of it. Each firm takes into account the rivals'
reaction. The products produced may be homogeneous or heterogeneous. If the product
is homogeneous it is known as pure oligopoly. On the other hand, if the products can be
differentiated it is known as differentiated oligopoly.
Bilateral Monopoly: It is a market form where one buyer faces one seller. When
bilateral monopoly exists, the single buyer and the single seller individually possesses
some power to fix the price at which the transaction takes place between them.
Monopsony: It is the complementary form of monopoly. In this market form there
exists only one buyer and a large number of sellers, other conditions remaining the same
as under monopoly.

Oligopsony: It is the complementary form of oligopoly. Here we have a few buyers and
a large number of sellers, other conditions remaining the same as under oligopoly.
Duopoly: It is a special case of oligopoly where there are only two sellers, all other
conditions remaining the same as under oligopoly.
In the modern analysis, markets are classified on the basis of three criteria:
a. Substitutability of products,
b. Interdependence of firms, and
c. The ease of entry.
The first two criteria use cross-elasticities of demand for the classification of the
markets while the third criterion uses Bain's concept of the condition of entry for the
classification of the markets.
The degree of substitutability of products can be measured by the cross-price elasticity
of demand for the goods produced by the two firms. Let us define epji =

as the
.
percentage change in the sales of the jth firm due to one percent change in the price
charged by the ith firm in the industry. If this elasticity is high, the products of the jth
and the ith firms are close substitutes. If the substitutability is perfect (i.e., if the two
firms are selling a homogeneous product) the cross-price elasticity will be infinity. On
the other hand, if the products are differentiated, the cross-price elasticity of demand
will be positive and finite. If the products are not substitutes, this elasticity will be zero.
Consider now the different market forms. In perfect competition and pure oligopoly we
assume that the product is homogeneous. Hence in these two market situations this
elasticity is infinite. In monopolistic competition and differentiated oligopoly, the
products are differentiated and hence this elasticity is finite and positive. The
monopolist has no substitute for his product. Hence this elasticity is zero for the
monopoly market.
The degree of interdependence between firms is measured by the quantity crosselasticity
of
demand.
The quantity cross-elasticity eqij =

measures the proportionate change in the

price of the jth firm resulting from a small change in the quantity produced by the ith
firm. The higher the value of elasticity, the stronger the interdependence of the two
firms. Thus if there are a large number of firms then each firm will ignore the reactions
of its competitors. In this case the quantity cross-elasticity is zero. On the other hand,
when the number of firms is small interdependence will be noticeable and this elasticity
will be finite. This happens in the case of oligopoly (pure and differentiated). In the case
of a monopolist, this elasticity will also be zero because, if the ith firm in another
industry changes its price it will have no impact on the quantity sold by the monopolist.
The third type of classification is based on Bain's concept on the condition of entry. The
condition
of
entry (E) is defined as

where Pa represents price actually charged by the firm and

Pc represents price under pure competition. E is positive for oligopoly (pure and

differentiated) but zero for perfect competition and monopolistic competition. In

monopoly it cannot be used since entry is totally restricted. The results of the three
criteria can be summarized in tabular form as follows:
Table 7.1 Classification of Markets
Classification of Markets
Type of Market

Value of epji

Perfect Competition
Monopolistic Competition

0 < epji <

Pure Oligopoly

Value of eqji

Value of E

0 < eqji <

E>0

Differentiated Oligopoly

0 < epji <

0 < eqji <

E>0

Monopoly

Blockaded entry

In this context it should be noted that the dividing line between the different market
structures is arbitrary. However, classification in one way or the other is necessary for
analytical purposes.
SOURCES OF MARKET IMPERFECTIONS
In most cases, imperfect competition can be traced to two principal causes. First,
industries tend to have fewer sellers when there are significant economies of large-scale
production and decreasing costs. Under these conditions, large firms can produce
simply more cheaply and then undersell small firms, which cannot survive. Second,
markets tend towards imperfect competition when it is difficult for new competitors to
enter an industry. In other cases, there may be reasons why it is simply too expensive
for a new competitor to break into a market. Let us examine the sources of
imperfections one by one.
Costs and Market Imperfections
The technology and the cost structure of an industry help to determine how many firms
that industry can support, and how big they will be. The key is whether there are
economies of scale in an industry. If there are economies of scale, then a firm can
decrease its average costs by expanding its output, at least up to a certain point. That
means the bigger firms will have a cost advantage over smaller firms.
The result is that when economies of scale prevail, one or a few firms will expand their
output to the point where they produce a significant part of the industry's total output.
The industry then becomes imperfectly competitive. It may be that a single monopolist
will dominate the industry. A more likely outcome is that a few sellers will control most
of the industry's output; or there might be a large number of firms, each with slightly
different products. Whatever may be the outcome, we must inevitably find some kind of
imperfect competition.

Barriers to Entry: Barriers to entry are factors which make it hard for new firms to
enter an industry. When barriers are high, an industry may have few firms and limited
pressure to compete. Economies of scale act as one common type of barrier to entry, but
there are others, including legal restrictions, high cost of entry, advertising, and product
differentiation which also act as barriers to entry.
Legal Restrictions: Governments sometimes restrict competition in certain industries.
Important legal restrictions include patents, entry restrictions and foreign trade tariffs
and quotas. A patent is granted to an investor to allow a temporary exclusive use of the
product or process that is patented. Government may also impose entry restrictions on
many industries. Typically, utilities like telephone, gas and cable, are given franchise
monopolies to serve an area in certain countries. Government can impose import
restrictions, which have the effect of keeping out foreign competitors. It could very well
be that a single country's market for a product is only big enough to support a large
number of firms. Then a protectionist policy might change the industry structure.
High Cost Industry: In addition to legally imposed barriers to entry, there are
economic barriers as well. In some industries the price of entry may be very high.
Companies may build up intangible forms of investment and these investments might be
very expensive for any potential new entrant to match.
Advertising and Product Differentiation: It is often possible for companies to create
barriers to entry for potential rivals by using advertising and product differentiation.
Advertising can create product awareness and loyalty to well-known brands. For
example, Pepsi and Coca-Cola spend hundreds of millions of dollars per year for
advertising their brands, which makes it very expensive for potential rivals to enter into
that market.
In addition, product differentiation, whether by itself or with extensive advertising, can
impose a barrier to entry and increase the market power of producers. In many
industries - such as breakfast cereals, automobiles, household appliances and cigarettes it is common for a small number of manufacturers to produce a vast array of different
brands, models and products. In part, the variety appeals to the widest range of
consumers. But the enormous number of differentiated products also serves to
discourage potential competitors. The demand for each of the individual differentiated
products will be so small that they will not be able to support a large number of firms
operating at the bottom
of their U-shaped cost curves.
MONOPOLY
Monopoly is a market structure in which there is a single seller, there are no close
substitutes for the commodity it produces and there are barriers to entry.
The main causes that lead to monopoly are as follows. Firstly, ownership of strategic
raw materials, or exclusive knowledge of production techniques. Secondly, patent rights
for a product or for a production process. Thirdly, government licensing or the
imposition of foreign trade barriers to exclude foreign competitors. Fourthly, the size of
the market may be such as not to support more than one plant of optimal size. The
technology may be such as to exhibit substantial economies to scale, which require only

a single plant, if they are to be fully reaped. For example, in transport, electricity,
communications, there are substantial economies which can be realized only at largescales of output. The size of the market may not allow the existence of more than a
single large plant. In these conditions it is said that the market creates a natural
monopoly, and it is usually the case that the government undertakes the production of
the commodity or of the service so as to avoid exploitation of the consumers. This is the
case of the public utilities. Fifthly, the existing firms adopt a limit-pricing policy, that is,
a pricing policy aiming at the prevention of new entry. Such a pricing policy may be
combined with other policies such as heavy advertising, or continuous product
differentiation, which render entry unattractive. This is the case of monopoly
established by creating barriers to new competition, as dealt earlier.
COMPARISON BETWEEN MONOPOLY AND PERFECT COMPETITION
GOALS OF THE FIRM
In both the models the firm has a single goal, that of profit maximization. It is assumed
that the firm is rational when it aims at the maximization of profit.
In both the models the owner of the firm is also the manager-entrepreneur. There is no
separation of ownership and management in these rational models.
ASSUMPTIONS
The product is homogeneous under perfect competition. In monopoly the product may
or may not be homogeneous. The main feature of monopoly is that the total supply of
the product is concentrated in a single firm.
In perfect competition there are a large number of sellers, so that each one cannot affect
the market price by changing his supply. In monopoly there is a single seller in the
market.
In perfect competition entry (and exit) is free in the sense that there are no barriers to
entry. However, in the short run entry is not easy: entry is a long run phenomenon. In
monopoly entry is blockaded by definition.
In both the models the cost conditions are such as to give rise to U-shaped cost curves
both in the short run and in the long run. The plant is planned to produce a single level
of output with minimum cost. There is no flexibility (reserve capacity) in the plant. In
the short run the U-shape is due to the inevitable results of the law of eventually
diminishing returns of the variable factors. In the long run all the factors are variable,
but eventually the efficiency of the management declines and this causes the LAC curve
to turn upwards beyond a certain (optimal) scale of output.
MONOPSONY
A market with one buyer of a good, service or a factor of production and many
competitive sellers is a monopsony. However, a monopsonist cannot purchase unlimited
amount of an input at a uniform price. The price which he must pay for each quantity
purchased is given by the market supply curve for the input. Since the supply curves for
most inputs are positively sloped, the price that the monopsonist must pay is generally
an increasing function of the quantity he purchases.

