Unit 1

Introduction to Micro Economics

Learning Objectives Introduction to Economics

By the end of this unit, you will be

Food and agricultural economics are significant and
able to understand:
fascinating! Every day, stories about the food and
● Introduction to economics
agriculture markets are posted on social media. This
● Use of economics course covers a wide range of fascinating and challenging

● Types of economics- Micro/ issues, including food costs, food safety, diet and

Macro nutrition, agricultural politics, immigration, globalization,

agricultural labor markets, obesity, antibiotics and
● Central problems to economy
hormones in meat production, hog confinement, and
● PPC more. As we proceed through the semester, look for
news stories about food and farm economics. Economic
education will be more valuable, relevant, and timely if it
focuses on food and agriculture.

Scarcity: The definition of economics is “the study

of choice.” Economic theory is built on the idea of
scarcity. The human situation is reflected in scarcity:
limited resources and boundless wants, demands, and
aspirations.

Scarcity: With fixed resources and unending wants and

needs.

We are unable to satisfy all of our wants since we have

limitless needs and a finite number of resources at

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Introduction to Micro Economics
our disposal. Because we can’t have everything, atomic model of an atom with its neutron, proton,
scarcity pushes us to make decisions. Scarcity is an and electron constituents. This hypothesis is
essential idea in all economics because it pushes backed by a significant amount of evidence despite
us to make decisions, and economics is the study the fact that no one has ever observed an atom
of making decisions. There wouldn’t be any need in real life. It is not difficult to criticize economic
to pick between options or engage in economics if models since we are typically more familiar with
there were no shortages. occurrences on the economic landscape than with
scientific observations.
The Difference Between Microeconomics and
Macroeconomics: Many oversimplifications and theoretical
constraints come to mind when we model supply
Microeconomics and macroeconomics are the two and demand. Real life is challenging. To grasp the
main subfields of the study of economics. complex real world, we must first simplify it. This is
how science always operates.
Microeconomics = The study of specific decision-
making entities, such as businesses and The Scientific Method
households.
The Scientific Method is applied in the development
Macroeconomics = The study of economy-wide and application of our economic models.
aggregates, such as inflation, unemployment,
economic growth, and international trade. Scientific Method = a collection of methods
for learning new information, expanding one’s
Microeconomics, the study of business and knowledge, or improving and integrating existing
household decision-making, is covered in this knowledge.
course. Our underlying premise is that whereas
businesses want to maximize profits, households Quantifiable evidence is a major part of the
aim to increase utility, commonly known as scientific method. So long as data supports a
satisfaction. theory, economists will stick with it. Changing or
abandoning the hypothesis if the model is refuted.
Economic Models and Theories Science advances through this imperfect process.
Science is limited, and humans continue to have
The real world is incredibly intricate. Consider how flawed knowledge, finite lives, and a quest to end
difficult it is for you to get ready for class in the poverty, sorrow, and suffering. “We must simplify
morning. There are so many potential problems! We reality to understand it,” repeated the author.
must simplify the real world in order to grasp our
convoluted environment. A model is an abstract, We shall work to eliminate opinions and value
not actual, depiction of the world. judgments from our debates, analyses, and
understanding of food and agriculture. This may
In physical disciplines like biology, chemistry, and be difficult given our education and experience. A
physics, we regularly employ models. Consider the corn farmer might claim, for instance, “The price

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Introduction to Micro Economics
of corn is higher, which is a positive thing,” but a strive to be impartial, professional, and neutral.
feedlot owner who purchases the grain would have When we offer our findings and observations to
a different opinion. Since there are always winners people or groups who might not agree with the
and losers in price changes, economists strive to results, it can be difficult at times. Although some
avoid categorizing price changes as “good” or people might disagree with the findings of these
“bad.” studies, economists make an effort to be fair and
neutral in publishing their research.
In their research on food and agriculture, economists

Use of Economics

How to distribute
How to achieve
resources?
social efficiency?

Opportunity cost
of decisions
Importance Give info to make
of informed choices
economics
Understanding
consumer behavior Give forecasts
How to fix for economy
market failure?

Figure 1.1: Importance of Economics

The use of economics can be understood based on contention for free market economists like Hayek
the above image of the importance of economics. and Friedman. Stiglitz and Krugman, among
other economists, contend that government
● Dealing with a shortage of raw materials: As
involvement can address both inequality and the
we run out of raw materials like gas and oil,
underprovision of public goods. For instance, is
economics gives a tool for considering potential
it more effective to encourage private health care
outcomes.
or should the government give free health care at
● How to distribute resources in society: How the point of use?
much should money be redistributed in society?
● The principle of opportunity cost: Politicians
Is inequality required to provide economic
promise more spending and lower taxes to win
incentives, or does it merely exacerbate existing
elections. Voters want lower taxes and increased
social and economic issues?
expenditure. An economist knows everything has
● How much should the government intervene? opportunity cost. Spending more on free college
The question of how much the government implies greater taxes and less elsewhere. £4,000
should get involved in the economy is a crucial a year for college may be a wonderful goal. Is
one in economics. Free markets and little it the finest public investment? Spending on
government involvement are the main points of primary education might be better.

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Introduction to Micro Economics
● Social efficiency: Free markets fail often. As we that there are various conceivable outcomes.
think economics are best used to solve market By doing this, an unduly ideological approach
failure. Driving into town causes pollution and should be avoided. An economist would be
congestion. Overconsumption. A levy on driving aware of a more nuanced view that in some
into towns can internalise the externality. New industries, like health care and transportation,
taxes are unpopular, but they could benefit government involvement can overcome market
society. You might not want to pay £10/week to failure and boost welfare. For instance, a
drive into a metropolis. If it saved you two hours government may subscribe to the idea that “free
of traffic, you might be willing to pay. markets are always best.” But it doesn’t follow
that government intervention is always the best
● Knowledge and understanding. Economists
course of action.
study poverty, unemployment, and low economic
growth to understand the economy. Should the ● Behavioural economics why do people behave
UK exit the EU? Immigration is a contentious as they do? Can governments gently influence
topic. Economic research can analyse free labour people to behave better, for example, by outlawing
movement’s costs and advantages. Immigration tobacco advertising? Do we experience prejudice
economics can be studied. This helps with and unreasonable behaviour? Can a bubble,
political decisions. for instance, cause us to lose a lot of money
on the stock market? The study of behavioural
● Forecasts: Understanding the current situation
economics looks at our decision-making
is easier than economic forecasting. Forecasts
processes.
aren’t always accurate, but they can assist
decision-makers anticipate consequences. The ● Applying economics in everyday life: Modern
UK decided to join the Euro in 2003. Economists economists have investigated the economic
said the UK might struggle with a shared factors underlying common social problems. For
monetary policy. With the UK in, the Euro wasn’t instance, Gary Becker believed that the economic
a good currency zone. This analysis led the UK to costs and benefits may account for the majority
not join. The analysis underestimated Euro costs. of crime.
If it were merely political, the UK may have joined.

● How to deal with an economic crisis. The 1930s

Types of Economics- Micro/ Macro
Wall Street Crash increased unemployment.
All people, both those with employment and those
Responses were debated. Taxes, tariffs, and
without them, as well as those with high incomes
benefits rose throughout the west. John M.
and those with low incomes, are worried about in
Keynes developed a new area of economics to
economics. The field of economics recognises
combat recurrent recessions.
that the creation of valuable goods and services
● Evaluation. Like mathematics, economics is not can result in environmental pollution issues. It
an exact science. It is hard to predict results with investigates the issue of how education spending
certainty since there are so many unknowable advances employees’ skills.
variables, but a skilled economist will be aware
that the outcome depends on several factors and It explores issues including how to identify when

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Introduction to Micro Economics
large corporations or labour unions are operating researching a lake, the macro insights about the
in a way that serves society as a whole and when overall food chain serve to explain the habitat in
they are doing so at the expense of others in order which certain plants and animals survive, whereas
to enrich their owners or members. It examines the micro insights about specific plants and animals
how expenditures, taxation, and restrictions by help to comprehend the overall food chain.
the government impact choices made regarding
In economics, the health of the macroeconomy
production and consumption.
affects the micro decisions made by specific
businesses. For instance, if the macroeconomy
By now, it ought to be obvious that economics
is expanding, businesses are more likely to hire
is a broad subject. Microeconomics focuses
employees. In turn, how well the microeconomy
on the behaviour of specific agents within the
functions ultimately rests on the choices made by
economy, such as homes, workers, and firms,
specific people and companies.
while macroeconomics examines the economy
as a whole. It focuses on big topics including
output growth, unemployment rates, price inflation,
budget deficits, and levels of exports and imports.
Microeconomics and macroeconomics are
complimentary viewpoints on the larger topic of the
economy rather than two distinct fields of study.

Consider the challenge of researching a biological

ecosystem, such as a lake, to comprehend why both
microeconomic and macroeconomic viewpoints
are helpful. One who sets out to research the lake Microeconomics
might concentrate on particular subjects, such as
What influences how individuals and households
specific species of fish or snails, specific types of
spend their budgets? Given their financial
algae or plant life, or the trees that surround the
constraints, which mix of goods and services
lake. Another individual might adopt a broader
will best satisfy their needs and desires? How do
perspective and instead take into account the entire
individuals choose whether or not to work, and if
lake ecology, including what consumes what, how
they do, whether to work full- or part-time? How do
the system maintains an approximate balance, and
people choose how much money to set aside for
how environmental pressures impact this balance.
the future or whether to borrow money to spend
The same lake is examined by both methods,
more than they have?
and both are beneficial, but the perspectives are
different. Similar to this, while both microeconomics What determines which items a company will
and macroeconomics examine the same economy, make and sell, and how many of each? What
they do so from distinct angles. factors decide the prices a business will impose?
What decides how a company will manufacture its
The micro and the macro insights should coexist,
goods? What factors into the number of employees
whether you’re studying lakes or economics. When
it will hire? How will a company fund its operations?
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Introduction to Micro Economics
When will a business decide to grow, cut back, or needs and less pressing wants. In actuality, the
perhaps shut down? The theory of firm conduct and choice dilemma is the fundamental issue with
the theory of consumer behaviour are two topics economies. More specifically, the challenge we
covered in this book’s microeconomic section. face is making the best choices for the aims to be
achieved and the methods for making use of the
Macroeconomics limited resources. Every economy deals with a
few core issues known as an economy’s primary
What factors determine a society’s degree of concerns. These are listed below:
economic activity? What influences the quantity of
products and services a country actually produces, ● What types of products and services must be

in other words? What factors into the number of created: What kinds of commodities and services

jobs in an economy? What factors affect a country’s should be produced is the first significant issue

standard of living? What causes an economy to a country’s economy faces. We must pick from a

grow or shrink? What leads businesses to increase variety of alternative collections of products and

hiring or decrease employee layoffs? And finally, services that can be produced since resources

what contributes to long-term economic growth? are limited. It could also mean whether to
generate consumer products or capital/producer
Macroeconomic health can be measured by a goods. Additionally, we must choose how many
number of objectives, the most significant of which items will be created in the economy.
are rising living standards, low unemployment, and ● Creating these products and services: How to
low inflation. What role can macroeconomic policy generate the sought-after items in the economy
play in achieving these objectives? The central bank is the next issue we must solve. Thus, the issue
of a country implements monetary policy, which of the production’s techniques becomes relevant.
includes measures affecting bank lending, interest if we should employ capital-intensive or labor-
rates, and financial capital markets. This is the intensive techniques. A capital-intensive method
Federal Reserve in the United States. Government of production suggests that more capital is used
spending and taxation are governed by the per unit of output than labour, in contrast to a
legislative branch of a country. In the United States, labor-intensive method. The decision is based
the federal budget is created by the Congress and on the resources that are available. The labor-
the executive branch. intensive technology can be used in an economy
with a labour surplus.
Central Problems to Economy
● Whom these products and services are
intended for: Once we have chosen the items
All economic issues are rooted in a lack of
to manufacture and the methods to employ in
resources. We are aware that resources are finite
their creation, we next face the issue of how
or in short supply compared to demand, but desires
to distribute those goods across the economy.
or goals are limitless. As a result, we struggle to
This is the issue with the distribution of national
decide between all of our desires. This is so that
revenue.
limited resources can be used for other things. We
must therefore pick between our most pressing ● Are the Resources Efficiently Used? Additionally,

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Introduction to Micro Economics
 we must ensure that finite resources are used the resources that are available, is also referred to
effectively. This is the issue of maximising as the Transformation Curve. Both of these terms
welfare or economic efficiency. refer to the same thing. To put it another way, it is
the potential cost of producing more of one thing
● Are all of the available resources being utilized?
in comparison to the units of the other thing that
Additionally, an economy must work to utilise all
are lost.
of its resources fully.

● How do we achieve growth in the economic

A PPC shows the maximum amount of one
sector? An economy must make sure it is
commodity that can be obtained for a given amount
achieving a sufficient growth rate so that it can
of another based on the availability of production
expand and develop more quickly. It should be
components, technology, and management.
able to alter the country’s structure from an
Microeconomics and macroeconomics use
agrarian to an industrial one while simultaneously
the concept to demonstrate a country’s output
raising the per capita and overall national GDP.
possibilities. All points on a production possibilities
An economy cannot be stagnant. Its productive
curve are either at their maximum or minimum
potential must always rise.
productive efficiency when resources are
distributed so that it’s hard to improve one good’s
It is obvious that conserving resources is an
output without reducing another’s. To enhance
economy’s main issue. Due to the scarcity of
productivity, a sacrifice—or opportunity cost—must
resources in connection to many demands and
be made.
purposes, the economising problem exists in all
economic societies.
The fullest and most effective use of all resources
is made, while still maintaining sustainability. The
PPC (Production Possibility Curve) curve for production possibility is not stationary.
With the expansion of resources and advancements
The potential for production A graph called a
in technology, it expands with time. This is so that
curve shows the trade-off between any two
we can produce more using the same amount
goods generated. The Production Frontier, which
of resources. In the table below, automotive
represents the greatest practicable quantities of
and computer production potentials are given.
two or more goods that may be produced given
Production scenarios E and F. The economy must

Production Possibilities Computers (in 000’s) Car (in 000’s)

E 5 15
F 10 10

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Introduction to Micro Economics
divert resources from car production to computer and ON cars, similarly.
production. Due to the resources being diverted
to the creation of computers, 5000 cars cannot Points E, F, or wherever on curve AB demonstrate
be made when it is decided to produce 10,000 the most practicable car-computer pairings. Since
computers. C is above AB, the economy can’t get there. Point D
is theoretically attainable but not optimal because
The production possibility curve is depicted in economic resources won’t be employed fully.
the adjacent Fig. (Production Possibility Curve
Example), which was created using the previous Some automobiles must be sacrificed to make
table. Cars can be made in OA units if all economic additional computers, i.e., cars can be converted
resources are put to use in the process. into computers. The marginal rate of transformation
is the rate of product conversion (MRT). In this
example, 5000 autos must be sacrificed to
manufacture 5000 computers. MRT rises as
one product is produced more than another. The
Production Possibility curve gets concave.

PPC uses:

Multiple applications exist for the production

possibility curve. It assists in identifying solutions
to the fundamental production-related issues of
what to produce, how to generate it, and for whom
in the economy. In addition, the government may
Figure 1.2: Production Possibility Curve Example use the concept of a production possibility curve if

If all resources went toward making computers, the it decides to shift resources, say, from necessities

economy would produce OB units. We get AB by to pleasures. Additionally, it can aid in directing

joining A and B. If the economy chooses to generate the transfer of funds from current consumer items

both cars and computers, it may stay on curve AB to capital goods and boosting the capacity for

at E or F. Point E produces OT and OS devices for manufacturing to reach higher levels of production.

computers and cars. F can make OM computers

Summary

Microeconomics is a subfield of mainstream economics that investigates the factors that influence the
choices that individuals and businesses make regarding the distribution of limited resources, as well as the
relationships that exist between these individuals and businesses.

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Introduction to Micro Economics
 Unit 2

Consumer Equilibrium

Learning Objectives Introduction

By the end of this unit, you will be

Perhaps one of the most fundamental ideas in
able to understand:
economics is the concept of demand and supply. An
● Utility analysis
essential component of the topic of economic theory is
● Types of utility- Cardinal /Ordinal the analysis of how prices for goods and services are

● TU and MU set on the market. Prices in a market-based economy

are determined by the interaction of supply and demand
● Law of Equi Marginal Utility
variables; to put it another way, they are the outcome of
● Law of Diminishing Marginal decisions made by buyers and sellers to buy and sell in
Utility the market. In other words, prices are the result of supply
and demand factors. This indicates that prices are the
result of the competition between supply and demand.

An economy’s market is made up of two distinct

participant groups: consumers and producers. While
supply analysis looks at supplier behaviour, demand
analysis concentrates on consumer behaviour. Based
on her actual purchasing habits, the customer indirectly
communicates to the manufacturer what he/she is willing
to purchase and how much he/she is willing to pay. If
the manufacturer can do so profitably, he/she provides
the product. Demand and supply forces work together
to reach an equilibrium price and output level that best
satisfies customers and generates the greatest profits
for producers.

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Consumer Equilibrium
Utility Analysis ● A good’s usefulness should not be equated with
its utility. The consumer’s well-being does not
Human desires are limitless and come in various necessarily increase when a want is satisfied. For
degrees of intensity. The tools at a man’s disposal instance, it is thought that using drugs, smoking,
are not only limited, but they also serve other or consuming other comparable activities is
purposes. Due to a lack of resources, the consumer bad for the consumer’s health. However, the
cannot fully satiate all of his desires. He must consumer thinks they are useful to him since he
decide which desire should be met first, and which may use them to fulfil his desires.
should follow if the finances allow. The consumer
is forced to make a decision. The “normative” element of utility is not an issue
in economics. Whether or not its intake improves
Consider a man who is thirsty. Instead of buying their well-being is immaterial. Customers are willing
tea, he visits the market and buys Coca-Cola to to pay a certain price and generate demand for a
quench his thirst. We’re here to look at the economic product as long as they anticipate receiving some
factors that led him to buy that specific good. There “pleasure” from it (i.e., as long as it serves some
is an easy solution. A commodity is purchased by purpose for them).
a consumer because it satisfies him. Technically
speaking, a consumer buys a product if it will be
useful to him.

A good’s utility is determined by how likely it is

to fulfil a human need. A good’s usefulness to a
consumer is the fulfilment he anticipates from
using it. It measures how much of his desire will be
satisfied (s).

Types of Utility- Cardinal /Ordinal

A good’s utility changes depending on how strongly
a desire is sated by using it. This fact generates a
Utility must be measured to be used in individual
few crucial conclusions.
and market-level consumer demand analysis. A
● A good’s utility varies from customer to consumer. buyer assesses the utility of an item against its
This is due to the fact that various customers cost. As long as the extra units’ utility exceeds their
may feel the same want to varying degrees. cost, he/she buys more.

● Because the strength of the desire(s) that the

Approach Based on the Cardinal Utilities
use of an item is intended to satisfy changes
over time, the utility of a good fluctuates even
The cardinal utility approach makes the assumption
for the same customer. This change could arise
that utility can be expressed as one of the cardinal
from a change in the consumer’s circumstances,
numbers—1, 3, 10, 15, etc. The usefulness of a
or it could happen during the act of satisfying the
good expressed in fictitious cardinal numbers
demand itself.

10
Consumer Equilibrium
provides us with a wealth of information about the behave in terms of demand.
preferences of the consumer. The utility is stated in
absolute standard units in cardinal measurements, To get over this restriction, Marshall argued that
such as 15 units for the first loaf of bread and 8 the utility of an item should be measured in terms
units for the second. of the amount of money the consumer is prepared
to spend on the commodity. According to this
The idea of cardinal utility was harshly attacked strategy, the utility of the first bottle of a cold drink
by Italian economist Pareto. According to him, the to the consumer is equivalent to five rupees and
utility cannot be measured or added. However, it that of the second bottle is equal to four rupees,
can be compared. He proposed that the scale of for instance, if the consumer is ready to pay, at
preference be used in place of the idea of utility. most, five rupees for the first bottle and only four
rupees for the second. This method was well-liked
A Method Based on Ordinary Utility and appeared to be helpful in assessing customer
demand choices since, in reality, people pay for
The ordinal utility approach is entirely arbitrary and their products in monetary terms.
unquantifiable. The utility is measured in ordinal
terms when it cannot be described in absolute TU and MU
terms. Only in respect to one another can utility
from two or more sources be “ranked” or “ordered.” The utility obtained from a good when it is
One source’s utility could be “equal to,” “greater consumed by a consumer changes with its quantity
than,” or “less than” another source’s usefulness. and results in three ideas, namely
The distinction, however, cannot be expressed in
terms of absolute or numerical units. ● Total Utility (TU)

● Average Utility (AU)

The utility is a subjective concept that differs
● Marginal Utility (MU)
from person to person and from scenario to
situation. Due of this, it is impossible to compare
When a customer purchases n individual units of
the utility of a good for two people or measure it in
product X, their “total utility,” abbreviated as “TU,”
absolute terms. This suggests that cardinal utility
is equal to the aggregate of the individual utilities
assessment is only a theoretical phenomenon with
associated with each unit. The average utility (AU)
limited applicability. Ordinal scales are the greatest
is determined by first calculating the total utility
way to quantify utility.
(TU), and then dividing that value by the total
number of X units (n). The term “marginal utility”
However, there are some situations where analysing
refers to the increased sense of satisfaction that
demand decisions necessitates using a cardinal
a customer experiences as a result of consuming
assessment of utility. Due to this, economists
one extra unit of “X.”
created a standard unit of utility measurement
known as the “util” (sometimes spelt “utils”). But
Symbolically,if U, stands for the utility of ith unit of
since “utils” is a subjective, arbitrary, and unreliable
good X, then
measure, it cannot predict how customers would

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Consumer Equilibrium
TUⁿ=ΣUi, i=1,2,3,..........n ● The three measurements of utility for a given
customer rely on how strongly he wants
AUn=TUn/n something to satisfy him.

● The intensity of good changes when a customer

MUn, TUn-TUn-1
eats it to fulfill a need. As a result, the consumer’s
stock of X has an impact on all three utility
In the case of an item that is “completely divisible,”
measurements.
the marginal utility of the nth unit of consumption,
also known as MU, is equal to the first derivative of ● Over time, the degree to which a desire is gratified
TU with respect to X; thus, MUn = dTU/dX describes is likely to alter. The ability of various things to
this relationship. satiate desires varies as well. The three metrics
of utility also change as a result of these factors.
It is obvious that a good’s utility to a customer is ● In general, not every customer experiences
directly correlated with how strongly the consumer wants with the same intensity. As a result, utility
wants to be pleased by consuming that good, which metrics differ from user to consumer.
is explained as follows:

Slices of bread Total Utility Average Utility Marginal Utility

Table 2.1: Average and marginal bread utility

Table (2.1) (Total, Average, and Marginal Utility of utility of slices decreases as well, and depending on
Slices of Bread) uses a hypothetical consumer who how many slices are consumed, it may potentially
eats bread to satisfy his hunger to explain the three turn negative or zero. Units of MU are displayed in
notions of utility. Bread should be eaten without column 4 of the table, “Total, Average, and Marginal
waiting too long between bites. Utility of Slices of Bread.” When the client eats the
ninth slice, it turns negative. In column 2, figures for
This presumption is crucial to ensuring that as TU are displayed. The sum of the MU in column 4 at
the consumer consumes more slices, his level of each step is known as TU.
hunger diminishes. By extension, the marginal
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Consumer Equilibrium
It is important to note that all three utility utility by the dark region, and marginal utility by the
measurements are equal for the initial slice. light area.
Furthermore, TU grows at a decreasing rate since
MU decreases with each additional slice of bread. Taking good X and assuming it is totally divisible
When MU approaches zero, it reaches its maximum, to illustrate the link between three utility metrics is
and when MU turns negative, it really decreases. a generalised strategy. Curves can define X’s TU,
In our case, TU increases up to the eighth slice AU, and MU. Figure’s interdependence smooths the
and then declines as the ninth slice is consumed three utility curves. (Combined, Median, Marginal)
since its MU turns negative (-4). It should also be
noted that AU declines along with MU, though more The total utility curve first slopes right and up. More
slowly. By comparing the data in columns 3 and 4 units of the commodity will increase its total utility.
you may confirm this fact. Over time, however, overall utility falls.

Figure 2.1: Total, average, and marginal bread utility Figure 2.2: Total, Average and Marginal Utility

Figure (2.1, 2.2) shows total, average, and marginal Overall usefulness rises slowly. The marginal utility

bread utility as a bar diagram (Total, average, and curve’s negative slope shows this. At maximum

marginal bread utility). X-axis steps represent one total utility, marginal utility is 0. Before this,

piece of bread. The height of a bar represents the decreasing marginal utility was always positive.

usefulness of its eaten segments. Dot-shaded Overall utility ceases growing. When consumption

bar shows MU of matched number of slices. The exceeds this point, marginal utility goes negative,

diagonally darkened region of a bar represents reducing overall utility.

consumed slices’ AU. Ninth slice MU is negative.

The bar’s height drops. AU’s darkened area is the It is generally accepted that MU decreases as

same. successive units of good X increase. This show:

Total utility is indicated by the bar’s height, average ● The marginal Utility Curve has a negative slope.

13
Consumer Equilibrium
● The marginal Utility Curve declines more slowly rupee on Good A is more useful than on Good B,
than the Average Utility Curve. As a result, AU he chooses A. The customer has two requirements:
curve is above MU curve and has a flatter slope.
● Marginal usefulness equals or exceeds
● The increase in the total utility curve is decreasing.
purchasing price. For good A, marginal utility >
When MU is 0, the distance from the X-axis is at
unit price, or MUa > Pa. MUa/Pa must equal 1
its greatest. When MU is negative, it then slopes
downward as well. ● The final rupees spent on all products establish
the marginal utility ratio, which is MUa/Pa and
Law of Equi Marginal Utility MUb/Pb. If MUa /Pa> MUb /Pb, a consumer can
get superior marginal value by switching from
When a typical consumer is faced with the following excellent B to good A. He can spend the same
situations, the rule of declining marginal utility is amount and get better overall value. Changing a
essential in determining his demand behavior and consumer’s expenditure between commodities
equilibrium. does not raise their total utility if the two ratios
are equal.
● The consumer is permitted to purchase all or a
portion of the listed items, such as A, B, C,…..N. According to the law of equity-marginal utility,

● Each good abides by the DMU law, and its customers are required to use their budgets in

schedule for marginal utility is known. such a way that the final buck or cent spent on
each product yields the same amount of additional
● Each product has a set price that the consumer
value. It’s in the code.
must pay. It is constant regardless of how much
the customer purchases.
Symbolically,
● The consumer is informed of the cost they will
incur. The consumer does not necessarily have MUa/Pa = MUb/Pb = MUc/Pc = .........= MUn/Pn
to spend the same amount on each commodity, (Consumer Equilibrium)
and the quantities can vary.
As a result, the consumer takes into account both
The answer to this issue is consumer equilibrium. the marginal utility and prices of the commodities
It describes the various quantities of commodities when allocating his budget to them. The consumer
that the consumer purchases, such as A, B, C,…..N. achieves maximum benefit from his expenditure by
The principle that guides the consumer’s choice in equating the ratios of marginal utilities to the prices
this situation is known as the law of equity-marginal of items. He can only hold this position, which is
utility. the finest one.

We assume the user allocates his entire spending It is evident that if there is a change in the consumer’s
among various items, considering their marginal equilibrium,
utilities and per-unit costs. Guided by marginal
utility, a consumer spends each additional rupee. ● His total expenditure
He spends his money accordingly. If spending a
14
Consumer Equilibrium
● Marginal utility schedule of any good which has 44 uses. The third rupee goes to good
D, which has 42 marginal utility. A and C cost 4.5
● Price of any good
rupees (not necessarily in this order). Good D costs

The principle of equal-marginal utility is illustrated 6 rupees. A and B cost 7.8 rupees (not necessarily

by the table (Application of the Law of Equi-marginal in this order). The last four rupees are split between

Utility). The choice of A, B, C, or D will cost the A, B, C, and D. (not necessarily in this order).

customer 12 rupees, and they can go in any order.

Four rupees go to D, three to A, two to B, and three
According to the first row, investing one rupee in
to C. He received 470 units of utility from A, B, C,
excellent A results in the production of 40 utility
and D. Any other allocation of his spending on
units. With that same rupee, you can purchase 38
these four things would reduce consumer utility. A
outstanding B. thus units.
customer can spend a rupee on any two or more

The consumer spends his first rupee on product D, commodities with equal marginal usefulness. We

which gives 45 units of utility and then spends each can’t be sure if the consumer will spend 4 rupees

subsequent rupee on the item with the highest on item A and 5 on item C, or vice versa. If his entire

marginal utility. The second rupee buys good C, spending is merely five rupees, he could buy either
item with the fifth rupee.

Expenditure MUa/Pa MUb/Pb MUc/Pc MUd/Pd

Table 2.2: Application of the Law of Equi-marginal Utility

A figure (Figure 2.3) above may also be used to

explain the Law of Equi-marginal Utility. In Figure
above the X-axis shows the amount of money spent
on good A in rupees, and the Y-axis shows the
equivalent marginal utility from that good per rupee
spent. This results in a downward sloping curve for
each good to which the consumer commits some
of his spending (like MUa /Pa). There are four of
Figure 2.3: Law of Equi-marginal Utility these curves in Fig. (Law of Equi-marginal Utility).

15
Consumer Equilibrium
The consumer uses rupees worth OA, OB, OC, and total amount of a good or nothing at all. This is
OD on items A through D. The final rupee spent on especially true with durable consumer products.
each of the four items had an usefulness of OF. He cannot, for instance, purchase a bicycle or a
half of a blouse. As a result, he doesn’t actually
Consumer Equilibrium Under Utility Analysis use the law of equity-marginal utility.

● The unrealistic nature of the law’s other

No change defines equilibrium. In consumer
presumptions also harms it. One of these
equilibrium, a buyer is satisfied with his purchase.
presumptions is that the consumer is fully aware
He finds equilibrium when he maximises his overall
of the costs and accessibility of every consumer
utility given his income and the cost of his items.
good. This is typically untrue, though. The
Any deviation from this concept harms the buyer.
consumer frequently lacks sufficient knowledge
of the costs of the products he is interested in.
A single-good consumer reaches equilibrium
He occasionally might be misinformed about a
when MU = Price, according to utility analysis.
product’s cost and/or availability.
If the additional unit’s MU is higher than the
product’s price, the consumer will buy it. He’ll buy ● The law presupposes that product utility
the commodity until its price equals its MU from schedules are independent. It implies that the
additional purchases. quantity of additional products purchased has
no bearing on the utility received from a single
Consumers reach equilibrium when there are good. But in reality, many products are related to
two or more commodities at a point where MU2- one another since they can be used in place of or
MU2=........=MUn if the cost of every good is the in addition to one another. In these situations, the
same. However, the equilibrium equation will be quantity of the linked good as well as the quantity
different if there are price discrepancies: MU1/ of the provided good effect the marginal benefit
P1=MU2/P2=............=MUn/Pn derived from the supplied goods.

