QUESTIONS Chapter 1 : Introduction to Economics 1) What is the importance of scarcity and choice in economics?

2) Distinguish between micro and macro economics. 3) How are economic theory and policy related? 4) State the importance of the Production Possibility Curve. Chapter 2 : Demand, Supply and Elasticity 1) What is demand schedule and demand curve? 2) Explain the law of demand. 3) Bring out the difference between change in quantity demanded and a change in demand? 4) Explain the various kinds of elasticity of supply. Chapter 3 : Macro Aggregates, Unemployment and Inflation 1) How is national income measured? 2) Distinguish between i) NNI-GNI ii) National Income at Market Price and Factor Cost iii) Personal and Disposable income. 3) Discuss the methods of calculating national income, pointing out the deficiencies of each method. 4) Discuss the various types of unemployment. 5) Explain what is inflation. Chapter 4 : Aggregate Demand and Aggregate Supply 1) Explain the unusual nature of the aggregate demand curve and general price level. 2) What are the three effects resulting from a change in the price on the aggregate demand?

3) Explain the two phases in an Aggregate Supply curve. 4) Differentiate between long run and short run supply. Chapter 5 : Output-Employment Theories 1) What is Says Law of markets? 2) Explain the role of effective demand in maintaining high level of employment. 3) Bring out importance of the multiplier. Chapter 6 : Money and Banking 1) What is the advantage of holding money as a paper currency over other kinds of wealth? 2) Explain the functions of money. 3) Explain the process of credit creation with the help of a numeric example. 4) Discuss how a central bank plays the role of a bankers bank? Chapter 7 : Fiscal and Monetary Policy 1) What is the role of fiscal policy in the modern economy? 2) Explain balance, surplus and deficit budgets. 3) Bring out relative importance of fiscal and monetary policies. Chapter 8 : Theory of the Consumer 1) Explain the terms Utility, Marginal Utility and Equimarginal Utility. 2) How does a consumer attain equilibrium? 3) Illustrate and explain Consumers surplus. Chapter 9 : Equilibrium of a Firm 1) How do returns of a firm behave? 2) What are the different types of cost you have studied? 3) Distinguish between

i) Fixed and Variable factors ii) Average and Marginal Cost Chapter 10 : Perfect Competition 1) Explain the features of competition. 2) Discuss i) Uniform price ii) Normal profit 3) What is equilibrium? How do firms attain equilibrium? 4) What is the equilibrium of an industry? 5) What is the effect of shifts in the demand and supply curves? 6) Discuss the types of equilibrium. 7) How can one construct a market demand curve and a market supply curve? Chapter 11 : Monopoly 1) Discuss the features and limits of monopoly. 2) Which are the factors that give rise to monopoly? 3) Explain the term Monopoly Equilibrium. 4) Can a monopolistic situation adversely affect the market? Give reasons for your opinion. Chapter 12 : Oligopoly Market 1) What is Oligopoly? 2) Explain the nature and importance of the Kinked demand curve. 3) Discuss Oligopoly equilibrium. 4) A cartel exploits consumers. Elucidate. Chapter 13 : Monopolistic Competition

1) To what extent can market imperfections reduce economic welfare? 2) Write a brief note on each of the features of monopolistic competition. 3) Chamberlin made certain assumptions to explain equilibrium under monopolistic competition. Which are these? Write a brief account of these assumptions? 4) Give an account of i) Equilibrium and Profits ii) Long run Normal Profits Chapter 14 : Labor Market 1) Explain the marginal productivity theory of demand for labor. 2) What is the nature of labor supply? 3) What are the effects of monopsony? 4) Compare and differentiate between monopsony and monopoly. Chapter 15 : Capital Market 1) Explain the nature of capital. How is capital formed? 2) How is the equilibrium rate of interest determined? 3) What is discounting or present valuation? **********