Let us consider the case of a monopsonist which describes an employer with

monopolistic buying power of labor. Monopsony has the following characteristics:
Firstly, the firm's employment constitutes a large portion of the total employment of
labor. Secondly, this type of labor is relatively immobile, either geographically or in the
sense that, if workers sought alternative employment they will have to acquire new
skills. Thirdly, the firm is a wage-maker in the sense that the wage rate it has to pay
varies directly with the number of workers it employs.
In some instances, the monopsonistic power of the employers is virtually complete
because there is only one major employer in the labor market. For example, the
economies of some towns and cities depend almost entirely on one major firm. The coal
mining concern, Bharat Cooking Coal Ltd. (BCCL) is the basic source of employment
in some of the districts of Bihar and West Bengal. A textile mill, a paper mill, or a food
processing unit operating in Haryana may provide most of the employment in its
locality. However, in other cases, oligopsony may prevail where three or four firms may
each hire a large portion of supply of labor in a particular market.
Monopsony Equilibrium
Let us suppose that a monopsonist firm is using 3 units of labor at a wage rate of Rs.60
per head. Its total factor cost for labor is Rs.180. Now the firm considers for an
additional unit of labor. Given the supply curve, the only way in which the firm can
obtain 4 units of labor rather than 3 units is to set a higher price: Rs.80. That will
increase the firm's total labor cost from Rs.180 to Rs.320. The marginal factor cost of
the fourth unit of labor is Rs.140. It includes Rs.80 that the firm pays for the fourth unit
of labor plus an additional Rs.20 for each of the 3 units the firm was already using,
since it has increased the price to Rs.80 from Rs.60. The marginal factor cost (MFC) of
labor thus exceeds the price of the factor. The MFC can be plotted for each increase in
the quantity of the factor the firm uses. As shown in figure 7.16, the MFC curve lies
above the supply curve. The MRP (Marginal Revenue Product) curve of the firm
represents the demand curve for labor. The curve is determined by multiplying the
marginal product of labor by the price of the good or service the firm produces.
Figure 7.16

The firm faces the supply curve for labor S and the marginal factor cost curve for labor
MFC. The profit maximizing quantity is determined by the intersection of the MRP
curve and MFC curves. In this case, equating MFC with labor demanded at point b, the
monopsonist will hire L* workers (compared
to under perfect competition) and pay
the wage rate W* (compared to
under perfect competition). Labor receives a wage
that is less than its marginal product.
BILATERAL MONOPOLY
We know that under monopoly a single seller in the market is able to determine the
price of the product. We have also seen that in a monopsony market there exists only
a single buyer who is able to determine the price. If a monopoly seller faces a
monopsony buyer, the situation is known as bilateral monopoly. Put differently,
market with a single seller and a single buyer is called bilateral monopoly. Suppose
that a labor union operates in a monopsony labor market, a union is like a monopoly.
It controls the supply of labor and acts like a single seller of labor. When the union
(i.e. monopoly seller) faces a monopsony buyer, the situation is one of bilateral
monopoly. This sort of situation generally arises in the labor market when the wage
rate is determined by the collective bargaining through the union of workers and the
employers. Let us suppose that a firm is the sole producer of lead sheets in India, and
there is also only one organization which uses these lead sheets in the form of lead
chambers, to regulate the spread of gamma rays in the environment. The market for
these lead sheets is a bilateral monopoly. Bilateral monopoly may also take place
between two individuals cut off from all economic activities of the rest of the world.

A monopolist does not have a supply function relating price and quantity. He selects a

point on his buyers' demand function that maximizes his profit. Similarly, a
monopsonist does not have demand function. He selects a point on his sellers' supply
function that maximizes his profit. Bilateral monopoly, as mentioned earlier, is a market
with a single buyer and a single seller. It is not possible for the seller to behave as a
monopolist and the buyer to behave as a monopsonist at the same time. The seller
cannot exploit a demand function that does not exist, and the buyer cannot exploit a
supply function that does not exist. In such a situation, three outcomes are possible.
Firstly, one of the participants may dominate and force the other to accept his price and
quantity decisions. Secondly, the buyer and the seller may collude or bargain to set
price and quantity. Thirdly, the market mechanism may break down. The theory of
monopoly and monopsony provide guidelines to the above possibilities.
The equilibrium under bilateral monopoly cannot be determined using the traditional
tools of demand and supply. There are some non-economic factors, such as bargaining
power, negotiating skills and other strategies of the two participant firms, which play an
important role in the determination of price. Under conditions of bilateral monopoly,
economic analysis can only define the range within which the price will eventually be
settled. Unless the exogenous factors are taken into account, economic analysis leads to
indeterminacy of the equilibrium.
In order to illustrate a situation of bilateral monopoly, let us assume that all lead sheets
are produced by one firm and bought by a single organization, Bhabha Atomic Research
Center (BARC). Both, the firm and BARC, are assumed to maximize their profits. The
equilibrium of the producer-monopolist is defined by the intersection of his marginal
revenue and marginal cost curves, which is depicted by the point E1 in figure 7.17. He will
maximize his profits if he produces Q1 units of lead sheets and sells it at a unit price of
P1. However, the producer cannot be a price maker because he is not facing a market
comprising of many buyers each of whom will be unable to affect the price level. As the
producer is selling to a single buyer, it is obvious that the latter can affect the market
price by his purchasing decisions.

Figure 7.17

As the buyer also maximizes profit, he tries to impose his own terms and conditions
to the seller, being aware of his relative power. As the seller determines the supply
conditions, the upward sloping portion of the MC curve of the seller represents the
supply curve to the buyer. The upward sloping portion of the MC curve implies that
as the monopsonist increases his purchases, the price he will have to pay rises.
However, the supply curve MC (= S) of the buyer (i.e. the monopsonist) is
determined by exogenous factors. It shows the quantity that the monopolist is willing
to sell at various prices. The increase in the expenditure of the buyer, (i.e. his
marginal outlay or marginal expenditure) caused by the increase in his purchases is
shown by the curve ME in figure 7.17. It can be said that the ME is the marginal cost
curve of lead sheets of the monopsonist buyer. It is the marginal outlay curve to the
total supply curve MC, which the buyer faces. The lead sheets (say, Q) are inputs for
the buyer. Thus, in order to maximize his profit he will like to purchase additional
units of Q until his marginal outlay is equal to his price, as determined by the demand
curve AR. The equilibrium of the monopsonist is shown by the point E2. Here, the
monopsonist likes to purchase Q2 units of lead sheets at a price P2, determined by the
point g on the supply curve MC (= S). It should be noted that the monopsonist does
not buy from a lot of small firms, which would have been price takers, but from the
monopolist, who wants to charge a price P1. Given that the buyer (i.e. BARC) wants
to pay P2 while the seller wants to charge a price P1, there is indeterminacy in the
market. If the two firms in the market do not negotiate, it is not possible to reach an
agreement regarding the equilibrium price (P*) which will be set somewhere in the
range between P1 and P2, i.e. P2 P P1, depending on the bargaining skills of the
monopolist and the monopsonist.

SUMMARY
In today's world, most market structures fall some where between perfect
competition and pure monopoly. A market is imperfectly competitive if the
actions of one or more buyers and sellers have a perceptible influence on price.
This broad definition of imperfect competition encompasses markets of many
different types, which can be distinguished by further classification. Product and
input markets are frequently classified according to the number of sellers and
buyers, which they contain. Product markets can be further classified with regard
to differentiation
Traditionally markets are classified on the basis of the number of sellers and
buyers and the nature of the product being sold in the market. Important kinds of
market structures are: (a) monopoly, where there is only one seller producing and
selling a product which has no close substitutes; (b) monopolistic competition,
where many sellers compete to sell a differentiated product in a market into
which the entry of new sellers is possible; (c) oligopoly, where there are only few
sellers so that there is interdependence among the sellers and the sellers are
aware of it. Each firm takes into account the rivals' reaction. The products
produced may be homogenous (pure oligopoly) or differentiated products
(differentiated oligopoly); and (d) perfect competition, where a large number of
firms sell a homogenous product. In the first three markets, the demand curve of
each firm slopes downward.
In monopoly market, there is only one seller producing and selling a product that
has no close substitutes. The monopolist firm is the industry and the demand of
the monopolist coincides with the industry demand. The monopolist can either
change price or quantity. The price elasticity of demand faced by the monopolist
is finite. Finally, since there is only one firm, entry is restricted or remote.
The main causes that lead to monopoly are:
a. ownership of strategic raw materials or exclusive knowledge of production
techniques with one firm,
b. patent rights for a product or production process,
c. economies of scale, or decreasing average costs,
d. government policies, and
e. high entry costs.
A monopolist attains maximum profit when it meets two conditions (a) MR =
MC and (b) slope of the marginal revenue should be less than the slope of the
marginal cost curve.

Under conditions of perfect competition the supply curve of a firm can be

determined from the MC curve in the short run. The supply curve is the portion
of the MC curve that lies above the AVC curve. The supply curve is upward
rising on the assumption that the firm maximizes profits. There is one-to-one
correspondence between price and quantity supplied in perfect competition.
However, under monopoly this unique relationship between price and quantity
supplied is absent and is therefore, the supply curve of a monopolist is
indeterminable.
When a lump sum tax is imposed, in case of a monopolist we need not
distinguish between the short run and the long run as under perfect competition.
This is because the monopolist generally realizes some excess profits both in the
short run and the long run. The effects of imposition of a profit or specific sales
tax are broadly the same with those in a perfectly competitive market.
A monopolist can charge different prices for the same good known as price
discrimination. A firm (monopolist) can exercise price discrimination only when
he has the ability to differentiate between consumers and consumers are unable
to resell the product. There are many forms of price discrimination, but the
standard method of classification identifies three types or degrees of
discrimination - first, second and third. First-degree price discrimination involves
charging the maximum price possible for each unit of output. Second-degree
price discrimination is an imperfect form of price discrimination. Instead of
setting different prices for each unit, it involves pricing based on the quantities of
output purchased by individual consumers. Third-degree discrimination is the
most commonly used form of price discrimination. It involves separating
consumers or markets in terms of their price elasticity of demand.
Monopsony is a form of market, where there exists only one buyer and a large
number of sellers, other conditions remaining the same as under monopoly.
Bilateral monopoly is a market form where one buyer faces one seller. When
bilateral monopoly exists, the single buyer and the single seller individually
possesses some power to fix the price at which the transaction takes place
between them.
Pricing of Factors of Production
According to the traditional analysis, different theories are required for the
determination of different factor prices because different factors of production have
different distinguished characteristics. Thus, we have theories of rent, interest, wages
and profit and these theories are distinct from the theory of product pricing. However,
according to the modern economists, the mechanism of determination of factor prices is
not fundamentally different from the mechanism of determination of product prices.
Just like product prices, factor prices are also determined by the forces of demand and
supply. The demand for any factor of production is determined by the principle of profit
maximization. The factor of production is demanded by the firm. By summing up the
demands of all the firms we get the market demand for any factor of production.

Similarly, the supply of any factor of production comes from the owners of that factor.
By summing up the supplies forthcoming from all the factor owners, we get the market
supply curve of that factor of production. At the intersection point of the market
demand and the market supply curves the price of that factor of production is
determined. This, however, happens when it is assumed that perfect competition
prevails in all the goods and factor markets.
Two further comments can be made about the theory of factor pricing:
Firstly, by factor pricing we mean the price of services received from any factor. When
we say that rent is the price of land, it does not mean that land is being sold in the
market for rent. Rather, rent is the price for the services received from land. The land
owner permits the tenant to use the land owned by him for rent. Thus, rent is the price
for
the
use
of
land
and
not
the
price
of
land.
Secondly, the theory of distribution can be considered from two standpoints. One may
be called the micro theory of distribution while the other may be called the macro
theory of distribution. In the micro theory of distribution we consider how the rates of
reward for various factors of production are determined. In other words, the micro
theory of distribution is concerned with the determination of the relative prices of the
different factors of production. On the other hand, the macro theory of distribution is
concerned with the determination of distributive shares of different factor incomes in
the national income. It deals with the determination of the share of rent, share of wages,
etc. in the national income of the country. For this reason, the macro theory of
distribution is also known as the theory of distributive shares.
NATURE OF FACTOR DEMANDS
Demand for a single factor: Let us consider a firm which employs only one factor of
production. Let us see how the demand for this factor of production is determined. We make
the following assumptions in our analysis:
i. The firm produces only one good X. This good is sold in a perfectly competitive
market. This means that the price, Px, of this good is given for all firms in the market.
ii.