● The law’s supposition that consumers can

Limitations of the Law precisely ascertain the marginal utility schedules
of all the commodities is dubious.
In actuality, there are a number of restrictions that
prevent consumers from putting the Law of Equi- The Principle of Increasing Substitutional Loss
Marginal Utility into practice. Here are a few of the
restrictions: According to the law, the marginal usefulness of a
product to a purchaser will drop when the stock of
● There are occasions when the presumption that that product grows alongside the consumer. In the
the items the consumer spends his money on end, it is canceled out and can even be a negative
are completely divisible—that is, that they may value.
be purchased even in incredibly little quantities—
does not hold true. Consumers are presented According to Marshall, the additional profit that an
with lumpy items. They cannot be divided into individual earns from a particular increase in his
extremely tiny amounts. He must purchase the stock of a product “decreases with every increase

16
Consumer Equilibrium
in the quantity that he now owns.” Legal Exemptions

If a consumer consumes enough of a good or DMU legislation is broken only if one or more
service, they can satisfy a single craving. This is the presumptions are compromised. Due to the fact
idea that if the want is continuously satisfied, its that a good’s utility depends on the consumer’s
intensity will decrease. Nothing should intensify it mental perception of the desire to be gratified and
while being satisfied. the item’s ability to do so, the law of DMU is broken
if, for whatever cause, a good’s utility is reduced.
The consumer shouldn’t let too much time pass
between units of the good, nor should he receive ● The consumer feels as though his want is more
unexpected news about his income or the good’s intense than before,
price. Before eating, food should be homogenous.
● Or the desire’s intensity grows.
Its subsequent units ought to have the same
technological requirements. Any alteration to them If two units of a good are consumed too far apart,
has the potential to alter the strength of the want their marginal utility tends to rise. Increasing a
being gratified, breaking the DMU law. consumer’s desire for a good may enhance its
marginal utility (such as a very little quantity of
Assumptions
water given to a very thirsty person).

The following are some of the Law of DMU’s

The following list includes certain DMU exceptions:
presumptions:

● Hobbies: Every additional unit makes certain

● The provided commodity’s units are all
hobbies, like collecting ancient coins or stamps,
homogeneous, or identical in terms of size, form,
more enjoyable. With the acquisition of each new
quality, quantity, etc.
unit, MU keeps growing.
● The consumption units are sized appropriately.
● Miser: When it comes to misers, avarice grows
The intake is typical.
with each extra unit of currency they acquire.
● The consumption never stops. The period
between consuming the following units is not Indifference Curve Analysis
very long.
Edgeworth is credited with being the first person to
● One type of commodity can only be consumed at
conceptualize indifference curves in the year 1881.
a time, according to the legislation.
Fisher, Pareto, and Slutsky contributed significantly
● Despite being a psychological construct, the law to its development. However, in 1934, Hicks and
believes that utility may be stated numerically Allen published an essay titled “A rethink of the
and can be measured cardinally. theory of value” in which they presented the results
● The consumer is a logical individual who seeks of a comprehensive research investigation.
the greatest amount of satisfaction.

17
Consumer Equilibrium
Meaning Indifference Map:

An indifference curve shows numerous consumer- A collection of indifference curves are expressed
valued pairings. The indifference curve is so named geometrically as an indifference map. More
because the consumer is indifferent to a particular contentment is indicated by a higher indifference
combination. curve. In the figure below, Indifference Curve No. V,
or IC5, IC1 displays the least satisfaction and IC5
Indifference Schedules: An indifference schedule is the highest satisfaction.
a table that represents the numerous combinations
of products that provide the consumer with an
equivalent level of enjoyment.

Two indifference Schedules:

Table

Figure 2.5

Properties of Indifference Curves

Table 2.3

By graphing the various combinations, we can turn ● A curve of indifference has a downward slope:

the indifference schedules into indifference curves. The quantity of one good must grow if the

Plotting different combinations of the indifference quantity of the other one falls for the customer

schedules No. I and No. II results in the indifference to maintain their level of satisfaction, according

curves IC1 and IC2 in the diagram. to an indifference curve that slopes downward to
the right.

Figure 2.4 Figure2.6: Indifference curve

18
Consumer Equilibrium
A difference curve won’t resemble Figs. (B), (c), or ● Indifference curves are origin-convex: This
(d) (D). Because the indifference curve in Fig. (B) suggests that as we move from the left down
is shaped like a horizontal straight line and the the curve to the right, the slope of an indifference
quantity of good X is raised but the quantity of curve diminishes. The commodities’ MRS is
good Y remains unchanged, the customer would declining. The indifference curve is thus convex
continue to be indifferent. The indifference curve to the origin. Two schedules in Table I make it
in Fig. (c) was shaped like a vertical straight line, obvious that as the quantity spent of X rises,
indicating that as the quantity of excellent Y rose, the quantity consumed of Y must fall. However,
good X remained constant. The indifference curve the rate at which Y of will be given up by the
in Fig. (d) slopes up and to the right. This indicates consumer slows down. Or to put it another
that when one proceeds to the right along the curve, way, the MRS xy is dropping. The consumer
the quantity of both items grows. These aren’t is anticipated to consume both commodities,
indifference curves, can they? therefore the rationale. A decreasing rate of Y
reduction results. An indifference curve that is
convex results from decreasing MRS xy.

Figure2.7

An indifference curve cannot be concave to the because the intersection point of two indifference
origin due to the fact that the MRS of X for Y curves would suggest that there are two separate
increases as more and more of X is substituted for levels of satisfaction, which is not feasible.
Y. This may be seen in figure (B).

Because a straight line would imply that MRxy

remains constant as more units of X are acquired
in place of Y as shown in the figure, an inequality
curve cannot exist (C). The typical shape of an
indifference curve is seen in Fig. A.

● Indifference Curves cannot cross one another Figure2.8

19
Consumer Equilibrium
Two difference curves—IC1 and IC2—intersect are independent in the sense that they are neither
at point C in the aforementioned diagram. Due to a substitute for nor a complement to one another,
the fact that Point A and Point B are on the same then they are parallel to one another.
indifference curve or IC2, they both exhibit identical
contentment. It is false to say that combination A
will be equivalent to combination B...

● An indifference curve above and to the right of

another indifference curve reflects preferred
commodity combinations and higher degrees
of contentment. Further from the origin,
an indifference curve indicates increased
satisfaction.
Figure2.10

● An Indifference Curve Does Not Touch Either the

Horizontal or Vertical Axis: If it does, like in the
figure below, it indicates that the consumer is
only buying one commodity, which is incorrect.

Figure2.9

IC2 in the aforementioned figure has a higher

indifference curve than IC1 because A2 is greater
than A1 when the same amount of commodity B is
used...

● Indifference curves might not be parallel to one

another: Indifference curves might or might not
Figure2.11
be parallel to one another. If the two commodities

Summary

A consumer who is completely content is said to be in a state of consumer equilibrium. The consumer’s
equilibrium refers to the situation in which an individual spends his or her allotted income on the purchase
of one or more commodities in order to achieve the highest possible level of satisfaction while feeling no
compelling need to alter the level of consumption currently being maintained, taking into account the prices
of those commodities.

20
Consumer Equilibrium
 Unit 3

Demand Analysis

Learning Objectives Introduction

By the end of this unit, you will be

Although we frequently use the word “demand” in our
able to understand:
daily activity, this phrase has a specific connotation
● Demand
in economics. Demand in economics is influenced by
● Determinants of demand a number of factors, most notably by human desires.

● Law of demand Demand is what happens when a person wants to

buy something and has the financial means to do so.
● Movements in demand curve
Demand is influenced by a number of things. Finding the
● Shifts in demand curve link between changes in these parameters and changes
● Why does demand curve slopes in demand is important since changes in these factors
downward have an impact on demand. The demand function is the
name of this relationship. The law of demand is stated
● Elasticity of demand
as other things being a constant change in price creates
the change in demand. The elasticity of demand is the
concept that when prices move proportionately, demand
changes proportionately as well. Therefore, it is crucial
for students to understand the relationship between
numerous factors and demand.

Demand is typically understood to signify a person’s

desire for something. Demand has a distinct meaning in
the field of economics than it does in everyday speech.
Demand in economics is always supported by having
enough money to buy a product on the market. As a
result, the definition of demand is given below.

21
Demand Analysis
“Demand in economics means to pay for the things Price Demand
sought,” claim Stonier and Hague. It denotes a
consumer who is financially capable and who is If all other factors remain the same, it refers to
willing to buy a product; as a result, the desire to varying amounts of the good that customers will buy
buy a product is converted into demand. Therefore, at a specific moment and at a range of speculative
purchasing power is crucial in generating demand. prices. Generally, we simply care about pricing and
demand. Only price demand was covered in depth
“Benham” defined it as “the amount of it which will in the foregoing discussion of the law of demand.
be bought per unit of time at the price; the demand
for anything at a particular price is the amount Income Demand
of it” (emphasis added). price, quantity, and time
requirements. Demand, therefore, consists of the
following components: purchasing power, price,
quantity, and time.

Demand

There are two key managerial goals for it, according

to Joel Dean in the book “Managerial Economics,”
namely to identify and quantify the factors that Figure 3.1: Income Demand (a)
influence sales.
The cost of the goods is one of the other elements
● Forecasting sales and that have to remain constant. On one side of the
● Manipulating demand. income demand schedule, various revenue levels
will be displayed, and on the other, the appropriate
The primary economic issue is secondary to all other amounts of the goods will be asked. Typically, the
goals. viz. preparing to make money. Understanding quantity of a good is demanded to increase with
the theory of demand is crucial if demand analysis the consumer’s money. This is especially true when
is to be used to help solve management difficulties. it comes to higher things, such as luxuries and

The term “demand” in economics refers to a comforts. Figure (Income Demand)(a) provides

desire that is supported by the required financial an illustration. The quantity demanded of the

capacity. The number of units of a good that can consumer’s income is depicted on the horizontal

be purchased at a particular price per unit of time axis.

is the quantity that is in demand. The demand has

The demand of consumers is OM when their income
three crucial characteristics:
is OY, and OMI when their income is OYI. This is the

Types of Demand situation with a superior or typical good, such as

butter in the current instance.

Demand comes in three different forms. Those are

22
Demand Analysis
 same want. As an analogy, given that tea and coffee
are both considered to be substitutes, customers
might decide to buy more tea rather than less
coffee if the price of coffee were to increase.

As coffee prices rise, tea demand increases. A fall

in coffee prices may reduce tea demand as people
drink more coffee. Tea’s cross-demand curve with
respect to coffee’s price will have an upward and
rightward slope. The figure illustrates that it will
Figure 3.2: Income demand (b) have a positive slope (Cross Demand). Tea demand
increases from OM to OM1 as the price of coffee
When a customer earns more money, his desire for increases from OR to OR1.
poorer things—basic necessities—falls while his
demand for higher ones rises.

Cross Demand

Figure 3.3: Cross Demand Figure 3.4

It refers to the varied amounts of a good people buy Since goods are frequently jointly wanted to
per unit of time at different costs of a related good. fulfill the same desire, the demand, for one thing,
Customer income and item price shouldn’t change, will always result in the demand for another.
among other considerations. Depending on how Complements include things like glasses and
the two goods are related, there may be a positive saucers. Bread and butter, a car and gas, a pen and
or negative connection between demand and price. ink, etc. Complements will result in a negative or
Two goods may be complements or replacements downward slope in the price of ink when viewed
(consumption rivals). from left to right. It implies that a decrease in ink
prices will result in a rise in pen demand, however,
When it comes to replacements, it is true that a the opposite is also true. As seen in the above
consumer’s need for another product will decrease figure, when the cost of ink decreases from ORI to
according to the amount of one product that he OR, pen demand grows from OM I to OM.
buys. This is because both products will satisfy the

23
Demand Analysis
To sum up, the following factors influence a
consumer’s desire for a good:

● The cost of that item,

● the costs of the associated commodities, i.e.

replacements, compliments, and

● Consumers’ levels of income.

Demand resulting from advertising and sales

promotion, a concept that is very significant to the
business sector, might be added to these.
Table 3.1: Demand Schedule

Law of demand The demand curve can be illustrated using the

demand schedule as shown below.
If everything else stays the same, the demand for
a commodity will increase as its price goes down,
and it will decrease when its price goes up, in
accordance with the rule of demand. This law is
based on observable facts and can be confirmed
with fresh empirical data because it is an empirical
law. The law shows that the link between price and
quantity desired is inverse. The rule is valid provided
that “other things remain constant.” Other factors
that affect demand include consumer income, the
cost of alternatives and complements, consumer Figure 3.5 : Demand

taste and preferences, etc. Only in the near term

do these factors remain consistent. Long-term, Demand curve: It shows the inverse link between a
they frequently undergo modification. The law of commodity’s price and demand. The demand curve
demand, therefore, holds only in the short run. therefore slopes downward. or descends left-to-
right.
Demand Schedule:

Demand Curve:
When the price is reduced from Rs. 5 to Rs. 1, a
consumer’s demand schedule reveals that the The total amount of consumer demand for an
required quantity increases from 10 to 50 units. It item on the market is known as market demand.
demonstrates how pricing and demand are in direct Customers purchase in different quantities and
opposition to one another. pay in different ways. The market demand is then
calculated at various prices by adding together all
Plotting the requested quantity along the x-axis
of the customer demand at a given price. It offers a
and the price along the y-axis creates the DD
24
Demand Analysis
timeline for the overall market demand. ● Income does not change.

● Prices for complementaries and substitutes

Two consumers, A and B, are present in the market,
remain constant.
as this table demonstrates.
● There is no alternative to the commodity.

● The population does not change.

Limitations:

The constraints of the Law of Demand are all the

aforementioned presumptions. They are listed
Table 3.2: Consumer Table below.
A and B consumers are looking for quantities of 20
+ 10, 25 + 15, and 30 + 20 at the pricing of 5, 4, and ● Change in income: Consumer income is likely to
3 Rs., respectively. At the aforementioned prices, it fluctuate. The Law of demand is ineffective.
indicates that the total market demand is 30, 40, ● Change in tastes and preferences: If tastes and
and 50 units, respectively. preferences change, the law of demand can’t be
demonstrated.
If a graph of this price-quantity-demand relationship
● Change in prices of other goods: If the prices of
is created. The demand curve shows a declining
substitutes and complementary commodities
slope. It demonstrates the asymmetry between a
change, then the “law of demand” cannot
commodity’s price and its demand. According to
demonstrate that there is an inverse relationship
the following figure (Figure3.6):
between the price of a product and the demand
for that commodity.
Assumptions :
● Population change: The law of demand does not
hold true if the population changes.

● Availability of close substitutes: In situations

where there are close alternatives available for
the consumer’s goods, the inverse relationship
that exists between price and demand will not be
satisfied by the law of demand.

Exceptions:
Figure 3.6 : Demand

The law of demand has very few exceptions.

The following presumptions form the basis of the
There will be times when it is not present. These
Law of Demand.
circumstances—which are known as exceptions—
● Consumer preferences and tastes never change. include the following:
In other words, nothing has changed.
25
Demand Analysis
● War: The law of demand is not applicable If a family needs 10 kg of rice each month, the
during times of war. At this time, the country leader won’t cut back. This would starve his family.
is characterized by a lack of a variety of items. While rice prices decline, he can’t eat 50 kg per
Therefore, people are buying more items at higher month instead of 10 kg. The nature of essentials
prices. It suggests that even though commodity inhibits price-sensitive consumption.
prices are high during a time of conflict, people
can continue to demand an increasing amount Movements in Demand Curve
of things.
While determining the demand schedule (curve/
● Economic depression: Another instance of the
function), the law illustrates the price-quantity
rule of demand not applying is the era of the
relationship; nevertheless, there are numerous
economic slump. Commodity prices are currently
additional elements that influence the demand
at their lowest point because there isn’t a high
schedule. It should be emphasized that while a
demand for them at this time. This indicates
demand curve’s slope is dictated by its price, its
that demand and price remain lower throughout
‘location,’ or distance from the origin, is determined
an economic downturn. As a result, the law of
by other variables. To put it another way, a good’s
demand is not in effect.
demand varies when:
● Status symbol commodities: Diamonds, valuable
stones, antique and ominous images, idols, and ● On the same demand curve, a consumer shifts
other precious items are status symbols that from one point to another (Movement along the
the wealthy always buy to demonstrate social demand curve).
distinction. These goods are bought for the
● When the position of the entire demand curve
status they grant the owner rather than for their
changes (Movement from one demand curve to
intrinsic value. Therefore, if the price of these
the other).
products decreases, so does the demand for
them, and vice versa.
A demand curve is produced assuming all variables
● Giffen goods: Giffen products are those that affecting consumer demand behavior, other than
are inexpensive or subpar. The rule of demand price, are constant. When the price of a good varies,
does not apply to them. Its demand tends to the consumer’s desired quantity shifts along the
decrease with a decrease in price and increase demand curve.
with a rise in price. Sir Robert Giffen investigated
this connection. As a result, it is known as Giffen Demand “contracts” when quantity decreases
goods. owing to price increases. The consumer’s demand
● Essential goods: The products that are essential curve rises. If the good’s price drops, the consumer
to human life. When a product’s price increases, purchases more of it. Thus, demand “grew.”
stays the same, or decreases, the user doesn’t
cut back on their daily consumption.

26
Demand Analysis
 Demand-Curve Shifts

Price-quantity relationship in the law of demand is

important. The corporate manager must be informed
of demand function changes (or curves). Many
products’ price adjustments have little effect on the
amount requested within price ranges. Earnings,
preferences, fashion, and business activity all
affect product demand. The firm’s decision-maker
is more concerned with demand curve alterations
than with demand curve movement.

Differentiate between demand curve movement

and demand curve shift. When a good’s price varies,
so does the amount demanded. These price-driven
Figure 3.7: Expansion/Contraction and Increase/Decrease in
Demand changes in demand are represented by movement
along the same demand curve.

Change in Demand Curve: Moving from One to the

Other Changes in Demand Could be Brought on by:

If the client’s desired quantity does not shift in ● Income changes of the customer.

tandem with the selling price, then the client ● Changes in customer preferences.
will shift from one demand curve to the other.
● Price changes for linked goods (substitutes and
When a customer reaches the rightward-sloping
complements).
outer demand curve, demand “increases.” This is
● Changes in external elements like social structure
“demand expansion.” When the inner demand curve
and fashion, etc.
shifts to the left, demand “drop.”

As a result, we are able to take into account the two

demand curves, D1 and D2, that were shown in the
preceding graphic (the expansion/contraction and
increase/decrease in demand curves respectively).
When the consumer is on the demand curve D1, he
purchases OM at a certain price of OA per unit of
X; however, when the customer is on the demand
curve D2, he purchases OM’. As a consequence of
this, a shift from point P on D1 to point C on D2 is Figure 3.8: Demand curve (a)
described as an “increase” in demand, whilst a shift
in the other direction is described as a “down” in
demand.
27
Demand Analysis
Demand increases from OM1 to OM2, but price Why Does the Demand Curve Slope
decreases from OP1 to OP2. Here, it is said that Downward?
the demand for the good has increased or grown.
Moving from point A to point B along the demand A downward-sloping demand curve shows that
curve represents this. On the other hand, demand more is demanded at a lower price. The demand
decreases from OM2 to OM1 if the price increases curve represents the law of demand geometrically.
from OP2 to OP1. In this case, it is said that the Quantity is shown horizontally and prices vertically.
goods demand has decreased. Moving from point These variables explain this shape:
B to point A on the demand curve D1D1 illustrates
this. ● Law of diminishing marginal utility: Demand
law is consistent with falling marginal utility.
The demand follows diminishing marginal utility.
The normal client doesn’t quantify marginal
utility, yet when he buys more of a good, he has
less satisfaction or utility. The maximum price
a consumer will pay for a good is its marginal
utility. He won’t buy in bulk till the price is down.

● Application of the principle of multiple uses:

Some products have a variety of purposes. If
the cost of that commodity is too high, just that
usage will be in great demand, according to the
Figure 3.9: Demand curve (b)
consumer. When the price drops, less important
Changes in income, style, preferences, etc. affect uses will increase demand. When energy is
the demand curve, not price. The ceteris paribus expensive, just lights are used. As it becomes
hypothesis is relaxed; factors other than price cheaper, fans, air conditioners, refrigerators, and
influence demand, and the consequences are kitchen ranges will use it.
portrayed as shifts or changes in demand, indicating ● New purchasers: If a good’s price decreases,
an increase or decrease in demand. The demand some people who previously couldn’t afford
Curve shows this change (b). OP1 needs OM1. it could suddenly be able to do so. Thus, more
buyers will increase overall demand.
As income rises, more output is needed to meet
● Income effect: A lower price increases a
demand, OM2, at the same price as OP1. D2D2
consumer’s real income. He can buy more of the
causes OM2; be aware. Demand shifted. A fall in
product. Price increases reduce his real income.
income may lower demand for a good at the same
He’ll buy less. Consumers don’t spend most of
price. Shifting demand curves up or down increases
their income on one thing, hence the income
or decreases demand.
effect is small. The income effect is powerful if
a buyer spends a large amount of his wage on a
single commodity.

28
Demand Analysis
● Substitution Effect: When a good’s price drops
without being followed by a drop in the cost of its
alternatives, buyers find the product to be more
alluring. They are now consuming more of the
commodity, which causes the demand for it to
increase or increase. The substitution effect is
thus at work. The opposite is also true. Where, q = Initial demand
● These two factors combine to produce the shift
in demand for a good brought on by a price Δ q = Change in demand

adjustment. Because the consumer would not

Δ p = Initial price
choose the same commodity over other goods,
the substitution impact is typically higher than
p = Change in priice
the income effect.

e = Elasticity of demand.
Demand Elasticity

The rate at which demand changes in response to

price changes is referred to as demand elasticities.
Only the inverse link between a commodity’s price
and demand is expressed by the law of demand.
The corresponding change in demand to the =2 Therefore elasticity of demand is equal to 2.
proportionate change in price, however, is not
mentioned. Therefore, “Alfred Marshall” develops There are three distinct types of demand elasticity.
the idea of demand elasticity. Demand might be elastic, inelastic, or indeterminate

According to the definition of elasticity of demand, ● Price Elasticity of Demand

it is the ratio between the proportionate change in
● Income Elasticity of Demand
quantity sought and the proportionate change in
the price of a good or service. This indicates that ● Cross Elasticity of Demand

the elasticity of demand displays the percentage

Price elasticity of demand: Price elasticity of
change in demand to the percentage change in
demand examines how price changes affect
price. The degree of correlation between demand
consumer demand. This shows how prices affect
and price is thus expressed by the demand’s
customer demand. Marshall coined the term
elasticity. It measures how quickly the quantity
“demand price elasticity.” He defined it as the ratio
required changes in response to a change in price.
of quantity change to price change. First used by

The elasticity of demand is mathematically “Marshall” It’s denoted by:

represented as follows:
So the following formula is used to determine
demand elasticity:

29
Demand Analysis
 by price changes. As a result, it is known as fully
inelastic demand. The diagrammatic representation
is as follows.

Infinitely Elastic Demand:

Demand is said to be completely or infinitely

elastic when a tiny change in price causes a very
significant change in demand. The diagrammatic
representation of it is as follows.
Figure 3.11: Demand (ii)

Demand curve is DD. The curve is vertical and

parallel to the Y axis. It demonstrates that the
quantity needed remains constant while the price
varies. Demand remains OD I despite a price shift
from OP to OP1. e. same.

Relatively elastic demand (e 1): When there

is a considerable shift in consumer behaviour
in response to a change in price, we say that
demand has elastic properties. To put it another
Figure 3.10: Demand (i)
way, we say that the demand is relatively elastic
when the amount of change required in quantity
The demand curve (DD) is a horizontal, straight line.
is more than the amount of change in price. In
It demonstrates how even a minor price decrease
this particular scenario, the degree of flexibility
can result in an infinite rise in demand. Demands
in meeting consumer needs is more than 1. (e 1).
are extremely sensitive, and demand elasticity is
In a diagrammatic representation, it is shown as
unlimited.
follows:

Perfectly Inelastic Demand:

In the graph, the price change (PP1) is less than the
When a price change, regardless of how large or demand change (QQ1) The demand curve for DD is
small, has no effect on the demand for the good therefore flatter.
or service. In this situation, demand is unaffected

30
Demand Analysis
 Diagrammatic representation:

Figure 3.12: Demand (iii)

Demand that is relatively inelastic, or e 1, is as

follows:

When demand changes slower than price, it’s

deemed inelastic. This means a large price change
will have a small effect on demand. Diagram of it: Figure 3.14: Demand (V)

The demand curve with a downward slope is DD. It

demonstrates that the change in quantity requested
QQ1 is greater than the change in price PP1.

As a result, the price elasticity of demand is 1, or

what is known as unitary elastic demand.

This approach compares and measures the change

in overall expenditure on a good brought on by a
price adjustment. The three comparisons of these
adjustments are as follows.

● whenever prices alter (rise or fall). does not

Figure 3.13: Demand (iV)
cause a change in the overall expenditure on a
Demand curve with a downward slope is DD. commodity, which occurs when the price of a
It demonstrates that the change in quantity product varies but the total expenditure does not
demanded QQ1 is smaller than the change in price change or stays the same.
PP1. The demand is hence inelastic.
● If the price of a commodity goes up, this will
result in a reduction in the total amount spent
Demand Elasticity, Measured in Units (e = 1):
on that commodity, but if the price goes down,
Unitary elastic demand occurs when a price change this will result in an increase in the total amount
equals a demand change. Demand varies directly spent on that commodity. When the elasticity of
with price. Consequently, demand elasticity is 1. demand is greater than one, this phenomenon is

31
Demand Analysis
 known as elastic demand. (e>1). curve to the upper section lets you estimate demand
elasticity at any point. Find this ratio on the demand
● If the price increases or decreases, the overall
curve. Ratio defines inflection point.
expenditure changes accordingly. Inelastic
demand refers to this kind of elasticity.

The following table aids in the explanation of this

method:

Proportional Method:

A comparison is made using this method

between the percentage change in demand and Figure 3.15: Demand

the percentage change in price. The elasticity of

Demand curve DD1 is a straight line. It is 4 inches
demand can be calculated with the help of the
long. Points A, B, and C are located on the curve. B
formula that is presented below.
serves as a midpoint, dividing the DD curve in half.
BD = BD1 = 2, therefore. The center of segment BD
is where a point is located. Consequently, BA = AD =
1. Similar to B Point, C Point is located in the middle
of segment BD. BC = CD1 = 1, so.

Elasticn.....
Geometrical Method (Point Elasticity):

Utilizing this method, one is able to determine the

degree to which demand is elastic at any given
Demand at point A is therefore more elastic than
position along the demand curve. whenever a
one.
straight line can be used to illustrate the demand
curve. To calculate the degree of elasticity of
demand at each point along a demand curve, the
formula that can be found below should be utilized. As a result, the elasticity of demand at point B is 1.

Calculating the ratio of the lower half of the demand

32
Demand Analysis
 Therefore, Changing alternative costs affects a
good’s demand. Two related commodities are
subject to demand elasticity. Two goods may be
At point C, the demand elasticity is smaller than 1.
complementary or substitutes. This is called cross-
demand elasticity.

Cross elasticity of demand can be defined as “the

ratio of proportionate change in quantity demanded
of related commodity A to a given proportionate
Elasticity of demand at point D = ∞
change in the price of related commodity B.”

This method allows for the measurement of

The following formula is used to determine the
demand elasticity at the point curve.
cross elasticity of demand.

Demand’s Sensitivity to Changes in Income:

Income elasticity of demand describes how income

affects a person’s desire for a good. Income affects Let’s say that A and B are two commodities that
demand. “Income elasticity of demand equals can be used in place of one another. The amount of
income change to demand change.” It measures commodity A that is desired increases if the price
how demand adapts to income fluctuations. of B increases while the price of A stays the same.
“Income elasticity of demand” is the ratio of Since consumers will choose A over B. In contrast,
demand to income. if the cost of A increases but the cost of B stays
the same. It causes the demand for commodity B
Mathematically, it’s: to increase. because consumers are now choosing
B over A.

Demand’s cross-elasticity may be 0 or infinite. It

could also be neutral or negative. Cross elasticity
may reach infinite when two commodities are
perfect substitutes for one another. Where two
items are not interchangeable, cross demand
elasticity will be zero. It indicates that a change in
one commodity’s price has no impact on the demand
for another. Infinity and 0 are the two extremes of
the cross elasticity. The level of substitutability is a
Cross-Elasticity of Demand: factor.

Every commodity on the market has a wide The cross elasticity of demand is positive (+ve)
range of alternatives or supplementary products. when the two goods are interchangeable. When

33
Demand Analysis
two products are mutually exclusive, their cross elasticity is negative (-ve).

Summary

Understanding the customer demand for a certain good or service in a given market is the primary objective
of demand analysis. Techniques of demand analysis are used by businesses in order to ascertain whether
or not they will be able to enter a market successfully and earn expected profits in order to progress their
business operations.

34
Demand Analysis
 Unit 4

Production Function

Learning Objectives Introduction

By the end of this unit, you will be

Production-oriented engineering. The field studies
able to understand:
producer behavior. Stigler defines “production function”
● Production
as the relationship between inputs and outputs.
● Short run production function
Land, labor, capital, and entrepreneurs are traditional
● Long run production function
production inputs, but knowledge and technology are
also important. “Production function” refers to the
technical relationship between the units of production
factors and a thing or service’s unit of production over
time. The production function shows the physical input-
output relationship.

Production

Production requires inputs to become outputs. Production

converts raw ingredients into final items over time and
space. Production transforms inputs into outputs.
Production economies include both services and goods
since they develop utilities. Production creates goods
and services.

A corporation combines inputs in different amounts

and proportions to produce different outputs. Flow
characterizes production. Its unit is produced per unit

35
Production Function
time. same (M.P.). In terms of mathematics, this may be
shown as,
Concepts
MP = n - n - 1
Total Production (TP):
where, MP = Marginal product
Total production equals all output units produced
in a given time unit from all inputs. Mathematically, n = The addition of one unit of the variable
it’s. In the short run, changing factor inputs boost component resulted in a rise in total production.
total output.
n - 1 = Total number of components before the
Average Production (AP): marginal unit increased

The term “average production” refers to the entire for instance: Assume that 26 workers were involved
production for a particular variable element. In in the production of 550 units of the commodity.
essence, we may calculate the average product There were 500 units produced overall with 25
analytically by dividing the total product by the people. The 26th worker’s marginal product is
number of variable elements. calculated as follows.