CHAPTER 1 : INTRODUCTION TO ECONOMICS 1.1 Definition and Nature Economics is a relatively new science: it came into being a little over two centuries ago. So far it has developed into three main stages: the Classical (Adam Smith 1776), the Neo classical (Marshallian 1885), and Modern Keynesian (Macro 1936) schools. Corresponding to these there are three distinct definitions of the subject. Initially it was considered as a science of wealth, through its fourfold activity of consumption, production, distribution and exchange. Marshall related the subject to economic welfare, most closely connected with the attainment and the use of material requisites of well being. However Lionel Robbins (1932) gave the subject a positive scientific basis. His definition is widely acknowledged: Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses. In this way, Robbins has at once relieved economics of both wealth and welfare considerations. It is now considered a science purely of human behavior in specific situations. Such an economic situation is one which is marked, on the one hand, by multiple ends (wants and their satisfaction) and, on the other, by scarce or limited resources (money, land, water, energy, capital etc.). This necessarily compels individuals to economize and optimize; for instance, one attempts to maximize ones satisfaction, profits, wages, salaries, etc. and minimize on ones resources (expenditure, cost of production and effort). This is likely to ensure the best results for all economic activities. Yet economics is neither the science of ends as such nor of scarcity. Resources though scarce, are capable of alternative uses. Land can be used for cultivation (of wheat, rice, cotton, etc.) or construction, or even for commercial purposes. Labor can be employed in various ways - in factories, for road construction, in agriculture etc. Capital can be used for the purchase of factory equipment, for raw materials, or for investing in shares and bonds, etc. Again from among multiple ends like purchasing a car, a house, or traveling abroad, etc. the one which is urgent and the most satisfying can be chosen. Hence under economics one studies the interesting way in which an individual or the society as a whole allocates its scarce resources. 1.2 Macro and Microeconomics These are two branches or rather methods of exposition of the science of economics. The distinction between them can best be explained by comparing their main features. As the terms suggest, macroeconomics deals with the market on a large-scale and its aggregate problems, while microeconomics concerns markets on a small-scale and individual aspects of the problems. There are six distinct aspects of the two approaches that are shown as in the following table: Microeconomics Individual consumers, producers workers, Macroeconomics Aggregate units such as state National or

(a) Units of the study

traders, etc. (b) Activities Optimization and maximization of personal gains and profits. (c) Origin Micro activities emerge on the demand side of consumers choices.

International economy. Long term growth, maintenance of high levels of production and employment. Problems of longterm growth depend upon the supply of productive resources This approach is functional under dynamic conditions and complex long run changes. It deals with complex, dynamic changes inviting the use of advanced mathematical techniques. Macro approach attempts to find the conditions of longterm expansions in output as a whole, assuming relative prices as constant (or significant).

(d) Conditions This approach is functional under static conditions and small time intervals. (e) Methods It is concerned with small adjustments, for which the application of a marginal method is suitable. Micro adjustments in resource A allocation are made in response to changes in relative prices of goods and services. The aggregate level of income or total economic activities is considered to be constant.

(f) Levels

This distinction between micro and macroeconomics as presented above is only a matter of theoretical convenience. The two approaches are complementary and not competitive; one cannot consider these to be watertight compartments. Moreover, the distinction is to be understood as relative in nature. The problems of a city municipal corporation are macro in nature as compared to those of individual citizens, but a city unit is micro as compared to the state, and the state unit is micro as compared to the nation and the national unit can be considered micro in the context of the global economy. Again all economic problems and activities, whether micro or macro are ultimately connected with making a choice and optimization. They emerge out of and are concerned with human behavior.

1.3 Positive and Normative Science Whether economics is a science or a subject of the humanities; and whether it is positive or a prescriptive science is a frequently debated issue. All material sciences such as physics, chemistry, biology, mathematics are pure, abstract and positive sciences. But social sciences like economics, politics, philosophy, history, etc., attempt to analyze human behavior, actions, motives and desires. Human behavior is quite unpredictable. Therefore the degree of positivity and accuracy is expected to be lower in social sciences. Yet the science of economics enjoys the benefit of quantification. Commodities such as machines, tools, land, fruit, clothing, etc. as well as services such as those of teachers, doctors, technicians, etc. which create utility, want and satisfaction are quantifiable. Hence economics has a slight edge over other social sciences. Though economic scientists have all along been striving to put it on a positive scientific footing, there is a limit within which this can be possible. In its initial stage, economics as a subject was introduced in the atmosphere of laissez-faire which was mainly dominated by free enterprise and individualism. But in the 20th century after the two world wars (1914-18 and 1939-44) and the period of the Great Depression (1929-33), the significance of individualism was considerably reduced. It has partly been substituted by large-scale public and governmental activity. Today all over the world, public authorities have been allocating 30 to 35 percent of the national income (Gross Domestic Product - G.D.P.) and national resources towards public expenditure alone. Since a great deal of public expenditure should follow the basic criterion of economic efficiency, this has led to an ever increasing interest in the analysis of the economic policy. Some of the goals that the economic policy aims at can be listed as follows: a. Output and employment: maintaining high levels of output and employment. All ablebodied citizens who desire to work should be provided with job opportunities. b. Aggregate Demand: maintenance of the high levels aggregate demands so as to avoid any fluctuation in economic activities and avoid the dangers of an economic depression. c. Steady Growth: direct the economy in a manner that will enable steady growth conditions. In order to ensure this large-scale public investment programs should be undertaken. d. Price Stability: maintaining fairly stable levels of prices and to check if the average annual growth rate of prices is compatible with the growth rate of productivity. Controlling inflation is a major challenge faced by modern public authorities. e. Redistribution of Income: Usually, market-place distribution of income is likely to be faulty. It may result in economic injustice by aggravating income and wealth inequalities. Public authority holds the responsibility of reallocating a part of the resources from better-off sections (with progressive taxation) into the hands of the poorer sections of the society. A variety of such goals of economic policy clearly suggest that a market place profitmaximizing criterion is not adequate to satisfy these objectives. Therefore public authority has to pursue egalitarian measures: thus the process of determining the norms of economic activity bring in normative considerations. Apart from matters of policy, economists often indulge in value judgments. This is precisely because economists themselves are economic agents or actors and they have their own ideological commitments. An economic researcher is himself