The objective of the firm is profit maximization.

Figure 10.1(a): Demand for one factor

iii.

There is a single variable factor, say labor, whose market is fully competitive.
Hence, the wage rate, (w), is given for all the firms. At this wage rate the supply of
labor to the individual firm is perfectly elastic. It is denoted by a horizontal
straight line parallel to the horizontal axis. At this wage rate the firm can employ
any amount of labor it wants.
iv.The production function is given by X = f (L), where, L represents labor. It
is assumed that the Marginal Physical Productivity (MPP) of labor is positive
and diminishing. The slope of the production function is the marginal physical
productivity of labor.
= MPPL.

The MPPL declines at higher levels of employment, given the law of variable proportions.
If we multiply the MPPL at each level of employment by the given price of output, Px, we
obtain the Value of Marginal Product curve VMPL. This curve shows the value of the
output produced by an additional unit of labor employed. The firm, being a profit
maximizer, will hire a factor as long as it adds more to total revenue than to total cost.
Thus, a firm will hire a resource up to the point at which the last unit contributes as much to
total cost as to total revenue, because total profit cannot be further increased. In other words, the
condition of equilibrium of a profit maximizer in the labor market is
MCL

where, MCL
or, w

VMPL
= marginal cost of labor

given that MC L

VMPL
= w.

So we see that profit will be maximized when the value of marginal productivity of labor

is equal to the wage rate. This is shown in figure 10.2, where we plot L along the
horizontal axis and VMPL and the wage rate along the vertical axis. From the assumption
that MPPL is decreasing, VMPL curve will also be decreasing. Now if the wage rate is w1,
the VMPL is equal to the wage rate at e1 where OL1 amount of labor is employed. In other
words, it can be said that when the wage rate is w1 the firm will demand OL1 units of
labor. If the wage rate now falls to w2 the firm will maximize profit by increasing its
employment to OL2. In other words, when the wage rate is w2, the demand for labor will
be OL2. In this way it is seen that under conditions of perfect competition in goods and
factor markets, the demand curve of a firm for a single variable factor is identical with
the Value of Marginal Productivity curve of that factor.
Figure 10.1(b): Image

Figure 10.2

The demand for a variable factor depends on

i.

The price of the input: The higher the price of a factor, the smaller the demand for the
services.

ii.

The marginal physical product for the factor, which is derived from the production
function.

iii.

The price of the goods produced by the factor: It should be noted that the VMPL is
the product of the MPPL times the price of the goods, Px.
The amount of the other factors which are combined with labor: An increase in the
collaborating factors will shift the MPPL outwards to the right and hence will raise
its VMPL curve, and vice versa.

iv.

v.

The prices of other factors: since these prices will determine their demand, and hence
the demand for labor.

vi.

The technological progress. Technological progress changes the marginal physical

product of all inputs, and hence their demand.

The market demand for a factor: The market demand curve for any input is not simply
the horizontal summation of the individual demand curves of all the firms. This is due to the
fact that as the price of the input falls all firms will seek to employ more of this factor and
expand their output. Thus, the supply curve of the goods shift to the right leading to a fall in
the price of the goods, Px. As the price falls, the individual demand curves will shift to the
left. This is shown in figure 10.3(a). Initially, w1 is the wage rate and the firm is at the point a
on the demand curve d1 and employs l1 units of labor. Summing over all the employing
firms, we obtain the total demand for labor L1 at point A in figure 10.3(b). Now suppose that
the wage rate falls to w2, Other things remain the same, the firm would move along d1to b1,
increasing the employment of labor to l12. However, other things do not remain the same.
When the wage rate falls, all firms tend to demand more labor. As a result output expands.

The supply curve of output shifts to the right and the price of the goods falls. As price falls
the VMPL curve shifts to the left. Suppose the new VMP curve is d2. Thus, when the wage
rate falls to w2 the firm will be in equilibrium at b and not at b1. Summing horizontally for
all firms, we get point B of the market demand curve. If the fall in the price of the good was
not taken into account we would have obtained the point B1. The point B1, does not,
however, belong to the market demand curve for labor.

The supply of a single factor, labor: In this part we shall concentrate on the derivation of
the market supply of a variable factor. The most important variable factors are raw materials,
intermediate goods and labor. The first two types are goods and hence their market supply is
derived on the same principles as the supply of any good. The supply of labor, however,
requires a different approach.
To begin with, we assume that labor is a homogeneous factor; all labor units are identical.
The main determinants of the market supply of labor are:
i.

The price of labor.

ii.

The tastes of the consumers, which define their trade-off between leisure and work.

iii.
iv.
v.

The size of the population.

The labor force participation rate.
The occupational, educational and geographical distribution of the labor force.

The relationship between the supply of labor and the wage rate defines the supply curve.
The other determinants can be considered as shift factors of the supply curve. Since we are
interested in the supply curve, we assume that all the other determinants are given. The
market supply is the summation of the supply of labor by individuals.
Figure 10.4(a): Image

The supply of labor curve is shown in fig. 10.4(a), where we plot the wage rate on the
vertical axis and the labor-hours of work offered on the horizontal axis. It is seen that the
supply curve of labor is upward rising, i.e. the more the wage rate, the higher is the amount
of hours of work offered, which is denoted in the figure by the points A*, B*, C*, etc.
However, at some higher wage rate the hours offered for work may decline, as shown in fig.
10.4(b). In fig. 10.4(b), if the wage rate is increased to w4 the individual will work less
hours, which corresponds to w2. If the wage rate increases still further, the hours supplied for
work decline even more. This pattern of response to higher wage rates produces a backward
bending supply curve for labor as shown in the fig. 10.4(b). Up to w3, increase in wage rates
create an incentive for increased supply of labor. However, higher wage rates create a
disincentive for longer hours of work. The reason for this behavior is the fact that longer
working hours imply less leisure hours. As the wage rate increases, the individuals income
rises, and this enables the worker to have more leisure activities. However, the time for such
activities is less. Hence beyond a certain level of the wage rate, the supply of labor decreases
as the worker prefers to use his income on more leisure activities.
The demand for a variable or factor depends on the price of the input, the
marginal physical product for the factor, the price of the good produced by the
factor, the amount of other factors that are combined with the factor, and the
technology progress.
The most important variable factors are raw materials, intermediate goods and
labor. The first two types are goods and hence their market supply is derived on
the same principles as the supply of any good. The supply of labor, however,
requires a different approach. The main determinants of the market supply of labor
are (assuming that labor is a homogenous factor) the price of labor, the tastes of
the consumers, which define their trade-off between leisure and work, the size of
the population, the labor force participation rate and the occupation, education and

geographical distribution of the labor force.

Although there is general agreement that the supply curve of labor by an
individual exhibits the backward-bending pattern, economists disagree as to the
shape of the aggregate supply of labor. However, in the long run the supply
curve must have a positive slope, since young people will be attracted to the
markets where the wages are high and also older workers may undertake
retraining and change jobs if the wage incentive is strong enough.
If perfect competition prevails in the goods and the factor markets, each firm
takes the market price of the factor as given and determines the quantity
demanded at that price from the principle of profit maximization.

2 MARKS:
1. What is a product market?
Define the following:
2. perfect and imperfect market.
3. perfect and imperfect competition.
4. Monopoly.
5. Monopolistic competition.
6. Oligopoly.
7. Duopoly.
8. Monopsony.
9. Bilateral monopoly.
10. What is called price discrimination? What are its types.
11. What are the factors of production?
12. What is called a factor market?
13. What is general equilibrium?
15 MARKS:

1. Explain the different market structures.

2. Explain about the perfect market.
3. Explain the various types of imperfect markets.
4. Explain about price discrimination.
5. Explain the demand, supply and pricing of factors of production.
6. Explain about the general equilibrium and the efficiency of competitive markets.
UNIT IV PERFORMANCE OF AN ECONOMY MACRO ECONOMICS
Macro-economic aggregates circular flow of macroeconomic activity National
income determination Aggregate demand and supply Macroeconomic
equilibrium Components of aggregate demand and national income multiplier
effect Demand side management Fiscal policy in theory.
Macroeconomic Aggregates
We have explained several concepts and Macroeconomic Aggregates which form the
basic terminology of macroeconomic analysis. Like other empirical sciences, economic
analysis deals with those concepts which can actually be measured, things such as
prices of industrial production, stock prices, interest rates, gross investment, number of
the unemployed, national income, or the general price level.
The concepts like national income and national product are most significant in
macroeconomic accounting. As the accounting statement of a firm provides information
on the flow of revenues and expenses fully to show the firm's performance, the national
income accounts supply similar information for the economy as a whole. They provide
a comprehensive overview of how the economy is doing. Without a measuring rod for
national income aggregates it would be difficult to assess the performance of the
economy and the economic phenomenon as such. In this chapter, an effort is made to
explain how the flow of an economy's output is measured and why the major economic
aggregates are considered as important business and market movers.
THE CONCEPT OF THE NATIONAL PRODUCT
Among the various aspects that shape the economy is the nation's capacity to
produce goods and services and keep various factors of production employed. The
GNP growth rate, the most important indicator of the nation's economy, shows
whether the nation's income is expanding or contracting, and thus, it is the broadest
statistical aggregate of our economic output and growth. The estimates of GNP and
national income provide the policy makers and business community with the most
useful tool for analyzing an economy's economic performance, both in the shortterm and long-term periods. However, it is crucial to prepare the accurate and
reliable estimates of the national product for purposes of meaningful economic

analysis and reliable forecasting.