MP = TP26 - TP25 = 550 - 500 = 50 units

TP = Total Product

QVF = The Quantity of Variable Factors

Suppose there are 30 workers working and the daily Additionally known as an “incremental product,”
output of the commodity is 1500 units. this ratio.

AP = 1500/30 = 50 units/workers The Short and Long Run:

Marginal Production (MP): Short Run: The term “short run” refers to a time
frame during which at least one production input
The word that is used to describe the additional that is under the producer’s control is variable and
unit that is created by the final variable component at least one input is fixed.
is called marginal production. To phrase it another
way, the introduction of a variable factor results in Long Run: The long run is a time frame during which
a shift in the production as a whole. Technically all production inputs that are under the producer’s
speaking, the addition that was made to the final control are erratic.
product is considered to be a marginal product
because all of the other parameters remained the It is dependent on the production activity at hand

36
Production Function
to determine whether or not it falls within the an electric utility business, may define the short
category of long-run or short-run production. Some term as the number of years required to develop
producers may only provide the show for a limited and construct a new generation unit.
time, which could be as little as a few days. The
short-term impacts on others may linger for a good Typically, the company operates in the short run
number of years. In addition, whether an input is at all times. i.e., one or more factors’ input rates
fixed or variable is determined by whether the time are fixed. However, the majority of businesses are
under consideration is the short run or the long run constantly thinking about or preparing changes
in the study. The four concepts are intricately linked to their full operational scope that would affect
to one another and interdependent in many ways. all input rates. As a result, it is believed that the
company has long-term goals yet executes them
quickly. A car manufacturer, for instance, might
have six plants with a maximum annual production
capacity of 1.5 million cars. It could take several
years to construct a new plant. The company
operates its current plants at any given time, which
is a short-run decision. However, based on the
demand environment that exists today and in the
future, the company will decide whether to increase
Production with One Variable Input: or decrease plant capacity in the long run.

There will be two approaches to the optimal Production with Two Variable Inputs:
production problem. In this section, it is assumed
that the production period is long enough for one To estimate the best input rates when both capital
production factor’s input rate to be fixed. In other and labour are changeable, a separate set of
words, the time is not long enough to alter the rate at analytical tools must be used. The firm might
which that factor is input. Therefore, the challenge tackle the issue of effective resource allocation in
is to establish the best rate for the variable input production in one of three ways.
given the output price, the price of the variable
input, and the production function’s description ● Produce output at a pace that maximises profit.
of the production technology. The ideal rates for It will be demonstrated that in the scenario where
both the variable inputs, labour and capital, will be profits are maximised, the marginal revenue
established in the section that follows. product for each input will be equal to the input
price.
The short-run is referred to as the time frame ● Increase the amount spent on labour and capital
in which one of the inputs has a set amount. On inputs to create a given production rate.
the other hand, over the long term, all inputs are
● Increase output for a given expenditure on labour
variable. Different companies will have different
and capital.
short-term time frames. The short-run for some
businesses might only be a few days. Others, like

37
Production Function
Constrained optimization difficulties are what is one factor in a combination of factors is invested
known as the first two issues. The limitation in after a point.”
problem (1) is a set cash outlay for labour and
● Stigler: When increasing equal increments of
capital. The restriction in problem (2) is a required
one input while keeping other inputs fixed, the
output rate that is defined. However, in issue (3),
marginal product declines.
the company looks for the output level that will
maximise profit; neither the production budget The law of diminishing returns is what this is
nor the desired output level is constrained. The known as. This law explains how changes in
production function’s own boundaries are the only factor proportion affect output. The law of varying
ones that place restrictions on the company. proportions, therefore, gets its name. The law
of variable proportions is essentially this: If we
Short-Run Production Function continue to use a certain factor or more and more
of it, the marginal physical consequence of the
Variable components must be modified whereas
variable factor will eventually begin to decrease
fixed manufacturing factors cannot be. A short-run
while some of the other factors remain the same
production function is a relationship between inputs
or remain fixed.
and outputs when one variable is kept constant. It’s
called the law of shifting proportions.
Assumptions of the Law:

In other words, the result also changes in a normal

● Production technologies and methods never
name if one factor is held constant while the other
change.
factor is changeable. The law of varying proportions
● One production factor is changing while a few
provides an explanation for this relationship. The
are kept fixed.
corporation uses changeable components in
varying proportions along with fixed infrastructure ● Any combination of several manufacturing
and machinery in the short term. With the permanent elements is possible.
plant, more variable parameters, such as people, ● Production factors can be divided. The production
working hours, shift sizes, raw materials, etc., can process takes a certain amount of time.
be employed to boost production. It becomes vital
to monitor what happens to the overall physical The following table serves as an illustration for this
output when fixed plants and machinery are law.
combined with ever-increasing amounts of variable
components. The law of changing proportions
reveals the solution to this quandary. This is how it
is explained:

Definitions:

● Benham: “The marginal and average products of

that element will drop first when a proportion of Table 4.1

38
Production Function
Assume that a 4-acre piece of land is a fixed
component of production. Labor is a variable
component that increases progressively in the
same ratio as 1, 2, 3, 4, 5, 6, 7, 8, 9, and so forth.
Total product (TP) rises by 10, 24, 42, 58, 58, 57,
55, and 52 as labor share declines. Both marginal
and average goods see an increase as shown by
the following numbers: 10, 14, 18, 10, 6, 0, -1, -2, and
-3; and 10, 12, 14, 13, 11.60, 9.67, 8.14, 6.87, and
5.77, respectively. It demonstrates that the total
product increases at an increasing pace as 10, 14,
and 18 till the third laborer is employed. This law’s
first stage, which exhibits an upward trend, is now
Figure 4.1
in effect.

A diagram can be used to explain this law.

The second stage starts with the fourth to sixth
workers being employed. Total product (TP) rises,
The graph shows the variable factor’s quantity on
while the rat is diminishing, i.e. 10, 6, and 0. The
the OX axis and total output on the Y axis. Total,
stage of diminishing returns is referred to as such.
marginal, and average products are abbreviations.
The marginal product (MP) hits zero at this point,
These curves show how to input labour changes
and the total product reaches its highest point.
their shape.

The third stage starts when the total product’s

Explanation:
marginal labor growth falls to the seventh level. I.e.,
the marginal product turned negative at this stage, This diagram shows the following three phases:
becoming -1, -2, and -3. Thus, the stage of negative
returns is what it is known as. Typically, a company ● First stage: At this point, the total product (TP)
cannot enter this level. curve increases. It’s convex to Y before concaving
to X. Before dropping, it reaches N1. TP rises
Out of these three stages, a company or producer is slowly at first. MP and AP both rise, but MP rises
willing to stay in the second, where the total amount quicker. Decreased returns describe this period.
of output is still at its peak. In this approach, the MP curve peaks then fall. At “S,” it cuts the AP
table illustrates how total product rises initially with curve, while the MP curve persists above. The
an increasing rate when land is held constant and if first step of the law of changing proportions is
a firm continues to employ more and more workers point S, where the TP curve accelerates.
after a certain point, it climbs with a falling rate. ● Second stage: After N (NN1 segment), the TP
curve displays a rising trend with a diminishing

39
Production Function
 rate. The highest point is N1. After this, it drops Long-Run Production Function
(N1 ). While MP is 0 at this point, TP is at its
maximum. Long-term is when a corporation can change
The fact that the MP curve is dropping and contacts production aspects. Both permanent (land, plant
the X-axis at point M1 before the third stage starts & machinery, top management) and changeable
is crucial in this situation. The second stage was factors (labour, limited resources, fuel, etc.). A
therefore located between the points MM1 and N corporation might change its production size
N1. The stage of declining returns is what this phase over time. It’s crucial to know how production
is known. Because there is a limited total product, size affects a company’s cost curves. The Law of
each company (produce) is willing to generate up Returns to Scale provides the solution to the query
to this point. We can keep some manufacturing factors constant
while modifying others, per the law of variable
● Third stage: This stage starts at point M1, where
proportions. We delete or reduce all production
the MP curve intersects the X-axis, and follows
factors in the same ratio, per the law of returns
the maximum point N1 of the TP curve. The
to scale. This alters a company’s capacity for
employment of additional labour at this stage
production or its scale of production. The production
leads the TP curve to flatten. While the AP curve
function with two variable inputs is another name
continues to decline but remains positive, the
for this. Long-term, the company modifies all
MP curve turns negative. The stage of negative
production-related aspects in accordance with its
returns is what this phase is known.
needs. When both the inputs of labour and capital
are considered to be movable, we can analyse the
No business prefers to run in the first and third
interaction between them. The output’s response
stages. because the whole product is growing at a
to changes in scale is taken into consideration. All
growing rate in the first stage. Production is thus
inputs are raised in the same proportions as the
profitable, and the company is eager to increase
scale is increased. Total output rises when inputs
output. Due to poor results, we are in the third
are distributed equally, first with an accelerating
stage. The company cannot function profitably at
rate. Next comes a steady rate, and lastly a rate of
this time.
return that is declining.

Summary

In the field of economics, the concept of a production function describes the technological relation that
exists between the number of physical inputs and the quantity of output of commodities. In mainstream
neoclassical theory, one of the most important notions is called the production function. This concept is
used to describe the marginal product and to differentiate allocative efficiency, which is one of the primary
concerns of economics. To address allocative efficiency in the use of factor inputs in production and the
resulting distribution of income to those factors is one of the most important purposes of the production
function. This is accomplished while abstracting away the technological problems of achieving technical
efficiency, as an engineer or professional manager might understand it.

40
Production Function
 Unit 5

Concepts of Cost

Learning Objectives Introduction

By the end of this unit, you will be

Every business decision involves costs. Correct pricing is
able to understand:
vital. Cost perceptions differ due to multiple perspectives.
● Cost
While decision-making cost concepts estimate what will
● Types of cost- TC, AC, MC happen (in the future), financial records represent what

● Short run cost happened (expenditure in the past). Dean says, “Cost
ingredient combinations suit different management
● Long run cost
issues. Disparities emerge from updates to accounting
● Revenue records, such as deletions, additions, recombinations of
● Types of revenue- TR, AR, MR items, price-level changes, and new measurements.”

Cost

A company operates in order to maximize profits. Profits

are the money that a company keeps after producing and
selling its products or services. However, the producer
must lose something in order to gain something. This
means that the producer must pay expenses in order to
generate income.

An expense made by a company to manufacture goods

and services for market sale is referred to as a cost. In
other terms, a cost is the amount of money that is taken
out of the business before the proceeds from the sale of
the goods are received. To generate goods and services,

41
Concepts of Cost
a producer must pay a variety of expenses. These costs come in many different forms.

Table 5.1

Fixed costs (FC): costs that remain constant Economic cost: Actual direct expenses (accounting
regardless of output changes. Fixed expenses could costs) and opportunity costs are both included in
include the price of constructing a manufacturing, the economic cost. As in the case of taking time
insurance premiums, and legal fees. Your fixed from work for a training program. You can be
costs do not change, regardless of whether your required to pay the direct cost of £200 in addition
output does or does not change. to losing a week’s pay of £350. Thus, £550 is the
entire economic cost.
Variable costs (VC): costs that change depending
on the volume of output. For instance, you would Accounting costs: This represents the cost
need to use more raw materials, like metal, if you associated with producing a specific good. Your
produced more cars. This price fluctuates. required variable and fixed costs are included in
accounting costs.
Semi-variable cost: The cost of labor may be semi-
variable. This is a variable cost since in order to Sunk costs: These expenses have already been
build more cars, you must hire additional people. paid for and cannot be recovered. Sunk charges
But even if you didn’t make any cars, you might still were non-refundable in the event that you quit the
need some staff to maintain a vacant plant. industry. For instance, you will never be able to
recover advertising expenses made to break into a
Total Cost (TC): = Fixed + Variable Costs market. If you purchase a machine, you may be able
to sell it if you decide to leave the sector.
Marginal costs: The price of manufacturing an
additional unit is called the marginal cost. If the Avoidable costs: cost savings opportunities. You
price of three units is 1500 and the price of four won’t have to pay for more raw materials and
units is 1900. The fourth unit has a marginal cost electricity if you stop making cars. Occasionally
of 350. referred to as an avoidable cost.

Opportunity cost: is the term used to refer to the Explicit costs: These expenses, which are visible
alternative that comes in second place. If you put on the accounting sheet, are ones that a company
one million dollars toward studying pancreatic directly pays. Explicit costs must be stated clearly
cancer, you won’t have any money left over to study and can be either fixed or variable.
skin cancer.
42
Concepts of Cost
Implicit costs: These are opportunity expenses,
which don’t always show up on a company’s
balance sheet but nonetheless have an impact
on it. A company would lose out on revenue if, for
instance, it used its resources, such as a printing
press, to create leaflets for a charity.

Market Failure

● Social costs. This represents society’s overall Figure 5.1: Cost curve in short run
expense. It will incorporate both internal and
external costs (costs incurred by a third party). Short-term total costs are shown (Cost curve in
Alternatively known as “True expenses” the short run). Fixed costs are a horizontal line
● External costs. This is the price a third party must parallel to OX, regardless of output. Variable costs
pay. For instance, some people may experience are output-based. Zero output, zero variable costs.
passive smoking if they smoke. The external Total variable costs start at zero and climb since
cost is that. production is zero (indicating that with increasing
output the variable costs are also increasing). The
● Private costs. what you have to pay. For instance,
total cost curve shows fixed and variable costs at
a packet of smokes costs £6.10 privately.
each output level. F-off. Since there’s no output, the
● Social marginal cost. The overall expense total cost is fixed. Average unit price. Instructions:
incurred by society due to the production of an
additional unit.

Types of Cost- TC, AC, MC

The term “Total Cost” (TC) was shorthand for the Where AC = Average Cost
total number of rupees that were invested in the
production of each tier of output. The overall cost And TO = Total output
rises proportionately with the amount of output
(TC). The entire amount that a manufacturer spends Since TC = TFC + TVC
in order to reach a particular level of production is
comprised of both the total amount that is spent on
fixed expenses and the total amount that is spent
on variable expenses. because of this the

Total costs = Total fixed cost + Total variable costs.

In symbols, TC=TFC+TVC. Where AFC = Average fixed cost and

AVC = Acerage variable cost

43
Concepts of Cost
As a result, the average cost (AC) corresponds =TVC2-TVC1 (Because TFC2=TFC1,
exactly to the same value as the average of the by definition in short run)
average fixed cost (AFC) and the average of the
average variable cost (AVC). AFC stands for =rate of change in variable costs.
“output-based fixed cost,” which is another name
for the AFC. One way to think about the AVC is as As a result, in the near term, the marginal cost is
being analogous to the variable cost incurred for distinct from the fixed cost and is the marginal
each individual unit of output. variable cost.

One way to think about the marginal cost is as Relationship Between AC and MC
the rate at which total costs shift in response to
alterations in production (MC). When there is an
increase in the output of one unit, there is also an
increase in the overall cost, and the amount that
is referred to as the marginal cost is the increase
that occurs when there is an increase in the overall
cost. If it costs TCn to produce n units of output,
and it costs TCn+1 to produce n units, then the
marginal cost is determined by subtracting TCn+11
from TCn. If the price per unit for n items is TCn
and the price per item for n-1 items is TCn-1, then Figure 5.2: AC vs MC

the marginal cost is calculated as TCn minus TCn-

1. This is an alternate approach that can be taken When marginal cost is higher than average cost, the

to calculate the cost. When anything is calculated average cost rises. In the same way that marginal

using the equation C = f(x), where dcC represents cost declines when average cost declines, so too

the total cost and X represents the output, the will average cost. Assuming marginal cost is equal

conclusion that may be drawn is that to average cost, however, the average cost will not
vary. An illustration of the connection between MC
and AC is provided above.

It can be demonstrated that in the short run, MC is

independent of fixed costs. Let C represent the total
fixed cost at a lower output level and TC represent
the total cost at a higher output level.

Thus MC=TC=TC2-TC1
Figure 5.3: AC-MC curve (a,b)

= (TFC2+TVC2)-(TFC1+TVC1)

= TFC2-TFC1+TVC2-TVC1

44
Concepts of Cost
As can be observed in Figure AC-MC curve (a, b), a company’s fixed plus variable costs.
when the AC curve is falling, the MC curve is also
falling more quickly than the AC curve, and vice TC = TVC + TFC
versa when the AC curve is rising.
The company must use more of the variable inputs
The MC curve crosses the U-shaped AC curve at CL in order to enhance output production. Total variable
and the inverted U-shaped AC curve at H. While AC cost as well as overall cost will consequently rise.
curve falls, MC curve falls faster, and as AC curve As a result, total variable cost and total cost rise
climbs, MC curve passes through its lowest point along with output.
to outpace it.
Similar to the marginal product example, marginal
Note that a change in AC cannot predict a change cost is similarly undefinable at the output level of
in MC’s direction. It is possible for MC to dip or zero. Here, it’s crucial to remember that fixed costs
rise while AC rises, and vice versa. On the basis cannot be altered in the short term. Whatever
of variations in AC, nothing regarding MC can be change in total cost there is when we alter the
predicted. The example that follows will help to output level is solely attributable to the altered total
make the point. Let’s say a batsman scores 50 variable cost. Marginal cost is therefore the rise in
runs on average over the course of four innings. If TVC caused by the production of one additional
he only scores 40 runs in the following innings, his unit of output in the short term.
average score will drop to
At every manufacturing level, total variable cost
equals marginal costs up to that level. Regardless
of production, this is true. Check this using Table’s
than the score on average. Although it cannot be model (Various Concepts of Costs). Average
ruled out, we cannot say that the marginal score of variable cost at a given production level equals
the fifth inning is less than that of the fourth inning. sum of marginal costs up to that level.
However, it is also possible that he had a “duck”
in the fourth inning or in an earlier inning, in which Shapes of the Short Run Cost Curves
case the marginal score of the fifth inning may be
significantly higher.

Short Run Cost

Some production factors are fixed and can’t be

modified. Total fixed cost is what a corporation
spends for fixed inputs (TFC). This cost is fixed
regardless of output. The corporation can only
adjust variable inputs short-term to change output.
Total variable cost is the amount a company
spends on variable inputs (TVC). Total cost (TC) is Figure 5.4: Costs (TVC,TFC,TC)

45
Concepts of Cost
 Figure 5.5: Average Fixed Cost Figure 5.6: The Total Fixed Cost Curve

Figure (Costs (TVC, TFC, TC)) shows a typical firm’s The AFC can also be determined from the TFC
total fixed cost, total variable cost, and total cost curve. The TFC curve is shown in Figure, as the
curves. The X-axis is output, the y-axis is cost. TFC horizontal straight line that intersects the vertical
accepts c1 and does not change regardless of axis at F. Total fixed costs are OF at level q0 of
output. A horizontal straight line intersects the cost output. The TFC curve’s equivalent point at q0 is A.
axis at c1. q1 TVC and TC are both c2. Let AOq0 be the angle. The AFC is in q0.

The TFC/q ratio is known as the AFC. The constant

TFC. As a result, AFC declines as q rises. AFC is
arbitrarily big when output is extremely close
to zero, and as output increases toward infinity,
AFC decreases until it is zero. Any output value q
multiplied by the matching AFC yields the same
result, which is the constant TFC.

The figure shows a firm’s average fixed cost curve.

The vertical axis measures AFC, horizontal axis
measures output. The average fixed cost at q1
output is F. Determining the TFC:

TFC = AFC x quantity = OF x Oq1 = the area of the

Figure 5.7: The Average Variable Cost Curve
rectangle OFCq1

Now let’s examine the SMC curve. Marginal cost is

the cost of producing one more unit. According to
the law of shifting proportions, a factor’s marginal
product rises as employment rises but then falls.
This indicates that the amount of the factor
46
Concepts of Cost
originally needed to produce each additional unit
of output decreases and subsequently increases
as a function of time. As a result, the SMC initially
decreases with the factor price provided before
rising later. Consequently, the SMC curve has a “U”
shape.

SMC is undefinable at the output level of zero. The

area under the SMC curve up to a certain level of
output determines the TVC at that level.

How does the AVC curve appear now? It is simple

Figure 5.8: The Total Variable Cost Curve
to verify that the SMC and AVC for the first unit
of output are identical. As a result, the SMC and
Examine SAC. SAC is AVC+AFC. AVC and AFC
AVC curves begin at the same location. After that,
diminish as output rises. SAC decreases. As output
SMC decreases as production rises. The average
increases, AVC rises but AFC falls. Initially, AFC
marginal cost, or AVC, declines as well, albeit less
declines more than AVC rises, and SAC falls. As
so than SMC. After a certain point, SMC begins to
manufacturing increases, AVC overtakes AFC. SAC
increase. However, AVC keeps declining as long as
is expanding. The SAC curve is U-shaped.
SMC’s value is less than the current level of AVC.
The SMC’s value surpasses the value of AVC once
AFC’s vertical difference is above AVC’s curve.
it has increased sufficiently. The AVC then begins to
Right of the AVC minimum is the SAC minimum.
increase. As a result, the AVC curve has a “U” form.

SMC is less than SAC as SAC declines, just like AVC

If AVC is falling, SMC must be lower. As AVC
and SMC. SMC rises as SAC rises. SMC intersects
increases, SMC must rise. SMC curve cuts AVC
SAC at its minimal point.
curve at its minimum point.

Figure displays a firm’s short-run marginal, average

The figure shows horizontal output and vertical
variable, and average cost curves (Short run
TVC (The Total Variable Cost Curve). OV at output
marginal cost, Average Variable Cost, and Average
level q0 is the total variable cost. Assume E0q0=.
Cost Curves). First-quarter AVC output is low. Left
Estimate the AVC at time q0 as
of q1, SMC is below AVC. Right of q1, SMC>AVC.
q2 is the SAC curve’s minimum, where the SMC and
SAC curves converge. SMC is less than SAC. SMC
is bigger than SAC, which grew in q2.

47
Concepts of Cost
 output. Inputs must be increased, but not by more
than doubling, to do that. As a result, the cost the
company pays to engage those inputs likewise
needs to go up by not quite doubling. What is going
on with the average price here? It must be true
that as long as IRS is in operation, average cost
decreases as firm output rises.

Figure 5.9: Short run marginal cost, average variable cost and

average cost curves.

Long Run Cost

Over time, every input is variable. There are no

recurring fees. Therefore, over time, the overall
cost and the total variable cost are equal. Cost per
unit of output, or long-run average cost (LRAC), is a
concept in economics. Figure 5.10: Long run marginal cost and average cost curves.

DRS suggests that if we wish to raise the output

The marginal cost of production in the long run by a specific percentage, we must also increase

is the change in total production costs per unit the inputs by a greater percentage. The cost thus

(LRMC). When production goes from q1 -1 unit to rises by an amount greater than that proportion.

q1 units, the incremental cost of producing the q1th Therefore, as long as DRS is in business, the

unit is average cost must be increasing as the company’s

output grows.

LRMC = (TC at q1 units) - (TC at q1 - 1 units)

According to CRS, an increase in inputs will logically

Shapes of the Long Run Cost Curves lead to an increase in output. So long as CRS is in
operation, the average price stays the same.
According to IRS, if we boost all the inputs by a
specific percentage, the output will increase by It is asserted that IRS is seen at the initial stage of

a percentage more than that percentage. Inputs production in a normal firm. The CRS and DRS are

must be increased by less than the output must then placed after this. As a result, the LRAC curve

be increased by the input increase. The cost also has a “U” form. Its upward rising portion correlates

rises more slowly as compared to the input prices. to DRS, while its downward sloping portion

Consider the scenario when we wish to double the corresponds to IRS. CRS is seen at the LRAC curve’s
48
Concepts of Cost
minimum point. including various variations of the same product.
So, after, let’s say, a week, what will be his total
Concepts of Revenue income?

Revenue The solution is really quite easy. List the prices

of the items he sold during the week first. Next,
The amount a person obtains from selling a specific mention the various quantities of the commodities.
amount of the product is referred to as revenue. Third, determine the shopkeeper’s overall earnings
for the specified week. This can be demonstrated in
You know a market commodity’s price. Multiplying the following manner:
price with quantity estimates revenue. Let’s write.
The shopkeeper sold 100 kg of basmati rice, 70
Revenue = Price of the Commodity x Quantity of litres of sunflower oil, 100 packages of cookies,
the Commodity. and 150 kg of wheat flour within the allotted week.
Basmati rice costs Rs 35 per kg, sunflower oil costs
The vendor is responsible for selling a certain Rs 90 per litre, and wheat flour costs Rs 22 per kg.
quantity of the product during the course of the
allotted time period. As a result, when people talk The shopkeeper’s overall revenue can be determined
about a vendor’s total income, they are referring to in the method below.
the whole amount of money that the seller made
during that time period. Our representation of it is in ● Total revenue from rice = 35 x 100 = Rs. 3500
the form of TR, where TR stands for total revenue. ● Total revenue from oil = 90 x 70 = Rs. 6300
In order to make it simpler to write, let’s refer to the
● Total revenue from flour = 22 x 150 = Rs. 3300
price as “P” and the quantity as “Q.”
● Total revenue from biscuit = 10 x 100 = 1000
Example: A transaction results in the sale of one
quintal of wheat. Wheat costs 15 rupees per Total Revenue from all goods = Rs. 14,100

kilogramme at the current market price. How much

money does he make in total?
Types of Revenue- TR, AR, MR

Keep in mind that every commodity has different

pricing. A merchant offers customers a variety of
goods. Consider a grocery or hardware store as an
example. In a supply store, a vendor sells a variety
of goods, including rice, wheat, several kinds of
Figure 5.11
dal, chocolate, oil, etc. You can also find several
We have demonstrated that a corporation believes
sorts of edible oils, such as refined, sunflower and
it can sell an unlimited number of units of a good
mustard oil, soya bean oil, etc., as well as different
by establishing a price that is either lower than
types of rice, such as basmati, parmal, and cella. A
or equal to the market price in a market that is
retail store owner sells a wide variety of products,
comprised entirely of competitors. Nevertheless,
49
Concepts of Cost
if this is the situation, there is without a doubt no A total revenue curve shows how total revenue
reason for establishing a price that is lower than varies with sales volume. On a total revenue curve,
what the market will bear. To put it another way, the the X-axis shows production or sales and the Y-axis
price that the corporation decides to charge for the shows revenue. The figure shows a company’s
good is precisely identical to the price that it would revenue curve. Three observations apply. When the
fetch on the market should it make the decision to output is zero, total revenue is zero.
sell some of the items.

A company produces revenue by selling the

goods or services it makes to customers in the
marketplace. Let’s say that p stands for the good’s
unit price on the market. Let us assume that q is the
quantity of the good that was manufactured by the
corporation and then sold at the price p. The total
revenue (TR) of the company is calculated by first
multiplying the firm’s output by the current market
price of the good, which is denoted by p. (q). Hence,

TR = p × q Figure 5.12: Total Revenue curve

Take a look at the following numerical example The link between an organization’s entire revenue
to help put things into perspective. Let there be and its yield level is depicted by the total revenue
fierce competition in the candle business, and let curve for that company. The market price is
the going rate for a box of candles be Rs 10. Table represented by the slope of the curve, Aq1/Oq1.)
(Total Revenue) depicts the relationship between
total revenue and output for a manufacturer of Thus, TR crosses at point O. Second, output
candles. Observe that TR equals zero when no increases revenue. “TR = p q” is a straight line since
boxes are sold; TR equals 1 x Rs 10 =Rs 10 when p is constant. The TR curve is a straight line rising.
one box of candles is sold; TR equals 2 x Rs 10 = Rs Third, consider the slope. When production is one
20 when two boxes of candles are manufactured; unit, total revenue (vertical height Aq1 in Figure
and so on. (Total Revenue curve)) equals p. The straight line’s
slope is Aq1/Oq1 = p.

Total revenue per unit of output is the definition of

an organization’s average revenue (AR). Recall that
TR equals p q if the output of a business is q and
the market price is p. Hence

Table 5.2

50
Concepts of Cost
In other words, the average revenue for a price- between a firm’s output level and the market price.
taking corporation is equal to the market price. The market price expressed as a vertical height of
the price line, is p.)

Graph (Price Line). On the y-axis, we indicate each

production level’s average revenue or market price
(x-axis). Since the market price is p, we can draw a
horizontal straight line at p. Linear pricing. AR curve
is affected by ideal competition. The demand curve
is reflected in pricing. Elastic demand. Unlimited
units can be sold at price p.

The rise in total income for each unit increase in a

firm’s output is known as its marginal revenue or
MR. Two boxes of candles sold for a total of Rs. 20
Figure 5.13: Price Line
in sales. Three boxes of candles sold for a total of
Rs. 30 in sales.
Cost Line. The pricing line depicts the relationship

Summary

In economics, one of the most important ideas to understand is that of cost. It is a term that refers to the sum
of money that is paid for the acquisition of any products or services. The idea of cost can be understood in
a more straightforward manner as a monetary valuation of the resources, materials, risks, time, and utilities
that are expended in the process of acquiring goods and services.

51
Concepts of Cost
Economics and Management Decisions

Unit-6
Case Study: The Finance
Minister’s Dilemma
The FM of the country is a worried man these days. The Government’s provisions of the Fiscal Responsibility and Budget Management
expenses on defence, salaries, pensions, subsidies are expanding (FRBM) Act, he is neither allowed to borrow much nor is he allowed
rapidly. With the existing tax revenue, the Central Government is to create deficits. Concerned over this state of affairs, he has set up
finding it difficult to meet the burgeoning expenditure. Due to the a task force to suggest measures to increase government revenue
through taxation. The units sold for these items are as follows:

The task force considered the issue in detail and finally shortlisted
three products, an excise duty on which could be the major source
of revenue to the Government.

These three items are as follows:

Apparels Computers Cars
10 crores p.a. 10 lakhs p.a. 2 lakhs p.a.

Textiles Computers Cars

A study group appointed by the task force has estimated that if the
tax rates are uniformly raised by 10% across the board, the sale of
On an average, these products have a before-tax price of Rs. 1000, apparels, computers and cars will decrease by 5%, 10% and 20%
Rs. 20,000 and Rs.3,00,000, respectively. The existing tax rates on respectively. The left parties supporting the Government want that
the ad valorem basis are 20%, 10% and 25% respectively. essential items such as apparels, should not be taxed, while luxuries
items such as cars can be taxed heavily.
Assessment Questions

1. Find out the price elasticity of the above-mentioned items.

2. How does an increased tax rate affect revenue generation in the long
run?

3. Study the price elasticity of essential goods and the corresponding

curve for them.