involved in the activities that he is supposed to observe and analyze. By way of example, if he is confronted with a choice between some percent rise in the inflation rate and a rise in the rate of unemployment then he is less likely to prefer the increase in the rate of unemployment. Even otherwise, various statements of economic importance contain an element of value judgment. This can be illustrated by the following statements: a. b. c. d. 'Perfect competition is a just form of the market.' 'Workers must receive minimum wages.' 'Wage cut solution to reduce unemployment may be good economics but bad politics.' 'That government is the best which spends the least.'

All such statements with their content of value judgments make the science of economics prescriptive or normative in nature and reduce its positive strength. 1.4 Positive Economic Theory and Analysis It will be noticed that value judgments and normative elements are unavoidable in economic discussions. Yet economists and researchers take the effort of preserving and developing the scientific content of the subject matter. There is a standard theoretical model generally used and improved upon in most analytical work. This model emerges out of neo-classical techniques introduced at the beginning of this century. Professor Danie M. Hausman in his recent book Inexact and Separate Science of Economics has brought out several basic features of this theoretical model. The important features are : (A) Marginal Approach: The standard theoretical model used in economics is also called a marginal method or approach. This is because all optimizing decisions are taken at the margin under this method. Margin or marginal change means infinitesimally small changes in an economic entity under consideration, such as utility, cost, factor services, wage rate, quantity demanded or supplied, etc. Such a small or marginal change is in fact a mathematical tool used in calculus. In mathematics, the first derivative of any algebraic function is known as the rate of change. In economics, marginal value or quality serves exactly the same purpose. This can be illustrated as: (C) Production Possibility Frontier and Efficiency: Efficiency is an important condition to be fulfilled during the production of goods and services. Economics provides an efficiency test in all the possible economic activities. Only when the economic agents are acting efficiently (maximizing or minimizing accordingly) can their behavior be called rational and only then can they be subjected to a scientific inquiry. In the process of production, a simple analytical tool is employed in the form of a production possibility frontier (P.P.F) and a related schedule. This can be illustrated as: Production Schedules Units of X Units of Y MRS 0 20 -

1 2 3 4 5

18 15 11 6 0

(1 - 2) (1 - 3) (1 - 4) (1 - 5) (1 - 6)

i. Schedule: The table above showing the varying units of X and Y goods produced is called a Production Possibility Schedule. It is a schedule in the sense that at any moment, if we consider the units of X (say 3) to be produced, then the maximum possible units of Y which can be produced (11) can also be known. It is not necessarily based on an empirical or any trial and error method. The relevant information is a result of certain economic hypothesis about production behavior. The schedule is based on certain important assumptions. These include the following : a. b. c. d. The total quantity of various resources and services available for production is fixed. All available resources must be fully utilized. Technical conditions and knowledge (methods of production) remain fixed; and, Only two goods X and Y are produced with these resources.

This shows that, at one extreme, a maximum of 20 units of Y can be produced but only by completely sacrificing the production of X (which is zero at that stage). On the other hand, if all the resources are employed to produce 5 units of X then the production of Y will have to be completely forgone. However, the combinations in between these two extremes show that any desirable combination of the two goods (1-18, 2-15....) can be produced conveniently. There are some interesting features or properties of the P.P. Schedule. First, with every increase in the units of X produced, the units of Y must decrease. This is because the assumption in this analysis is that all the resources of the economy are being utilized to produce only these two commodities (X and Y). Second, with every additional (marginal) unit of X produced, the number of units of Y to be forgone continues to increase. Whereas the first unit of X requires only 2 units of Y to be sacrificed (that is 20 18), the second unit of X needs 3, and the third needs 4 units of Y to be sacrificed. With an increase in the production of a particular commodity, there is simultaneously a decrease in the production of the second commodity. This is technically known as the marginal rate of substitution (MRS). This is shown in the third column of the schedule. Since the MRS increases progressively, the production of X becomes more and more difficult. This is based on the famous law given by Ricardo: the Diminishing Marginal Returns principle. The schedule can be inverted by reading it upwards, in which case, one can assume that more and more units of Y can be produced at an increasing rate of sacrificing the production of X units.

