Principles of

Economics
 Principles of
Economics

D N DWIVEDI
Professor in Economics
Maharaja Agrasen Institute of Management Studies, Delhi
Former Reader, Ramjas College
University of Delhi

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Second Edition
ISBN: 81-259-1651-2
Copyright © Author, 1985, 2005

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 Preface to the Second Edition
Although basic principles of economics remain
the same as delineated in the first edition of this
book, the need for bringing out its second edition
was felt for three reasons. First, “Principles of
Economics” is being reintroduced in the
economics syllabi of various universities. The way
these syllabi were designed it created an
impression that there are two kinds of
economics—microeconomics and macro-
economics—with some specialized branches. The
system seems to be returning to the earlier form
of first giving students a comprehensive view of
the basic principles and then initiate them to its
two major branches with increasing emphasis on
macroeconomics and international economics.
This new trend has enhanced the relevance and
usefulness of this book. Secondly, there is a greater
emphasis on using quantitative method of
elaboration and exposition of economic theories
in recent years while the use of high-level
mathematics is being underplayed. So, there was
a need for introducing simple quantitative
methods in the presentation of theories. Thirdly,
the application of economic concepts and theories
to real life problems is of late also being
emphasised and this is also finding entry into
management, medical and engineering courses.
So application content has been brought into focus
in this second edition.
The primary objective of writing this test has
been to provide a comprehensive text on the basic
principles of economics for undergraduate and
postgraduate students in a compact volume. This
book will also be of immense use to students
preparing for competitive examinations, like IAS,
IES, CA, MBA and BBA degree and diploma
courses, economics paper in engineering and
medical courses. In nutshell, it is an all-purpose
book for the students of economics. The students
of the latter categories who begin with virtually
no economics background often find it difficult to
comprehend the complex theories of economics.
For them this book is a boon. It begins with simple
introduction to economics as a social science,
then moves on to basic economic problems of
individuals, firms and the society focusing on
the problem of scarcity and choice making finally
discussing the higher levels of economic theories.
Parts II to VI deal with microeconomic theories.
Graphical illustrations and simple algebraic
formulations have been used, wherever necessary,
for clear exposition of economic theories. Review
questions and exercises are given at the end of
each chapter to help students assess their own
understanding of economics.
Thus, substantial changes have been made
for this edition and the subject matter has been
reorganized. While most chapters are rewritten,
expanded and updated, some new have been
added. The new chapters are listed below.
Chapter 1. Introduction to Economics: (An
abridgement and updated version
of earlier Ch. 1, 2 and 3).
Chapter 2. The Economy and Its Basic
Problems: Scarcity and Choice.
Chapter 3. The Laws of Demand and Supply
and Market Equilibrium:
(Constitutes a new part—Part II:
Fundamentals of the Market
Economy).
Chapter 6. Failures of the Market Economy and
the Role of the Government.
Chapter 21. Factor Market: Factor Demand and
Supply.
Chapter 22. Theory of Wage Determination (A
revised version of earlier Ch. 24).
vi
Chapter 23. Rent, Quasi Rent and Economic
Rent (A rewritten version of earlier
Ch. 26).
Chapter 26. Product Exhaust Theorem.
Chapter 29. Introduction to Macroeconomics
Chapter 30. The Circular Flow Model of the
Economy.
Chapter 39. Inflation: Meaning, Measure and
Effects
Chapter 40. Theories of Inflation and Control
Measures
Most other chapters are rewritten with
additional topics as listed below:
 Meaning and Measurability of Utility;
Consumer Equilibrium: The General Case;
Derivation of Demand Curve has been added
(Ch. 7)
 The Corner Solution: The Extreme Choice; The
Composite Goods Case; Goods, Bads and
Neuters (Ch. 8)
 Meaning of Production; Some Basic Concepts
(Ch. 11)
 Economies of Scale: Why LAC Decreases; Cost
Functions and Cost Curves (Ch. 14)
Preface to the Second Edition
 Game Theory Approach to Oligopoly (Ch. 19)
 Some Early Thoughts of Interest Theory;
Classical Theories of Interest (Ch. 24)
 Partial Vs. General Equilibrium, Walrasian
General Equilibrium Model; The Process of
Automatic Adjustment (Ch. 27)
 Cardinal Utility Approach: Social Welfare is
the Sum of Individual Utility; Pareto Approach:
Social Welfare as Social Optimum; The New
Welfare Economics: Compensation Criteria for
Welfare Judgement; The Bergson Criterion: The
Social Welfare Function (Ch. 28)
 Shift in Aggregate Demand Function and the
Multiplier (Ch. 32)
 Meaning of Economic Growth; Factors in
Economic Growth (Ch. 37)
The book is thus being presented with significant
qualitative improvement and with most
comprehensive coverage.