In simple terms, GNP is the sum of all final goods and services produced during a
specified time period, usually a year, with each class of goods and services
measured at its market value i.e. at price usually paid. If the same is estimated in
terms of factor cost i.e. the sum of all income earned by the factors of production
(i.e. wages and salaries, rents, interest and profits), then the aggregate is GNP at
factor cost. In the definition provided above, the term 'final' is used to avoid the
possibility of double counting and to ensure that only the value of final goods and
services is counted in the GNP. Why? Because the value of an intermediate class of
goods is embodied within the value of final goods and services. The term 'gross'
refers to the fact that depreciation (or capital consumption) of structures and
equipment is not deducted from the value of output. Moreover, the aggregate GNP
is a 'flow' concept. It is typically measured in terms of an annual rate i.e. over a
period of time. For instance, India's GNP was Rs.14,13,200 crore in 1997-98. This
means that Rs.14,13,200 crore worth of final goods and services were produced
during 1997-98. In stating flow variables it is important to be specific about the time
period in question. For example, it is meaningless to say that a person's income is
Rs.3000, because it is not clear whether the income is Rs.3,000 per week, per
month, or per year. Thus, the GNP is a device designed to measure the market value
of production that flows through economy's various industries and shops per year.
When measuring GNP, or any other aggregate of national product, we are interested
in the final value of goods and services. In other words, we are only interested in the
value added at each stage of production process. Value added is the difference
between the value of goods and services as they leave one stage of production and
their costs when they entered that stage. We will consider one example - production
of bread - to explain the concept clearly. As shown in figure 3.1, there are many
stages in production of bread, from the production of wheat by the farmer to milling
of wheat into flour, the baking of bread by the baker and its final sale to the
customer by the retail shop owner.
RELATIONSHIP AMONG EIGHT VARIANTS OF NATIONAL PRODUCT
AGGREGATES
We have shown the distinction between national product at market prices and
national product at factor cost, based on whether or not net indirect taxes have been
included. And there is also a distinction between gross or net national product
according to whether investment is inclusive of capital consumption or not. Further,
a distinction has been drawn between domestic and national product, according to
whether we are measuring net factor income from abroad (i.e. the net return on
factors owned by nationals of the country concerned) or whether we are measuring
what is produced within the domestic economy. This implies that there are eight
possible combinations of national product aggregates, as shown below.
Gross Domestic
(GDP)

Productat market prices (MP)

Gross
(GNP)

National

Net
Domestic
(NDP)

at factor cost (FC)

Productat market prices (MP)
at factor cost (FC)
Productat market prices (MP)

at factor cost (FC)

Net National Product (NNP) at market prices (MP)
at factor cost (FC)
The way that these national product aggregates are related to each other can be
understood from the figure 3.2.
Figure 3.2

We can sum up the differences between gross and net, market prices and factor cost and
national and domestic concepts in the following way:
Gross
Market
Prices

= Net + Depreciation
= Factor Cost + [Indirect Taxes Subsidies]

National

= Domestic + Net Factor Income from

Abroad

There are some national product aggregates that are more frequently met with and we
have several ways of ordering them. One of these is as follows:

i. Gross domestic product at market price + net factor income from abroad equals
ii. Gross national product at market prices - net indirect taxes (indirect taxes - subsidies)
equals
iii. Gross national product at factor cost - capital consumption (depreciation) equals
iv. Net national product at factor cost, which is popularly known as national income.
THE MEASUREMENT OF NATIONAL INCOME: OUTPUT, EXPENDITURE
AND INCOME METHODS OF MEASUREMENT
There are three methods of calculating national income, and they are all conceptually
equivalent to each other. These are: the output method, the income method and the
expenditure method.
These three measures give rise to several different ways of describing the various
macro-aggregates employed in compiling the national accounts and these are described
and illustrated in the tables.
The Output Method: The output method is followed either by valuing all the final
goods and services produced during a year or by aggregating the values imparted to the
intermediate products at each stage of production by the industries and productive
enterprises in the economy. The sum of these values added gives the gross domestic
product at factor cost which after a similar adjustment to include net factor income from
abroad gives gross national product at factor cost.
This approach is used to estimate gross and net value added in the primary sectors - Ex.
Agriculture, and allied activities, forestry and logging, fishing, registered
manufacturing, etc. - of the Indian Economy.
The Expenditure Method: The expenditure method aggregates all money spent by
private citizens, firms and the government within the year, to obtain total domestic
expenditure at market prices. This includes consumer spending and investment i.e. total
domestic spending. It aggregates only the value of final purchases and excludes all
expenditures on intermediate goods. However, since final expenditure at market prices
includes both the effects of taxes and subsidies and our expenditures on imports while
excluding the value of our exports, all these transactions have to be taken into account
before we obtain gross national product by this method.
For instance, in the case of private consumption expenditure, quantities of goods and
services entering private consumption are estimated by deducting from quantities
produced, quantities used up in intermediate uses, purchased by government, etc.
Similarly several items of machinery and equipment are identical and market values of
their outputs are added together to estimate capital in the form of machinery and
equipment.
The Income Method: The income approach to measuring national income does not
simply aggregate all incomes. It aggregates only those of that residents of the nation,
corporate and individual, that obtain income directly from the current production of
goods and services. It aggregates the money payments made to the different factors of
production i.e. factors income and excludes all incomes which cannot be considered as
payment for current services to production (i.e. Transfer incomes and which therefore

do not enter national income). What is factor payment for the producers is factor income
for factor owners. It includes wages and salaries (W), rent (R), interest (I) and profits
(P). The last includes profits of companies and the surpluses of public corporations.
Thus, the total of all factor income gives total domestic income which once adjusted for
stock appreciation gives gross domestic product at factor cost. If we then add on net
factor income from abroad we have obtained one measure of gross national income or
more popularly known Gross National Product.
In those cases, where the market prices of goods and services equal this unit factor cost
of production, the national income and the net national product at factor cost are equal.
This happens when business transfer payments and government subsidies to businesses
and indirect business taxes are zero. As a result, the GNP equals the national income
plus the depreciation of capital.
OTHER MEASURES OF NATIONAL OUTPUT
There are five alternative measures of national product and income:
1. Gross national product
2. Net national product
3. National income
4. Personal income
5. Disposable income
The bar charts illustrates the relationship among five alternative measures of national
product. The alternatives range from GNP, which is the broadest measure of output, to
disposable income, which indicates the funds available to households for either personal
consumption or saving.
Figure 3.4 Five Alternative Measures of Income

GNPMP measured through expenditure method is the sum of Consumption (C), Gross
Private Domestic Investment (I), Government Purchases (G) and Net Exports (E-M).
Exports include factor income received from abroad and factor income paid abroad is
included in imports. Therefore, net exports include net factor income from abroad
(NFIA). By deducting depreciation from GNPMP we get NNPMP. By deducting net
indirect taxes from NNPMP, we get NNPFC, widely known as National Income.
Through income method, national income can also be calculated by summing up
payments to all factors of production: Land, Labor, Capital and Entrepreneurship.
Factor payments to land are rents, to labor wages, to capital interest payments and to
entrepreneurship profits. Therefore national income computed through income method
is equal to the sum of rents, wages, interests and profits. Total profits can be either from
incorporated business or unincorporated business. Profits of incorporated business are
corporate profits and profits of unincorporated business (like self-employment, small
scale industries, etc.) are proprietors' income.
Personal income is the total income received by individuals that is available for
consumptions, saving and payment of personal taxes. When we subtract income that is
earned but not directly received from and add income that is received but not earned
during the current period to national income we get personal income. Thus, corporate
profits (profits before taxes) which are equal to corporate profit taxes plus retained
earnings plus dividends and social insurance taxes are deducted and transfer payments,
both government as well as business transfer payments, net interest (net interest paid by
government to persons minus interest paid by consumers) and dividends are added to
National Income to get personal income.
Disposable income is the income available to individuals after personal taxes i.e.
Disposable income = Personal income minus personal taxes. It can be either spent on

consumption or saved.
An important fact brought out from these relationships is that the estimates of net
national product calculated at factor cost and those of the national product or income are
one and the same. In other words net national product at factor cost and national income
are identical macroeconomic concepts.
DIFFICULTIES IN MEASURING THE NATIONAL INCOME
There are some conceptual and statistical problems in measuring national product.
Some items are excluded from the national income accounting, even though they would
be properly classified as "current production" of goods and services. Sometimes
production leads to harmful side effects which are not fully taken into consideration. A
brief discussion of some of these limitations of national products is given below.
Non-market Production
The national product fails to account household production because such production
does not involve a market transaction. As a result the household services of millions of
people are excluded from the national income accounts. For instance, house work done
by house-wives is not included but the same work done by a paid servant is. Their
exclusion results in some oddities in national income accounting and underestimates our
national product.
Imputed Values
Some self supplied goods and services are given as imputed value for their inclusion in
national income accounts. For instance owner-occupied houses and the value of food
consumed by the farmers themselves. Sometimes this may result in overestimation or
underestimation of national product.
The Underground Economy
There are many transactions that go unreported because they involve either illegal
activities or tax evasion. Most of these underground activities produce goods and
services that are valued by purchasers. However, these activities are unreported and not
included in national income accounts. They do not figure in our national product
estimate.
"Side Effects" and Economic "Bads"
National income accounts make no adjustment for harmful side effects that
sometimes arise from several productive activities and the events of nature. If they
do not involve market transactions, economic 'bads' are not deducted from national
product. When private property rights are not defined properly, air and water
pollution are sometimes side effects of the process of economic activity and reduce
our future production possibilities. Similarly the growing defense expenditure and
the greater outputs of military equipment might increase the national product but the
moot point is whether the country has become better off or not. Since national
accounts ignore these negative aspects of growth and development, it tends to
overstate our real national output.

Leisure and Human Costs

According to Simon Kuznets, the inventor of GNP, the failure to fully include leisure
and human costs is one of the grave oddities of national income accounting. National
income accounts exclude leisure, a commodity that is valuable to everybody. Similarly,
national product also fails to take into account human costs of employment in terms of
the physical and mental strains associated with many jobs. On an average, jobs today
are relatively less strenuous and less exhausting than they were some 40 years ago, but
they have become perhaps more monotonous. These limitations reduce the significance
of national product comparisons in the long run.
Double Counting
There is a possibility that some output may be counted twice. Thereby the measure of
national product is exaggerated. We must exclude the value of inputs if they have
already been accounted for. Because the distinction between intermediate products and
final products is vital in connection with the welfare significance of the national product
measure.
THE USES OF NATIONAL INCOME STATISTICS
National income statistics have four main uses:
i. As an instrument of economic planning and review.
ii. As a means of indicating changes in a country's standard of living.
iii. As a means of comparing the economic performance of different countries.
iv. To indicate changes in the economic growth of a country.
AS AN INSTRUMENT OF ECONOMIC PLANNING AND REVIEW
The statistics provide important background information on which the government can
base its decisions. Private corporate sector can also use the statistics to assess future
prospects. The figures help in answering numerous questions, such as whether the
economy is growing and at what rate. Which industries are declining and which
expanding? What is happening to consumer spending, savings, investment and the
economy as a whole?
AS A MEANS OF INDICATING CHANGES IN A COUNTRY'S STANDARD OF
LIVING
National income statistics are used to assess changes in the standard of living within a
country. If the national income increases, it is normally assumed that the standard of
living has improved. However, this may not be the case and certain factors have to be
taken into account to understand why the living standard has not improved:
- National income statistics may be expressed in market or current prices and therefore
show an increase due to inflation. Real national income or national income at constant
prices, where statistics are expressed as an index of prices, is a more reliable indicator.
- To calculate real national income or national income at constant prices for year X:

National income at market prices

x
- National income must be related to the size of population. When national income is
divided by the total population, this gives per capita (or per head) national income.
Another problem, however, is that this says nothing about the distribution aspects of a
national income.
The increase in national income may be accompanied by high social costs such as
pollution, congestion and damage to the environment. There may be less leisure time,
too.
- The national income increase may be due to more exports and fewer goods for home
consumption or more defense spending. Both these situations may not improve citizens'
standard of living.
- National income statistics say nothing about the quality of output
TO INDICATE CHANGES IN ECONOMIC GROWTH OF A COUNTRY
The best indicator of economic growth is changes in real national income per capita.
However, usually growth is expressed in terms of percentage changes in GNP.
Economic growth is usually thought to be desirable because it means a better standard
of living for citizens and more wealth to be allocated. More money can be spent on
social overheads such as education, health, etc.
Nevertheless, economic growth may involve social costs, as indicated above. Indeed,
economic growth does not necessarily bring happiness and total well-being.
It is a fact that our economic growth during the past two decades has been disappointing
compared to that of other developing and newly industrialized countries (NICs) such as
China, Taiwan, South Korea, Singapore, etc.
The reasons for this may include:
- poor management of public and private sector undertakings;
- damage done by industrial disputes and frequent lockouts;
- education not fitting industry's needs and requirements;
- lack of investment in new technology;
- propping up old and declining industry;
- government taxation policy reducing the amount of money corporate sector has for
investment;
- constant changes in government economic policy - high interest rates, high exchange
rates, inflation followed by changes in administered prices, budget deficits, etc.;
- low quality of labor;
- low levels of productivity;
- lack of consistency in managing the economy and policy; and
- fragile Balance of Payments (BoP) situation.