4. What would you suggest the FM about increasing the tax rates on
these items?

5. According to you, which additional items can be taxed further without

having any impact on demand and revenue generated? Why?
 Unit 7

Producer’s Equilibrium

Learning Objectives Introduction

By the end of this unit, you will be

Once everything has reached a state of equilibrium, there
able to understand:
is no need for change. When a business produces a
● Producers’ equilibrium
product or provides a service, it has reached a level of
production at which it does not plan to either increase or
decrease the amount of what it produces. This situation
is what economists call “the producer’s equilibrium.” This
producer’s equilibrium situation could consist of either
achieving maximum profit or a reduction in losses.

Producers’ Equilibrium

Profit

Gain for any company is measured by its profit. A

businessperson will advertise their product in the hopes
of making a profit from their customer. Therefore, he
places bids that are greater than the initial price of his
goods or the amount that it cost him to produce them
initially. If the customer accepts his bid, he gets a profit;
but, if he sells it for less, he loses money.

If you want to make a profit off of the sale, you should

set the selling price higher than the original price. Every
company is defined by its profit and loss statements. The

52
Producer’s Equilibrium
profits are completely kept by the proprietor of the in one of two circumstances:
company.
● When Price Falls with rising in output (It happens
under Imperfect Competition). In this situation,
Producer’s Equilibrium
the firm follows its own pricing policy. However,

If there is neither an increase in earnings nor a drop it can increase sales only by reducing the price.

in profits, the organization is in equilibrium. The ● When the Price Is Fixed (It happens under Perfect
corporation is making its most profit during this Competition). In this case, the firm is required
equilibrium bubble. to accept the same pricing set by the sector. It
implies that any quantity of a good can be sold
The output at which a producer maximizes their for that certain price.
earnings is known as the producer’s equilibrium.
Therefore, if a producer’s profits are at their highest Total Revenue-Total Cost Approach:
points, he can reach the producer’s equilibrium. If
there is no room for adjusting the output’s quality When a corporation has achieved the equilibrium
to either increase profit or decrease loss, an stage, it is when it has maximized its profits, or more
organization is in equilibrium. Consequently, we specifically, when it has maximized the difference
have between its total revenues and total costs. After
reaching this point, the producer will no longer have
Profit = Total Revenue - Total Cost any reason to increase or decrease their output,
and they will be considered to have reached a state
Which is Written as P = TR - TC of equilibrium.

As a result, the equilibrium output level is the one According to the TR-TC concept, the point in
where total income minus total cost is at its highest. the output level that represents the producer’s
To reach the producer’s equilibrium, use one of two equilibrium is the one where the difference between
methods: TR and TC is positively maximized to the greatest
extent possible, and where the total profits decline
Total Revenue - Total Cost (TR - TC) Approach as more units of output are generated. This is the
point in the output level that the TR-TC concept
Marginal Revenue - Marginal Cost (MR - MC) identifies as the point in the output level that best
Approach represents the producer’s equilibrium.

Understanding isoquant curves and iso-cost lines is Producer’s Equilibrium (When Price Remains
essential to determining the producer’s equilibrium. Constant):
You can determine optimum productivity by
comprehending these two ideas. Each producer wants the level of production at
which he can make the most money when TR and
One more thing needs to be clarified before we TC diverge the most and the price remains the
move on. Producers can reach the equilibrium level same at all output levels (as in the event of perfect

53
Producer’s Equilibrium
competition). Let’s illustrate with a table where the market price is Rs. 10 per unit: Equilibrium producer
(When Price Remains Constant)

Table 6.1: Producer’s Equilibrium (When Price remains Constant):

Producing either 3 units or 4 units will result in equilibrium. At this output level, the distance
a maximum profit of Rs. 9 according to Table between the two curves (shown by GH) is at its
(Producer’s Equilibrium (When Price Remains greatest and the tangent to the TC curve (at point
Constant)). However, the producer will reach G) is parallel to the TR curve
equilibrium at 4 units of production since both
requirements for the producer’s equilibrium are met
at this point:

● Producer is earning maximum profit os Rs. 9;

● Total profit falls to Rs. 8 after 4 units of output.

In the graph below, the P OQ level of output where

the vertical gap between the TR and TC curves is
the highest will be used to establish the producer’s Figure 6.1: Producer’s Equilibrium (a)

54
Producer’s Equilibrium
The tangent to the TC curve isn’t parallel to TR at Each producer aims to produce at the level where he
OQ1 or OQ2 numbers. The producer is in equilibrium can make the maximum profit when the difference
at OQ units. between TR and TC is the biggest and the price
lowers with increased output. In other words, each
Producer’s Equilibrium (When Price Falls with producer produces at the level of output at which
Rising in output): he can make the most money (as in the case of
imperfect competition).

Table 6.2

The producer will be in equilibrium at 4 units

of output since both of the conditions for the
producer’s equilibrium are met at this level, as
shown in Table (Producer’s Equilibrium (When Price
Falls with Rising in Output)).

Figure 6.2: Producer’s Equilibrium (b)

55
Producer’s Equilibrium
In the image that was presented earlier, the below MC, profits will fall.
producer’s equilibrium will be determined by using
the OQ level of output that corresponds to the While MC MR, equilibrium is not attained because
point at which the vertical gap between the TR and greater production can enhance profits. When
TC curves is the greatest. At this output level, the MC > MR, the producer is out of balance because
tangent to TR curve (which is located at point H) of benefit cost. MC - MR means the company is
and the tangent to TC curve (which is located at balanced.
point G) are aligned in parallel, and the disparity
between the two curves (which is represented by 2. After MC = MR, MC is greater.
the distance GH) is at its highest.
MC = MR is required for equilibrium, but it’s not
MR-MC Approach: enough. This allows MC = MR at different output
levels. When MC exceeds MR after equilibrium, that
Producer’s equilibrium, according to the MR-MC output level stays.
approach, refers to the stage of the output level at
which: If MC is higher than MR, exceeding MC = MR will
reduce profits. Increasing production can boost
1. MC = MR: profits if MC is less than MR after MC = MR output.
The first criteria must be reinforced by the second
As long as MC is lower than MR, it is lucrative for to attain producer balance.
the producer to continue producing more because
doing so contributes to the producer’s overall Producer’s Equilibrium (Constant Price):
profits. The only time he stops creating more is
when MC and MR are equal to one another. Firms are able to sell any amount of output at the
market price while the price is constant. At all
2. MC is Greater than MR After MC = MR Output output levels, the price or AR remains constant.
Level: Additionally, the income (MR) from each extra
unit is equal to the AR. Therefore, the AR and MR
When MC exceeds MR after equilibrium, it signifies curves are identical. The producer seeks to reach
that increasing production will result in a drop in the output level at which MC equals MR and MC
profitability. exceeds MR after reaching the MC = MR output
level.
A producer’s equilibrium requires the following two
conditions to exist: Let’s illustrate with a table when the market price is
Rs. 12 per unit: Equilibrium producer (When Price
1. MC = MR: Remains Constant)

We know that MR adds one unit to TR and MC adds

one unit to TC. Any producer wants to boost profits.
A corporation compares its MR and MC. If MR falls

56
Producer’s Equilibrium
 Table 6.3

Both the output levels of 2 units and 5 units satisfy At the output level OQ that corresponds to point
the MC = MR requirement, as shown in Table K, the producer’s equilibrium is established since I
(Producer’s Equilibrium (When Price Remains MC = MR at this point, and (ii) MC is greater than
Constant)). But only at 5 units of output is the MR following MC = MR output level. The X-axis in
second condition—”MC becomes greater than Fig. (Producer’s Equilibrium (c)) displays output,
MR”—fulfilled. Therefore, at 5 units of output, the whereas the Y-axis displays revenue and costs. The
producer will be in equilibrium. Let’s now examine X-axis is parallel to a straight line in both the AR and
equilibrium determination with the aid of a diagram: MR curves. This curve has a U-shape. OQ level of
output, which corresponds to point K, will be used
to define the producer’s equilibrium since only at
point K do the two conditions below become true:

Even though point R also meets the first criteria

(i.e., MC = MR), it is not the point of equilibrium
because it only does so. In other words, when
both requirements are met, the producer will be in
equilibrium at point K.

Figure 6.3: Producer’s Equilibrium (c)

57
Producer’s Equilibrium
Summary

The condition known as “Profit Maximization” is meant to be understood as “Producer’s Equilibrium.” When
a producer reaches the level of output at which he realizes the greatest amount of profit, he has achieved
the state of equilibrium. The production level at which a producer achieves either maximum profitability or
equilibrium is referred to as the equilibrium output. If production was increased to any other level, the profit
earned by the producer would be less than the maximum possible profit.

58
Producer’s Equilibrium
 Unit 8

Supply Analysis

Learning Objectives Introduction

By the end of this unit, you will be

The two forces of supply and demand work together to
able to understand:
establish a product’s price on the market. According to
● Concept of supply
Alfred Marshall, an item’s supply scarcity and its intense
● Determinants of supply want are both presents at the same time. If the supply

● Law of supply and demand are known, it will be possible to comprehend

how the price is set. One of the two “blades of the
● Shifts in supply curve
scissors” that influences pricing is the idea of supply,
● Movements in supply curve which resembles the other blade, viz. demand.
● Elasticity of supply
Concept of Supply

Supply and demand are opposites. It’s how much a

merchant wants to sell at a specific price and time. Stock
vs. supply. On-demand stock is a seller’s stock. The seller
may not always sell all his products. He adjusts how
much he’s willing to sell based on market conditions. A
seller often simply sells his commodity as supply. Supply
is a vendor’s supply at a certain price and time. Supply is
actual supply, not stock.

Determinants of Supply

The overall amount of an item or service that is offered

on the market at any given time is impacted by a variety

59
Supply Analysis
of factors. Among the crucial elements are the Ambition of a business: The objective of a company,
following: such as profit maximization, sales maximization,
or both, is also accountable for influencing the
Costs of the production factors: One of the availability of a good or service on the market. If
determining elements that affect the market a company wants to maximize profits, it can do
supply of a product is the price of factor inputs so under specific circumstances by reducing the
like land, daily workers, wealth, raw materials, etc. market supply of an item, but maximizing sales will
For instance, if labour costs increase, the supply of result in an increase in supply.
the product will decrease as a result of the higher
labour expense. Natural factors: Natural factors like climatic shifts,
especially in the case of agricultural products, have
Changes in technology: The improvement of an impact on their availability.
machinery, better organisational and managerial
practices, and changes in technology as a Expectations of the producer or the seller changing:
consequence of ongoing research and development Like the demand curve, the supply curve is created
aid business units or firms in lowering their cost of for a certain time frame. if there is a significant shift
production. All of this substantially increases the in market expectations regarding future prices.
market supply at the current prices. For instance, if a corporation anticipates a rapid
increase in the price of a thing or service, it may
Related goods price (Substitutes): The cost of decide to hold back current production from the
related commodities has an impact on the product’s market, which may affect the supply of the good.
supply as well (say AB). If the price of a substitute
good, CD, rose, the manufacturer would move the Law of Supply
allocation of resources from AB to CD. This would
increase the goods supply. When a product’s price rises, more of it is available
for purchase; when it falls, less is. Price and supply
Change in the industry’s firm population (Market): and demand have direct and inverse correlations.
Profitability also affects the number of businesses If all other things remain constant, a good’s supply
in a sector, which changes how much of a good rises as its price rises and falls as its price falls.
is available on the market. For instance, more
businesses entering the market due to better profits Factors Determining Supply
would result in more goods being supplied across
● The supply of a commodity is determined by a
the price spectrum.
number of variables.

Taxes and subsidies: The supply of a good on ● The most crucial factor is the commodity’s
the market may be impacted by a change in the price. Sellers want to sell more when the price
government’s fiscal policy, such as a change in tax increases, and vice versa.
rates or the number of subsidies. Firms could offer ● Price increases for production inputs increase
more of a good at a given range of pricing if the tax their cost of production, which in turn reduces
or subsidy on it were reduced or increased. profits and, as a result, supply. Therefore, a

60
Supply Analysis
 decrease in the supply of good results from an ● Numerous other variables affect supply,
increase in the cost of manufacturing. Similar to including shifts in governmental policies, war or
this, increasing supply is brought about by falling depression fears, climate circumstances, income
production costs. disparities, transportation and communication
infrastructure, producer agreements, etc.
● Any alteration in the costs of competing goods
would affect the supply of a good by leading
This Is What The Supply Role Looks Like
consumers to choose one over the other.

● Innovations or inventions that alter technology It is a condensed representation of the many

have an impact on the supply by changing the variables affecting the supply of an item. In symbols,
cost of production. The cost of manufacturing
S = (P1, P2,......Pn, F1,.........Fn, T, O, Od)
decreases with an advancement in the company’s
production technology, allowing it to produce
Where,
more at the set price than it previously could. As
a result, supply would rise. ● P is its price,

● The supply is also based on the producing unit’s ● S is for the availability of a thing
goal. The supply would be greater if the company
● P2 to Pn are the prices of all other goods,
prioritized revenue or sales maximization over
● F1 to Fn are the costs of all production inputs,
profit maximization.
● T is for technology,
● The market supply would expand as the number
of businesses manufacturing a good increased. ● is the firm’s goal, and

● Supply is influenced by sellers’ predictions ● Od are the determinates.

about future prices. During an inflationary
period, producers would cut back on supply in Supply curve and schedule:
anticipation of future price increases.
The supply schedule displays the different amounts
● A decrease in supply results from the
of the commodity that are being sold at varying
implementation of a sales tax or excise levy,
prices. One can create a person’s supply schedule
whereas an increase in supply results from a
in accordance with the demand schedule by doing
government subsidy.
the following:

Table 7.1

61
Supply Analysis
A supply curve can be obtained by graphically The supply curve is depicted in Figure (Supply
illustrating the data. curve), and it slopes upward from left to right.
Let’s say a pen costs Rs. 3 per unit, and a person
is selling 40 of them for that amount. As the Table
and the Curve demonstrate, a rise in price will result
in amplification in supply. The SS curve illustrates
the relationship between supply and pricing. The
Market Supply Curve is created by adding the
supply curves of each person seller of the good in
a market horizontally using the lateral summation
Figure 7.1: Supply curve procedure, as shown in Figure below.

Figure 7.2: Derivation of Market supply curve from Individual Supply curve

A sells OP1 OMI, while B sells 0M2. If only A and ● As the price grows, the market’s existing sellers
B sell at OP1, the market supply is OM (OMI + continue to increase their sales.
OM2). Both suppliers sell more items for 0P2 and
● More sellers are drawn to the market to sell when
the market supply is OMI (OMI+ 0M2). In a similar
prices rise. The elasticity of supply curves for
way, we compute market supply amounts at
producers in a market ultimately depends on how
various prices to construct SS. Blending SA and SB
costs change with increased output since profit
produced this market supply curve.
is the goal for sales, which depends on cost of
production and pricing.
The market supply curve is significantly more
elastic than the individual supply curves for the
following reasons:

62
Supply Analysis
Exceptions to the Law of Supply on the price at which it can be sold on the market,
suppliers are prohibited from making offers to
Many different types of goods fall under the general sell more at higher rates. It is not possible for
application of the rule of supply. There are a few producers to conduct independent experiments
exceptions to this rule, though, when a change in with either of the criteria.
a good’s price does not result in a change in its
● Agricultural products: Agricultural producers
supply in the same direction. The law of supply
are unable to offer larger quantities since there
does not always hold true in all marketplaces and
is a limit to their production, which also prevents
in all situations. The law of supply does, in reality,
them from increasing their supply despite higher
have many significant exceptions.
pricing.

● Expected change in a good’s price: A change ● Artistic and auction goods: Such items are

in a good’s actual price causes a change in its difficult to raise or decrease in supply. Thus, even

supply in the same direction, whereas a change if prices rise, it is challenging to supply higher

in a good’s expected price causes a change in quantities.

the supply in the opposite way. When a product’s

price is anticipated to rise, the provider reduces
Shifts in the Supply curve
supply to avoid selling more at higher prices in the
The change in price is the primary element
future and less at cheaper prices in the present.
affecting supply changes. The price of the product
● Monopoly: The law of supply may not apply if a
in the market is taken into account by sellers when
small number of vendors dominate the market’s
planning their production and supply. The amount
supply side. For instance, even though the price
supplied increases with a rise in price, while it
is higher, a monopoly (single supplier) may not
decreases with a decline in price. Therefore,
always offer a larger amount delivered. Due to its
variations in price cause the supply to expand and
dominance of the market, the monopolist is free
contract.
to determine prices based on supply and demand
factors without being constrained by supply-side
costs.

● Competition: Due to increasing competitiveness,

oligopoly and monopolistic competition may sell
more items at lower prices, flouting the supply
rule.

● Perishable goods: To prevent losing money

because the product was damaged, the supplier
would offer to sell more at a lesser price when
the product was perishable.
Figure 7.3: Increase in Supply
● Legislation restricting quantity: When the
government places limits on the amount of a
commodity that can be supplied or places a cap
63
Supply Analysis
 In economics, it is presumptedthat businesses
share the goal of maximizing profits rather than just
making a profit. Due to the fact that most businesses
could provide other goods in addition to the one in
question, it is doubtful that they would be willing
to sell huge quantities of it at a very cheap price
because doing so means minimal earnings after
accounting for manufacturing expenses. In fact,
there must be a price below which no businesses
would be willing to supply a good because it
Figure 7.4: Decrease in Supply would not even come close to covering the lowest
possible cost at which each unit of that good might
Increased supply occurs when the quantity sold be produced.
rises without the price changing or when the same
quantity is offered at a lower price. Even at a lower Supply Change: Expansion/Contraction vs.
OPI, Figure’s market supply (OM) is the same. Increase/Decrease in Supply
Alternately, supply rises from OM to OMI at OP2
while the supply curve moves from SS to S1S1. The slope of a supply curve is controlled by its
Here, supply grows. Since supply is smaller, we can price, but its “location,” or distance from the origin,
consider the contrary. If the same quantity is sold is determined by other factors. Alternatively said,
for a higher price or a smaller quantity is sold for supplies for an excellent shift when
the same price, the supply has decreased.
● On the same supply curve, a producer goes from
In Figure, the same amount of OM is sold at a higher one point to another (Movement along the supply
price (OP2), or a lesser amount of OMI is sold at curve).
the same price (OP1). Increased supply shifts the ● When the supply curve as the position of a whole
supply curve to the right; decreased supply shifts it change
to the left.

Movement along Supply Curve: Quantity offered

Movements in Supply Curve rises with price, and falls with price decline. The
supply curve is positive and right-sloping, unlike the
Positive Supply Curve Slope:
demand curve.

According to the law of supply, price and supply are

Contraction in supply is the word used to describe
positively correlated. Supply slopes right-to-left. It
a decline in supply due to a price increase. The
means supply rises as price rises and lowers as
supplier descends the supply curve in this instance.
price falls. Why does the supply rule act this way?
The supplier advances up the supply curve and
offers to sell more of the good if the price of the
Following are some of the justifications or
good decreases, on the other hand. This is referred
explanations provided by economists in this regard:
to as supply “expansion.”

64
Supply Analysis
As a result, the expansion and contraction of the in supply, respectively.
supply can be stated as follows:
Elasticity of Supply
Supply Growth / Reduction:
Supply elasticity measures how a supply responds
to price changes. Supply elasticity measures how
● When the price of the good varies, the producer
much supply changes when prices change. It’s the
travels along the supply curve and modifies the
amount delivered relative to a % price change.
quantity supplied.

● A growth in the quantity available as a result of

a price increase is referred to as an expansion in
the supply of that commodity.
The amount supplied typically increases as prices
● In the event that the product’s price decreases, rise. Likewise, when prices drop, so does the
the manufacturer moves down the supply curve amount supplied. The relationship between price
and sells less of the good. This is referred to as a and supply increases over time. Therefore, supply
decrease in the availability of the good. elasticity will always be favorable.

Switching supply curves: If supply changes without When a completely inelastic supply curve is a
price, the supplier flips supply curves. When a vertical straight line, supply elasticity is zero. It
producer goes to the right of the supply curve, means that supply won’t change when prices rise.
supply “increases.” When supply shifts to the left, In the alternate limiting case, a small price rise leads
it’s called a “reduction.” to a tremendous increase in quantity delivered.

To calculate the degree of supply elasticity, we

utilize the formula above. The elasticity of supply
equals two if proportionate increases in quantity
supplied are twofold proportionate increases in
price. Supply has unitary elasticity if it fluctuates in
proportion to price changes in the same way that
supply does.

How elastic one supply curve is in a range or at a

certain point is crucial. It’s crucial to understand
the geometric estimation of supply curve elasticity.
The above formula calculates supply elasticity.
Figure 7.5: Change in Supply

As a result, in Fig. (Change in Supply), we can take

into account supply curves S’ and S” that diverge
from supply curve S and indicate a drop and a rise
65
Supply Analysis
The Easticity of Supply is Unitary Therefore, a supply curve that is a straight line and
passes through the origin has unitary elasticity.

Figure 7.6: Elasticity of supply equals one

The straight line supply OS curve in Figure (Elasticity

of supply equals one) goes through the origin O.
The amount supplied increases from OM to OM1
when the price increases from OP to OP1.
Figure 7.7: Elasticity of supply greater than one

How elastic is the supply now?

Triangles OKM and KLN resemble each other, so

Triangles KLT and QKN resemble each other,

Equation (1) can be created by entering this value.
therefore
Supply Elasticity

66
Supply Analysis
By including this in our equation (2) from above, we
obtain

Elasticity of supply less than one This shows that a supply curve's
elasticity is less than one when it crosses the X-axis.

Supply Curve Elasticity:

Drawing a tangent on the supply curve determines

less than one This shows that a supply curve's elasticity. If the tangent crosses the origin, supply
elasticity is less than one when it crosses the X-axis. elasticity equals 1. Y-axis crossings are several.

Figure 7.8: Elasticity of supply less than one

The supply's elasticity can also be determined in the

same way. Figure above shows how the X axis is
cut off at Q by the supply function SS. The elasticity
of supply in the range Ks is
Figure 7.9: Elasticity of supply in Supply curve

Depending on the period under consideration,

supply elasticities change. The amount offered
for sale within a particular time period will be less
given a slight change in price in the short term
than it will be in the long term. The elasticity will
be higher the longer the period to which the supply
curve is associated.

Short-term supply may be inelastic, whereas long-

term supply may be extremely elastic. As a result,
Equation (3) is produced when we enter this value whereas the elasticity of demand has no temporal
as the input. dimension, the elasticity of supply does.

67
Supply Analysis
Applications of the Elasticity of Supply Concept know-how, and entrepreneurial talent. Rent’s
share of total earnings rises with a factor or
There are various applications for the supply- output’s supply elasticity. If a factor’s supply
elasticity concept: is elastic, it earns no rent (the supply curve is
a straight line parallel to the horizontal axis). If
● It aids us in understanding how an increase
a factor’s supply is inelastic, as with a nation’s
in demand for an item affects its price. It will
land, all of its profits are rent. Supply elasticity
depend on the supply’s elasticity, among other
affects a factor’s rent income.
things. The less the price increase must be to
persuade sellers to put more of the product up ● Economic planning can benefit from the supply

for sale, the more elastic the supply is. elasticity notion. For the creation of production
plans in less developed nations and to prevent
● We may better appreciate the _quasi-rent they
unwarranted inflationary pressures caused by
receive by comparing short-run and long-run
shortages, knowledge of the supply elasticities
supply inelasticity of capital assets, technological
of at least the major industries is crucial.

Summary

When manufacturers conduct supply analysis, it helps them determine the impact that alterations in
production and policy will have on the number of finished items that are available for sale. For instance,
newer, soon-to-be-developed technology may make it possible to produce more things in the same amount
of time as before.

68
Supply Analysis
Economics and Management Decisions

Unit-9
Case Study: Buying Versus
Making
Shiraz Ltd. has been involved in the business of manufacturing appx. 80,000 units per month. All the raw materials were being
of ball bearings for last eight years and has been producing only sourced locally, and the whole manufacturing process was carried
a single variety of the ball bearing. With an initial sales level of in-house only.
15,000 units per month, they have now risen their production to
Now after well establishing their foothold in the market, the
company is planning to expand its operations and add different
products to its portfolio. Presently, they are operating from their
premises located at the city center with an area of 55,00 sq. ft. but threefold.
now they are looking to add another 50,000 sq ft of space to handle
The aggressive expansion plans of the management have given
their expansion plans. But due to the scarcity of land in the city, the
a new headache to Mr. Mohan, the Operations Manager of the
prices have increased to almost double in last 3 years.
company. He is worried that at present the company is facing a

The production operations are handled by Mr. Shahbaz, Production shortage of workers, from where would he arrange for the new

Head of Shiraz Ltd. His expertise has ensured that the production ones to keep up with the expansion plans. He has sent a request to

has been increasing on year on year basis. But, there has been one
alarming trend regarding the quality complaints which have risen up
to 0.5% from an average of 0.2% since last two years. Additionally,
there has been high levels of dissatisfaction amongst the workers
regarding their workload as well as salary levels.

Due to the scarcity of workforce, Mr. Shahbaz is unable to take

any strict action against the workers who waste their work time
in socializing and wasteful activities, and the workers are taking
advantage of this fact. In order to keep up with the rising demand
and maintain the production levels, Mr. Shahbaz has to employ
workers on overtime. As result, the overtime costs have risen by
 of the company should go ahead with expansion plans. The Finance
Manager said that expansion of operations would help in reducing
the costs through economies of scale and give a further boost to
the profits.

But, Mr. Mohan expressed his reservations regarding scarcity

of manpower, quality control, and production schedules. At this
juncture, the Marketing Manager discussed the possibility of
Production outsourcing. Here Mr. Shahbaz came up with his
concerns regarding the fact that the outside agencies are bound
Mr. S. Sharma, Director (Operations) to put the expansion plans on
to charge more money, straining their profit margins and as well as
hold and instead focus on improving and consolidating the existing
setup. possible issues regarding delivery schedules.

After considering the request, Mr. Sharma called a meeting of all Then Mr. Sharma asked the Purchase Manager, Mr. Rajesh to put

the concerned department heads to try and find a solution to the forth his views. He said that as the expansion plans would ensure
problem. In the meeting, the Marketing Manager expressed extreme more business for the suppliers, suppliers would not hesitate and
sentiments regarding the growth prospects of the company. He held they company should go ahead with expansion plans as with each
the opinion that as the country’s economy is booming, the company passing day there is a potential loss of business. Here the Finance
should also take advantage of that and backed by the brand image Manager came up with his inputs that the cost-benefit analysis
of buying against in-house production shall be done to arrive at a Secondly, Mr. Mohan came up with his report and stated the
decision. following facts:

After careful deliberation, Mr. Sharma asked Mr. Shahbaz to – A Supervisor at a monthly salary of Rs. 8,000/- and an annual
work around the future sales projections given by the marketing increment rate of 10%
department and work out the cost of production accordingly. HE
– Cost of worker remuneration to be pegged at Rs. 4 per Unit,
asked the purchase manager, Mr. Rajesh to gather the purchase cost
thereafter a 10% reduction in the second year, no change in the
of few key components of the ball bearings with newly increased
third year and an annual increase of 10% for subsequent years.
order quantities.

– Cost of material to be pegged at Rs. 14/- per unit with anan- nual
Later, Mr. Sharma called a review meeting and there Mr. Mohan, and
increment rate of 10%
Mr. Naresh who have collected the necessary data were asked to
present the compiled data. – Cost of fuel and Power at Rs. 2/- per unit with yearly increase of
10%
Firstly, Mr. Suresh (Marketing Head) put forth his sales forecast
– Cost of indirectlabor at 50% that of fixed labor.
wherein he put the future sales estimates at following figures:

1st Year 2nd Year 3rd Year 4th Year 5th Year – Purchase of new machinery worth Rs. 60 Lakhs and production
300,000 500,000 700,000 900,000 1,000,000 life of 5 years
Lastly, Mr. Rajesh came up with the following data:

– Components from the supplier at a price of Rs. 22 for initial two

years with an annual increment rate of 10% subsequently.

– Cost of transportation at Rs. 2 Per unit initially and thereafter an

enhancement of Rs. 0.20 for every year

– Cost of inventory will be fixed at 5% of the material cost.

Assessment Questions

1. On the basis of above data, what is more, economical for Shiraz

Ltd.: in-house Production or Outsourcing Manufacturing

2. Are there any other factors that Shiraz Ltd should look for while
taking a decision?
 Unit 10
Market Structure
and Its Pricing
Learning Objectives Introduction
By the end of this unit, you will be
Market structure in economics refers to how different
able to understand:
industries are categorized and distinguished based on
● Market in economics
the level and nature of their competition for products
● Types of market
and services. It is based on characteristics that influence
● Perfect competition how companies that compete in a certain market act and
perform.
● Monopoly

● Monopolistic competition Market

Structures
● Oligopoly

● Duopoly
Perfect Monopolistic
Competition Oligopoly Monopoly
Competition

The number of buyers and sellers, the capacity for

negotiation, the degree of concentration, the degree
of product differentiation, and the ease or difficulty of
joining and leaving the market are some of the elements
that affect how a market is structured.

In order to understand market systems, a number of traits

or behaviors demonstrated by different actors might be
thoroughly explored. The following seven essential traits
typically serve to define these markets.

69
Market Structure
● The buyer structure of the sector. money, or any combination of these to another
party. A market is a gathering place for buyers and
● The rate of consumer turnover.
sellers to transact business.
● How much do products differ from one another.

