Part 2: Unit 1 Role of

Financial Institutions
and Markets
By Galijang Shampang
 Exchange Economy
• The exchange of one scarce resource for another –
economic exchange
• Economic activity is driven by the need to exchange these
scare resources.
• The exchange is driven by “needs and wants”
• The need and desire to “consume” drives individual
economic actions and provides the motive for engaging in
an exchange of scarce resources.
• Through exchange, consumption is satisfied by a process
called production.
Exchange Economy without money –
Barter Exchange
• Direct exchange of goods against goods without use of
money is called barter exchange
• Also referred to as C.C Economy – Commodity to
Commodity Exchange
•  A person gives his surplus good and gets in return the
good he needs.
• Increased transaction resulted in inconvenience in trading
• Rising trading cost – “Search cost” and “disutility of
waiting”
 Problems of Barter Exchange
1. Lack of double coincidence of wants - Seller has to
find out a person who wants to buy seller’s good and at the
same time who must have what the seller wants.
2. Lack of common measure of value - In what proportion
the two goods are to be exchanged.
3.  Lack of standard of deferred payment - Disagreement
about the quality of the good, specific type of the good and
change in the value of the good to be paid in future.
 Contd.
4) Indivisibility of goods – How to exchange goods of
unequal value?
5) Difficulty in storing wealth – High storage cost

Hence, paper money was invented as a medium of exchange

Real investment and Diminishing
Returns
• In any system of production, there comes an optimal point where
increasing the quantities of one input while holding all other
inputs constant yields progressively smaller output results.
• Optimal point – where all systems are working at peak efficiency.
• Three states – below optimal, optimal point and diminishing
marginal productivity.
• To increase productivity, investment should be directed towards
expanding overall system.