AS A MEANS OF COMPARING THE ECONOMIC PERFORMANCE OF

DIFFERENT COUNTRIES
National income statistics give a guide to the standard of living in two different
countries. However, there are again some difficulties:
- The statistics may be calculated differently.
- To avoid the effects of inflation and population size, the statistics are best
presented as real national income per capita.
- The distribution aspects of national output does not figure in the statistics.
- There is the problem of the exchange rate between the currencies of the two
countries.
- The size and composition of unrecorded transactions may differ between the two
countries.
- The two countries may have different cultures and climates, therefore commodities
required in one country are not in demand in the other.
- National income statistics tell us nothing about the number of doctors per head of
population, the availability of leisure activities, the crime rate or the number of
people physically or mentally ill.
The Aggregate Demand Curve
The aggregate demand curve shows the combinations of the price level and the level of
output at which the goods and money markets are simultaneously in equilibrium. Let us
now go on to the derivation of the aggregate demand.

In the figure 6.1 the aggregate demand curve is derived from the ISLM framework.
Suppose the given price level is P0 and the nominal stock of money is . The real
stock of money is then

and the LM curve corresponding to this stock of real

money is shown in the top panel of figure 6.1.

The IS curve is also shown.
The economy is at the equilibrium point E. The output is Y0 and the interest rate is
i0. Thus when the price level is P0, the goods and the money markets are in
equilibrium at an income level of Y0.
The point E in the lower panel of figure 6.1 shows the income and price
combination (Y0, P0).
Now, if the price level falls from P0 to Pl, the real stock of money in the economy
increases to

(for the same nominal stock of money

). This increase in the real

stock of money shifts the LM curve downwards to LMl

. The new equilibrium is

at the point El. At El, the income is higher at Yl and the interest rate is lower at il.
Thus when the price level is Pl, the goods and the money market are in equilibrium
at an income level of Yl. We see that when the price level falls from P0 to Pl, the
income level rises from Y0 to Yl. The converse happens when the price level rises.
Thus we get a downward sloping aggregate demand curve.

Aggregate Demand Policies

Both fiscal and monetary policy changes shift the AD curve. Let us see how,
starting with a fiscal expansion. See figure 6.2. In the upper panel, the initial LM
and IS schedules correspond to a given nominal quantity of money and the price
level P0. The equilibrium is at point E and there is a corresponding point on the
AD schedule in the lower panel. When there is a fiscal expansion, the IS schedule
shifts outward and to the right. At the initial price level there is a new equilibrium
at point El with higher interest rates and higher level of income and spending.
Thus at the initial level of prices, P 0, equilibrium income and spending are now
higher. This is shown by plotting point El in the lower panel. Point E l is a point on
the new aggregate demand curve AD l. Doing a similar exercise at other points on
the original AD leads us to the derivation of the new aggregate demand curve ADl.
We see that the aggregate demand curve has shifted to the right because of fiscal
expansion. A fiscal contraction produces the opposite result.

Now, let us study the effect of change in monetary policy on the aggregate demand
curve. See figure 6.3. An increase in the nominal stock of money implies a higher real
money stock at each level of prices and thus shifts the LM curve to LMl in the upper
panel.
The equilibrium level of income rises from Y0 to Yl at the initial price level, P0.
Correspondingly, the AD curve moves out to the right, to ADl, with point El in the lower
panel corresponding to El in the upper panel. The AD curve shifts up in exactly the same
proportion as the increase in the money stock. For instance, at point K the price level, Pl,
is higher than P0 in the same proportion that the money supply has increased. Real
balances at K and ADl are therefore the same as at E on AD.
AGGREGATE SUPPLY (AS)
We now shift our attention to the supply side of the macroeconomy. Aggregate supply
explains the production and pricing side of the economy and the behavior of the
businesses as a whole. This is something contrary to the Keynesian model (which is
based on demand side of macroeconomy) where the price level was assumed to be
constant and output was demand determined. This implies that aggregate supply is
perfectly price elastic up to the full employment level of output. However, to have a
more realistic bent of analysis, we relax the assumption of constant price level and
allow aggregate supply to vary with changes in the price level. Moreover the behavior

of the aggregate supply is not as straightforward as the behavior of aggregate demand

because we must distinguish between aggregate supply in the short run and aggregate
supply in the long run. In the short run, the interaction between aggregate demand and
aggregate supply determines the level of the output, employment, and capacity
utilization as well as the price level (the source of inflation). In the long run, a decade or
more say, aggregate supply is considered as the major factor behind economic
development and well-being of a nation. Let us begin with aggregate supply in the short
run.
Aggregate Supply in the Short Run
Production takes place in business sector on the basis of an expected price for its
output. However, costs are incurred in anticipation of sales. This is the risk of
production since firms cannot know in advance how much this output will sell
for. If the actual price achieved exceeds the expected price, firms will experience
a higher than anticipated level of profits and this will encourage an increase in
production. This implies that the short run AS curve slopes upward from left to
right for part of its range because at any point in time there is a limit on the output
of goods and services. This limit increases as with increased production, the
availability of idle resources decreases and this `limit' is reached when the
production reaches full employment level of output. When the resources available
are fully employed the short run aggregate curve will become vertical. At this
point, further increases in price level will have no effect on output.

Aggregate Supply in the Long Run

In the short run, the discrepancy between actual and expected price level causes changes
in output and employment. But in the long run, if all other things remain constant, the
higher price level will come to be accurately expected by firms, narrowing down the
difference between expected and actual price levels. This is important because in the
long run, the costs incurred by business firms rise as economic agents react to higher
prices. Wage earners, for example, now pay more for the same basket of goods and
services they used to purchase earlier. A hike in wage rates will be bargained for and the
same will be reflected in higher prices by the suppliers of goods and services.
As we have seen, the higher level of output in the short run was possible only because
the unanticipated rise in the price level led to higher profits to business firms. As soon
as the costs increase in line with final prices, the incentive to produce higher levels of
output disappears and the production reverts to its original level. In this situation, the
level of output will be at its natural rate and deviations from this state are possible only
when actual price level differs from the expected price level in the short run. Thus, in
the long run, the natural rate of output is the equilibrium rate of output for the economy.
As shown in figure 6.5 the short run aggregate supply curve is given by ASS and ASL is

the long run aggregate supply curve. The level of output is given by Q which is the
natural rate of output.
FACTORS RESPONSIBLE FOR CHANGES IN AGGREGATE DEMAND
The Aggregate Demand curve shows an inverse relationship between the quantity of
goods and services demanded and the price level, other things remaining constant.
However, there are several other factors, which might affect aggregate demand apart
from the price level. These factors include the level of income, the rate of interest, the
exchange rate, expected rate of inflation, government policy, business expectations and
so on.
In the long run the changes in aggregate demand cause changes in nominal income only
by changing the price level. Because in the long run the level of real income is fixed at
the natural rate. Depending on whether the change in aggregate demand is expected or
unexpected it may encourage business firms to increase aggregate supply in the short
run. But in developing economies like India, the rise in aggregate demand, in many
cases, results in spiralling inflation on account of supply bottlenecks and inadequate
infrastructural facilities, sometimes demanding stringent monetary controls.
A change in Income: This is one of the major factors affecting disposable income
and thus, aggregate demand. If institutional change or technological innovation
enhances the efficiency of factor inputs and shifts the natural rate of output to a
higher level, this implies an increase in aggregate supply in the long run. This, in
turn, results in higher level of real incomes to the community, because the higher
level of output will provide higher incomes. However, according to monetarists, a
rise in nominal income caused by an increase in the money supply will also result in
expansion of aggregate demand. If the money supply increases economic agents will
be holding increased money balances, and consequently they will increase
consumption spending.

Rate of Interest: One of the reasons for downward sloping of aggregate demand curve
is that as the price level rises the rate of interest will also rise and this in turn will reduce
expenditure. As the price level rises, the cost of capital also rises and this will dampen
with the decline in expenditure, both consumption and investment spending. The
analysis is as follows. Interest rate changes depend on several factors, apart from the
changes in price level. When the rate of interest changes and other things including the
price level remain constant, this alters the real cost of lending or borrowing. If the rate
of interest falls and the price level is constant, firms will be more willing to borrow to
finance investment spending and households will be encouraged to borrow to purchase
consumer goods. Therefore, the implication is that a decline in rate of interest when
price level is constant will lead to an increase in aggregate demand i.e. AD curve shifts
upward to the right, and a rise in interest rate when the price level is constant will work
as a disincentive to the business firms and finally lead to a fall in aggregate spending or
aggregate demand.
Government Policy: The changes in the fiscal policy, to a very large extent, can
powerfully influence the aggregate demand. It is an established fact that if all other

things remain equal an increase in government spending on goods and services imply an
outward shift of the aggregate demand schedule. However, an increase in transfer
payments or a reduction in taxation of incomes increases disposable income, leading to
an increase in consumption spending. All this implies an increase in aggregate demand.
The aggregate demand can also be increased, by cutting other taxes such as excise
duties, which will result in increased spending power.
In most of the developing countries including India, there is a significant change in
fiscal policy in recent years. The emphasis is now more on the effect of government
borrowings caused by an excess of spending over revenue from taxation (i.e. a budget
deficit which is essentially a revenue deficit) on the money supply. But it is argued
particularly that a budget deficit causes an increase in the money supply, and that it is
through this way the aggregate demand increases. Whatever may be the case, it is not
disputed that a budget deficit will shift the aggregate demand curve outwards. It
happens the other way if the government cuts its expenditure and/or raises the rate of
taxation.
A Change in the Exchange Rate: The changes in the prices of exports and imports are
due to the changes in the exchange rate. Particularly the price foreigners pay for exports
will fall, if the exchange rate falls and the price for imports paid by the domestic
residents will increase.
The result is that, though there has been no change in the domestic price level, exports
will increase and imports will fall. This specifically implies that aggregate demand will
increase at each and every price level when there is a fall in exchange rate.
The situation is different if the exchange rate rises. The proposition changes with
respect to the prices paid by the foreigners and domestic residents for exports and
imports respectively. The former have to pay increased prices for their exports and there
is fall in the price paid for imports for the latter. Consequently demand for exports will
fall while demand for imports will rise although the change in exchange rate will have
no direct effect on the domestic price level. This implies that if there is a rise in the
exchange rate, there is a fall in aggregate demand at each and every price level.
Change in the Expected Rate of Inflation: Any change in the expected rate of
inflation will tend to affect aggregate spending, provided that other things remain
constant. If the expectation of the economic agents is that there will be a rise in the
inflation rate in future, they also expect a fall in the value of their real money
balances in future. Acting accordingly they will bring forward many of their
spending plans which they are able to. Therefore an increase in the expected rate of
inflation is followed by a rise in aggregate demand and a reduction in the expected
rate of inflation causes a reduction in aggregate demand.
Change in Business Expectations: The investment decisions are highly influenced by
the expectations of the future. Confident and optimistic decision takers push up their
investment levels expecting a spurt in sales. Therefore the aggregate demand also rises.
Conversely there will be a fall in aggregate demand, if the investments are discouraged
due to business pessimism.
FACTORS RESPONSIBLE FOR CHANGES IN AGGREGATE SUPPLY