● The nature of input costs Typically, a trade requires the participation of two
parties. But to provide competition and restore
● The number of market participants.
equilibrium to the market, at the very least, a third
● Amount of vertical integration within the same
party is needed. As a result, among other things,
sector.
a market in a condition of perfect competition is
● Market share held by the biggest competitor. characterized by a large number of active buyers
and sellers.
By cross-examining the above aspects against
each other, common traits can be established. As Demand/Supply:
a result, categorizing and separating companies
in related areas is made easier. Economists have A market determines the costs of commodities
distinguished four types of market designs based and other services regardless of the situation.
on the aforementioned criteria. They include Supply and demand dictate these rates. The idea
oligopoly markets, monopolistic competition, of supply and demand is one of the core tenets of
perfect competition, and monopolistic competition. economics. Demand is produced by buyers, but
supply is produced by sellers.
Market in Economics
When supply and demand are balanced, markets
The trade of products and services can take place attempt to achieve some level of price equilibrium.
in a market, which is a gathering place for interested However, this equilibrium can be thrown off by
parties. The people involved are typically buyers and elements other than prices, such as incomes,
sellers. The market might be actual, like a physical expectations, technology, production costs, and the
store where people interact in person, or it could be number of consumers and sellers.
virtual, like an online market, where there is no face-
to-face interaction between buyers and sellers. A Simply said, what people desire and how willing
market is characterized by a few basic elements, they are to buy determines the number of goods
such as the presence of buyers and sellers, as well and services that are offered. When customers
as a commodity that can be bought and sold. request more products and services, sellers, up
their production. Then, in order to make a profit,
Understanding Markets producers raise their prices. Companies must
lower their pricing and, as a result, the quantity of
Any location where two or more people can come goods and services they offer to consumers when
together to conduct an economic transaction, even consumer demand declines.
one that doesn’t require legal cash, is referred to
as a market. A market transaction can entail the
transfer of commodities, services, information,

70
Market Structure
Physical and Virtual Markets payments, making them harder to track.

Markets are physically transacted places. Retail In planned or command economies, where the
stores and similar firms sell products to wholesale government supervises production and distribution,
marketplaces and distributors individually. Amazon underground marketplaces thrive. When there’s
and eBay are online retailers and auction sites where a shortage of a good or service, the black market
trades can be made without a physical connection. steps in.

Markets may develop naturally or in order to Advanced economies can have unlawful markets.
facilitate ownership rights over products, services, When prices restrict the sale of products or services,
and information. Markets are frequently divided especially when demand is high, “shadow markets”
into developed and developing markets whether result. Ticket scalping is a shadow market. When
considered at the national or another, more granular concert or theatre tickets are in high demand,
regional level. This distinction is based on a variety scalpers buy a lot and sell them at excessive prices.
of variables, such as income levels and the degree
to which a country or region is open to foreign trade. Auction Market

For the selling and purchase of specific lots

of products, an auction market gathers a large
number of individuals. In an effort to outbid one
another, purchasers or bids compete for the sale.
The highest bidder wins the items up for auction.

Types of Market Livestock, bank-owned properties, and art and

antiques are the most often auctioned items.
The types of products supplied, the location, Many now conduct their business online. U.S., as
the length of time, the size and makeup of the an illustration, regular auctions are used by the
client base, the size, the legality, and many other Treasury to sell its bonds, notes, and bills.
elements all have a significant role in how different
markets are. There are additional types of markets Financial Market
where parties might assemble to carry out their
transactions in addition to the two most popular Any location where bonds, currencies, securities,
ones, physical and virtual. and other financial instruments are traded between
two parties is referred to by the general phrase
Underground Market “financial market.” These marketplaces serve as
the cornerstone of capitalist societies and give
Underground or black markets are illegal markets companies access to cash and liquidity. They could
where transactions occur without government be real or imaginary.
or regulatory knowledge. Illegal markets exist to
avoid taxes. Many include cash or non-traceable

71
Market Structure
Features of a Market where vendors uphold order and regulations among
themselves, or broad-reaching and universally
A market’s characteristics might be used to accepted, like an international trade deal.
characterize it. These are essential for the market
to operate. The most fundamental traits that How Do Markets Work?
influence a market are as follows:
Markets are settings where buyers and sellers
● Arena: The platform where transactions between can congregate and exchange goods. High levels
buyers and sellers take place is this one. of active buyers and sellers are a necessary
Remember that a physical location isn’t always characteristic of a market that is experiencing
implied by this. It can also refer to the general perfect competition. Prices for commodities and
area where everyone participating is dispersed. other services are set by the market. Supply and
demand dictate these rates. Demand is produced
● Buyers and sellers: There must be buyers and
by buyers, but supply is produced by sellers. When
sellers for the market to operate properly. If no
supply and demand are balanced, markets attempt
one is purchasing what someone else is selling,
to achieve some level of price equilibrium.
the market cannot exist. These organizations,
which include companies, people, and even
governments, may carry out their interactions
Perfect Competition
both physically and virtually owing to the internet.
It describes a market environment in which a
● One commodity: A single market depends on relatively large number of buyers and sellers are
a single commodity, hence there needs to be engaged in trading a single, homogenous good
a linked commodity present for a market to at a predetermined price. As an illustration, ideal
function. The wheat market, for instance, buys competition has never existed recently. The
and sells wheat as a commodity. Although there agricultural goods market is the most comparable
are many different types of electronics, they all illustration of this type of market that we may have
fall under the umbrella category of electronics. (like wheat and rice).

Other characteristics include pricing flexibility, Competition Features:

competition, and the ability to freely purchase, sell,
and exchange products and services. ● A huge quantity of buyers and sellers: In the
market, there are a lot of buyers and sellers of
Regulating Markets the item. Because there are so many vendors
and customers, each seller’s share of the entire
A regional or governing organization that
supply and each buyer’s share of the total
establishes the market’s character, with the
purchase is negligible. In such circumstances, the
exception of underground markets, sets the rules
market forces of supply and demand decide the
and regulations that apply to most marketplaces.
price of an item, and each buyer and seller must
This may be the case whether the regulation is
accept the same price. As a result, the market is
local and ephemeral, like a pop-up street market
characterized by homogeneous pricing.

72
Market Structure
● Homogeneous product- The market’s items are all three of the following three requirements are met,
homogeneous, meaning they are the same in the competition is said to be “Pure Competition.”
every way, including size, form, quality, color, and
so on. Since each company creates things that ● Buyers and sellers in extremely vast numbers.
are 100% the same, their goods can be perfectly ● One-of-a-kind product.
interchanged. No one company has the authority
● Entry and exit rights.
to demand a greater price for its goods.

● Freedom of entry and exit- Each seller is allowed A broader definition of “Perfect Competition” In
to enter or leave the market as they like. In addition to three essential prerequisites, four more
other words, any new company is free to begin requirements must be met for the market to be
manufacturing, and any current company is free totally competitive:
to halt production and exit the sector. It indicates
that over time, all businesses will only make ● Perfect communication between buyers and
typical profits. In the short term, a company may sellers.
have extraordinary earnings or losses.
● Perfect production factor mobility.
● Perfect knowledge among buyers and sellers-
● No selling or advertising fees.
The market price is publicly disclosed to both
buyers and sellers. It implies that no business ● None for transportation.
is able to charge a different price and that no
customer will agree to pay a higher price. As a AR (Demand Curve) and MR Curves of a Firm Under

result, the market has consistent pricing. Perfect Competition:

● Perfect production factor mobility: Land, labor,

A corporation is able to sell any output at the price
cash, and entrepreneurs are all free to move
of the market when there is perfect competition.
from one location to another as well as from
It indicates that the additional revenue (MR) the
one company to another. The factors have the
company receives from the good will equal the
freedom to relocate to the sector where they may
price of the good on the market (i.e. AR). In this
obtain the best price.
case, both average and marginal revenue remain
● No selling (advertisement) cost- As homogenous the same, meaning that AR = MR. The AR (also
items are sold by businesses and are perfect known as the Demand Curve), as well as the MR,
substitutes, advertising costs are necessary for will be horizontal or parallel to the X-axis. This can
complete completion. be seen in the figure (8.1).

● No transportation costs- The assumption that

transportation costs are zero ensures that prices
are uniform across the market. A producer is free
to sell his goods wherever, and a consumer is
free to purchase them anywhere he wants.

Pure Competition and Perfect Competition: When

Figure (8.1)

73
Market Structure
Perfect Competition Makes a Firm a Price-Taker, to the entire set of businesses. An individual firm
Not a Price-Maker: cannot affect the price on its own in a market with
perfect competition because its share of the overall
The demand and supply of the entire industry supply is so small. The intersection of the market
determine a commodity’s price in a market with supply and demand curves is where the price is
perfect competition. In this case, the industry refers decided. As a result, the sector is known as a price
maker. The ensuing figure illustrates this.

Figure (8.2)

Non-Competitive Markets: - Characteristics of Monopoly: -

● Single seller: - When there is a monopoly, a single

Markets that lack pure and ideal competition
seller dominates the market. Because of this, the
are considered non-competitive markets. These
monopolistic firm and industry are one and the
markets can take one of three major shapes:
same, and the monopolist has complete control
oligopoly, monopolistic competition, or monopoly.
over the product’s supply and pricing.

Monopoly ● No close alternate: - There is no close equivalent

for a monopolist’s product. Therefore, the
The two words MONO+POLY combine to form the monopoly corporation is unafraid of competition
word MONOPOLY. The word “monopoly” means from both new and existing items.
“one seller” or “one producer” in this context since
● Restrictions on entry and exit: - Strong obstacles
“Mono” means “one” and “Poly” means “seller.”
prevent existing businesses from leaving and
new businesses from entering. Monopoly can
Monopoly describes a market condition where
consequently see unusual long-term profits and
there is just one vendor of a good with no direct
losses. These obstacles may be brought about
competitors. Indian railways, as an illustration.
by legal limitations such as patent or licensure
rights or by limitations put in place by businesses

74
Market Structure
 through cartels. acknowledgement that the product or technology
they developed or manufactured cannot be
● Price discrimination: - A monopolist may charge
produced by anyone else. It serves to support
various clients different prices for the same
and acknowledge the firms’ R&D efforts as well
commodity. Price discrimination is the name
as to insure their risk. The term “patent life” refers
given to it.
to the duration of a patent. For 15 to 20 years,
● Price maker: - Firm and industry are synonymous
perhaps.
in monopoly situations. Thus, the firm has total
● Cartel – Sometimes, while maintaining their
control over the production of the industry. As
separate identities, producers of a certain
a result, the monopolist sets its own prices and
commodity band together to form one
acts as a price-maker. By altering the product’s
organisation known as a cartel in order to
supply, it might affect the market price.
maximise profits. The “Organisation of Petroleum

Reasons for Emergence of Monopoly: - Exporting Countries (OPEC)” is the most well-
known cartel, which created a near-monopoly in
The establishment of monopolies has a number of the oil industry.
causes, including:
AR (Demand curve) and MR curves of a Monopoly
● Government Licensing – It indicates that Firm: -
a company must obtain permission from
the government before entering a market. The monopoly corporation does not have control

Government attempts to ensure that there is only over the product’s demand. Monopolist will need to

one firm operating in the market by refusing to lower the price in order to increase the amount of

issue licenses to new firms. product available for sale. As a result, the demand
curve for monopolistic firms is downward sloping.
● Patent Rights – Patent rights are obtained
Since there is no close substitute for a monopolistic
when a company or producer receives official
market’s product, the AR (or Demand Curve) is
steeper.

Figure (8.3)

75
Market Structure
Monopolistic Competition ● Lack of perfect knowledge: - The market’s
availability of a wide range of distinct items
Monopolistic competition describes a market makes it exceedingly challenging for consumers
environment where there are numerous businesses to acquire complete market knowledge, which
selling closely related but distinct products. encourages both buyer and seller exploitation.
Consider the market for goods like soap, toothpaste, ● Lack of perfect mobility of factors: - Since
and air conditioning. etc. various prices are charged for the same factor
of production in monopolistic markets, this
Monopolistic Competition Characteristics: prevents factors of production from moving
freely from one location to another.
● Many/large numbers of sellers: - There are
numerous businesses selling closely related, ● Selling costs: - Selling costs are the costs
yet somewhat distinct, goods. Each business associated with the product’s marketing, sales
runs autonomously and holds a little portion promotion, and advertising. These expenses
of the market. Therefore, the market price is are made in an effort to convince customers to
only somewhat within the control of a single choose one brand of a product over a rival’s.
corporation. ● Independent price policy: - Under monopolistic
● Product differentiation: - Product differentiation competition, a company cannot be both a price
is the practice of differentiating products based maker and a price taker. Each company, however,
on attributes such as brand, size, color, and has some control over the pricing by creating
shape. This gives a particular company some a distinctive product or building a special
monopoly ability to control the market price of reputation.
its goods.
AR (or Demand Curve) and MR of a Monopolistic
● Freedom of entry and exit- Each seller is allowed
Competition: -
to enter or leave the market as they like. In
other words, any new company is free to begin
A corporation in monopolistic competition faces
manufacturing, and any current company is free
the AR and MR curves of a FLATTER curve that
to halt production and exit the sector. It indicates
slopes downward. Because the additional product
that over time, all businesses will only make
can only be sold at a lower price, the demand curve
typical profits. In the short term, a company may
has a negative slope.
have extraordinary earnings or losses.

Figure (8.4)

76
Market Structure
Oligopoly the businesses in an oligopoly attempt to avoid
price competition. They adhere to a tight pricing
The term “oligopoly” describes a market condition policy. When prices tend to remain constant
when a small number of companies sell similar despite changes in supply and demand, this is
or undifferentiated goods. For instance, there is referred to as price rigidity. Businesses compete
a market for goods like cold drinks, cars, steel, with one another through a variety of strategies,
cement, etc. including advertising and offering superior
services to clients.
Features of Oligopoly: - ● Nature of the product: - Companies operating in
an oligopoly may create uniform or differentiating
● Few firms: - There aren’t many big companies.
(heterogeneous) goods. An industry is referred to
The precise number of firms is unknown. An
as a Pure or Perfect oligopoly if the businesses
important share of the total output is produced
produce a homogeneous good (such as cement,
by each firm. There is intense competition
LPG cylinders, etc.). The industry is known as an
between many enterprises, and each firm tries to
impure or imperfect oligopoly if the firms produce
outsmart the other by manipulating both prices
a differentiated good (such as soft drinks, cars,
and output volume.
etc.).
● Interdependence: - Interdependence is the
● Very difficult entry of new firms: - Due to a
concept that one firm’s activities have an impact
variety of factors, including a high entry barrier
on those of other firms. When deciding on its
and patent issues, oligopoly makes it highly
price and output levels, a firm takes into account
challenging for new players to enter the market.
the activity and response of its competitors.

● Indeterminate of demand curve: - When a Types of Oligopoly: -

company lowers its price to increase sales in
an oligopolistic market, it also impacts other Collusive oligopoly: - It is referred regarded as a
companies. So, in response, other businesses collusive oligopoly when the enterprises come to
also start to lower their rates. It is impossible agreements regarding a uniform pricing output
to know with confidence a producer’s precise policy to be persuaded by them. Collusions come
behavioural pattern. As a result, the demand in two flavours.
curve that an oligopolist must deal with is kinked-
shaped and uncertain. ● Cartels
● Group behaviour: - In an oligopolistic market, ● Price-leadership
companies may form alliances and cooperate.
The goal of this arrangement is for businesses Non-collusive oligopoly: - Non-collusive oligopoly
to maximise profits. When they operate is defined as when businesses in an oligopoly
independently, there is a price war; yet, they may market freely compete with one another and do not
decide on a price that is profitable for all parties. enter into agreements over price and output.
● Non-price competition: - For fear of a price war,

77
Market Structure
 Basis Perfect Monopoly Monopolistic Oligopoly
Competition Competition

1. Number of Very large number Single seller Large number Few sellers
Sellers of sellers of sellers

2.Products Homogenous No close Differentiated May be

products substitute products homogenous or
heterogenous

3.Price Policy Firm is a price Firm is a price Firm is price maker Price is rigid
taker maker with to some extent due to fear of price war
constraint

4. Entry of new forms Free entry Restricted entry Free entry Very difficult entry

5. Profits in long run Normal profits only Can earn abnormal Normal profits Can earn abnormal
(AR=AC) profits(AR>AC) only(AR=AC) profits(AR>AC)

6. Control over price No control over Full control over No control over Interdependence
market price market price market price exists for pricing policy

7. Demand curve Perfectly elastic Less elastic More elastic Indeterminate

(Ed=∞) (STEEPER (FLATTER demand curve(or Kinked)
downward sloping) downward
slopping)

8. Selling costs Not required Very negligible High selling cost is High selling cost is involved
involved

9. Market Perfect knowledge Imperfect Imperfect Imperfect

knowledge knowledge knowledge knowledge

10. Mobility of Perfect mobility Imperfect mobility Imperfect mobility Imperfect mobility
factors

Duopoly particularly when deciding how to price products

and how much to produce.
A market arrangement known as a duopoly has just
two sellers (producers). The fundamental style of A competitive environment in the market is
oligopoly competition is this. The two competitors necessary for competition production. For instance,
offer conflicting goods and services and cater to a according to the Cournot model, the amount of
variety of customers. production serves as a competitive basis for
determining prices and outputs in markets that are
Players in this market rely heavily on strategy, fully competitive and monopolistic. The two players
78
Market Structure
could cooperate dishonestly in order to get more typically maintain a careful check on this market.
market share and financial advantage. Therefore, the two cannot cooperate due to the
stringent regulation of regulators.
Duopoly and Oligopoly
● Monopolies have significant power. The
two businesses might potentially pursue a
A particular kind of oligopoly is a duopoly. There
differentiation strategy in addition to managing
are various businesses with significant market
the market supply. Each product will have a
strength in the oligopoly sector. In order to reduce
number of devoted clients as long as they employ
the threat of new entrants, entry barriers are
a differentiation strategy, providing a sizable
likewise high. Few businesses have a substantial
amount of monopoly power.
market share, giving them the power to regulate
supply. Additionally, firms’ ability to demand higher ● The entry threshold is high. It may result from

prices thanks to a differentiation strategy is another structural limitations brought on by market

element of market power. dynamics like economies of scale. Alternately,

both businesses have consciously created entry
Market power is divided between two companies in hurdles including low-price initiatives and brand
a duopoly. Each has sizable monopoly power and a loyalty.
high degree of strategic dependency. ● Scale economies are significant. Due to the
market being dominated by just two companies,
The strategic choices made by one manufacturer each business experienced strong sales.
have a big effect on other manufacturers. Due to
this, collusive behaviour is likely to be introduced Examples of Duopoly
into the market. And when that occurs, the two
businesses behave monopolistically. Visa and Mastercard – Two organisations that
handle credit card transactions control 80–
Characteristics 90% of the market and earn extremely lucrative
commissions from handling payments. Visa has a
● There are two producers on the market. Both
market share of 60%, Mastercard 30%, and American
producers have a sizable customer base, which
Express 8.5%, according to Reuters. The EU
gives them significant negotiating power.
Commission is looking into Visa and Mastercard’s
● Producers are very dependent strategically. One market share for possible monopoly power. The EU
company’s strategic choices and activities have compelled the two businesses to lower their prices
a big impact on the rival. for travellers paying in other countries.
● Collusive behaviour has a high probability. Due to
their mutual dependence, they are more inclined Mobile phone operating systems. Mobile operating
to work together to obtain large market profits. systems are dominated by Apple and Android, with
other competitors accounting for just 2.7% of the
● There might be stiff competition. When the
market (Macworld)
two are not working together, this occurs. To
prevent anti-competitive behaviour, regulators
Aeroplane manufacturers. Boeing and Airbus are a

79
Market Structure
classic duopoly, controlling 99% of the market for constant. The approach also counts on participants
commercial manufacture and dominating the airline not conspiring.
manufacturing industry. Prior to Airbus’ founding
in 1970, Boeing had a monopoly. In the 1990s, Each firm has no reason to alter output or prices
Airbus had grown to be a significant adversary. Due after the market reaches equilibrium. No company
to its extremely high fixed costs and significant will be improved by the change. As a result, output
economies of scale, the airline manufacturing and prices are steady over the long term. Between
sector cannot reasonably support multiple rivals. perfect competition and monopolistic competition,
Some particular airline routes: There are two equilibrium will be the result of Cournot’s
airlines that offer direct flights between London competition (output and price).
and Edinburgh on these routes: Easyjet and British
Airways. In the specific market for direct air flights,
there is a pure duopoly.

Coca-cola and Pepsi: Coca-Cola and Pepsi are

the two most recognised brand names in the cola
industry. Coca-Cola held 43% and Pepsi owned 29%
Bertrand Duopoly
in 2018, for a two-firm concentration ratio of 68%.
(Statista)
The Cournot model’s foundation for competitiveness
was questioned by French mathematician and
Duopoly Types
economist Joseph Bertrand. He contends that
pricing, not output volume, determines the level of
Duopoly marketplaces can be explained using two
competition.
major models:

According to Bertrand’s model, each business

Cournot Duopoly
believes that since the products available on the

As the name implies, this model was developed market are identical, consumers will select the

by French mathematician and philosopher Antoine vendor offering the best (lowest) price. In order

Cournot. to prevent losing market share, other businesses

would act similarly when one company lowers their
According to the Cournot model, market competition pricing. Following one company’s price reduction,
and, consequently, the results of the competition the market enters into a price war.
are determined by quantity. Both businesses will
operate at a rate that simultaneously maximises The price battle rages on. Each business will still

profitability and chooses output. turn a profit even though the price is still over the
marginal cost, and there is still room for price
Each business creates in accordance with what reductions. Therefore, when the prices of the two
its rivals and the market are providing. Both enterprises are equal, or at the marginal cost, the
presumptively believe that the rival’s output remains

80
Market Structure
market will reach equilibrium. This is why creating a silent monopoly seems
advantageous for both businesses (collusion).
The Bertrand model makes the same homogeneous Together, the two can decide on a price that will
product assumption as the Cournot model. The two allow them to split the market’s earnings in half.
businesses did not conspire. However, these strategies can be complicated and
frequently infringe on anti-monopoly laws.
Implications for Competition
Competition Through Quantity
Every firm in a duopoly market is dependent on
one another strategically. It has an impact on how When quantity rather than price is the primary factor
particular businesses run, creates items, advertise in competition, duopolies typically perform better.
things, and set prices. Each business splits profits and market share.
Prices and output will stabilise until it reaches
The strategies each corporation chooses to employ equilibrium, as in the Cournot model.
determine the results of the competition. They both
might use a pricing method similar to the Bertrand Each business will likewise see substantial profits.
model. Alternately, they could both adopt a quantity- Both businesses are permitted to set prices that
based competing strategy. are greater than the marginal cost and above the
perfectly competitive price (while the market is
In addition, in contrast to the previous two models, still monopolistic). To put it another way, they each
the company might adopt collusive or differentiating possess monopoly power.
actions to produce superior earnings.
Competition Through Quality
Competition Through Price
Another aspect of competitiveness in a market
Price wars may result when two businesses with a duopoly is quality. Each business tailors its
compete on price, especially if their products are products to attract customers.
similar. The products of each company can perfectly
replace one another due to product homogeneity. Differentiation introduces a monopolistic
Consequently, a cheaper price is taken into account component to the market. Customers will be
when purchasing by the consumer. They have no devoted to each product, giving the business more
justification for favouring or sticking with one brand monopoly power.
over another.
Consider Android and iOS in the market for
Because customers will switch when a company smartphone software. Android was created by
lowers its price, a competitor’s market share is Google with the goal of capturing and controlling
eliminated. Competitors will similarly cut costs to the mass market. Similar to how Apple’s iOS
avoid losing market share. Price conflicts start, monopolises a more upscale market, it also targets
persist, and end when prices are equal to marginal this segment.
costs, eradicating profit potential.

81
Market Structure
Summary

The term “market structure” refers to the manner in which different businesses are categorised and
distinguished from one another in line with the degree and character of rivalry for the sale of goods and
services in each sector. Perfect competition, oligopolistic markets, monopolistic markets, and monopolistic
competition are the four subtypes that make up this category.

82
Market Structure
Economics and Management Decisions

Unit-11
Case Study: Prices Slashed
Down for Medicines
On the occasion of ending of 20 years of price fixing strategies, consumers. However, the body representing small retailers in
numerous big supermarkets announced amazing discounts and pharmaceutical sector has said that many might close their
significant price reductions across a vast range of medicines, business; threatening the community services.
vitamins and energy syrups. From Last night, a vast array of popular
medications like cough remedy, painkillers, indigestion medicines, There could be seen a rush amongst some of the biggest

nutritional supplements have witnessed a steep fall of upto 50% in supermarket chain to offer highest price reductions, which they
their prices and have become significantly cheaper. claim offer “Millions of pounds worth of savings.” For instance,
Tesco offered an almost 40% reduction in Anadin Extra, which will
The office of reasonable transaction called it superb news for
now be sold for £1.29 for 16 tablets. Similarly, Nuda is now offering
a 16 pack of Paracetamol for 68p as compared to the earlier price
of £1.95,and a 16’s pack of Nurofen Tablets is now being sold for
£1.10rather than £2.29.

These steep reductions were possible only after opposition to a

High Court action brought by Office of Fair Trading, was withdrawn
by Community Pharma Action Group, an umbrella organization
of small pharmacies. Under this action, Office of Fair Trading
had sought abolition of resale price maintenance in the pharma
industry. The resale price maintenance was introduced almost three
decades earlier in order to ensure the survival of small pharmacies, Over 2500 Over the Counter (OTC) products will come under the
which form almost 66% of the total 13,500 registered pharmacies purview of this ruling only,but prescription drugs would continue
in Britain and have been serving both rural communities as well as to be sold by pharmacists only. As the competition will intensify,
local high streets. the prices are going to fall even further. For instance, in the USA
where the medication prices are unregulated, similar products are
The Community Pharma Action Group had to back out after the available at much lower prices.
Hon’ble Justice Buckley ruled that there is not sufficient proof to
establish that abolition of resale price maintenance would deal According to Mr. Richard Hyman, Chairman of Verdict Retail
a death blow to local pharmacies or would lead to any reduction Consultancy “Medicines and supermarkets are a perfect competition

in therange of products being offered. But the Action Group’s

Chairman, David Sharpe, strongly opposed this decision. He said
that “It is a sad day for Britain as most of the small pharmacists
will not be able to withstand the might of big Supermarkets, who
have more buying power and aggressive pricing.” He further added
that “The biggest sufferers will be the elderly, disabled individuals
and Young mothers, who used to rely on the experience and free
advice of a local pharmacist in addition to a host of services. Our
only hope is that they will remain loyal and would give us the power
to fight on”.
because Medicines are small, fit on small shelves and would give the
supermarkets an opportunity to shout out the amazing discounts Assessment Questions
they are offering. This would make medicines a part of every weekly 1. How would you describe the market structure for sale of
shopping list.” medications and vitamins?

Whereas the Proprietary Association of Great Britain, there 2. The comment about the barriers to entry for pharma sector.

presentative of medicine and food supplement manufacturers, said 3. Will the change in law bring about any changes in the
that they were disappointed by this development, John Vickers, structure of the market?
Director General of Fair Trading was really ecsta tic and said that
4. Elaborate on the counter-effects of the abolition of resale
“This is an excellent news for customers as now they can enjoy
price maintenance on the medication industry.
the benefits of more competitive prices of general household
medications. This will help save millions of pounds every year.” 5. Similar concerns as voiced above were raised when RPM
was abolished for book sales in the year 1995, but since
then almost 10% of bookshops have shut down. Compare
this situation with one being faced by small pharmacies
and comment on their future.

6. Will the rising popularity of internet affect this situation

somehow? Please Elaborate.
Whisky Still Tops in Indian Market In High Spirits

Case Study The market for whisky grew 30.7% value of Rs. 1.24 trillion from
2011 to 2016 while the market for rum contracted by 9% to Rs.
Whiskey held the major share of Indian Spirits Market and accounted
19,135 crore.
for 61.2% volume in 2016, with sales witnessing an annual growth
rate of 3.8% over the period of 2011-16.

Graphic: Paras Jain/Mint

With no challenger in the vicinity, Whiskey is still the undisputed

favorite spirit for liquor drinkers in India.

According to data from Global Data, a leading consumer research

firm, Whisky held the major share of Indian Spirits Market and attributed to changes in customer taste as well as distribution
accounted for 61.2% volume in 2016, with sales witnessing an issues.”This statement holds significance because,during the period
annual growth rate of 3.8% over the period of 2011-16. Careful when whiskey has registered significant growth, consumption of
analysis of the data shows that the Indian Spirits market registered alternative spirits has seen a sharp decline. For e.g., Rum constitutes
an annual growth rate of 2% from 2011 to 2016, with Whiskey being almost 10% of the Liquor market by volume in 2016 but has seen a
the most significant contributor. percentage fall of 2.3% per annum during 2011-16. During the said
period, market for whiskey grew by a whopping 30.7% to almost Rs.
According to Apoorva Nema, Consumer Analyst at Global Data
1.24 Trillion whereas the market for rum shrunk by almost 9% and
“This amazing growth registered by Whiskies can be attributed to
now stands at Rs. 19,135 crores.
the fact that a large base of Indian middle-class shifted preferences
to premium whiskeys.” This observation has been backed by data from Euromonitor, which
clearly shows that liquor firms which focussed on whiskey have
There are eight major categories of Liquor comprising Spirits
registered a steady growth in their market share,but those who
Markets in India, namely: Whisky, Vodka, Tequila and Mezcal, Brandy,
focussed on sales of Rum have not witnessed any growth at all
Gin and Genever, Speciality Spirits, Rum,and Liqueurs. Despite the
and have rather seen adecline in their sales. This trend is further
fact that Liquor companies have introduced and promoted different
substantiated by the following example
variants of tequila, rum, gin and other spirits aggressively, but this
has had no bearing on the sheer dominance of Whisky in the market. Pernod Richard India Pvt. Ltd., well known for their whiskey brands
Royal Stag and Blender’s Pride has seen its market share, of total
According to Nema “The decline in consumption of rum can be
alcohol sales, jump to 7.1% from 5.3% between 2013-2016. Whereas and Mezcal, both obtained from Mexican Agave Plant, have seen a
in comparison, Mohan Meakin Ltd, renowned for their Old Monk CAGR (Compound Annual Growth Rate) of 11.6% during 2011-16,
Rum, witnessed a stagnant market share of 2.3% to 2.5% during the one of the highest jumps witnessed in the market. But these two
same period. liquors comprise only 0.1% of the total spirits market.

But this does not mean that everything is bleak. According to data Additionally, no major company in India manufactures Tequila and
from Global Data, Liquor companies are expected to see growth in Mezcal. Diageo PLC, the parent company of United Spirits Ltd., has
specialized spirits segment. For instance, Mexican Spirits Tequila recently acquired a well known premium tequila brand “Casamigos”
from George Clooney for appx $ 1 Billion.

Assessment Questions

1. Do you think whiskey is taking monopoly advantage of having

a different target audience?

2. In which category you can segment the liquor market in?

 Unit 12

Introduction to
Macro Economics
Learning Objectives Introduction to Macro Economics

By the end of this unit, you will be

In the field of economics, Ragner Frisch coined the term
able to understand:
“Macro” in 1933. It was also used by mercantilists and
● Macro economics
physiocrats in the 16th and 18th centuries in their ideas.
● Macro economics’ uses Matheor, Sismondi, and Marx worked with macroeconomic

● National Income issues in the 19th century. Prior to Keynes, contemporary

macroeconomic analysis was developed by Walras,
● Methods of calculating NI
Wicksell, and Fisher. In many of his articles, J.M. Keynes
made considerable use of the macro technique. Greek
term for huge is macro. Macroeconomics is the study of
large-scale economic aggregates.