I am extremely grateful to Shri Piyush
Chawla, Director Publishing and Marketing of
Vikas Publishing House for giving me an
opportunity to revise the book.
Comments and suggestions will be gratefully
acknowledged.
D N Dwivedi
 Preface to the First Edition
The aim of this book is to provide a standard and
comprehensive text on a wide range of principles
of economics. It is addressed to the undergraduate
and post-graduate students of Indian universities
and to the candidates for IES and IAS
examinations. It would meet the requirement of
also those who want to possess a textbook in
economics for general reference.
Writing a textbook, in economics these days
is somewhat similar to producing a commodity
with ‘product differentiation’. The salient features
of this book that distinguish it from other similar
books may be briefly mentioned here. Unlike most
advanced texts, this book provides a non-
mathematical treatment of economic concepts and
theories. But, unlike many other texts that rely
solely on verbal and imprecise description, this
book uses the modern tools of economic analysis
in the exposition of the subject-matter. It presents
the complex economic theories in a clear and
precise manner with the help of self-explanatory
diagrams and simple algebra. Besides, an attempt
has been made throughout to equip the reader
with classical and modern tools of economic
analysis and their relative merits. In view of the
fact that many students from other disciplines
take to economics at a fairly advanced stage, the
discussion on each topic begins at an elementary
level and proceeds by stages towards the higher
levels. Also, a list of standard texts and important
papers is given at the end of each chapter to
facilitate advanced study of the subject.
In preparing this book, I have heavily drawn
from the writings of the reputed economists. My
debt in this regard is incalculable. I am indebted
to my friend and colleague Mr. R. R. Suresh for
going through several chapters of the book and
making valuable suggestions. I gratefully
acknowledge the help I have received from
Mr Ramesh Bhatt and Mr Chandra Shekhar
Sharma, both of Sriram College of Commerce
(Delhi), in writing the chapters on linear
programming and profit theory, respectively. I owe
also to my wife and son who were deprived of
their due share in my time during the preparation
of this book.
The comments and suggestions to improve
the book shall be gratefully acknowledged.
D N Dwivedi
 Contents
Preface to the Second Edition v Elasticity; Price Elasticity of Supply; Review
Preface to the First Edition vii
Part I
INTRODUCTION
1. Introduction to Economics 1
What is Economics?; The Scope of Economics; Is
Economics a Positive or a Normative Science;
Methodology of Economics: What Economists Do
and How; How Reliable are the Economic Laws;
Why Economic Laws; Review Questions and
Exercises.
2. The Economy and Its Basic Problems:
Scarcity and Choices 16
The Economy and its Working; Kinds of Economic
Systems; Production Possibilities of an Economy;
The Basic Problems of an Economy; How Market
Mechanism Solves the Basic Problems; How
Efficient is the Market System; Reasons for the
Failures of the Market System; The Government
and the Economy; Review Questions and Exercises.
Part II
FUNDAMENTALS OF MARKET ECONOMY
3. The Laws of Demand and Supply
and Market Equilibrium 37
Introduction; The Law of Demand: Price-Demand
Relationship; The Law of Supply; The Supply
Function; Equilibrium of Demand and Supply:
Determination of Equilibrium Price; Review
Questions and Exercises.
4. Elasticities of Demand and Supply 55
Price Elasticity of Demand; Determinants of Price
Elasticity of Demand; Price Elasticities and
Marginal Revenue; Price Elasticity and
Consumption Expenditure; Cross-Elasticity of
Demand; Income Elasticity of Demand; The
Elasticity of Price Expectations; The Uses of
Questions and Exercises.
5. Market Equilibrium and Disequilibrium 71
Introduction; Meaning and Uses of Equilibrium;
Kinds of Equilibria; Partial and General
Equilibrium; Short-term and Long-term
Equilibrium; Unique and Multiple Equilibrium;
Review Questions and Exercises.
6. Failure of the Market Economy and
Role of the Government 86
Introduction; Imperfect Market Information and
Market Failure; Growth of Monopolies and
Market Failure; Market Failure in Case of Public
Goods; Public Provision of Public Goods;
Externalities and Government Intervention;
Review Questions and Exercises.