We know that changes in input costs such as wages, oil and other input prices will cause
changes in aggregate supply. Most of the factors which affect the position of the
aggregate supply curve in the short run also affect the position of the aggregate supply
curve in the long run. However, there are situations when there is a shift in the short run
aggregate supply curve which will have no effect on the long run aggregate supply
curve. These factors are, changes in costs of production, supply disturbances,
investment and technological changes. There are several factors which affect aggregate
supply as explained below.
Change in Costs of Production: The short run aggregate supply curve indicates the
level of the output that will be produced at a given level of price. An increase in the
input costs such as labor or raw material costs, other things remaining constant, will
reduce the output that the business firms are willing to supply at a given price level.
Therefore the short run aggregate curve shifts upward from right to left.
However, an increase in the cost of producing any given level of output does not alter
the long run aggregate supply curve, irrespective of changes in the costs in the short
run. Similarly a reduction in the input costs will have the opposite effect on the short
run aggregate supply curve, but again it will have no effect on the long run aggregate
supply curve.
Supply Shock or Supply Disturbances: Any increase or decrease in current output is
temporarily caused by occurrences of supply disturbances, or supply shocks. For
example, favorable weather conditions will cause a bumper harvest while unfavorable
conditions will cause a shortage. For economies which are predominantly agricultural
like India, the effect on aggregate supply will be very significant. In such countries a
natural calamity or disaster such as major floods and drought will also adversely affect
aggregate supply. As these disturbances are of a temporary nature, with the return of
normalcy the aggregate supply will return to the previous level.
Investment Spending and Technological Changes: The other important factors which
influence the aggregate supply both in the short run and the long run are investment and
technological progress. If other things remain equal, the productivity of an economy
will increase with the investments in additional capital assets. Therefore, the three
factors discussed above, namely costs of production, supply shocks, investment and
technological change can shift aggregate supply curve in the short run, but will have no
effect on the long run aggregate supply curve.
Availability of Raw Materials: The productive potential of any economy is
determined by the availability of raw material which is an important factor of
production. The availability and accessibility of additional raw materials input will
expand the productive base of any economy. An increase in availability of raw materials
initially costs low to businesses and this implies an outward shift in AS curve.
Consequently with a fall in costs of production and constant price levels, the profits
from any given level of production increase and therefore firms are encouraged to
expand their output. Naturally the output is also on the higher side due to the
availability of more raw materials.

Supply of Labor: The outward movement of both short run and long run aggregate
supply curve is due to the increase in supply of labor, provided other things are
constant. Other things remaining constant, in the short run, an increase in the labor
supply will bid down the market wage and thus raise the profits for businesses from
producing any given level of output. In the long run, the increase in supply of labor will
enable an increase in the natural rate of output, which will enlarge the productive base
of the economy.
Human Capital: It is a known fact that any economy with more highly skilled labor
force has greater productivity. The nexus between the Human Capital and factors like
education, training and health care have an important bearing on aggregate supply.
Increase in training initiatives in order to raise the skill levels of the labor force will
shift the short run aggregate supply curve as well as long run aggregate supply curve
outwards.
Incentives: The role of incentives in improving the supply side of the economy is
gaining considerable importance in the recent years. A lot of emphasis is laid on
increasing incentives leading to an increase in productivity factors of production. Thus
the incentives are considered as an important factor directly affecting the aggregate
supply both in the short run and in the long run.
AGGREGATE SUPPLY,
EMPLOYMENT

AGGREGATE

DEMAND

AND

LEVEL

OF

As is the case with the supply and demand function for a single business firm
determining the equilibrium price and output for its product, the aggregate supply
and aggregate demand functions determine the equilibrium price level and output of
an economy. According to this level of output, there is some employment which is
given by the production function (i.e. a functional relationship between inputs and
outputs) for that corresponding level of output. J M Keynes showed that this level of
employment may fall significantly from the desirable level of employment. In other
words, at the current market wage, the number of workers seeking gainful
employment may exceed the number of workers actually absorbed or employed in
the economy. Even then, this situation of less than full employment can be an
equilibrium situation, which is called a less-than-full employment equilibrium - a
normal phenomena in real life. Keynes says that in a free enterprise capitalist
economy laissez-faire less-than-full employment is possible. On the contrary
classical macro analysis with its underlying assumptions i.e. wage, price flexibility
negated any possibility of underemployment situation in the economy. However the
happenings of 1930s Great Depression and the recessionary conditions prevailing in
industrialized countries since 1970 proved fatal to the orthodox thinking and forced
governments to resort to fiscal measures as advocated by Keynes. A detailed
analysis of this will be explored as we proceed.
Fiscal Policy

Until the advent of the Keynesian Revolution, it was widely held that a

responsible government would contain its expenditure within the bounds of its
revenues and that budgets should always be balanced. However, during times of
war or other natural calamities, this principle was set aside. The Keynesian
revolution eventually altered our view of budgetary policy, especially in the
private enterprise economies like the USA, the UK and other Western economies.
By the early 1960, economists and policy makers as well as citizens started
realizing that the government's expenditure and revenue policies and the budget
deficit or surplus should reflect the state of the economy.
After being largely accepted and put into practice for about two decades
following the Second World War, the Keynesian view of budgetary conduct and
the role assigned to the government in fine tuning the economy, have now come
to be questioned. And the conventional view of budgetary conduct has now
returned to the center of policy debate. The reasons for this are manifold.
They include a growing disillusionment with traditional Keynesian economic
remedies for inflation and unemployment and the theory that public expenditure
simply replaces private expenditure with little impact on the overall level of
aggregate demand and output. This is known as the crowding-out effect.
However, economists and policy makers would accept that the government can
influence the level of domestic economic activity to some extent and it must be
realized that the blanket requirement for budgetary balance means that
governments must cut their spending during recessionary conditions when tax
revenues fall. This, in turn, limits government intervention by reducing injections
into the circular flow and further worsens the recessionary conditions. It was one
of the central insights of Keynes' General Theory that governments could use the
budget to stabilize the economy by acting counter-cyclically. According to him,
abrupt changes in demand are a potential source of both recession and inflation.
Policies that effectively stabilize aggregate demand will substantially reduce
economic instability. Even if we partly accept this view, it implies governmental
determination to moderate economic fluctuation through its fiscal and monetary
instruments and to go ahead with rising budget deficits during recessionary
conditions. The government in a developing economy like ours can influence
income levels and moderate economic fluctuations through taxation and
expenditure policy. Taxation and expenditure policies are used, for instance, to
make the distribution of wealth and income more equitable, by laying higher
average rates of tax on the rich and providing safety net benefits to the lower
income groups. Taxes and subsidies are also widely used to influence relative
prices in order to discourage some utilities e.g. the consumption of tobacco and
alcohol, and encourage others e.g. investment in agriculture and industry. Further,
at a macroeconomic level, rather than the microeconomic level, the balance of tax
revenue and expenditure can be affected to influence the overall amount of
spending or aggregate demand in the economy which, in turn, influences output
and employment. Assuming all other factors to be constant, tax cuts by affecting
households disposable income tend to stimulate aggregate demand while
reductions in government expenditure will have the dampening effect by

adversely affecting aggregate demand in the economy.

THE FISCAL INSTRUMENTS
The tax and expenditure policies together constitute fiscal policy of a government. The
fiscal policy has a direct bearing on the level of aggregate demand and the level of
economic activity. It refers to policies pertaining to taxes and government expenditure
including transfer payments. The overall conduct of these policies play an important
role in maintaining economic stability, including high employment and control of
inflation. Raising public expenditures will be expansionary as demand is increased,
initially in the public sector and then transmitted to the private sector. Tax reduction,
similarly, may be expansionary as taxpayers are left with a higher level of income and
tend to spend more.
In designing a tax-expenditure system the government must balance a number of
conflicting considerations. The tax-expenditure system has significant effects on the
relative prices of goods, labor and capital and affects resource allocation, saving and
investment. The incidence of tax burden and the distribution of benefits from
government expenditure can have substantial income distributional effects. However,
the fiscal policies need to be handled in such a manner that the basic objectives
including allocation, distribution and stabilization aspects can be taken care of at the
same time.
Tax Policy and Structure
A good economic analysis, considers the joint effect of both the aspects: (a) the revenue
side of the budgetary policy, and (b) the expenditure side of the budgetary policy. Let us
first examine the principles, the structure and the requirements of a good tax system.
Receipts, on the part of the government, may take place in either of the three forms:
taxes, charges and borrowings. Taxes and charges are withdrawn from the private sector
without leaving the government with a liability to the payee, whereas, borrowing
involves a withdrawal made in return of the government's promise to repay at a future
date and to pay interest in the interim. Taxes are compulsory imposts whereas charges
and borrowings involve voluntary transactions. Moreover, among these three forms,
taxes provide the largest volume of receipts.
Principles of Taxation
The principles of taxation are generally constructed following the equity objective. This
implies that every taxpayer should contribute his fair share to the cost of government,
though there is no such agreement about how the term fair share should be defined. The
question of equity objective following fair distribution involves considerations of social,
philosophy and value judgment. Distribution should be arranged so as to maximize total
satisfaction and that distribution should meet certain standards of equity, which in a
limiting case, may be egalitarian. However, considering the question of distributive
justice, two basic strands of thought may be distinguished. One approach rests on the
"Benefit Principle" and the other on the "Ability to Pay Principle".
According to the Benefit Principle different persons should be taxed in the proportion of