Macro Economics

The study of economic aggregates or averages is the

focus of macroeconomics. Some examples of economic
aggregates include total employment, national income,
national output, total investment, total consumption, and
total savings. Macroeconomics also examines general
price level, wage level, and cost structure. The study of
aggregate economic interactions, including how and
why aggregative values vary and how and why they are
determined, is known as aggregate economics.

According to Edward Shapiro, the study of the economy’s

83
Introduction to Macro Economics
overall output, employment, and price level is known economy, whereas microeconomics utilizes
as macroeconomics. aggregates retailing to individual households,
businesses, and industries. In addition to focusing
According to Bouldings, “Macroeconomics does on the major averages and aggregates of the entire
not deal with the individual quantities or incomes system, macroeconomics also aims to describe
but with the aggregates of these quantities, not these aggregates in a usable way and investigate
with the individual incomes but with the national their relationships and determinants.
income, not with the individual prices but with the
general price level, not with the individual output The Difference Among Microeconomics and
but with the national output.” Macroeconomics

According to Ackley, macroeconomics deals with The two main subfields of economic theory are
economic affairs in the broad and is concerned microeconomics and macroeconomics. Professor
with the overall dimensions of economic life. Ragnar Frisch of the University of Oslo is the author
of these two terms. Since just a small portion of
Macroeconomics is often called the theory of the economy is covered by microeconomics, this is
employment and income. Unemployment, economic already known. It investigates how each individual
turmoil, inflation/deflation, worldwide trade, and unit—a person, a business, or an industry—behaves
economic growth are all covered. It’s the study of economically. Product and factor pricing, as well as
factors that affect employment and unemployment. the notion of economic wellbeing, are all studied
It studies the impact of investment on output, in microeconomics. Given that it focuses primarily
revenue, and employment in business cycles. It on the costs associated with various variables, it is
investigates how the total amount of money affects occasionally referred to as pricing theory.
the overall level of prices in the financial world. The
macroeconomic analysis covers the issues with the On the other hand, macroeconomics examines
balance of payments and foreign aid in international the aggregates of the entire economy. In other
trade. Macroeconomic theory primarily examines words, it is an examination of every unit taken
the issues with calculating a country’s total income as a whole. It is an examination of the economy
and the factors that influence its fluctuation. as a whole. It addresses aggregates including
overall employment and income, general price
Finally, it examines the factors that promote level, overall output, consumption, and investment,
economic development and those that slow among others. Therefore, theories of income,
down progress. Aggregates are studied in output, employment, and growth are studied in
both macroeconomics and microeconomics. macroeconomics. A diagram is provided below to
However, microeconomic aggregation differs further clarify the distinction.
from macroeconomic aggregation. Aggregation
in microeconomics refers to the interrelationships Consider the entire economy as a circle. Every
between individual households, individual time we examine a topic within the circle,
businesses, and individual industries. Therefore, macroeconomics is involved. Say there are four
macroeconomics uses to tie them to the overall companies/firms in the economy: A, B, C, and D. We

84
Introduction to Macro Economics
are studying microeconomics if we are examining Understanding the ideologies that are prevalent
the price of goods sold, the employment created, and influencing a given government administration
or the production produced by firm A. Additionally, can also be extremely useful. How a government
if A and B combine to form an industry (an industry approaches taxation, regulation, spending, and
is a group of businesses that produce goods of other related measures will depend in large part
a similar nature), and we examine any element on its fundamental economic tenets. Investors can
of this industry, we are once more studying at least obtain a peek at the likely future and take
microeconomics. confident action by having a deeper understanding
of economics and the effects of economic
decisions.

Areas of Macroeconomic Research

Although the science of macroeconomics is

somewhat wide, two particular areas of inquiry
serve as good examples of the subject. The first
area is what influences long-term economic growth
or rises in the level of national income. The second
Figure 9.1 focuses on the factors that contribute to and are
Limits of Macroeconomics affected by short-term changes in employment
and national income, generally referred to as the
Understanding the constraints of economic theory economic cycle.
is also crucial. Theories are frequently developed
in a vacuum and lack specifics related to the real Economic Growth
world, such as taxation, regulation, and transaction
costs. In addition to being extremely complex, the An economy is said to be experiencing economic
real world also contains ethical and social issues growth when its total output rises. In order to
that resist quantitative study. support economic policies that will encourage
growth, progress, and growing living standards,
It is crucial and worthwhile to monitor the key macroeconomists work to understand the elements
macroeconomic indicators like GDP, inflation, that either stimulate or slow down economic
and unemployment even in the face of economic growth.
theory’s limitations. The economic environment
in which businesses operate has a considerable Business Cycles
impact on the performance of those businesses,
and consequently, the performance of those The levels and rates of change of important
businesses’ stocks. An investor can make smarter macroeconomic indicators, such as employment
judgments and identify turning moments by and national production, occasionally experience
studying macroeconomic information. ups and downs, expansions, and recessions, in
a process known as the business cycle, which is

85
Introduction to Macro Economics
superimposed atop long-term macroeconomic total savings, total investments, per capita income,
growth trends. the standard of living of the populace, total
employment, trade cycles, inflation, etc. According
Its Uses to professor Ackley, it investigates the forest as a
whole rather than specific trees or microeconomics.
The topics of macroeconomics include national It is sometimes referred to as the Aggregative
income, gross national product, total consumption, approach because it examines aggregate behavior.

Macroeconomics is a way of economic research of viable demand. Effective demand should be

that is both theoretically and practically significant. raised in order to end unemployment by raising,
total output, total income, total investment, and
● To comprehend how the economy operates: Total
total consumption.
income, output, and employment are statically
● In national income: It was crucial to study
quantifiable, making it possible to analyze the
the reasons for the Great Depression’s
consequences of how the economy is operating.
overproduction and unemployment. National
● In economic policies: From the perspective of
income data predicts economic activity and
economic policy, macroeconomics is very helpful.
income distribution among social groupings.
Particularly developing nations have a plethora
● In monetary problems: Macroeconomics can
of domestic issues, like overcrowding inflation,
be used to correctly analyze and comprehend
a payment imbalance, general underproduction,
financial issues. Adopting monetary and fiscal
etc. The regulation and management of these
strategies for the entire economy can help
issues is the primary duty of the governments.
combat changes in the value of money, inflation,
No government has the power to change people’s
and deflation.
behavior to solve these issues. Therefore,
studying macroeconomics is helpful for finding ● In economic growth: Macroeconomics also
solutions to these challenging financial issues. includes a study of economic growth. Planning
for development benefits from a knowledge of
● In general unemployment: An example of
macroeconomics. Plans are developed and put
macroeconomics is the Keynesian theory of
into action to boost overall national income,
employment. Effective demand determines how
output, and employment in order to advance the
many people are employed in a given economy.
state of the economy overall.
It, in turn, is reliant on both total supply and total
demand. Unemployment is brought on by a lack ● In business cycles: Macroeconomics is

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Introduction to Macro Economics
 important because it may identify the root causes outlays. The expenditure technique adds family,
of economic oscillations and suggest solutions. private, and government spending to national
revenue.
● For figuring out how particular units behave:
Demand for particular products is influenced
Current-price National Income:
by overall economic demand. It is impossible
to comprehend the factors behind the decline
National income at current prices is the monetary
in demand for specific products without first
value of all commodities and services produced in
analyzing the factors contributing to the deficit in
a nation.
aggregate demand.
A base year’s national income is at constant prices.
Thus, macro economies broaden our understanding National income at constant prices is used for
of how an economy operates by examining how comparisons. Let’s compare national income at
national income, output, and employment behave. current and constant prices using the following
Additionally, it aids in addressing the issues of table. The economy produced steel, automobiles,
unemployment, inflation, economic instability, and rice, and other items from 2000-2005. The year 2000
growth. is used to calculate national income at constant
prices. Columns 3 and 5 list future prices. Assume
National Income & Related Aggregates both years’ production and services were equal. At
current rates, the national income is Rs. 740 and Rs.
National Income 600 constant. At steady prices, the national income
is 40 rupees greater today. It’s a mirage. Although
National income is the value of final goods and national income has risen, 2005 output has not, due
services produced throughout a fiscal year. Total to higher prices. National income at constant prices
spending, total factor income, and total output can is more useful for estimating economic growth.
also be used.
When comparing national income, use the formula
It’s a country’s annual factor earnings (wages, rent, below to convert current values to constant prices.
interest, and profit). Rent, wage, interest, and profit
are paid for land, labor, and capital, accordingly.
These prizes indicate the economy’s national
income. National income is a nation’s annual
2000 2005 N.I.in 2005

Products Q P Q P At At current
constant prices
prices
I 2 3 4 5 4x3 4x5

Rice 10 05 10 07 50 70
Car 20 10 20 12 200 240
Steel 10 20 10 25 200 250
Services 15 10 15 12 150 180
600 740

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Introduction to Macro Economics
Q (Quantity) in Units; P (price) in Rs. payments. Products and services flow. National
income consists of both goods and money.
Circular Flow of Income
The following presumptions are taken into account
The total factor income (earnings from labor and to explain the circular flow of revenue in the two-
property) from a country’s most recent output of sector simple economy model.
goods and services is the nation’s national income.
● The economy is shut down. There is no foreign
This concept is depicted as a circular flow in the
sector, in other words;
figure below, which is titled “Income flow in a circle.”
● While providing production inputs, households
Consider an economy with just two sectors: do not generate anything.
consumers and businesses. Families are
● The only sector that produces is the commercial
essentially consumer units, and they own the
or industrial sector;
manufacturing inputs. While families offer these
● Whatever businesses make is sold, and stocks
businesses services related to the factors of
don’t build up;
production, firms manufacture goods. Production
factors are compensated. The sum of enterprises’ ● Consumers or the household sector do not save
wages, rents, interest, and profits must equal the any money and instead spend all of it;
net production’s sales value. Households use these
● Taxes, government spending on products and
earnings to buy a range of goods and services. As a
services, and other things are absent.
result, corporations provide productive services to
households in exchange for income, and consumers Leakages are those variables that cause spending
purchase goods in return. to decrease, whereas injections cause spending
to grow. As an illustration, families typically save a
portion of their income. Savings lead to leaks in the
economy’s income stream or flow. Similar to this,
when we pay taxes to the government, that amount
is deducted from our income. This is yet another
significant type of leakage. On the other hand, if
the government spends money on products and
services, income rises, and output is stimulated.
The economy is receiving a boost from this.

Concept of National Income

Figure 9.2: Circular flow of income

Before calculating national income, we must

Circular flow of revenue refers to payments and comprehend these concepts. National income
receives for products, services, and factor services is measured by GDP, NDP, personal income,
between economic sectors. Flows can be money disposable income, and private income.
or genuine. Money flow includes income and

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Introduction to Macro Economics
Gross National Product (GNPmp) of final goods and services produced by a country’s
population in a year less fixed capital consumption/
Gross national product is the total market value of depreciation (NDPmp). Depreciation is the wear-
a nation’s finished goods and services in a given and-tear cost of capital goods during production.
year (GNP). It’s a monetary indication of current To increase commodity availability in the economy,
economic activity. When computing GNP, only depreciation must be subtracted.
final products and services should be considered.
When determining GNP, foreign factor income NDPmp = GDPmp – Depreciation
is considered. The term “final goods” refers to
products that are being bought for their intended NDPmp = GNPmp - net Factor income from Abroad
purpose only—not for resale or further processing. - Depreciation
Items that go through one or more production
phases before becoming finished goods are Net National Product at Market Price (NNPmp)
referred to as intermediate goods. In other words,
they contribute to the manufacturing of finished NNPmp is the market value of all products generated
goods. The worth of these goods and services in a nation by its citizens after depreciation. Thus,
would be double counted if we did so. The gross
national product estimate is inflated as a result of NNPmp = GNPmp – Depreciation
double counting. In essence,
NNPmp = NDPmp + net income from abroad
GNPmp = GDPmp + Net Factor Income from Abroad
NNPmp is a better indicator of the economy’s
Gross Domestic Product (GDPmp) genuine output than GNPmp.

The GDPmp is the monetary worth of all finished Gross Domestic Product at Factor Cost:
goods and services produced within a nation’s
domestic market in a calendar year at market- Gross domestic product is measured using the

prevailing prices. The value of foreign factor earnings of the production factors, or GDP at factor

income received by citizens of a nation is not taken cost. It is the total of all income earned within

into account when calculating GDP. A nation’s many a country’s domestic territory, including wages,

production sectors typically create a set quantity of interest, and rent. We employ the following to

commodities and services, such as rice, fertilizer, obtain GDPfc:

cement, steel, and the services of physicians,

GDPfc = GDPmp - Net Indirect Taxes (Indirect Taxes
educators, engineers, and attorneys, among other
- Subsidies)
things. The GDPmp is the sum of the monetary
values of all these goods and services. Thus,
GDPfc = GNPmp - Net Factor From Abroad - Net
Indirect Taxes
Net Domestic Product at Market Prices (NDPmp)

Net domestic product at market prices is the value

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Introduction to Macro Economics
Gross National Product at Factor Cost: to refer to NNP at factor cost.

It is the total of all income that regular citizens of a Methods of Calculating NI

country receive from different sources of output in
the form of wages, rent, interest, etc. Net Output Method

GNPfc = GNPmp - Net Indirect Taxes This approach totals the net final output or net
value created by all the enterprises over the course
GNPfc = GDPmp - Net Indirect Taxes + Net Factor of a year to calculate national income.
From Abroad
The steps listed below can be used to determine
Net Domestic Product at Factor Cost: national income using the product method:

The term “net domestic product at factor cost” ● The establishment of production units and the
refers to the method of calculating a nation’s GDP assignment of each to one of the following three
by dividing it by the amount of money earned by the industrial sectors: The first step is to locate each
factors that contribute to its domestic production. individual manufacturing unit and classify it
Thus, under one of the three categories of the industrial
sector.
NDPfc = GDPfc - Depreciation
● An estimation of the increase in net value: Net
value added is calculated from gross output,
National Income OR Net National Product at Factor
intermediate consumption, depreciation, and net
Cost:
indirect taxes. Businesses can calculate their
gross production by multiplying their output by
It is the total value of all finished goods and services
market prices. Gross output is the sum of all
produced by citizens of a nation, both within its
companies’ sales and stock-value changes. Net
boundaries and outside of them, based on the
value added at market price is the gross value
factor costs of such goods and services. To put it
of output minus intermediate consumption and
another way, it is the portion of a nation’s revenue
depreciation. Deducting net indirect taxes yields
that is distributed to its individual residents. In
net value added at factor cost. Net indirect taxes
essence,
are indirect taxes minus subsidies. NDP at factor
cost is the overall net value added by a nation’s
National Income/NNPfc = Domestic Factor Income
industrial enterprises.
+ Net Factor Income from Abroad

National Income/NNPfc = GNPfc - Depreciation

Because payments to the various elements of

production are included as a component of factor
cost, the phrase “national income” can also be used

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Introduction to Macro Economics
● Estimation of Net Factor Income From Abroad: Thus,
The final step entails estimating the net factor
income from other countries and combining that National Income or NNPfc = NDPfc + Net Factor
figure with the net domestic product in order Income from
to arrive at the national income, also known as
NNPfc. The term “net factor income from abroad” Caution Should be Exercised When Estimating
refers to the amount of money that expatriates National Income Using the Product Method
living in a nation earn in comparison to the
amount of money that native-born inhabitants The following table provides a summary of the
of that country earn working outside the country. items that are and are not included:

Items to be included Items to be excluded

1. Own account 1. Sale and purchase of

production of fixed second hand goods.
assets.
2.Sale and purchase of
2. Food and other items bonds and shares.
for self consumption.
3. Services of
3. Imputed rent of owner housewives.
occupied houses

Difficulties of the Product Method in market conditions.

● Whether or not services should be counted as

When using the product approach to estimate part of national income is still up for debate.
national income, the following issues occur:
● Inadequate and unreliable data, particularly in
disorganised and unincorporated businesses, is
● Price stability is lacking. These frequently
a significant issue when attempting to calculate
alter. Finding the value of inventories might be
national revenue using the value-added approach.
challenging in these circumstances.

● The pricing of commodities that are maintained Income Method

for personal consumption and do not enter the
market is difficult to ascertain. For instance, it is We are aware that the four main production
difficult to estimate the value of owner-occupied factors—land, labour, capital, and organization—
buildings or imputed rent. help with production and are compensated for their
● It is never possible to make a clear-cut contributions. Factor income is the compensation
difference between intermediate goods and final received by the factors of production in exchange
commodities. For some, intermediate products for their labour. Both cash and in-kind compensation
may be final goods. is given to the factors. This is the producer’s factor
cost, which is the same as the factor income
● It becomes challenging to calculate depreciation
received by the production factors.
when a capital good’s value varies owing to shifts
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Introduction to Macro Economics
The income method calculates the nation’s income and other purposes), corporate taxes (taxes
at the point where primary factors are paid for their imposed on a company’s income), interest, rent,
use of the production process. In other words, the royalties (payments made for the use of mineral
total of all incomes attributable to the main factors deposits, patents, copyrights, trademarks, etc.),
of production is used to calculate national income. profits, and other types of property income. Self-
Rent, labour, interest, and profits are added together employed people with mixed-income combine
to create national income. wage and property sources.

● Estimation of domestic factor income: The

Following is a quick explanation of the procedures
total money produced by each industrial sector
to be followed when using the income technique to
is used to calculate domestic factor income. In
calculate national income:
other words, the value of domestic factor income
is equal to the entire compensation paid to
● Identifying production facilities and grouping
employees, property income, and mixed-income
them according to industrial sectors: Finding
by all the production units inside the domestic
manufacturing companies that use factor
economy within a given accounting year.
services and categorising them into different
industrial sectors, such as primary, secondary,
Precautions in the Estimation of National Income
and tertiary, is the first step.
by Income Method
● Classification of factor incomes: Employee pay,
property income, and mixed-income are factor The elements to be included and excluded for
incomes. Pay includes earnings, salary, and estimating national income using the income
social security from producers. Dividends (part of method are shown in the table below.
a company’s profit distributed to shareholders),
undistributed profits (retained for development

Items to be included Items to be excluded

1. Value of production for 1. Income received from sale

self consumption such as and purchase of second hand
agricultural products. goods.

2. Imputed rent of owner 2.Income received from sale

occupied houses and purchase of bonds and
shares.

3. All transfer payments

like pensions, scholarships,
subsidies.

4.Illegal incomes such as

income from smuggling,
gambling, etc.

5. Corporate taxes

6. Interest on national debt

7.Wealth tax, Death duties, Gift

tax

8.Windfall gains, such as

income from lotteries.

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Introduction to Macro Economics
Difficulties of the Income Method ● Government final consumption expenditure: This
accounts for expenses incurred in administration,
The income technique presents the following defense, the upkeep of law and order, education,
challenges for determining national income: and other areas, among others.

● Domestic capital formation on a gross basis: It

● It is difficult to assess the heterogeneous income
comprises the producers’ purchases of capital
of independent contractors. It is challenging
goods. It raises the economy’s capital stock.
to obtain trustworthy information from the
unorganized or unincorporated sector. ● Net exports of goods and services: Net exports
are calculated as the value of imports minus the
● Some economists believe that since the national
value of exports of goods and services.
debt’s interest is employed for useful purposes,
its worth should be taken into account. As a
Following is a quick explanation of the procedures
result, there is debate regarding whether to
to be followed when computing national income
include it.
using the expenditure method:
● The basis for calculating the amount of income
received in the nation is an individual’s income ● Estimation of private final consumption
tax returns (a record of their earnings). Only expenditure: The number of goods and services
a relatively small minority of those who earn purchased is multiplied by their retail prices to
money actually pay taxes in undeveloped nations. determine the final consumption expenditure by
As a result, the income technique may only be households and nonprofit organizations acting
somewhat useful in these nations. as households.

● Estimation of government final consumption

Expenditure Method
expenditure: The cost to the government is used
to determine government final consumption
The expenditure technique calculates national
expenditures because there is no market price
revenue at the point of disposition or spending.
for government services. This is thus because
By calculating final spending on a gross domestic
the government as a whole does not engage in
product by families, the government, and the private
market commerce. The amount of employee
sector, it calculates national income.
salary and the price of the goods and services
the government purchases is the cost to the
Final Expenditure Components
government. Therefore, the net worth of the
goods and services the government has acquired
The following constitutes the gross domestic
on the domestic and global markets, as well as
product’s final outlay:
staff remuneration (wages and salaries), are
included in final consumption expenditures for
● Private final consumption expenditure: It covers
the government.
purchases made by households and privately
funded nonprofit organizations including clubs, ● Gross domestic capital formation is estimated:
schools, and hospitals. It includes stock changes, plant and equipment
purchases, and building expenditures.
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Introduction to Macro Economics
● Net exports: The final step is to calculate the ● The cost of purchasing shares, bonds, and
value of net exports, which is the value of total other similar paper titles should not be included
exports less the total value of total imports of because they merely serve to demonstrate the
goods and services. ownership of property. The buying and selling of
shares, bonds, etc. do not result in any tangible
Precautions in the Estimation of Expenditure goods being produced.

● Pensions, scholarships, unemployment benefits,

Following are the items that should be included and
and other transfer payments shouldn’t be
excluded when assessing national income using
included in the calculation.
the spending method:

To prevent double counting, expenses for

● Because they represent a component of the stock
intermediate or semi-finished goods should be
of products generated in the past, expenses for
disregarded.
used goods shouldn’t be included.

Summary

The behavior of an entire economy, including its markets, enterprises, customers, and governments, is the
subject of study in the field of economics known as macroeconomics. Inflation, price levels, the pace of
economic development, national income, gross domestic product (GDP), and fluctuations in unemployment
are some of the macroeconomic phenomena that are investigated by macroeconomics.

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Introduction to Macro Economics
 Unit 13

Money and Banking

Learning Objectives Introduction

By the end of this unit, you will be

Though it is immediately recognisable, money is
able to understand:
difficult to describe, according to economists and other
● Money and its evolution
intellectuals. This is so because a wide range of objects
● Functions of money has served as money throughout recorded history.

● Central bank and its functions Because of this, it cannot be characterised in terms of
its physical characteristics, such as the material it is
● Commercial bank & its functions
constructed of, its weight, size, shape, colour, chemical
● Monetary policy makeup, etc. Numerous modifications have been made
● Fiscal policy to the precise form of money.

Money And Its Evolution

By examining the development of the payment system,

and the means of carrying out transactions in the
economy, we may get a clearer understanding of the
purposes of money and the forms it has taken over time.
Over the course of many centuries, both the payment
system and the nature of money have changed. Precious
metals like gold and silver were once the primary method
of exchange and the primary form of currency. Later,
paper assets like currency and checks started to be
employed in the payments system and were seen as
being equivalent to money. The future definition of money
will be significantly impacted by the direction that the

95
Money and Banking
payments system takes. commodities and services he cannot provide
himself, specialization—the process by which one
The current monetary system was developed in continues to produce a certain good or service that
three phases, namely: he can produce best—has developed. By doing this,
one becomes an expert in that field. This resulted
1.Direct Production from an overreliance on one another. Contrary to
barter trading, money is employed as a medium of
This is a scenario in which a single person produces exchange because an entrepreneur is confident in
all the commodities and services required by him exchanging his surplus items for money, allowing
without assistance from anyone else. When a him to continue producing them in big quantities
home was totally independent of other families and therefore develop into an expert in the field.
during the Stone Age, this was feasible. The man In addition to this, the money he got is typically
was self-sufficient in production throughout this accepted by others as payment for debts. The
time. He got all he needed from his family. Man world’s financial development is currently at this
didn’t specialise in a competitive good. stage.

2.Indirect Production Using the Barter System

According to the evidence we have, barter trade

began in Mesopotamia in approximately 6000 BC.
When a guy creates more goods and services than
he and his household require, he sells the extra
to other people. The man was able to make all he
and his family required throughout the Stone Age.
Types of Money
However, as time went on, man’s demands and
wants grew; as a result, he could not completely
Africa and Nigeria used commodities as money
meet his own requirements and those of his family.
before modern money. Slaves, tobacco, cowrie
He, therefore, had to rely on other people to meet his
shells, beads, textiles, iron-hoe blades, salt bars,
diverse demands. To do this, he started producing
kissy coins, and tea. Gold and silver have been
a lot and trading his surplus for other people’s
European currencies. Pure, quasi, commodity, legal
surpluses. For instance, a farmer who produces
tender, and token money. Metallic, paper, credit, and
more maize than his household needs but is unable
pseudo money.
to make the cutlass he needs must trade his extra
maize for it with a blacksmith who is willing to trade
Commodity Money or Metallic Money
his cutlass for maize. Bartering is the practice of
exchanging one good for another.
Metal money. Early currency was gold and silver.
Due to their scarcity and value, other metals like
3.Money-Based Indirect Production:
copper, brass, nickel, aluminum, and bronze were
also used as money. Precious metals like gold or
Because man is dependent on others for the
silver are obvious candidates for use as money.
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Money and Banking
Commodity money is formed of precious metals lot of cash with you. Cheques were a significant
or another valuable commodity. All but the most innovation that increased the effectiveness of the
primitive cultures used commodity money until payment system. Payments that are sent back and
a few hundred years ago. A payment system that forth frequently cancel each other; if checks weren’t
uses exclusively precious metals is complex and used, a lot of money would be moved. Cheques
hard to move. Then, coins, either traditional or allow for the settlement of payments that cancel
token, made up metallic money. Token coins have a each other out without the need to exchange any
face value higher than their underlying value, while money. Thus, using checks enhances economic
ordinary 3 coins do not. efficiency and lowers the transportation expenses
related to the payments system. Cheques also
Fiat Money or Paper Money have the benefit of being able to be written for any
amount up to the account balance, which makes
Next in payments was paper money (pieces of large-scale transactions simpler. Cheques are
paper that function as a medium of exchange). also advantageous since they offer quick receipts
Fiat currency is paper money. Payment on demand. for purchases and considerably prevent loss from
Because of legislation, it’s called this. Legal tender, theft.
yes. Initially, paper money was convertible into
coins or precious metals. Fiat money is a legal However, there are two issues with a check-based
tender that cannot be converted into coins or payment method. First of all, sending checks from
precious metals. Paper money is lighter than coins one area to another takes time. This is a particularly
or precious metals, but it can only be used as a critical issue if you are paying someone who has
medium of trade if people trust the government to be paid immediately but is located somewhere
entities that issue it and if counterfeiting is difficult. else.
Paper money has become legal, therefore a nation’s
currency can be altered anytime. In 2002, numerous Quasi or Near Money
European states converted to the euro.
This includes objects that are used to make
Credit Money or Cheques payments but are not actual money. They are known
as financial assets since no one can be made to
This includes, among other things, negotiable accept them as a form of exchange. They are
instruments like checks and draughts. Since they simple to turn into money. These include, among
are not frequently acknowledged as a form of others, certificates of deposit, postal and money
payment like coins and notes and since no one can orders, treasury bills, debenture bonds, dividend
be forced to accept them, they are not recognized warrants, and treasury bills.
as legal currency. As a result, they are viewed as
discretionary funds. When someone writes a Electronic Payment
check, they are giving their bank instructions to
transfer funds from one account to another when Electronic bill payments and commercial
the check is deposited. Cheques make it possible transactions have become more affordable because
to conduct transactions without having to carry a of the advent of affordable computers and the

97
Money and Banking
growth of the Internet. In the past, you had to drop Like prepaid phone cards, stored-value cards are
cash into the bank or use checks to pay your bills, acquired for a predetermined cash amount. Smart
but now banks have websites where you can log in, cards are enhanced stored-value cards. It can be
make a few clicks, and send your payment online. loaded with virtual money from the owner’s bank
In addition to saving money on the stamp, paying account using a computer chip. ATMs, laptops with
payments becomes (nearly) enjoyable and requires smart card readers, and phones with specialized
minimal effort. Banks now provide electronic hardware can load smart cards.
payment services that can save you from having to
log in to pay the bill online. Instead, you can have E-cash, a third kind of electronic currency, is
regular payments taken out of your bank account frequently used to pay for goods and services
automatically. When paying a bill electronically online.
rather than with a check, estimated cost savings
per transaction exceed one dollar. Thus, the usage Characteristics of Money
of electronic payments is significantly increasing in
the United States, although Americans still lag far Any product that serves as a medium of exchange
behind Europeans, notably Scandinavians, in this must have the qualities that are typically associated
regard. The rest of the world, especially China, is with money, including:
rapidly catching up.
● Acceptability

● Divisibility

● Homogeneity

● Durability

● Portability

● Cognisability

E-Money ● Scarcity

Electronic payment technology can replace checks Functions of Money

and cash with electronic money (e-money). The first
electronic money was debit cards. By electronically A couplet that effectively summarises the purposes
transferring money from their bank accounts to of money is as follows:
a merchant’s account, consumers can use debit
cards to buy goods and services. Debit cards are The four roles of money are: “A Medium, a Measure,

faster than cash and are accepted where credit a Standard, and a Store.”

cards are.
Three broad categories can be used to group the

The stored-value card is advanced e-money. purposes of money:

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Money and Banking
Primary Functions worth for him, i.e., no economic function or
utility. Throughout recorded history, thousands
Money’s primary or original functions are its of objects have served as money, or as a medium
principal functions. The following are the main of exchange. There are many different types of
uses of money: money available nowadays. The most common
type of money among these is legal tender,
● Medium of exchange: One of the most crucial
or official currency, which includes both coins
and traditional uses of money is as a means
and currency notes. Money provides greater
of exchange. A medium of exchange is money.
economic freedom than currency, although non-
Because there was no double coincidence of
currency modes of payment like checks, credit
wants, the exchange was challenging in the
cards, etc. are significantly more prevalent in
barter system. The restrictions of the barter
terms of quantity. It benefits us to make other
system may be removed with the development of
people’s products accessible. The requirement
money. There is a universal purchasing power of
for money to function as a medium of exchange
money. Money serves as a means of exchange;
is that it be widely accepted. Anything that is
it is obtained via the sale of one’s goods and
intended to serve as money must be generally
services and then applied to the purchase of
regarded as acceptable by everyone. To put it
further goods and services.
another way, everyone should accept payment in
● The fundamental principle behind this concept cash for goods and services. Therefore, nothing
is that a seller may accept, in exchange for the operating only as a means of the transaction can
sale of profits, an object that has no intrinsic be referred to as money.