Figure 1 ii) P.P.F. graph: Figure 1 illustrates the Production Possibility curve. It is strictly based on the information given by the schedule. The units of X have been measured along the horizontal (x) axis and those of Y along the vertical (y) axis. The six points a to f are then the result of mapping out the values of varying combinations of the two goods in the schedule. On joining these points we obtain a continuous curve which is known as the P.P.F. curve, since each point on the P.P.F. represents maximum producible units of X and Y with the given quantities of resources. It is also known as a transformation curve since the resources are transformed into varying units of the two goods. Note that all points on the P.P.F. are efficient, in the sense, all available resources have been utilized fully and efficiently. Any point such as g inside the curve is inefficient and hence not desirable (though possible). At such a point, units of one or both the goods are produced in smaller quantities than what is otherwise possible. Hence the resources are either utilized inefficiently or wastefully. On the other hand, any point outside the curve such as H is not attainable (though desirable) with the given amount of resources. Hence the only points, both desirable and possible, occur along the P.P.F. curve. The curve slopes downwards and bulges outwards. Such a shape satisfies the two properties (the Y units diminishing as the X units increase, and an increasing rate of sacrificing Y units) manifested by the P.P.F. Schedule. Such a curve is called strictly concave to the point of origin. (D) Substitution and Opportunity cost: The production possibility frontier hints at the principle of substitution. Resources in a given scenario are always limited or scarce. With the given quantity of resources, either 5 units of X or 20 units of Y can be produced. But these resources can be alternatively used either to produce X or Y or any combination of the two goods. Again with limited resources, every additional unit of X requires sacrificing the production of some units of Y. Therefore units of X are substituted for those of Y. The resource thus released from the production of Y units and utilized in the production of X is called opportunity cost of producing X units. The principle of opportunity cost is stated exactly in the same manner. It is the cost equivalent to the amount of a product that would have been otherwise produced, or the amount of resources which could have been otherwise used in the next best

productive activity. The opportunity cost is the real cost of production and is a theoretical concept. It differs from the market or money cost of production. The underlying principle of substitution was introduced and made widely applicable by Alfred Marshall in a variety of economic activities. In the present example it applies to goods produced with limited resources. But it can be generalized in various ways. Though resources are scarce, each unit of a resource is capable of being alternatively used. When it is used in some productive activity, some other activity for which this resource unit could have been used will have to be forgone. That is the opportunity cost or the cost of the highest valued alternative of that particular choice. For example, a small piece of land is capable of serving the following three purposes. Also given the respective revenue that each purpose would yield. i) Cultivation of wheat - $80 ii) Cultivation of cotton - $120 iii) Construction purposes - $150 When a piece of land is actually used for the (B) purpose, though it can yield $120 its opportunity cost is $80, since it is the next best alternative forgone. Similarly when it is used for the purpose (C), though its actual yield is $150 its opportunity cost is $120. The difference, if any, between actual yield and opportunity cost is called economic rent. Thus when land is used for (B) or (C) purposes, the amount of economic rent is $40 (120-80) and $30 (150-120) respectively. If the land is used in the (A) capacity then both - the amount of yield and opportunity cost are identical and there is no economic rent. (E) Errors or Pitfalls: In modern times, economics is no doubt being developed on a positive scientific basis. But unlike other physical sciences, economics suffers from a certain weakness. It is after all a science based on human behavior which is not predictable. This makes economic analysis less accurate. There are a variety of other empirical and technical reasons that contribute to its inaccuracy. Most of the economic theories are tailor-made to suit competitive market conditions. But the markets in reality are likely to consist of imperfections. The knowledge of the economic agents, the mobility of resources, the availability of information, future uncertainties, changes in tastes and technical conditions are some of the causes of imperfection in the market system. A technical error arises out of the statistical and theoretical tools employed. In algebraic and geometric methods the degree of precision depends on the degree of correlation between the two variables: the stronger the correlation, the greater the predictive value of any change. But sometimes, the correlation coefficient may lead one to false predictions. In that case, it is called a spurious correlation. Economic realities are sometimes not amenable enough to be able to fit into the technical requirements of mathematical or statistical precision. Two specific pitfalls that one can encounter in economic analysis are fallacy of composition and false-cause fallacy. The first one refers to the assumption that if one company will gain from a particular policy, other related companies will gain as well. However, this may not always be the