the benefit they receive from the various public services. The Benefit Approach will
ideally allocate that part of the tax bill which defrays the cost of public services, but it
cannot handle taxes needed to finance transfer payments and serve redistributional
objectives. So the truly equitable tax system will differ depending on the expenditure
structure of the government. The benefit criterion, therefore, is not one of tax policy
only but of tax- expenditure policy also.
Taxation, according to the Ability to Pay Principle, calls for people with equal capacity
to pay the same, and people with greater capacity to pay more. Under this approach, the
tax problem is viewed by itself, independent of expenditure determination. A given total
revenue is needed and each taxpayer is asked to contribute in line with his ability to
pay. The higher the income or wealth of the person the higher is his tax burden. If
income is used as an index of the ability to pay, then income taxation is the appropriate
instrument and people with the same income should pay the same tax. Using tax
systems organized along the ability to pay principle are more redistributive in the sense
that, they raise funds from higher income group to increase the incomes and
consumptions of the lower income group.
Neither approach is easy to interpret or implement. For the benefit principle to be
operational, expenditure benefits for particular taxpayers must be known. For the ability
to pay approach to be applicable, we must know just how this ability is to be measured.
These are formidable difficulties and neither approach wins on practicality grounds.
Moreover, neither approach can be said to deal with the entire function of tax policy.
For benefit taxation to be equitable, it must be assumed that a "proper state of
distribution" exists to begin with. This is a serious shortcoming since, in practice, there
is no separation between the taxes used to finance public services and the taxes used to
redistribute income. The ability to pay approach better meets the redistribution problem
but it leaves the provision for public services undetermined.
Notwithstanding these shortcomings, both principles have important, if limited,
application in designing an equitable tax structure, one which is acceptable to most
people and preferable to alternative arrangements.
Horizontal and Vertical Equity
Taxation, according to ability to pay, calls for people with equal capacity to pay the
same, and for people with greater ability to pay more. The former is referred to as
horizontal equity and the latter as vertical equity. The horizontal rule merely applies the
basic principle of equity under the law. If income is used as the index of ability to pay,
income taxation is the appropriate instrument and people with the same income should
pay the same tax. The vertical equity rule is also in line with equal treatment but
proceeds on the premise that this calls for different amounts of tax to be paid by people
with different ability to pay. Person A, whose income is higher, should pay more than
person B. In this sense both equity rules follow from the same principle of equal
treatment and neither is more basic than the other.
However, implementation of either rule requires a quantitative measure of ability to
pay. Ideally this measure would reflect the entire welfare which a person can derive

from all the options available to him, including consumption (present and future),
holding of wealth and enjoyment of leisure. Unfortunately such a comprehensive
measure is not practical, basically because the value of leisure cannot be measured.
Choice of the Base
The distribution of the tax base is of great importance because it shows where the
money comes from. Income has served as the base of personal taxation under the
income tax. More recently there has been growing support for consumption as a
superior choice. But both income and consumption base advocates agree that the
respective bases should be defined comprehensively.
Considering the income as the base, it should be thought of as a person's entire
accretion to his wealth, including all forms thereof. While analyzing a person's
economic capacity and hence ability to pay, his capacity is increased whether
income accrues in the form of money income (such as wages, salaries, interest or
dividends), imputed income (such as imputed rent from owner occupied housing), or
as an appreciation (whether realized or not) in the value of assets.
If we consider consumption as the base, the requirement of comprehensiveness calls
for inclusion of all forms of consumption, whether it takes place in the form of cash
purchases or whether the consumption stream is derived in imputed form. Since
income equals increase in net worth (or saving) plus consumption, whereas the
consumption base includes consumption only, the consumption tax differs from the
income tax by excluding income that is saved.
Both the bases being defined comprehensively, the question is which is the better
base to choose? According to Hobbes, vise should be taxed and virtue be rewarded.
Let us consider an example. Assume that A and B are two individuals, both with an
income of Rs.10,000 per period. A consumes all of his income in the period he
receives it whereas B saves and consumes in the next period. Let
us consider the impact of income tax on A and B. A pays income tax only for one
month but B pays it for the two periods. This is because, after paying the same tax as A
in the first period, B further pays a tax on interest income in the next period. Say, B's
total tax paid amounts to Rs.1120 against Rs.1000 only for that of A. Under the
consumption tax, A pays Rs.1000 in the first period, whereas B pays Rs.1100 in the
next period. Since a tax postponement is a gain to the taxpayer it is reasonable to
consider the discounted value of the tax burden. So, it is seen that, though both A and B
pay the same amount of taxes under the consumption tax, but B pays more under the
income tax structure. It can, therefore, be said that the consumption tax approach gives a
better solution compared to the income taxation approach. In this context it should be
noted that consideration of income as the base, manifests itself in the form of direct
taxes and consumption-base in the form of indirect taxes. This is because direct taxes
are imposed on the income or wealth of the taxpayer and indirect taxes are imposed on
the commodities and services consumed by the taxpayer.

2 MARKS:
1. What are the macroeconomic aggregates?
Define the following:
2. GDP.
3. GNP.
4. NP.
5. NI.
6. PI.
7. DPI.
8. Write down the various definitions of National Income.
9. What are called aggregate demand and aggregate supply?
10. What is called macroeconomic equilibrium?
11. Define multiplier.
12. What is called dynamic multiplier?
15 MARKS:
Explain the circular flow of macroeconomic activity.
1. Explain the components of national income.
2. Explain the ways to determine national income and the difficulties in measuring
it.
3. Explain the factors determining national income.
4. Explain the components of aggregate demand?
5. Explain the determinants of aggregate supply.
6. Explain the types of multiplier.
7. Write in detailed manner about the types, working, assumptions and the effect of
multiplier.
8. Explain about the demand side management.

9. Write an essay on Fiscal Policy.

UNIT V AGGREGATE SUPPLY AND THE ROLE OF MONEY

Short-run and Long-run supply curve Unemployment and its impact Okuns
law Inflation and the impact reasons for inflation Demand Vs Supply factors
Inflation Vs Unemployment tradeoff Phillips curve short- run and long-run
Supply side Policy and management- Money market-Demand and supply of money
money-market equilibrium and national income the role of monetary policy.
Monetary policy is concerned with the supply of money in the economy and costs of
borrowing it. The broad aim of the policy is to control the growth of the money supply
so as to avoid an excessive rate of inflation. But what exactly is meant by 'money
supply'?
Money is as money does. If the authorities aim to control the growth of money supply,
they must first define which variables they are going to control. Thus, we have to define
the range of assets which performs the functions of money. But, it is very difficult to
define because some assets perform some of the functions of money and different assets
perform different functions of money.
At various times in the past, societies have used gold, silver, sea shells, precious stones
and other commodities as money. When commodities are used as money, people use
valuable resources to expand the supply of the commodity money. Thus, the
opportunity cost of commodity-based money is high.
But, if a society uses something as money that costs little or nothing to produce, more
scarce resources will be available for the production of desired goods and services.
Thus, most modern nations use fiat money, money that has little or no intrinsic value.
Though its intrinsic value is nil, people are willing to accept fiat money because they
know it can be used to purchase real goods and services. This is a matter of law. The
government has designated currency as 'legal tender' - acceptable for payment of debts.
The value of money is derived in the same way as the value of any other commodity is
derived. The value of a rupee is measured in terms of what it will buy. Therefore, its
value is linked to the price levels. An increase in the prices means a decline in the
purchasing power of money. Thus, if supply of money grows more rapidly than growth
in the real output of goods and services, with the constant rate of use of money, prices

will rise because the quantity of money will be more relative to the availability of
goods. This is a situation of 'too much money chasing too few goods.
MONEY SUPPLY - COMPONENTS
Determining what should be included in the money supply is not as easy as it appears.
Money is sometimes defined as anything generally acceptable as a medium of
exchange.
THE MEASURES OF MONETARY AGGREGATES
Since July, 1935, the concept of money supply as compiled by the RBI was the sum of
currency with the public and demand deposits with the banking system. This came to be
known as 'narrow money' and represented as M1. The concept of 'broad money', also
referred to as Aggregate Monetary Resources, equivalent to the sum of M1 and the time
deposits with the commercial banks was first introduced in the financial year 1964-65.
On acceptance of the Report of the Second Working Group in March, 1970, a series of
new aggregates, given below, came into effect
M1
= Currency with the public* + Demand Deposits with the Banking System +
Other Deposits with the RBI
M2
=
M1 + Post Office Savings Bank Deposits
M3
=
M4
=
Certificates)

M1 + Time Deposits with the Banking Syste

M3 + Total Post Office Deposits (excluding National Savings

* Currency in circulation = Currency with the public + Currency with the commercial
banks.
Out of the four concepts of money supply, RBI emphasizes two concepts viz., narrow
money (M1) and broad money (M3). These are the concepts which are extensively used
not only by the monetary authorities but also by the people of academic interest.
Narrow money excludes time deposits based on the argument that they are income
earning assets and therefore illiquid. On the contrary, broad money includes time
deposits following the argument that, as time deposits are income earning assets and
people have acquired them by converting cash into time deposits for earning future
interest income some amount of liquidity is incorporated in time deposits. Now-a-days
as banks are following liberalized norms, partial or even full convertibility is allowed to
time deposit holders, which has made time deposits even more liquid in nature.
A basic flaw of the RBI in the process of accounting broad money is that it considers only
time deposits with the banking system and excludes the huge volume of money held by
the public with the Non-Banking Financial Companies (NBFCs).
The M2 and M4 measures of money supply include post office savings account and
other deposits with the post offices. As these are also considered to be liquid assets they
should form a part of the aggregate monetary resources of the public. However, the RBI
considers the use of data on M2 and M4 as conspicuous by their near absence and does
not attach much importance to the above measures. The basic reason for this is that

during the pre-1969 period the post offices catered the facilities of the banking system
due to the suboptimal banking system network.
Later when the banking network improved by leaps and bounds in the rural and semiurban areas the strength of this reasoning lost its sharpness. Moreover, there were some
operational problems encountered with the functioning of the postal department. Firstly,
the time lag involved in the monthly flow of data from the postal department, which
renders the relevant aggregates less significant. Secondly, there exists some amount of
opaqueness in the manner the deployment of postal deposits take place, as the postal
department is a part of the general government.
Comparing M1and M3, we find that the latter captures the balance sheet of the banking
sector, whereas M1 does not adequately capture the transactions balances of entities
because of the manner in which savings deposits with banks are partitioned into demand
and time categories purely on the basis of interest applications.
In the context of developing countries, there are essentially two main approaches to
money stock determination: the money multiplier approach and the balance sheet or
structural approach. The money multiplier approach focuses on the relationship between
money stock and reserve money, while the structural approach favors analysis of
individual items in the balance sheet of the consolidated monetary sector in explaining
the variations in the money stock.
The positions of Keynesianism were fortified by the fact that from the latter half of the
1940s to the mid-1960s, there had been no deep economic crises in the countries of
Western Europe practising government regulation. The unusually long post war upswing
in the United States in the 1960s, which lasted for nearly eight years, was proclaimed by
the advocates of Keynesianism to be a triumph of the new Keynesian economic policy.
The structural and cyclical crisis of the 1970s, especially the 1974-75 crisis, and the
inflation which became chronic and irreversible, all of this, taken together, disrupted the
economic policy and led to obvious confusion as to how the economic difficulties were to
be tackled. There was a collapse of the standard Keynesian schemes of business cycle
policy, according to which efforts were made to contain inflation, which usually
coincided with the upward phase, by limiting demand, and to overcome the crisis by
expanding. Another phase in Keynesian crisis is that disenchantment with Keynesian
economics developed during the post-1968 period when the rate of growth of output
declined, the rate of inflation increased coupled with rising unemployment. This
paradox of stagflation is inconsistent with the tenets of Keynesian economics that
cyclical movements in prices and outputs relative to trend are positively correlated. This
led to reconsideration of theories underlying policy making and rival schools of thought
such as Monetarist School, Rational Expectations and Supply-side Economics (popularly
known as Reaganomics). Supply-side economics represent a return to orthodox classical
economics and its recent more formal statement the New Classical Macroeconomics.
In this chapter, we discuss the determination of income and employment from three
different view points i.e. monetarist rational expectations and supply-side economics. The
policy recommendation associated with these schools differ considerably from those
offered by Keynesian economic analysis.