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Money and Banking
● Measure of value: The standard measure of value These operations are also referred to as derivative
or unit of account used to express the values operations. The following are money’s secondary
of all commodities and services is typically purposes: -
money. By adding the values of a wide range of
commodities and services with different units, ● Standard of deferred payment: Future or deferred
accounting systems become meaningful. The payments are made in units of money, which
appraisal of good was a challenging undertaking acts as the benchmark for deferred payments.
in the traditional barter economy since it changed This function is applicable to payments like
depending on the variation in the good that was insurance premiums, rent, salary, and pensions.
exchanged. It was nearly impossible to maintain The acts of lending and borrowing are simply
accounting records for identical reasons. stated in monetary terms. Money is thought to
Money’s invention has been used as the basis for be the greatest option for these transactions
determining value. due to its features of value stability, widespread
acceptance, and durability.
The term “unit of account” refers to the monetary
● Store of value: Because it is simple to spend and
unit used in calculations. Money is used to express
store, money also functions as a store of value,
the prices of commodities and services. This made
which is its fourth purpose. Both over the short
it easier to calculate the ratio of exchange between
and long terms, money acts as a store of value.
any two items. Money is not a perfect indicator
By serving as a store of value, money gives people
of value, though. Because of this, its own worth
the security they need to deal with unforeseen
changes over time. The value of money fluctuates
circumstances and pay off the debt that is
from place to place and through time, unlike
denominated in money. Commodities could not
other invariant physical units of measurement
be kept in storage for an extended amount of
(kilogrammes, metres, litres, etc.). to satisfy the
time in a barter exchange system. Money may be
standard of value. It is crucial that monetary units
kept in storage for a very long time because of its
be constant. It must uphold the constant value.
special qualities of durability and value stability.
Numerous social and economic issues are always
People now save money from their incomes for
brought about by altering monetary units. It is
the future as a result of this trend.
common knowledge that the value of money, or
● Transfer of value: The transfer of value or
purchasing power, fluctuates; it rises during periods
purchasing power is accomplished through the
of declining process and declines during periods of
use of money. By giving away goods or property
rising prices. The unit of account function is thus
to other people and jointly purchasing goods and
a desirable but not essential property of money,
property, people transfer value. The exchange of
according to certain economists.
things in far-off areas has been made easier by
money.
Secondary Functions

Contingent Functions
Money’s secondary purposes are those that are
comparatively less significant. Due to the fact
Four contingent functions of money were mentioned
that this function derives from core functions.

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Money and Banking
by Prof. Kinley. The following are these activities. Central Bank and Its functions

● Basis of credit: The use of credit instruments The central bank runs a country’s financial
including checks, draughts, bills of exchange, and system. The central bank is the leading institution
promissory notes are growing significantly in the in a country’s financial system, which includes
modern era. The issuance of credit instruments is commercial banks. It affects how the monetary
based on a cash reserve. The issuance of a credit and financial system is governed, controlled, and
instrument like a check is based on monetary evolved. A central bank is the nation’s principal
deposits. So, a basis for credit is money. financial organisation and can oversee, direct, and
● Distribution of national income: On this support the financial system, subject to legislative
foundation, the national banks also extend limits. It prioritises the national economy before
credit. The collaboration and coordination of personal riches and is not profit-driven.
several production factors result in income. The
factors receive a monetary distribution of this Up until the turn of the 20th century, central banking

national revenue. The financial value of each was developed as a result of a delayed assessment

factor’s contribution is calculated. In the era of some already-existing commercial banks. The

of contemporary specialised labour, it would majority of these banks were privately owned, but

be challenging to distribute production across thanks to their strength and overwhelming size, they

factors in the absence of money. were able to gain certain authority that was regarded
as central banking. Over time, nevertheless, codes
● General form of capital: Almost all capital or
and ethics of laws and customs governed their
wealth today is stored in the form of money. As a
labour. As a result, central banking evolved into
result, capital is more liquid and mobile.
a separate institution. Early in the 20th century,
● Maximum benefit: Money helps people enjoy central banks were established by means of formal
their own gains more. The law of equi-marginal legislation.
utility asserts that humans are happiest when
all commodities have equal marginal utility. In the 1920s, the International Financial Conference
People spend money to equalise marginal utility in Brussels proposed establishing a central bank to
and maximise satisfaction. Producers spend on manage the financial system. Following then, many
other factors to equalise marginal productivity. Central Banks were founded. The creation and
This increases production and producers’ profits. implementation of a nation’s monetary and credit
policies are within the purview of the central bank,
which has additional duties. In every economy, the
central bank serves as the primary regulatory body
for the nation’s banking and financial system. The
RBI, our nation’s national bank, was established in
1935.

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Money and Banking
Functions of a Central Bank ● The monetary system of note issuance and
circulation becomes more uniform as a result.
Central bank operations varied throughout time.
● The country’s money supply can be better
Their development was driven by the need to
managed by the central bank. It boosts citizens’
find new ways to direct, regulate, and aid the
trust in the nation’s monetary system.
financial system (particularly, the banks). Central
● Paper money’s monetary management becomes
bank actions have often followed major world
simpler.
economies’ financial institutions. A central bank
does two things: ● It enables banks to exert control over the way
that private banks create credit.
● Leading Functions
● The printing of paper money brings in revenue for
● Other Functions the central bank as well.

● Giving the central bank the exclusive ability to

issue notes prevents political meddling in note-
Leading Functions issuing decisions.

(a) Issue of notes: With an ever-increasing number Initially, central banks were privately held and
and variety of financial products, institutions, and engaged in business competition with other banks.
markets, a nation’s whole financial system requires Therefore, they were inclined to issue too many
a steady flow of legal tender money. The volume notes back then in order to increase their income.
and makeup of this legal cash frequently change to The authorities believed that action needed to
reflect the shifting demands of the economy. As a be done in order to stop this abuse of the right
result, the country’s central bank is given exclusive to monopoly note issuing. Partial or complete
authority to issue money. elimination of the incentive to issue too many
notes—i.e., guaranteeing that the assets the central
The economy’s bank note issuance is monopolized
bank purchases in exchange for its note issue
by the central bank. For two reasons, the central
are not income-producing—was attempted as a
bank is granted the exclusive right to issue notes:
solution to this issue. Gold bullion and coins were
to be used as the non-income-producing assets to
● A central bank’s liabilities are the currency notes
support the note issue.
it issues, and in exchange, it receives some
assets that can provide income for it.
Without making any mention of the note’s gold-
● It is possible to guarantee that the central bank
backed backing, a maximum issue limit may be
does not overissue currency notes by suitable
set. This approach is obviously quite constrictive.
law or other means.
The availability of legal money is unable to
keep up with the rising demands of a growing
The following list outlines the principal benefits of
economy. Legislatively changing the limit can be
giving the central bank the exclusive power to issue
quite laborious and disruptive. There may be a
notes:
requirement that the percentage of gold supporting

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Money and Banking
a note issue must not fall below. system of centralized cash reserves.

● The central bank’s cash reserves can be used to

(b) Banker to the banks: The central bank’s second
advance the welfare of the country.
main function is to bank the banks. Commercial
banks and central banks share the same clients.
As the bankers’ bank and the nation’s top bank,
It protects member banks’ cash reserves, provides
the central bank is the lender of last resort. If
loans when needed, and advises on financial and
commercial banks can’t meet their financial needs
economic matters. Three ways the central bank
from other sources, they may contact the central
benefits bankers:
bank. The central bank helps commercial banks by
rediscounting qualifying securities and exchange
● As keeper of the commercial banks’ cash
bills.
reserves
The following are the key benefits of the central
● As the lender of the last resort
bank acting as the lender of last resort:
● As clearing agent
● It boosts the economy’s entire credit structure’s
elasticity and liquidity.
The central bank serves as the commercial banks’
friend, philosopher, and mentor. The central bank ● It makes it possible for commercial banks to

oversees the maintenance of the commercial continue operating even with little capital on

banks’ cash reserves in its capacity as custodian. hand.

Every commercial bank is required to maintain a ● In times of need, it offers financial assistance to
specific proportion of its cash balances as central commercial banks.
bank deposits. Commercial banks may use these
● It makes it possible for the central bank to have
cash reserves in emergency situations.
control over the nation’s banking sector.

The following benefits result from centralizing cash

reserves at the central bank:

● The public gains trust in the nation’s banking

sector as a result.

● As opposed to if these sums were distributed

among the many banks, it offers the foundation
for a broader and more flexible lending system.
The central bank functions as these banks’ clearing
● During times of seasonal stress and financial
house because it is the custodian of their cash
problems, centralized reserves can be utilized to
reserves. Since every bank has an account with
the maximum extent and most effectively.
the central bank, it is simple for the central bank
● Through the use of a variable cash-reserve ratio, to resolve disputes amongst banks with the least
the central bank is able to affect how much credit amount of cash. The central bank’s clearing house
is created by commercial banks thanks to the function benefits from the following:

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Money and Banking
When banks settle their claims and counterclaims, reserves are linked. Capital flows, trade credits,
it minimizes the use of cash resources. and other factors affect foreign exchange reserves.
The central bank must balance opposing impulses
● It lessens cash withdrawals, allowing commercial between domestic money supply, price level, and
banks to generate credit broadly. exchange reserves.

● It fully updates the central bank on the commercial

(e) Management and regulation of exchange rate:
banks’ liquidity situation.
The management, control, and stabilization of

Banker to the government: The nation’s central the currency rate are related duties that fall under

bank serves as the government’s banker as well. the purview of the central bank. When the central
bank is also in charge of managing official foreign
The central bank serves the government in the exchange reserves, this duty is made easier. With
same capacity as a commercial bank and serves its the constantly expanding worldwide links, the need
clients as a “Banker to Government.” It keeps track for a stable exchange rate has become apparent. It
of federal and state government finances, takes was crucial in this situation that this task was carried
government deposits, grants short-term loans, out by an experienced agency, and the nation’s
collects government checks and draughts, and central bank is thought to be the greatest such an
provides foreign exchange resources for paying organization. Being the top financial institution in
off foreign debt, buying foreign commodities, and the nation, the central bank has access to the most
other payments. data and is skilled at determining financial patterns
and the kinds of corrective actions that are required.
The central bank collects taxes and other government It also has a number of regulatory authorities over
debts. It controls the national debt by seeking the financial system. It can think about and take the
public financing. It represents the government at additional procedures necessary to guarantee the
conferences and financial organizations. success of the exchange rate actions.

The central bank assists the government on (f) Credit control: Today, a central bank’s primary
economic, monetary, financial, banking, and responsibility is to regulate credit growth in order
fiscal issues such as deficit funding, currency to achieve a stable general price level and a
depreciation, trade policy, and foreign exchange number of other socioeconomic goals. The right
policy. and authority to rule over all banks have been
granted to the central bank. For credit control, a
(d) Foreign Exchange Reserves Custodian: The central bank can use a variety of quantitative and
guardian of the foreign cash acquired from many qualitative techniques, such as bank rates, open
nations is the central bank. This has grown to be a market operations, adjustments to the reserve
crucial role for the central bank. These days, as a ratio, selective restrictions, etc. Credit regulation
result of its ability to stabilize the currency’s external has evolved into a key duty of a contemporary
value. This system enables the government to central bank. In the past, the phrase “credit control”
better manage and coordinate the nation’s financial refers to limiting credit and money supply. The
affairs. Market money and foreign exchange phrase is currently used to refer to a wider range of

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Money and Banking
concepts, including the components of money and For India, the Reserve Bank of India
credit, their flows, how they are distributed among
borrowers and alternative uses, and the terms and For Europe, European Central Bank
conditions that go along with them. Due to the fact
that “money cannot manage itself,” credit control is Commercial Bank & Its functions
necessary. Money and credit flows tend to amplify
cyclical variations when left to unchecked market A commercial bank is an organization with the
forces. legal right to offer a range of financial services,
such as savings accounts, consumer and business
Other Functions loans, etc. In the past, commercial banks could
only accept valuables or cash as security deposits,
(a) Collection of data: Almost all central banks check the purity of coins, or swap one jurisdiction’s
frequently gather statistical data pertaining to currency for another. Most of the foundational
economic aspects of money, credit, foreign currency, elements of contemporary banking, such as foreign
banking, etc. on a periodic basis. For the purpose of exchange, interest collection, and loan granting,
researching various facets of the aforementioned were established by the 17th century.
issue, committees and commissions have been
established. The following two categories broadly classify the
duties performed by commercial banks:
(b) Developmental banking: Lack of capital
formation, which is primarily caused by a lack of
saving and investing, is the fundamental issue
facing less developed nations. As a result, the central
bank can be crucial in fostering capital formation
by encouraging investment and mobilizing savings.

An underdeveloped nation is said to need an all-

encompassing strategy to address its issues with
growth and poverty. Although the central bank Primary Functions

plays a vital part in its growth policy by regulating

(a) Accepting deposits: The public, businesspeople,
the amount of money and credit as well as other
and others can deposit money with commercial
aspects of it, much more is required to make it truly
banks in the form of
effective. When viewed in this light, a central bank’s
responsibilities begin to encompass a far wider
● Saving Deposits
range of activities than is typically thought of in the
case of central banks in industrialized nations. ● Time Deposits

● Current Deposit
Distinct nations have different central banks. For
example, To promote saving in the economy, banks under the
saving deposits program allow small deposits from
105
Money and Banking
individuals or households. Secondary Functions

Fixed deposits are accepted for a predetermined (a) Agency service: Banks represent their clients
amount of time. In comparison to savings deposits, by providing a range of services on their behalf,
it offers a larger rate of interest. including:

If a customer has a current account, the bank ● Bills, draughts, checks, dividends, etc. collection
agrees to honor all checks written against their
● insurance premiums, loan payments, rent, and
deposits, provided there are sufficient funds in the
other expenditures, etc.
account. The current account balance frequently
● Act as a customer’s representative for stock
experiences overdrafts up to a certain limit. On
exchange activities including the buying and
these types of deposits, no interest is given.
selling of stocks, etc.
Business homes typically use these.
● serving as an executor, administrator, or trustee
(b) Lending of fund: Lending money to customers for a client’s estate.
in the form of loans and advances, cash credits,
● Other services like filing tax refund claims and
overdrafts, and bill discounts, among other vital
preparing income tax returns are available.
activities, is one of the many tasks performed by
commercial banks. (b) General utility services: Commercial banks
offer a variety of general utility services, such as
Loans are similar to advances that banks give to
traveler’s checks, lockers for valuables, debit and
their clients for a set length of time at an agreed-
credit cards, etc.
upon interest rate, with or without the need for
security. In this scenario, banks credit the loan Monetary Policy
amount to the client’s account, which allows him to
withdraw it as needed. We meant the type of policy that affects changes in
the money supply when we said “monetary policy.”
Banks provide their customers with the Cash Credit As a result, it only makes sense to characterise
Facility, which allows them to borrow cash up to a credit policy as a policy that considers changes
certain level against the security of products. in the credit supply. A nation’s monetary policy is
determined by the Central Bank and entails using
A bank’s overdraft policy permits customers
monetary measures to control the cost, availability,
to temporarily overdraw up to a predetermined
and use of credit and money in order to accomplish
amount. Banks also discount bills. After discounts
specific objectives. These goals are:
and commissions, banks credit bills to consumers’
accounts, which will be returned when the ● Maximising feasible output
instrument matures.
● High rate of growth in GDP

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Money and Banking
● Full employment the economy is driven by a free market. The area
of the economy that receives the additional credit
● Price stability (optimal rate of inflation) Greater
supply or that it is drained from is therefore of little
equality in the distribution of income and wealth
concern to the authorities. The entire economy may
● Positive balance of payments
or may not experience the impact.
● High rate of savings and investment
(a) Bank Rate: “Bank rate” is the central bank’s
● Reduction in Income Inequalities
interest rate. Central banks utilise it to manage the
● Regional Balance Development
money supply. “Bank rate” is the discount rate used
by the central bank. Both rates equalise central
Monetary policy governs the money supply.
bank borrowing costs.
Lowering interest rates boosts economic stability
and growth. In India, monetary policy refers to the
The bank rate, the rate at which the central bank
choices the government and RBI make to stabilise
grants credit despite being the country’s lender
the money supply, credit, and interest rates, and
of last resort, determines current interest rates.
their effects on macroeconomic variables like
When the market must pay more for central bank
savings, investments, output, prices, and income.
funding, corporate interest rates climb. Higher
Monetary theory optimises monetary policy.
interest rates are expected to limit loan demand
and hinder investment activity. Higher borrowing
Through tools for credit control, RBI carries out the
costs enhance manufacturing and supply costs,
monetary policy. These tools are divided into two
prompting suppliers to raise prices or absorb the
categories:
increase. First, falling market demand causes a
recession. In the second case, new investment is
stifled. A lower bank rate raises the market interest
rate. Lower borrowing costs hurt the corporate
sector’s cost structure. As bank rates rise, business
loan demand typically declines and vice versa.

1.General or Quantitative Credit Control Measures

(b) Open Market Operations (OMO): When the bank

These regulations do not discriminate between rate is insufficient to control money and credit, the

banks or the purposes for which credit may be central bank may use open market operations. This

granted. These have no specific guidance as to how tool refers to the Central Bank’s endeavour to sell

they might be applied; rather, they are motivated by and acquire commercial paper and government

the desire to affect the overall level of credit in the securities to regulate credit. OMO now includes

banking system. They merely seek to control the swapping or the simultaneous purchase and selling

total amount of credit and money accessible to the of securities with different maturities. OMO is

economy. They do not make a distinction between confined to government securities.

the types of borrowers receiving loans or the

Open market mechanisms affect the economy both
purposes for which borrowers use the loans. These
ways. First, through affecting market credit and
measures are employed with the presumption that
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Money and Banking
interest rates. When the central bank sells securities needs or to close a short-term deficit, the RBI lends
and collects the proceeds, the market’s money money to bankers in exchange for securities that
supply is lowered. Loss of cash balances reduces have been approved. A lower repo rate will boost
commercial banks’ ability to create loans. Overall, the banks’ ability to borrow, which will raise the
market access to credit and money is reduced. The amount of money they have available for lending.
central bank purchases assets to raise money and As a result, the availability of credit will expand. The
credit on the market, resulting in a market loss. alternative idea is called a reverse repo rate. Due
to the favourable interest rates, banks may transfer
(c)Variable CSR: The conventional tools of more money to the RBI as the reverse repo rate
quantitative credit management, bank rate policy, rises, which will reduce their ability to provide loans.
and open market operations all have flaws that
make them unsuitable for serving the needs of 2.Selective Credit Control Measures:
developing nations. As a result, the variable reserve
ratio—a completely novel and unconventional By their very nature, these policies aim to control
device of quantitative credit control—became particular economic sectors. Selective credit
popular. In order to manage credit, the central bank control measures are implemented by giving
employed two different forms of reserves. the banks clear instructions. They may practise
discrimination between banks, borrowers, and the
The central bank can regulate the amount of reasons for extending credit.
credit in the market by altering these ratios. Does
the central bank provide both pros and cons? By The following credit control methods are typically
changing these ratios, once enters the system. employed by the central bank:
Depending on the economy’s needs for money and
the reserve requirement, the central bank may alter ● Determining the margin and the maximum loan
this requirement. amount that can be secured by securities.

● Giving instructions to commercial banks that

Higher CRR limits banks’ ability to lend, while include statements and cautions that regulate
lower CRR increases it. CRR lowers bank earnings. their operations
Central bank deposit rates are lower than market
● Credit is rationed to limit the uses to which it is
rates. The minimum balance a bank must maintain
made available.
depends on its deposit liabilities. Most banks have
larger-than-needed central bank deposit accounts. ● Convincing people morally to support the
monetary policy.
(d)Repo rate and reverse repo rate: Repo and ● Direct action against negligent commercial
Reverse Repo Rate are additional tools employed banks
by the central bank in addition to the one mentioned
above. When commercial banks need to borrow Fiscal policy
money from the central bank because they are low
on cash, the cost at which they do so is referred Fiscal policy is the process by which the government
to as the repo rate. In order to cover their ongoing modifies the amount of money it spends and the

108
Money and Banking
tax rates it levies in order to have an impact on and Additionally, this policy is employed when the
keep track of the country’s economy. economy is experiencing a recession and the rise
in the national income is insufficient to maintain the
The fiscal policy is made up of a number of population’s standard of living.
component policies or a combination of policies.
These include spending on welfare, taxes, and Therefore, lowering taxes and increasing
subsidies. Fiscal policies are also influenced by government expenditure would stimulate economic
specific investment and disinvestment practices development and lower unemployment rates.
as well as debt and surplus management. Budget, Nevertheless, this is not a long-term fix. because
taxation, public spending, public revenue, public there can be a budget deficit as a result. The
debt, and the economy’s fiscal deficit are a few of government should therefore use this with care.
the main tools of fiscal policy.
Neutral Fiscal Policy
The government may adjust public spending and
taxation to counteract unfavorable changes in This strategy indicates a balance between public
private investment and consumption. spending and tax revenue, which also means
that public spending is funded entirely by taxes.
Various Types of Fiscal Policies Additionally, the overall budget result will have no
impact whatsoever on the volume of economic
Contractionary Fiscal Policy activity.

This entails boosting taxes or reducing government Additionally, monetary policy is influenced by and
spending. As a result, tax income is more than flows into fiscal policy. The government has a
surplus when more money comes in than it goes
out. A deficit occurs when the government spends
more than it takes in. It must borrow money from
domestic or international sources, use its foreign
exchange reserves, or print money in an equivalent
quantity to cover the higher expenses. Other
economic factors frequently are influenced by this.

Inflation results from an excessive amount of

government spending. Additionally, it reduces the
money printing, in general. A government debt
economy’s total demand, which slows economic
crisis results from excessive foreign borrowing.
development and lowers inflationary pressures.
The government’s excessive domestic borrowing
could result in higher real interest rates and the
Expansionary Fiscal Policy
domestic private sector’s inability to access capital,
“crowding out” private investment. Therefore, it
Typically, this is done to help the economy. As a
may be said that the budget imbalance is a double-
result, the economy’s growth rate is accelerated.
edged sword that needs to be handled with extreme

109
Money and Banking
caution. taxation is India’s main source of resource
mobilization.
Fiscal Policy of India
● Public savings: By lowering government
spending and raising the surpluses of public
Main Objectives of Fiscal Policy in India
sector businesses, the resources can be
mobilized through public savings.
Prior to discussing the goals of India’s fiscal
policies, it is important to understand the overall ● Private savings: The government can raise
goal of fiscal policy. money from the private sector and households
through efficient fiscal initiatives like tax benefits.
● The following list of general fiscal policy goals: Resources can be raised by the government
issuing treasury bills, issuing government bonds,
● Achieve and retain full employment.
etc., borrowing from domestic and international
● To maintain the current price level. lenders, and financing the deficit.
● To maintain the economy’s growth rate.
2. Reduction in inequalities of income and wealth:
● To keep the Balance of Payments in balance.
Fiscal policy seeks to achieve social justice or
● To encourage the economic growth of developing equity by minimizing income disparities among
nations. the various societal groups. Rich persons are
subject to higher direct tax rates than lower-income
India’s fiscal strategy has traditionally had two categories, such as income tax. Additionally,
main goals: enhancing economic growth and indirect taxes are higher for semi-luxury and luxury
guaranteeing social justice for the populace. goods, which are primarily used by the upper middle
class and upper class. To better the lives of the
The following goals are intended to be attained
underprivileged in society, the government devotes
through the fiscal policy:-
a sizeable percentage of its taxable income to the
implementation of Poverty Alleviation Programs.
1.Development by effective mobilization of
resources: Making sure that the economy grows
3.Price stability and control of inflation: Controlling
and develops quickly is fiscal policy’s main goal.
inflation and maintaining price stability is one of
The mobilization of financial resources can
the fiscal policy’s primary goals. As a result, the
help to attain this goal of economic growth and
government always strives to keep inflation under
development. Fiscal policy has been utilized by the
control through the reduction of fiscal deficits, the
national and state governments of India to mobilize
introduction of tax savings plans, the efficient use
funding.
of financial resources, etc.

Mobilizing the financial resources involves:

4.Employment generation: Through efficient fiscal
policies, the government is making every effort
● Taxation: The government attempts to mobilize
to increase employment in the nation. Direct and
resources through effective fiscal policies
indirect employment has been produced as a result
through both direct and indirect taxes because
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Money and Banking
of infrastructure investment. Small-scale industries 7.Increases national income: The effectiveness of
are encouraged to invest and create jobs by having fiscal policy is what drives the desired outcomes in
lower taxes and levies. The Government of India the economy. The country’s direct and indirect tax
has launched a number of rural employment rates are raised by the government when it seeks
programs to address issues in rural areas. Similar to increase national income. Other approaches
to this, self-employment programs are used to give include lowering the tax rate to encourage more
technically skilled individuals in metropolitan areas people to pay their fair share of taxes.
employment.
8.Development of infrastructure: The infrastructure
5.Balanced regional development: The government of the nation is improved when the government of
is undertaking a number of projects to address the concerned nation spends money on projects like
the regional imbalances in the nation, including roads, dams, schools, trains, and other amenities to
the construction of dams on rivers, the generation promote citizen welfare. The key to accelerating the
of electricity, schools, highways, and industrial nation’s economic growth is a better infrastructure.
projects. Public money is used to do this.
9.Foreign exchange earnings: When a nation’s
6.Reducing the Deficit in the Balance of Payment: central government offers incentives to producers
To increase exports from the nation, the government of goods for domestic consumption, such as
occasionally offers export incentives to exporters. exemptions from customs duties and reduced
Import-controlling methods are also used in the excise taxes, it encourages foreign investors to
same way to limit imports. Therefore, the combined boost their investments in the host nation.
effect of these policies is an improvement in the
nation’s balance of payments.

Summary

Banks are well-organized institutions that provide borrowers with loans and take deposits from customers
who wish to borrow money. On the other hand, money is the vehicle of exchange that enables one person to
purchase goods from another, hence money is essential to the process of bartering.

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Money and Banking
 Unit 14

Aggregate Demand and

Aggregate Supply

Learning Objectives Introduction

By the end of this unit, you will be

The demand for all products and services taken together
able to understand:
is what economists mean when they talk about “aggregate
● Aggregate demand, aggregate
demand.” In another formulation, “it is the total amount of
supply
purchases that investors, investors, and the government
● Deficit demand and excess are willing to make,” “it is the full amount of purchases
demand that investors”

● Government demand and the

Consequently, the four elements listed below make up
economy
aggregate demand or aggregate expenditure:

● Demand arising from household consumption:

Household consumption demand is the total amount of
products and services needed by all U.S. households.
Household disposable income directly affects
consumption demand. A household’s disposable
income stimulates consumption. Income rises faster
than consumption. Increasing household income
boosts savings.

● Private investment demand: The term “investments”

refers to monetary quantities that are put toward
the production of new forms of capital. The current
interest rate, as well as the marginal efficiency of the
capital both, have an effect on private investment.
An entrepreneur will keep investing up until the point

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Aggregate Demand, Aggregate Supply
 where the rate of interest reaches the same level Investment spending and consumer expenditure
as the marginal efficiency of capital (MEC). together make up aggregate demand. Simply said,

● Demand from the government for various goods

Y=C+I
and services: Government is now a significant
consumer of goods and services. These are
Where, Y = Income or aggregate demand;
required by the government in order to fulfill
public necessities such as the upkeep of law
C = consumption demand
and order, infrastructure, roads, schools, and
hospitals.
I = invested demand
● Net export demand: Net exports measure foreign
demand for a country’s products (exports minus The schedule for aggregate demand, which
imports). It’s influenced by trading partners’ trade displays levels of investment and consumption, is
policies, relative goods prices, country incomes, as follows:
currency rates, etc.

Level of Consumption Investment Aggregate

income expenditure expenditure expenditure
(Y) (C) (I)
(C+I)

0 10 10 20
5 15 10 25
10 20 10 30
15 25 10 35
20 30 10 40
25 35 10 45
30 40 10 50

Table 11.1

Aggregate Supply

It is a measure of the sum of an economy’s output

over a given time period. GDP is the only metric
that matters. Income is subsequently dispersed
to factors in the form of wages, rent, interest, and
profits, which together equal the whole cost of
production, which is reflected by the total supply.
The cost of production in an economy must be
passed on to those who undertake it. Thus,

Figure 11.1: Aggregate demand curve Aggregate Supply = Consumption + Saving

113
Aggregate Demand, Aggregate Supply
Y=C+S vairables.

where Y, consumption, saving, and total factor The aggregate supply schedule displays levels of
income, or gross domestic procuct, are the three investment and consumption as follows:

Level of Consumption Saving (S) Aggregate

income expenditure Supply
(Y) (C) (C+S)
0 20 -20 0
10 25 -15 10
20 30 10 20
30 35 -5 30
40 40 0 40
50 45 5 50
60 50 10 60

Table 11.1
The graphic below depicts the aggregate supply Economy’s surplus demand is (excess demand). At
curve. As shown below, the aggregate supply curve full employment, demand is AB lengths larger than
is a straight line that makes a 45 degree angle with supply. Inflationary gap: When aggregate demand
the origin. is AY and aggregate supply is BY. AY, demand
exceeds supply. AY-BY=AB (inflationary gap).

Figure 11.2: Aggregate supply curve

Deficit Demand and Excess Demand

Figure 11.3: Excess demand

When demand exceeds supply at full-employment
income levels, there is excess demand. “Inflationary Impact of Excess Demand on the Economy
gap” is disparity between full-employment demand
and supply. When expected expenditure exceeds If the economy suffers involuntary unemployment,
existing output, an inflationary gap arises. A demand will enhance employment and output. Full
growth in demand beyond full employment does employment and rising demand will cause price
not affect output or employment, only prices. Fig. hikes and inflation. Production and employment
114
Aggregate Demand, Aggregate Supply
can’t rise. A minor rise in labor productivity could competitive;
boost output, but short-term economic cycle
● Elasticity of the supply of production inputs;
estimates don’t consider this.
● Impact of labor unions

Deficient Demand
If the economy is competitive (has many producers),
a decline in total demand will cause prices for
Deficient demand occurs when the total demand
products and services to drop quickly. However, if
for goods and services is less than the total
the economy is oligopolistic (characterized by a
supply at full employment income. Also called
small number of dominant sellers), then output and
the “deflationary gap.” Widespread unemployment
employment will be more significantly impacted
stems from deflation. A surplus economy develops
than prices. In this kind of economic organization,
when supply exceeds demand. It’s inadequate.
output and employment may decline.