case. The second one refers to a condition when two events are positively correlated or appear simultaneously. In such a case, they may be assumed to have a causal relation as well. However, this is again a false assumption: one needs to look at other related components as well. ********** CHAPTER 2: DEMAND, SUPPLY AND ELASTICITY 2.1 Fundamental Concepts Demand and supply are basic concepts in economic analysis. This is because economics is fundamentally concerned with ends and means. The quantities of various goods demanded are expected to bring satisfaction of different wants or ends, the supply of these goods is conditioned by the availability or scarcity of resources which act as the means of production. Both the terms demand and supply have technical implications. By demand, we mean the quantity of any commodity that buyers are willing and have the ability to buy. Both the conditions must be satisfied together before goods can be demanded. One who smokes wishes to purchase cigarettes but he must have enough money or resources to do so. Similarly, a quantity of a commodity is said to be supplied only when a seller is willing to sell it at the market price. The two concepts of demand and supply are, however, relative in nature and conveniently interchangeable. For example, a person may visit a distant wholesale market and purchase 50 small cans of beer at a somewhat lower price than what he would have paid in the local market. Therefore 50 cans of beer can be said to be his demand for the commodity. On his way home he meets a friend B who requests for 10 cans of beer at a particular price. If the bargain is acceptable, A will sell 10 cans to B, which will consist of his (that is As) supply and the remaining 40 cans will then be his demand. Later on if a close relative of A (say C) requests him to part with 5 cans of beer on a no profit no loss basis, then that becomes a further part of his supply and his demand is reduced to 35 cans of beer. Similarly a shopkeeper who begins with 200 cans of beer (which is his supply) may retain 10 cans for himself and for his family members (this is known as self-consumption). In that case, his supply is reduced to 190 cans and demand would be 10 cans. Finally demand and supply are mutually opposing concepts, in the sense that demand is an inverse (falling) function of the price, while supply is a direct (rising) function of the price. This is explained in the following sections. 2.2 Demand Schedule, Function and Law D(demand) qd 10 8 4 Schedule P 0 1 2

1 0

3 4

(A) Demand Schedule : The various quantities demanded of a particular commodity are presented here in a schedule. At arbitrarily chosen prices, the quantity of a commodity an individual consumer is expected to demand, is explained by the schedule. Since quantity demanded (qd) depends on the relevant prices of goods, the two can be expressed in the form of an algebraic function as well. The schedule shows that as price goes on rising (from zero to 4) the quantity demanded goes on falling (from 10 to zero). The scheduled information has been presented in the form of a demand curve in Figure 2 (below). In the figure, the units of quantity of the goods have been measured along the horizontal axis (OX) and the respective prices have been shown along the vertical axis (OY). The curve intersects OY axis at point A which shows highest price at which quantity demanded is zero. On the contrary the curve intersects OX axis at point B showing largest quantity demanded where price is zero. Both OA and OB are said to be intercept quantities when one of the variables assumes zero value. Note that demand curve is sloping downward. This follows the law of demand (given below). But the demand curve of such a shape is obvious from the fact that quantities demanded and price in the demand schedule hold an inverse relationship.

Quantity Demanded qd Figure 2 (B) Demand Function: The price-demand relationship shown above can be expressed in the form of a demand function as follows: qd = 10 - 3P On substitution of any scheduled value of P we get the relevant value of the quantity demanded. Thus when P = 1 then qd =10 - 3 (1) = 7 or when P = 3, then qd = 10 - 3 (3) = 1 etc. (C) Law of demand: The law of demand explains the inverse relation between quantity and price in general. It can be stated as follows:

"Ceteris Paribus (other things remaining equal), the quantity of a good demanded will rise (expand) with every fall in its price and the quantity of a good demanded will fall (contract) with every rise in its price." In a functional form this can be stated as, qd = f (P) [ Y, Ps, N, Z ]const. This explains that qd, the quantity of a good demanded functionally depends on its price P. However, the quantity demanded is also causally related to other factors such as income of an individual (Y), prices of substitutes (Ps), number of members in the family (N) and the tastes of the consumer (Z). In order to satisfy price-demand relation, the effect of these other variables has been restrained by assuming them to be constant. Initially, the law of demand was based on the principle of diminishing marginal utility (DMU). But in that case it was implied that utility is cardinally or absolutely measurable. There were other practical difficulties in the DMU approach as well. Therefore recently attempts have been made to place the law of demand on the empirical and realistic basis. One such attempt is in the form of Indifference Curve (IC) analysis. Under the IC approach it is enough to measure utility in ordinal or relative terms. (D) Rise or Fall and Increase or Decrease in demand: On a given demand curve as we move downwards from point A in the direction of B, the quantity demanded goes on rising with every successive fall in price. On the contrary, moving from point B to A shows a fall in the quantity demanded with every successive rise in the price. Marshall has called this process rise and fall or expansion and contraction in the demand. Therefore, in this case the price of the quantity (and the change in it) plays an important part. Here, a change in the quantity demanded is indicated with movement along the demand curve (up or down accordingly). This change is subject to the ceteris paribus condition. On the other hand, other factors are also likely to alter the quantity demanded. This can be expressed by a shift in the curve. Such an upward shift in the demand curve (Figure 3) has been shown by a new and higher demand curve (A1B1) in the figure.