MONETARISM
This school argues that disturbances within the monetary sector are the principal causes
of instability in the economy. According to monetarists, the money supply is the principal
determinant of the levels of output and employment in the short run and the price level in
the long run. It is based upon the monetarist formulations of the demand for money
function and the transmission mechanism
Friedmans Demand for Money Function
The demand for money is viewed as being stably related to a few key variables.
Monetarists argue that the demand for money is no longer a function solely of the
interest rate and income, but that the rate of return on a much wider spectrum of
physical and financial assets will influence an individuals demand for money.
According to Milton Friedman, money is only one way of holding wealth. Wealth
can be held in other forms such as bonds, equities, physical goods and human
capital. Individuals act in such a way as to ensure that the rate of return at the
margin is equal across the complete range of physical and financial assets that they
could purchase. If wealth increases more money is demanded. If either the bond or
equity interest rate increases, individuals demand less money since bonds or
equities are now relatively more attractive to hold than money. Similarly, if rate of
inflation rises, it becomes relatively more expensive to hold money as it
depreciates in value during inflation. As a result, if the expected inflation rate rises,
the amount of money demanded will be reduced. The ratio of physical capital to
human capital and the variables which affect tastes and preferences are assumed to
be constant in the short run. Thus, money is seen as being substitute for all other
assets and the demand for money is therefore a function of the rates of return on all the
other assets.
In contrast, of course, money was seen as a substitute for financial assets only in the
Keynesian economics and thus, it was the rate of return i.e. the interest rate, that
influenced the demand for money. However, in practice if the rate of return across all
physical and financial assets moves to equality then the interest rate will clearly serve as
a proxy for these. Thus the modern quantity theory of the demand for money can be
represented in similar fashion to that of Keynes as follows:

where
Y
r

f (Y, r)

demand for money

income

interest rate

Though both the schools use this functional form in empirical work, the underlying
theories, however, are very different. Monetarists maintain that the demand for money

function is better determined statistically than either the consumption or investment

demand function and this shows their preference for monetary policy rather than fiscal
policy.
Friedmans formulation of demand for money function is significant, because with an
increase in the money supply various portfolio adjustments occur. These adjustments
are very crucial to the monetarist view of the transmission mechanism.
In most versions of the IS-LM model, the money supply is assumed to affect income
through the interest rate and investment. According to monetarists adjustment takes
place over a broad range of assets and that the IS-LM framework is too narrow to
capture the essence of the adjustment process. As a result they offer an alternative view
of the adjustment or transmission mechanism.
For example, if the countrys central bank increases the money supply through open
market purchases of Treasury securities, according to Friedman and others, the effects
are two-fold: the price of the securities increases, thereby reducing the yield, and the
composition of the publics portfolio (collection of assets) is altered. The public now
holds more money and fewer securities. Since the public does not want to hold this
much money, individuals try to rearrange their portfolios so as to reduce their money
holdings. For example, suppose they first attempt to purchase marketable securities. As
the purchases take place, security prices increase and yields decrease. As a result, the
demand for other assets, including equities and real assets such as houses and land,
increases. With the increase in demand, the prices of these assets increase. The increase
in the price of real assets has, according to Friedman, some additional effects. With
higher prices, the production of real assets is stimulated and the demand for resources
used in their production increases. Moreover, increase in the price of these assets means
that the price is higher relative to the prices of services. For example, it is now relatively
less costly to rent an automobile than to buy one. Thus, the demand for services
increases correspondingly.
To summarize, an increase in the money supply results in increased expenditures for
financial and real assets and for services. The increases in expenditures include rise in
both investment and consumption spending.
Thus, the monetarists, led by Friedman conclude that an increase in the money supply
leads to a significant increase in aggregate demand. In the short run, an increase in the
money supply results in increase in both output and the price level. In the long run,
increase in the money supply affects mainly the price level. Friedman believes that the
long run growth rate of output is determined by real factors, such as the saving rate and
the structure of industry. Thus, in the long run, more rapid increases in the money
supply result in higher rates of inflation, but not higher growth in real output and
employment.
Monetary Policy Vs. Fiscal Policy
According to monetarists, money is very important in determining the level of
aggregate demand and that monetary policy is very potent. In contrast, they claim that

fiscal policy, unless accompanied by a change in the money supply, is impotent, at least
in the long run. In maintaining that fiscal policy is ineffective, monetarists stress that an
increase in government spending must be financed by a tax increase, by issuing
government debt, or by issuing high-powered money. If the increase is financed by a tax
increase or by issuing government debt, they claim that the increase in government
spending is offset by the decrease in private spending (known as crowding-out
effect), which occurs as a result of the tax increase or increase in government debt.
Since the increase in government spending results in a corresponding decrease in
private spending, private spending is said to be crowded-out by the government
spending. As a consequence, little or no increase in output occurs in the long run. In
contrast, if the increase in government spending is financed by an increase in highpowered money, private spending is not crowded-out and this results in higher growth
rates of output and employment.
To summarize, monetarists argue that monetary policy is very effective and powerful.
They regard changes in money stock as the most important cause of changes in output,
employment and prices. At the same time they consider fiscal policy, unless supported
by changes in the money supply, as ineffective. On the contrary, Keynesians, although
conceding the effectiveness of the monetary policy, contend that fiscal policy, even in
the absence of a change in the money stock, is reliable. They maintain that the
government should maintain an activist stance with a combination of tax and
expenditure policies to maintain the desired levels of output and employment through
manipulation of aggregate demand or effective demand.
SUPPLY-SIDE ECONOMIC ANALYSIS: RISE OF NEW CLASSICAL
ECONOMICS
Critiques of orthodox Keynesianism connect economic instability and the cyclical
nature of economic growth with the financial instability of the capitalist economy. They
believe that the uncertainty and the imperfect information tend to produce fluctuations
in the economic situation precisely because the capitalist economy has an elaborate
system of monetary and financial institutions which are especially susceptible to change
under the impact of optimistic or pessimistic expectations of the business community.
Rational expectations together with efficient market clearing constitute the two central
tenets of the New Classical Macroeconomics, which pretend to show that any attempt to
stabilize the level of output and unemployment in the short run is inefficient and will
not alter the value of real variables. In view of the failure of demand management
policy of Keynesianism, the rise of the theory of rational expectations combined with a
natural rate of employment focussed attention on the supply-side economics. The New
Classical Economics as a school of thought fundamentally rejects Keynesian
propositions. The main tenets of the Keynesianism are summarized below.
Keynesian Propositions
i.

Prices and wages respond slowly to excess demand or supply, especially

slowly to excess supply.

ii.

The unemployment rate is a good, but imperfect, barometer of the

pressure of aggregate demand on the productive resources of the economy.

iii.

In an economy with underemployment of labor and capital, more labor

and capital services will be supplied, if demanded along the ongoing path of
wages and prices, without accelerating their increase (Tobin 1977).

iv.

Cyclical movements of output and price, relative to their trends are

positively correlated.

v.

Keynes suggested .... that it was easier to stabilize real economic

variables by moving aggregate money demand to a given path of money
wages than by moving wages relative to a given money demand (Tobin
1977).
vi.
A crucial Keynesian proposition is that prices including money
wages are sticky in the short run .... prices and wages that increase relative
to trend depend inversely upon excess supply of labor and commodities.
Demand management policy to eliminate deficiency of demand (Okun Gap
y < q or

is less than unity or 0 < MPC < 1) consists of: (a) raising

government
expenditure (G) or lowering tax rates (T) and (b) following an accommodative
monetary policy to stabilize the nominal rate of interest by letting the money supply (M)
grow with the expansion of the economy, as described by an equation.
M = M (y)
In the initial phase of recovery, the target should be the maintenance of current rates of
interest.
Keynesian economics, which dominated academic macroeconomics in the 1960s,
demonstrated its ability to eliminate the gap between potential and actual output. A
sustained expansion was engineered in 1960s without any significant inflation. All this
changed in 1970s. But it has not provided a better alternative theory to guide policy in
1970s and 1980s. That is the reason New Classical Economics totally rejects the premises
and implications of Keynesian economics concerning the efficacy of demand
management policy to influence the gap between potential and actual output. Following
global recession in 1970s, Oil Crisis in 1973 and in the aftermath of the war of Vietnam,
the Keynesian propositions no longer characterized the state of macroeconomic theory.
Summarized in the table are the events which were inconsistent with the Keynesian
propositions and the model described above.
What is Supply-side Economics Market Freedom
Markets must be allowed to work more freely and steps taken to improve this efficiency
by:
a. freeing them from government controls (e.g. income policy, minimum wage

regulations, pricing policies of the nationalized industries);

b. promoting competition;
c. restricting the power of trade unions;
d. the privatization program;
e.
introducing competition in the natural monopolies by new devices;
f.
removing institutional barriers in the capital market (e.g. exchange control,
the Stock Exchange);
g.
using the rate of interest (the price of liquid capital) as the main weapon
for adjusting aggregate demand

2 MARKS:
1. Write about the short run and long run supply curve.
2. What is unemployment and explain the factors of unemployment?
3. What are its impact?
4. Define inflation.
5. What is called a money market?
6. Write about the demand and supply of money.
15 MARKS:
1. Explain Okuns Law.
2. Explain the types, reasons and the ways to control inflation.
3. Explain about the money market.

4. Explain the supply side policy and supply side management.

5. Explain the money market equilibrium.
6. Write an essay on monetary policy.