The subsequent Fig. Deficient demand in the

The supply-side elasticity of major production
economy is explained by this phenomenon. At full
parameters affects output, employment, and prices.
employment, it can be shown that the aggregate
A competitive economy and elastic factor supply
demand, measured by CD length, is less than the
won’t influence prices (small changes in price
aggregate supply. Aggregate supply is CY, while
result in infinite changes in the supply of factors).
aggregate demand is DY, forming what is known as
Changes in output and employment correspond to
a deflationary gap.
demand. Prices decline if the supply of factors is
inelastic.

The impact of trade unions is equally significant.

It’s possible that unions won’t accept lesser pay. In
other words, manufacturers will be forced to reduce
output and employment if salaries are prevented
from falling along with a decline in overall demand.

Demand Causes:

The following are crucial elements that affect

Figure 11.4: Deficient demand whether there is too much or not enough demand

Economy’s Deficient Demand: in the economy:

Deficient demand’s effects on output, employment, ● An increase in government expenditures that is

and pricing can all be studied separately. However, not accompanied by an equivalent rise in taxes

it should be noted that its impact depends on a If government spending is greater than receipts,

number of variables, some of which are significant. deficient demand may result.

● Without an increase in the current savings, there

● Whether the economy is oligopolistic or
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Aggregate Demand, Aggregate Supply
 is an increase in investment (caused by prior Taxes, especially corporation and income taxes, can
savings). without a comparable rise in taxes. be decreased to boost real demand by promoting
Deficient demand could result from the lowered private investment. Government spending on
autonomous investment. transfer payments, such as unemployment benefits,
tax collections, etc., inevitably decreases during
● The surplus in the balance of payments is
recessions. To increase demand, robust public
growing. Deficient demand could result from
works projects may be implemented.
growing balance of payments deficits.

● The supply of consumer products and services

Monetary Policy
will decrease if available resources are employed
to produce goods other than consumer goods. Monetary policy is the process by which central
There will be surplus demand since the available banks influence the economy’s money supply.
output is insufficient to meet the total demand. That is to say, it is related to fluctuations in interest
In contrast, a decrease in capital formation will rates and market access to credit. Higher interest
result in insufficient demand. rates result in more expensive loans, which deters
real demand. As borrowing costs rise, investors
Corrective measures for excessive and insufficient
grow discouraged. Therefore, surplus demand is
demand
decreased. On the other side, a declining interest
rate lowers the cost of borrowing. Borrowing by
In general, there are the following strategies for
investors is encouraged to increase. The low rate
overcoming excessive or insufficient demand:
of interest will boost investment if the marginal
efficiency of capital stays constant. Deficient
Fiscal Policy
demand hence tends to be addressed in the
economy.
Government spending and taxation policy refer
to this. Fiscal policy affects aggregate demand
Availability of Credit
greatly. In a scenario of excessive demand, it may
be beneficial to limit government spending in order
Credit is produced in the economy by commercial
to lower the budget deficit and increase incomes
banks. It is necessary to affect bank credit in order
and revenues through non-inflationary means, such
to affect credit availability. Following are some key
as borrowing and progressive taxes.
financial instruments that a nation’s central bank
can use to manage credit:
Borrowing will lower people’s purchasing power,
which will lower effective demand. Similar to ● Cash reserve ratio: Each commercial bank
taxation, which removes money from circulation must hold a minimum portion of its deposits
and lowers the real demand. Increased government with the central bank. Raising this ratio reduces
spending can be used to address an increase in the commercial banks’ cash reserves. They must
budgetary deficit, while other inflationary methods borrow money. The economy’s excess demand
such as printing more money can be used to decreases. In low-demand, credit-expanding
address deficient demand. scenarios, the central bank lowers the cash

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Aggregate Demand, Aggregate Supply
 reserve ratio. Banks will have more funds to lend a specific monetary policy before asking for it.
and credit to create. This operates in oversupply and undersupply.

● Bank rate: “Bank rate” is the interest rate a central

bank lends to commercial banks. Increasing this
rate raises borrowing expenses. Credit contracts.
Insufficient demand lowers bank rates. When
the bank rate is lowered, the interest rate falls,
too. The credit supply expands. This is because
businessmen borrow more.

● Open market operations: “Open market

operations” describe how the central bank trades Foreign Trade Policy
government assets. These procedures affect
cash reserves and the cost and availability of Exports and imports are the main components
borrowing. Commercial banks or their clients of foreign trade. A favorable international trade
buy these assets, but the central bank sells them policy can have a significant impact on both
when demand is high. Government securities excessive and insufficient demand. More exports
sales reduce bank cash holdings, limiting their boost revenues immediately and raise spending.
ability to lend credit and rejecting deposits. The However, increased revenues also increase the
central bank’s securities purchases increase need for imports. As a result, a portion of the
commercial banks’ cash reserves. Governments money earned by the economy is used to buy items
distribute money to commercial banks and their that are imported into the nation but produced in
clientele. Deposits and credit rise. Demand is other economies. This will lower the extra demand
corrected. to some extent.

● Changing margin requirements: The amount

An economy might build up its import surplus and
that must be put down as a percentage when a
minimize the inflationary gap in order to remedy
company borrows money to finance the purchase
for excessive demand (excess of imports over
of stock. The central bank increases the margin
exports). Selling a nation’s overseas asset holdings,
requirement to reduce excessive demand. Credit
obtaining loans from other governments or other
taken out for speculative purposes is discouraged
international organizations like the IMF, World Bank,
when margin restrictions are increased. This
etc., and receiving grants from other nations are all
causes economic activity to decline, which has
ways to increase or establish an import surplus.
a disinflationary effect. The central bank reduces
the margin requirement to address inadequate
It is possible to reduce inflation by limiting wage
demand.
growth and raising output by making better use of
● Moral suasion: A nation’s central bank utilizes idle (inactive) capacity already in place. A wage
moral suasion to request, advise, and suggest to increase that is accompanied by a rise in labor
commercial banks. The central bank meets with productivity is preferred since it strengthens the
commercial bank leaders to explain the need for position of supply. However, when wages rise

117
Aggregate Demand, Aggregate Supply
without a corresponding rise in productivity, costs by the administration. This particular demand term
and prices also rise. takes into consideration the demand coming from
all levels of government, including the federal,
An increase in production through increased state, and municipal levels. This sum does not
investment is not advised in an inflationary take into account transfer payments such as social
environment as it would just drive up prices even insurance, welfare assistance, or unemployment
more. Without making significant new investments, compensation.
the output can be increased by fully utilizing
the industrial sector’s significant underutilized This model treats the demand from the government
potential. In other words, prices won’t increase in the same way that it does the demand from
while real output does. investments; specifically, it assumes that the
demand from the government is exogenous. This
Surplus exports aid in battling insufficient demand. shows that its value is decided independently
An excess of exports increases overall demand. of the model and is not dependent on any of the
Increasing net foreign investment can boost variables contained inside the model in any manner.
exports. In order to increase exports, an economy Furthermore, this value is not dependent on any of
may have to give up some of the items that are the external factors that may affect the model. The
produced domestically but are in high demand following is an easy formula that can be used to
overseas. The government may increase exports in a calculate the demand from the government:
number of ways, including by removing superfluous
regulations, offering tax breaks, subsidies, and GD = G0,
other incentives, using cutting-edge technology,
and building out contemporary infrastructure. where the “0,” or naught, subscript on the right
side indicates that the variable is exogenous or
Government Demand and the Economy autonomous. In words, the equation says that
government demand is given exogenously as G0.
The phrase “government demand” refers to the
desire for goods and services generated in the The word “government demand” refers to the desire
economy by governing bodies of a nation. This for goods and services generated in the economy by
demand is known as “public sector demand.” For governing bodies of a nation. This demand is known
instance, when the government buys an airplane as “public sector demand.” For instance, when the
for the navy, it creates a demand for goods and government buys an airplane for the navy, it creates
services that have been produced by private a demand for goods and services that have been
businesses. This demand can be satisfied by produced by private businesses. This demand can
meeting the needs of the government. Other be satisfied by meeting the needs of the government.
forms of demand for government services are Other forms of demand for government services are
actually created by the government on their own; actually created by the government on their own;
for example, when teachers volunteer their time to for example, when teachers volunteer their time to
instruct students in public schools. This is also the instruct students in public schools. This is also the
case with respect to several other demands made case with respect to several other demands made

118
Aggregate Demand, Aggregate Supply
by the administration. This particular demand term investments; specifically, it assumes that the
takes into consideration the demand coming from demand from the government is exogenous. This
all levels of government, including the federal, shows that its value is decided independently
state, and municipal levels. This sum does not of the model and is not dependent on any of the
take into account transfer payments such as social variables contained inside the model in any manner.
insurance, welfare assistance, or unemployment Furthermore, this value is not dependent on any of
compensation. the external factors that may affect the model. The
following is an easy formula that can be used to
This model treats the demand from the government calculate the demand from the government.
in the same way that it does the demand from

Summary

The link between the quantity of a commodity that producers seek to sell at various prices and the quantity
that consumers wish to buy is known as the supply and demand relationship in economics. In economic
theory, this is the primary model that is used to explain how prices are established. The combination of
supply and demand in a market will ultimately result in a price for a product being established. The price
that is determined as a consequence is what is known as the equilibrium price, and it is considered to
be an agreement between the consumers and the producers of the commodity. The market is said to be
in equilibrium when the quantity of a good that is produced by producers is equal to the quantity that is
purchased by consumers.

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Aggregate Demand, Aggregate Supply
 Unit 15

Foreign Exchange Rate and BOP

Learning Objectives Introduction

By the end of this unit, you will be

An open economy engages in multiple forms of
able to understand:
communication with other nations. In order to simplify
● Foreign exchange Rate and BOP
our study and explain the fundamental macroeconomic
dynamics, we had not previously taken into account this
element and had instead restricted ourselves to a closed
economy with no connections to the outside world. The
majority of modern economies are indeed open. These
links can be created in one of three ways.

● Output market: An economy can engage in

international trade in both products and services. As a
result, consumers and producers have a wider range of
domestic and imported items to choose from.

● Financial market: An economy can frequently purchase

financial assets from other nations. Investors now have
a choice between domestic and international assets.

● Labour market: Both businesses and employees are

free to select where to locate their production. The flow
of labour between nations is regulated by a number of
immigration regulations.

The movement of goods has long been considered a

replacement for the movement of labour. On the first two
links, we concentrate. Therefore, a country with an open
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Foreign Exchange Rate and BOP
economy is one that engages in trade with other monetary system was established.
countries in commodities, services, and, most
frequently, financial assets. For instance, Indians Gold was no longer a convertible asset into
can purchase goods made anywhere in the world, which national currencies could be exchanged
while some of India’s goods are exported to other as the number of transactions increased. Even
nations. though some national currencies are recognised
internationally, the money used in a trade between
As a result, there are two ways that foreign trade two nations is what matters.
affects Indian aggregate demand. First, when
Indians purchase items from abroad, this spending
leaks out into the economy, reducing aggregate
demand. Second, by acting as an injection into the
circular flow, our exports to foreign countries raise
the overall demand for items produced in the home
economy.
Balance of Payment BOP
Money is required for all transactions when items
are transported across international borders. There The balance of payments is often regarded as one
isn’t a single currency that is issued by a single of the most significant indicators of economic
bank on a global scale. Only when it is believed that health for any nation. It is an organised record of
the number of commodities that can be purchased every economic transaction that took place in a
with a specific amount of a given national currency given accounting year between the people who
won’t change frequently will foreign economic live in one country and the people who live in other
agents accept it. In other words, the value of the countries in the world. It is important to keep in mind
currency will remain stable. that the term “payments” does not refer exclusively
to transactions that involve payments made by a
Governments have in the past made an country; rather, it encompasses transactions that
announcement that the national currency will be involve receipts and payments made by a country.
freely convertible into another asset at a preset In the same vein, the term “balancing” does not
price in an effort to win over potential users. indicate a state of equilibrium or a favourable
Additionally, the value of the asset into which the circumstance; rather, it only denotes the presence
currency may be converted will not be subject to of an accounting balance on a balance sheet
the issuing authority’s control. Gold or other local consisting of revenues and payments.
currencies have traditionally been used as this
other asset. The freedom to convert at any time Therefore, the balance of payments transactions
and in any quantity, as well as the cost at which includes all foreign receipts and payments made
this conversion occurs, are two features of this in a particular year. Earnings and foreign currency
commitment that have impacted its legitimacy. In borrowings are examples of receipts, and both are
order to address these problems and guarantee credited to the balance of payments. The national
stability in international trade, the international accounting system records payments as debit

121
Foreign Exchange Rate and BOP
items when a country spends or lends foreign cash. goods balance is positive while having unfavorable
In a given year, a country’s total revenues indicate its conditions when the balance is negative.
financial inflows, while its total payments represent
its financial outflows. Services Account

Because the balance of payments is a schedule This account tracks the value of exported and
indicating debit and credit transactions, which imported intangibles. Balance of payments
must be equal, it must always be balanced from an “invisible things” The revenues and payments for
accounting or bookkeeping standpoint. Because it’s services are not documented at the port of entry
a schedule. Even when the two amounts are equal, or exit, unlike commodities. In contrast, imports
this does not mean the balance of payments is in and exports are recorded. Transactions related
equilibrium or good. Balance of payments can have to services include transportation, banking and
deficits and surpluses. Most balances of payments insurance, tourism, travel services, the purchase
statements include these major accounts: and payment of goods and services by tourists,
expenses incurred by students studying abroad,
● Goods Account. and the receipt and payment of interest, profits,
dividends, and royalties. These are investment
● Services Account.
income or expenses or “capital services” receipts
● Unilateral Transfers Account
and payments. “Service balance” is the sum of all
● Long-Term Capital Account positive, negative, and zero items in the services

● Short-Term Capital Account. account. Positivity is good for a country.

● International Liquidity Account

Unilateral Transfers Account

Goods Account
The value of gifts, grants, and payments for
reparations made to other nations is tracked in
This account maintains a record of the total value
this account. Government transfers and private
of both merchandise imports and merchandise
transfers make up both of its components.
exports for the specified time period. Within the
Government-to-government transfers occur when a
context of the balance of payments, these aspects
country receives foreign aid or military assistance
of income and expenditure are referred to as
from another nation during a crisis or war. Private
“visible items.” The scenario is referred to as having
transfers are sums of money sent to or received
a “goods balance” of zero if the revenues earned
from individuals in other nations. An illustration of a
from the sale of exported goods are equivalent to
private transfer is when an Indian software engineer
the sums paid for the purchase of imported goods.
employed by Microsoft in the United States sends
If there is a surplus of revenues over payments,
money to his parents who still reside in India.
then the goods balance is said to be positive, and
if there are fewer payments than receipts, then the
Long-Term Capital Account
goods balance is said to be negative. A nation is
regarded as having favorable conditions when its
The amount of capital that has entered or left the

122
Foreign Exchange Rate and BOP
nation over the course of a year is included in this term horizon. These are payments and receipts that
account. Long-term capital mobility is defined as have been made within the past year and a half. The
any quantity of money that has entered or left the vast majority of transactions involving short-term
country over the course of a year or longer. Private money are bank transfers that are used to finance
direct investments, private portfolio investments, commerce and communication.
and loans from the government to other nations
make up this account. Private direct investments are International Liquidity Account
those made by citizens, businesses, and individuals
of a nation both domestically and abroad. Private This account tracks foreign reserves. It involves
portfolio investments are those made in foreign international means of settling international
securities by individuals and businesses within a responsibilities. Table showing balance of payments
nation as well as those made in domestic securities surplus explains International Liquidity Account.
by foreign individuals. Foreign governments may The leading five accounts exceed total payments
receive loans from their own governments as well by $90 million. 970 million in receipts and 880
as loans from other governments to their own million in payments (200+300+80+50+250). Thus,
governments. there’s a $90 million balance of payments surplus
(970-880). Debit $90 million from International
Short-Term Capital Account Liquidity Account. Debit side reflects the purchase
or import of $90 million in gold, net addition to
The short-term capital account encompasses foreign reserves of $90 million, or short- or long-
not only bank deposits but also other forms of term capital lending to other countries.
payments and credit arrangements with a short-

Credit(Receipts) in Debit(Payments) in
$million $million
1. Goods Account 500 200

2. Services Account 100 300

3. Unilateral Transfers Account 70 80

4. Long-term Capital Account 100 50

5. Short-term Capital Account 200 250

6. International Liquidity Account 90

7. Balance of payments 970 970

90 million dollars will be credited to the International Account indicate a balance of payments surplus,
Liquidity Account if the balance of payments is while credits indicate a deficit.
negative. This is because it requires selling or
exporting $90 million in gold, drawing on $90 Six accounts make up a balance of payments. Here’s
million in foreign reserves, or borrowing $90 million a hypothetical balance of payments schedule.
from other countries or international financial
institutions. Debits in the International Liquidity From the table, we may infer the balance of

123
Foreign Exchange Rate and BOP
payments’ main notions. Balance of Trade, Current Balance, Accounting Balance of Payments, and
and Capital Account Balance of Payments, Basic Overall Balance of Payments. Here’s how these
thoughts break down:

Major Accounts Credit Debit Net surplus(+)

(receipts) (payments) Deficit(-)

1. Goods Account 20 18 +2

2. Services Account 10 25 -15

(A)Balance of Trade(1+2) 30 45 -13

3. Unilateral Transfers Account 30 12 +18

(B)BOP on Current account 60 55 +5

(1+2-3)

4. Long term capital account 15 12 +3

(C)BasicBalance(1+2+3+4) 75 67 +8

5. Short term capital account 5 4 +1

(D)BOP on Capital account 20 16 +4

(4+5)

Overall BOP(B+D) 80 71 +9

6. International liquidity account(F) 9

BOP Accounting balance 80 80 0

Balance of Trade of the three components shows the contribution

that international trade makes to GNP. It is important
The difference between the value of products and to keep in mind that the current account balance of
services sold to foreigners by inhabitants and the balance of payments includes all of the receipts
businesses of the home nation and those purchased that appeared due to earnings as well as all of the
from foreigners is the balance of trade or BOT. It’s payments that emerged owing to spending.
the gap between a country’s exports and imports.
When imports and exports are equal in value, Balance of Payments on Capital Account
the trade balance is in balance. Imports exceed
exports, causing a trade deficit. When exports are The long-term capital account and the short-term
worth more than imports, a trade surplus exists. capital account are both parts of the balance of
payments on the capital account. As a result, it
Balance of Payments on Current Account encompasses dealings that entail the transfer of
capital and investment either into or out of the
It is made up of three balances, namely the balance country.
of products, the balance of services, and the balance
of unilateral transfers. It is also referred to as “net Basic Balance
foreign investment” due to the fact that the addition
This is the total of the balance of payments on
124
Foreign Exchange Rate and BOP
both the current account and the long-term capital payments deficit is a debit. BOP is balanced if
accounts; it includes both of those balances. Due International Liquidity has no debits or credits.
to the fact that these tend to be very unexpected Deficits and surpluses are unfavorable BOP
and volatile, the balance of the short-term capital situations.
account is not taken into consideration in this
case. The reason for this is as follows: In addition, Foreign exchange market
the majority of countries do not keep separate
accounting for their short-term and long-term The foreign exchange market is a global over-the-
capital investments. counter (OTC) marketplace that is responsible for
determining the exchange rate that is used for
Overall Balance of Payments currencies all over the world. Other names for this
market include forex, FX, or the currencies market.
The total balance of payments on both the current Participants in these markets are able to purchase,
accounts and the capital accounts is displayed sell, trade, and speculate on the various currency
here. It encompasses all of a nation’s monetary pairs’ relative exchange prices.
dealings with the rest of the globe that take place
on an international level. Foreign currency markets include banks, forex
dealers, commercial companies, central banks,
Accounting Balance of Payments investment management firms, hedge funds, retail
forex dealers, investors, and central banks.
When we talk about the accounting balance of
payments, we mean that there should be an equal Foreign Exchange Rate
amount of debit and credit entries.
The rate at which one currency can be purchased
In the sense of record keeping, the balance of for another is referred to as the foreign exchange
payments must be in a state of balance at all rate (also known as the forex rate). It connects
times. The modifications made to the International the monetary systems of a number of countries
Liquidity Account in the balance of payments and makes it possible to make price and cost
schedule, which can be found either on the credit comparisons across international borders. For
side or the debit side, are what bring about this example, if we have to pay Rs 72 for one dollar, then
balance. the exchange rate is Rs 72 per dollar.

Balance of Payments deficit/surplus Let’s make things easier on ourselves by supposing

that India and the United States are the only two
When autonomous payments (debits) are more countries in the world and that there needs to be just
than autonomous receipts (credits), the balance one exchange rate established to accommodate
of payments is in deficit (credits). Autonomous them both.
payments (debits) equal autonomous receipts in
BOP equilibrium (credits). If International Liquidity
has credit, the BOP is negative. The balance of

125
Foreign Exchange Rate and BOP
Demand for Foreign Exchange Flexible Rate

People need foreign currency because they wish The dynamics of supply and demand in the market
to send gifts abroad, buy financial assets from a decide this exchange rate. Floating Exchange
certain nation, and buy goods and services from Rate is another name for it. The exchange rate
other nations. is established at the point where the supply and
demand curves cross, or at point e on the Y axis, as
The cost of buying a foreign good will go up (in shown in Fig. (Equilibrium under Flexible Exchange
terms of rupees) if the exchange rate goes up. Rates). The number of US Dollars that have been
With everything else being the same, this lowers supplied and sought at the exchange rate are
the demand for imports, which in turn lowers the represented by the point q on the x-axis. The Central
demand for foreign currency. banks do not participate in the foreign exchange
market in a system that is entirely flexible.
Supply of Foreign Exchange

The following are the reasons why a home country

receives foreign exchange: exports by a country
result in foreigners purchasing that country’s
domestic goods and services; foreigners send gifts
or make transfers to a home country, and foreigners
purchase the assets of a home country.

If all other factors remain constant, a rise in the

exchange rate will lower the foreign buyer’s cost
(measured in USD) when purchasing goods from Figure 12.1: Equilibrium under Flexible Exchange Rates
India. As a result, India’s exports rise, potentially
Figure If demand for foreign products and services
increasing the availability of foreign currency.
rises (for example, because Indians are traveling
Whether this happens relies on a number of
more), the demand curve will shift higher and to the
variables, most notably the elasticity of the demand
right (Equilibrium with Flexible Exchange Rates).
for exports and imports.
Increased demand for foreign goods affects the
exchange rate. Since e0=50, we must swap 50
Determination of the Exchange Rate
rupees for one dollar.

The methods used by various nations to calculate

At e1 = 70, we must pay more rupees for a dollar
the exchange rate of their own currencies vary.
(i.e., Rs 70). It displays the dollar’s rise against the
It can be decided using the Managed Floating
rupee’s fall. The increased exchange rate means
Exchange Rate, Fixed Exchange Rate, or Flexible
dollars cost more in local rupees. This is called
Exchange Rate.
rupee depreciation relative to foreign currencies
(dollars).

126
Foreign Exchange Rate and BOP
 bonds in nation A yield 8% and similarly priced
bonds in country B yield 10%, the interest rate
difference is 2%.

The high-interest rates in country B will draw

investors from country A, who will then sell their
own currency and purchase country B’s currency.
Investors in country B will likewise find investing
there more appealing at the same time, which will
lead to a decrease in their demand for currency from
country A. In other words, country A’s currency will
depreciate and country B’s currency will appreciate
Figure 12.2: Effect of an Increase in Demand for Imports in the Foreign
as the supply and demand curves for those
Exchange Market
currencies shift to the right and left, respectively.

Speculation As a result, an increase in interest rates at home

frequently causes the local currency to appreciate.
In any nation, money is a resource. Indians will want Here, it is implied that there are no limitations on
to hold pounds if they think the British pound would purchasing bonds issued by foreign countries.
appreciate against the rupee. Thus, when people
hoard foreign cash in the hope of profiting from the Income and the Exchange Rate

currency’s appreciation, exchange rates are also

impacted. In turn, this expectation may have the When customers’ incomes improve, their spending

following effects on the currency rate. Investors tends to follow suit. It’s also likely that the amount

believe that if they pay the dealer Rs. 80,000 and of money spent on things that are imported will

buy 1000 pounds at the present exchange rate of grow up. As a result of an increase in imports, the

Rs. 80 per pound, they may sell them for Rs. 85,000 demand curve for foreign exchange moves to the

at the end of the month, making a profit of Rs. right. The value of the nation’s currency is currently

5,000 and the pound appreciating to Rs. 85. If the on the decline. If incomes in other countries rise,

assumption raised demand for pounds, the rupee- this will lead to an increase in domestic exports

pound exchange rate would rise. and an expansion of the supply curve for foreign
exchange. There is a chance that the value of the

Interest Rates and the Exchange Rate local currency will decrease overall. The outcome
will be determined by whether or not exports are
The interest rate differential, or the difference in growing at a higher rate than imports. In general, if
interest rates across nations, is a short-term factor there is no change in any of the other components,
that is crucial in driving exchange rate fluctuations. a nation whose total demand grows more quickly
Banks, large organizations, and affluent individuals than the rest of the world would likely suffer a
own enormous sums of money that they move decrease in the value of its currency since imports
across the globe in search of the best interest rates. will outstrip exports. The demand for foreign
If we suppose that equally secure government currencies tends to fluctuate faster than the supply.

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Foreign Exchange Rate and BOP
Exchange Rates in the Long Run The RBI absorbs AB by buying dollars for rupees
in the foreign exchange market. The government
The purchasing power parity (PPP) hypothesis is can intervene to maintain any currency rate.
used when regulating exchange rates is flexible. As long as this involvement continues, it will
Exchange rates should gradually adjust such that accumulate foreign currency. If the government set
the same commodity costs the same amount the exchange rate at e2, there would be an excess
whether measured in rupees in India, dollars in the demand for dollars. To accommodate this demand,
U.S., yen in Japan, etc., as long as there are no trade the government would have to dip into its dollar
barriers like tariffs and quotas. Only transportation reserves. If not, a $1 black market might develop.
costs would differ (quantitative limits on imports).
The exchange rates between any two national Devaluation occurs in a fixed exchange rate
currencies alter over time to reflect variances in the system when a government move increases the
cost of living. exchange rate and lowers the value of the local
currency. On the other side, in a fixed exchange rate
Fixed Exchange Rates system, a revaluation is stated to happen when the
government lowers the exchange rate, making the
The government sets this currency rate. Figure domestic currency more expensive.
e shows the market-determined exchange rate.
Fixed-rate forex market. Let’s imagine the Indian Merits and Demerits of Flexible and Fixed Exchange
government wishes to stimulate exports by making Rate Systems
the rupee cheaper for foreigners. The government
would raise the currency rate from Rs 50 to Rs 70 The primary characteristic of a fixed exchange
per dollar. The government set e1 > e as a new rate system is the requirement of credibility in the
exchange rate. At this currency rate, supply exceeds government’s ability to keep the exchange rate at
demand.. the predetermined level. In a fixed exchange rate
regime, governments frequently have to intervene
to close the gap by using their official reserves if
there is a BoP deficit. People would start to distrust
the government’s ability to maintain the fixed rate
if they knew there weren’t enough reserves. This
could fuel rumors of a devaluation. It is said to be
a speculative attack on a currency when this belief
results in the aggressive buying of one currency,
causing the government to devalue. As was seen
before to the Bretton Woods System’s demise, fixed
exchange rates are vulnerable to these kinds of
attacks.
Figure 12.3: Foreign Exchange Market with Fixed Exchange Rates

The government has more freedom thanks to the

flexible exchange rate system and no longer needs

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Foreign Exchange Rate and BOP
to hold significant amounts of foreign exchange characterized as a controlled floating exchange
reserves. The main benefit of flexible exchange rate system without any formal international
rates is that they automatically correct surpluses agreement. It combines a fixed rate system and a
and deficits in the BoP as a result of changes in flexible exchange rate system (the float component)
the exchange rate. Additionally, countries gain (the managed part). This approach, also known as
independence in implementing their monetary filthy floating, allows central banks to buy and sell
policies because they no longer need to interfere foreign currencies anytime they deem it would be
to maintain an exchange rate because the market appropriate in an effort to control exchange rate
takes care of that for them. fluctuations. Therefore, official reserve transactions
do not equal zero.
Managed Floating

The globe has advanced to a system that is best

Summary

The conversion of one currency into another at a certain rate known as the foreign exchange rate is referred
to as a foreign exchange, also abbreviated as Forex or FX. The forces of supply and demand in the market
cause currency exchange rates to fluctuate continuously. This phenomenon applies to practically all of the
world’s currencies. The United States dollar, the Euro, the Japanese yen, the British pound, and the Australian
dollar are the currencies that are traded the most frequently around the world. The United States dollar is still
the most important currency, as it is responsible for more than 87 percent of the total daily value transacted.

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Foreign Exchange Rate and BOP
Economics and Management Decisions

Unit-16
Case Study: Impact of
Technological Advancements
on Employment Levels
Technological advancements not only lead to structural the city itself. But if these benefits do not expand to other cities in
unemployment but also regional unemployment. Technological the region, the capital city might enjoy the benefits but at the cost
advancement will benefit those locations mostly which have a high of suffering of smaller cities.
concentration of large corporations making use of such technology
and innovations such as London and New York. This advancement of Impact of technology on growth varies from country to country.

a world-class city such as London leads to drainage of employment For developed economies such as the United Kingdom, which is
opportunities from other regions of the United Kingdom. As a result, recovering from the 2008 crisis, growth had been stimulated by
till London continues its love affair with technological advancement, an enhancement in employment opportunities even though the
the benefits reaped from such advancement will be infused within productivity levels have been lingering towards the lower end. As a
result, if technological advancement within the country continues
to create regional unemployment, this could ultimately lead to a
slowdown in the growth of the economy as productivity did not play
a major role in the economic recovery of the UK.

Due to the rapid pace of technological advancements, which is

beyond management by humans sometimes also, there has been
a trend of destruction of jobs in low skill sectors. Simultaneously,
smaller cities are always trying to catch up with the technologically
superior cities leading to the creation of regional unemployment.
But it is pertinent to note that, although technological growth might
create structural and regional unemployment, its overall impact on
the long-term employment rate is insignificant.

This is where the role of Technologically advanced cities like

London becomes more important, for it is up to them to spread
the benefits of this growth to other regional centers by developing
infrastructure, research, and transportation links. Overall levels of
employment may not register significant fall as fall in demand of
low skilled labor is offset by an increase in other job opportunities
as well as people changing jobs between other sectors and trades.
But in the end, there could be a rise in greater inequalities due to the
polarisation of employment levels within different sectors.

Assessment Questions

1. What will be the impact of technological advancements on

employment levels?

2. Will there be any impact on inflation level of the country?