Figure 3

At a given price OP on the original demand curve (AB), the quantity demanded is Oq but on the new demand curve (A1B1) it has increased to Oq1. On the other hand, if we begin with the A1B1 demand curve as the initial demand curve and consider demand to have reduced (to AB) then the quantity demanded reduces from Oq1 to Oq. Such a change in the demand, arising out of a shift in the demand curve is known as an increase (if it is towards the right of the original demand curve) and a decrease (if it is towards the left of the original demand curve) in the demand, respectively. The demand curve may shift and quantity demanded may increase or decrease, due to changes in a number of factors (apart from price), say the income (Y) of a consumer (when he becomes richer or poorer). A similar effect can be noticed with a rise or fall in the price of substitute (Ps) goods. For instance, tea and coffee or soaps of different brands are substitutes of each other. Therefore a rise in price of pasta may result in a reduction in the consumption of pasta and simultaneously an increase in the consumption of bread to that extent and vice versa. Or the demand curve may shift and quantity demanded may increase at the old price if there is a sudden increase in the number of members in a family (N), (say because of the unexpected arrival of guests). Finally, a shift in the demand curve may also be the result of the change in the tastes of a consumer. A cigarette or liquor consumer may become addicted because of which his demand for such goods will rise remarkably even at the old price. There is an important difference between the change in the quantity demanded of a particular commodity and change in the demand for that commodity. While the former is influenced by the single factor: price, the latter is influenced by various other factors apart from price. A change in the quantity demanded is represented by a movement along the demand curve, while a change in the demand is represented by a shift of the curve (towards the left in case of a decrease and towards the right in case of an increase). 2.3 Supply Schedule, Function and Law (A) Supply Schedule: Just as goods are demanded by consumers, they are supplied by manufacturers or sellers. At any point of time quantity supplied by them is a function of the market price. Several such prices can be related to the relevant quantities supplied: this would give the supply schedule. In the given schedule, as price of the goods rises (from zero to 3) the quantity supplied also rises (from zero to 6 units). Supply Schedule qs 0 2 4 6 P 0 1 2 3

(B) Supply Function: Supply is a direct function of the price and it rises or falls with the price. This is because the law of supply is based on the behavior of the cost of production. Assuming

that manufacturers begin at the point where cost of production is minimal any further production and supply of goods can be possible only at an increasing additional or marginal cost per unit. Hence they can afford to supply more only at a rising price. Further, logically any seller would be willing to sell more goods if the price were to rise. The quantity supplied at the given range of prices as above can be presented in the form of an algebraic function: qs = 2P With the help of the function we can find the quantity supplied at any randomly chosen prices. For instance, when P = 3, qs = 6 or when P = 2, qs = 4 etc. (C) Law of Supply: The law of supply can be stated as follows: "Ceteris paribus, the quantity of a good supplied will rise (expand) with every rise in its price and the quantity of a good supplied will fall (contract) with every fall in its price." In a functional form this can be stated as : qs = f (P) [T, R, P] const. The quantity of a commodity supplied is thus a function of its own price. There exists a direct relationship between the quantity supplied and the price of a commodity. It is subject to the condition that other things should remain constant. In this case other things include mainly two things. These are technical conditions or methods of production (T) and the prices and quantities of the resources supplied (RP). With improved technical conditions, supply can be increased at the same old price, since the cost of production can now be reduced. Similarly with an enhanced supply of resources and a reduction in the prices of resources such as land, labor, raw materials etc. an increasing quantity of the commodity can be supplied at a constant or even falling price.

Figure 4 Figure 4 is the graphical representation (the supply curve) of the supply schedule. It begins at the point of origin where both quantity supplied and price are zero in value, and then it continuously rises upwards. This upward sloping curve indicates the positive relationship

between supply and price: there is a rise in the quantity supplied with every successive rise in the price. (D) Expansion or contraction and increase or decrease: Changes in the quantity supplied as a result of movement along the same supply curve has been described by Marshall as rise and fall or expansion and contraction of quantity supplied of the commodity. But if the supply curve shifts left or right of the original curve, the changes in supply of the good are known as increase or decrease.