Part III
THEORY OF CONSUMER DEMAND
7. Theory of Consumer Demand:
Cardinal Utility Approach 97
Introduction; Cardinal Utility Theory; The Law
of Diminishing Marginal Utility; Consumer ’s
Equilibrium, Derivation of Demand Curve;
Drawbacks of Cardinal Approach; Review
Questions and Exercises.
8. Theory of Consumer Demand:
Ordinal Utility Approach 106
Introduction; The Meaning and Nature of
Indifference Curve; The Diminishing Marginal
Rate of Substitution; Properties of Indifference
Curves; The Budget Constraint and The Budget
Line; Consumer’s Equilibrium; Effects of Change
in Consumer ’s Income; Effects of Price Change;
Income and Substitution Effects on Inferior
Goods; Complementarity and Substitutability; The
Corner Solution: The Extreme Choice; The
Composite Goods Case; Goods, Bads and
Neuters; Derivation of Individual Demand Curve;
x Contents
Comparison of Cardinal and Ordinal Utility
Approaches; Critique of Indifference Curve
Approach; Applications of Indifference Curve
Analysis; Review Questions and Exercises.
9. Recent Developments in
Consumption Theory 146
Introduction; Samuelson’s Revealed Preference
Theory; Neumann-Morgenstern Utility Theory;
Friedman-Savage Hypothesis; Hicks’ Revised
Demand Theory; Review Questions and Exercises.
10. Consumer’s Surplus 161
Introduction; The Marshallian Consumer ’s
Surplus; Hicksian Method of Measuring
Consumer ’s Surplus; Some Uses of the
Consumer ’s Surplus Concept; Review Questions
and Exercises.
Part IV
THEORY OF PRODUCTION AND
ANALYSIS OF COST
11. Theory of Production-I: Production with
One Variable Input 171
Introduction; Meaning of Production; Some
Concepts; Production Function; The Laws of
Production; Review Questions and Exercises.
12. Theory of Production-II: Production with
Two Variable Inputs 179
Introduction; Isoquant Curves; Marginal Rate of
Technical Substitution; Properties of Isoquant
Curves; Isoquant Map and Economic Region;
Other Forms of Isoquants; Elasticity of
Substitution; Laws of Returns to Scale: Long Run
Analysis of Production; Review Questions and
Exercises.
13. Optimum Combination of Inputs 194
Introduction; Budgetary Constraints and Isocosts;
Optimising Combination of Inputs; Choice of
Optimal Expansion Path; Change in Input Prices
and Input Combination; Review Questions and
Exercises.
14. Theory of Production Cost 200
Cost Concepts; Short-Run Cost-Output Relations;
Long-run Cost-Output Relations; Economies of
Scale: Why LAC Decreases; Diseconomies of
Scales: Why LAC Increases; Cost Functions and
Cost Curves; Review Questions and Exercises.
Part V
THEORY OF FIRM: PRICE AND OUTPUT
DETERMINATION
15. Objective of Business Firms and
Market Structure 219
Introduction; Objectives of Business Firms; Profit
Maximization; Alternative Objectives of Business
Firms; The Market Structure; Review Questions
and Exercises.
16. Price and Output Determination Under
Perfect Competition 233
A Prelude to the Theory of Firm; The Features
of Perfect Competition; Perfect Vs. Pure
Competition; Equilibrium of the Firm; Derivation
of Supply Curve of the Firm; Derivation of
Supply Curve of the Industry; Price and Output
Determination Under Perfect Competition; Price
and Output Determination in the Long Run; Long-
run Supply Curve of a Competitive Industry;
Review Questions and Exercises.
17. Price and Output Determination
Under Monopoly 247
Introduction; Monopoly: Definition and Sources;
Demand and Revenue Curves Under Monopoly;
Cost and Supply Curves Under Monopoly; Profit
Maximisation Under Monopoly; Why Absence of
Supply Curve Under Monopoly; Monopoly Vs.
Perfect Competition: Comparison of Long-run
Price and Output; Equilibrium of the Multiplant
Monopoly; Price Discrimination by Monopoly;
Measures of Monopoly Power; Review Questions
and Exercises.
18. Price and Output Under
Monopolistic Competition 268
Introduction; The Nature of Monopolistic
Competition; Foundations of the Monopolistic
Competition Model; Price and Output
Determination Under Monopolistic Competition;
Analysis of Selling Cost and Firm’s Equilibrium;
Critical Appraisal of Chamberlin’s Theory of
Monopolistic Competition; Review Questions and
Exercises.