Figure 5 In figure 5 we notice such a shift in the supply curve. On the original supply curve (OS) the quantity of goods supplied at price OP is Oq but when the supply curve shifts towards its left (i.e. S1 S1) then at the same price OP, the quantity supplied decreases to Oq1. If we begin with S1 S1 as the original supply curve, OS would represent a shift of the supply curve towards the right. In this case, quantity supplied increases at a given price. The supply curve undergoes a shift in it with a change in the technical conditions or the price and supply conditions of the inputs (resources). With improved techniques or methods of production, the degree of the efficiency with which some or all resources can be utilized will increase. This results in a favorable change in the cost of production. Similarly with improved supplies and reduced prices of the inputs, the cost of production tends to fall and an increased supply of a commodity becomes possible at a given market price. 2.4 Elasticity of Demand and Supply (A) Price Elasticity i) Elasticity of Demand: Elasticity of demand can be classified into two major divisions: one the highly elastic, unitary elastic and the highly inelastic type and two, the extreme cases of the perfectly elastic and the perfectly inelastic type. a) Highly elastic, Unitary elastic and highly inelastic: The laws of demand and supply are no doubt an important part of economic analysis. But the knowledge about demand and supply relations serves only a limited purpose. This is in view of the fact that both demand and supply

laws are applicable to all kinds of goods. However, an actual rise or fall in the quantity demanded or supplied with a small variation in the price may considerably differ for different goods such as food, automobiles, film shows, garments, hardware materials, machines, land etc. In other words it is important to know the extent of rise or fall in the demand with a given change in the price for each individual good. This is exactly the purpose served by the concept of price elasticity of demand; this concept is advanced and subtle in nature. It was first developed by Alfred Marshall; he has defined elasticity as follows: Elasticity of demand is the degree of responsiveness with which quantity demanded changes for a given change in price. In other words it is a proportional change in the quantity demanded to a proportional change in price. Price Elasticity of demand is then the ratio of the proportional change in the quantity demanded to the proportional change in price.

Proportional change in quantity can be expressed as the new quantity demanded.

where q1 is the initial and q2 is

Proportional change in price is similarly

where P1 is initial and P2 is the new price.

Elasticity ratio e is therefore, If symbols q and P are used for small variations in quantity and price respectively then,

Note that (q / (p is in the limit derivative or marginal change and p/q is the reciprocal of average change, therefore

Lets illustrate this. In our demand schedule example above, when price changes from 2 to 3 units, the quantity demanded changes from 4 to 1 units. Substituting these values we have:

Note that the elasticity ratio 3/2 is more than one and has a negative sign. Both these are important features. Numerical values explain the extent or degree of change in demand while the sign of the ratio explains the direction of change. Since the law of demand is based on the inverse relation between price and quantity, the elasticity of demand is always stated with a negative sign. The numerical value of elasticity can be equal to 1 (that is called unit) more than one or less than one. In case of unit elastic demand (e = 1) both price and quantity (demanded) changes occur in the same proportion. If the value of elasticity exceeds one (e > 1) then the percentage or proportional change in quantity demanded is greater than that in price and the good is said to be price elastic or highly responsive to a change in price. If the value of elasticity is less than one (e < 1) then the proportional change in quantity is smaller than that in price and the demand for the good is said to be price inelastic or not very responsive to a change in price. The information about the value of elasticity therefore serves an important purpose in classification of various goods as elastic or inelastic in demand. This helps in several practical and policy applications such as taxation, foreign trade, monopoly, price determination etc. There are four methods of measurement of elasticity of demand. These are percentage, proportion, outlay and geometric or point elasticity methods. The one mentioned last (point elasticity method) is the most accurate and can be explained conveniently with a given demand curve:

Quantity demanded

Figure 6 In the figure, AB is the demand curve and at any point on this, the elasticity of demand can be measured. At points R1, R and R2 the values of elasticity are:

At the mid point R on the demand curve, the value of elasticity is unit or equal to one. But above point R such as at R1, the value of elasticity is more than one and demand is highly elastic. On the other hand at a lower point such as R2 demand becomes inelastic as the value of elasticity is less than one. In general as we move in the direction of the Y axis, demand becomes more and more elastic. But as we move in the direction of the X axis, demand becomes less and less elastic. In other words at every higher price demand is relatively more elastic and at every lower price demand is relatively less elastic. This also explains that elasticity of demand differs not only from commodity to commodity but also for the same commodity at varying prices.

b) Two extreme cases: Besides the three explained above, two more extreme values of price elasticity of demand can be included in the analysis. These are: (i) Perfectly Price Elastic: At this extreme, for any small decrease in price, the increase in the quantity demanded is infinitely large. In such a case, demanders demand all the can. Here the demand is said to be perfectly price elastic (e = that is infinity). This is represented graphically as a horizontal demand curve (D1 in the figure above). (ii) Perfectly Price Inelastic: At this extreme, for any change in price there is no change in the quantity demanded. Therefore the demand is completely unresponsive to any change in price. In this case the demand is said to be perfectly price inelastic (e = 0). This is represented graphically by a vertical demand curve (D2 in the figure above).