19. Price and Output Determination
Under Oligopoly 278
Oligopoly: Meaning and Characteristics; Duopoly
Models; Oligopoly Models; The Game Theory
Approach to Oligopoly; Review Questions and
Exercises.
20. Some Topics in Pricing Theory 302
Introduction; Full-Cost Pricing; Limit Pricing:
Contents
Bain’s Model; Baumol’s Theory of Sales
Maximisation; Review Questions and Exercises.
Part VI
THEORY OF FACTOR PRICING
21. The Factor Market: Factor
Demand and Supply 311
Introduction; Marginal Productivity Theory of
Factor Pricing: An Overview; Marginal
Productivity and Factor Demand; The Factor
Supply: An Overview; Derivation of Individual
Labour Supply Curve; Derivation of Market
Labour Supply Curve; Review Questions and
Exercises.
22. Theory of Wage Determination 322
Introduction; Wage Determination Under Perfect
Competition in Product and Labour Markets;
Monopoly in Commodity Market and Perfect
Competition in Labour Market; Wage
Determination Under Monopoly in Product and
Monopsony in Labour Market; Perfect
Competition in Commodity Market and
Monopoly in Labour Market (Labour Union);
Wage Determination Under Bilateral Monopoly:
Collective Bargaining; Review Questions and
Exercises.
23. Rent, Quasi-Rent and Economic Rent 336
Introduction; Ricardian Theory of Rent; Quasi-
Rent: The Short-Term Rent on Fixed Factors;
Factor Price, Transfer Earning and Economic Rent;
Review Questions and Exercises.
24. Theories of Interest 342
Introduction; Some Early Thoughts on Interest
Theory; Classical Theories of Interest; The
Loanable Fund Theory of Interest; Review
Questions and Exercises.
25. Theories of Profit 349
The Meaning of Pure Profit; Theories of Profit;
Does Profit Enter the Cost of Production?; Review
Questions and Exercises.
26. Product Exhaustion Theorems 358
Introduction; The Adding-up Controversy;
Relative Factor Shares and Income Distribution;
Review Questions and Exercises.
Part VII
GENERAL EQUILIBRIUM AND
WELFARE ECONOMICS
27. The General Equilibrium 367
Partial Vs. General Equilibrium; General
xi
Equilibrium Approach; The Walrasian Approach
to General Equilibrium; Existence, Uniqueness and
Stability of General Equilibrium; Evaluation of
General Equilibrium Approach; Review Questions
and Exercises.
28. Welfare Economics 378
Introduction; Definition of Welfare Economics;
Nature of Welfare Economics; The Concept and
Measurement of Social Welfare; Classical Welfare
Economics: Smith’s Welfare Criteria; Neo-Classical
Welfare Economics: Pigou’s Welfare Economics;
Pareto’s Welfare Economics; Externalities and
Pareto Optimality; The New Welfare Economics:
Compensation Criteria for Welfare Judgement;
The Bergson Criterion: The Social Welfare
Function; Arrow Theorem of Democratic Group
Decision; Grand Utility Possibility Frontier and
Welfare Maximisation; The Theory of Second Best;
Review Questions and Exercises.
Part VIII
MACROECONOMICS
29. Introduction to Macroeconomics 406
What is Macroeconomics?; Major Macroeconomic
Issues; Macroeconomics in Perspective; Review
Questions and Exercises.
30. The Circular Flow Model of
The Economy 415
Introduction; Circular Flows in a Simple Economy
Model; Circular Flows of Goods and Money in a
Three-Sector Economy; Circular Flows in a Four-
Sector Model: A Model with Foreign Sector;
Review Questions and Exercises.
31. National Income:
Concept and Measurement 421
Some Basic Concepts; Measures of National
Income; Methods of Measuring National Income;
Choice of Methods; Measurement of National
Income in India; Growth and Composition of
India’s National Income; Review Questions and
Exercises.
32. Theory of National Income
Determination 430
The Keynesian Theory of National Income
Determination; Determination of National
Income: Two-Sector Model; The Consumption
Function; Derivation of Saving Function; A formal
Model of a National Income Determination; Shift
in Aggregate Demand Function and the
Multiplier; Shift in Aggregate Demand Function
and the Multiplier; Review Questions and Exercises.
 Principles Of Economics

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