ii) Elasticity of Supply: Like demand, elasticity of supply can also be classified into two major divisions: one the highly elastic, unitary elastic and highly inelastic type and two, the extreme cases of the perfectly elastic and the perfectly inelastic type. a) Highly elastic, unitary elastic and highly inelastic: Elasticity of supply can similarly be defined and computed at varying prices and quantities supplied. Elasticity of supply is the degree of responsiveness with which quantity supplied changes with a given change in the price. This can be expressed with a similar formula:

An important difference between the price elasticity of demand and that of supply is that the latter is positive in value (as against the negative value in case of elasticity of demand). This is obvious from the fact that supply is a direct function of price: and both quantity and price change in the same direction. This will be clear from the following example. The values of q and P have been selected from the supply schedule given above.

The elasticity of supply also shows variations in its value for different commodities. Accordingly supply elasticity for different goods can be unit, (es = 1) more than one (es > 1) or less than one (es < 1). The goods can then be categorized as relatively elastic or inelastic in supply. Elasticity of supply is also of considerable practical importance in its policy applications. b) Two extreme cases: Besides the three explained above, two extreme values of price elasticity of supply can be included in the analysis: i) Perfectly Price Elastic: At this extreme for any small decrease in price, the quantity supplied is infinitely large. In such a case, suppliers supply all they can. Here the supply is said to be perfectly price elastic (e = that is infinity). This is represented graphically by a horizontal supply curve (S1 in the figure below). ii) Perfectly Price Inelastic: At this extreme for any change in price there is no change in the quantity supplied. Therefore the supply is completely indifferent to any change in price (e = 0). Here the supply is said to be perfectly price inelastic. This is represented graphically by a vertical supply curve (S2 in the figure below).

Figure 8 (B) Income elasticity: Demand is a function, besides price (P) also of the income (Y) of an individual. However, income and demand hold a direct relationship, such that Y and Q rise or fall together. Hence the sign of elasticity ratio in this case is normally positive. Lets illustrate this : Assume that the values of Y and Q are as follows : Y1 = 100 Y2 = 120 Q1 = 16 Q2 = 18

In this case the value of income elasticity ey will be:

(C) Cross Elasticity: The price elasticity of demand that we have studied so far is also called the "own elasticity." This is because we have determined the elasticity for good A with the change in the price of the same good. However, various goods A, B, C etc. hold a mutual relationship. As such if we attempt to find the elasticity of demand for good B whenever the price of good A changes, then it is called a cross elasticity ratio. However, the goods A and B may hold either of the following relationships: i) Substitutes : as in case of tea and coffee or different brands of toothpaste, television sets etc. These goods are symbolized as BS which implies that B is a substitute of A. In this case,

whenever the price of A rises the demand for A will fall but that of B will rise. Therefore the relation between PA and QB is direct. Hence the sign of elasticity ratio will be positive. This can be illustrated as: PA 10 12 QA 8 6 QBS 8 10

ii) Complementary goods: Consider two complementary, good A - a vehicle and B - gasoline. In this case, with a rise in the price of A the demand for A (QA) will fall and similarly, the demand for B(QBC) will also fall. The sign of elasticity ratio will then be negative in sign. This can be illustrated as follows: PA 5000 6000 QA 100 80 QBC 40 35

2.5 The Concept of Equilibrium Both demand and supply functions independently serve important functions. However, it is important to bring them together in an attempt to establish equilibrium. The concept of equilibrium, though analytical in nature, is quite simple in practice. It can be defined as a point of equality or agreement between buyers and sellers. Since both demand and supply

quantities are shown in the scheduled forms these indicate mutual willingness of consumers and producers to purchase or sell respectively, varying quantities at varying prices. The schedules do not yet explain actual market price at which deals take place. This can be possible only when the quantities demanded and supplied are exactly equal at some uniform price. So long as this has not been achieved, some buyers or sellers are yet dissatisfied and may attempt to raise or lower the price. In this sense equilibrium is a point of complete satisfaction of the given behavior of buying and selling and hence an act of fulfillment of a given economic activity. Lets present and illustrate the establishment of equilibrium with the help of demand and supply functions in our earlier examples (in the sections given above). We begin with two equations: qd = 10 - 3P and qs = 2P By definition, demand and supply must be equal (qd = qs) for the condition of equilibrium. qd = 10 - 3P = qs = 2 P or 10 - 3P = 2P On solving this we find equilibrium price:

On substituting the value of price in demand and supply function we get, qd = 10 - 3P qd = 10 - 3 (2) = 10 - 6 = 4 qs = 2P qs = 2 (2) = 4 Hence equilibrium price is 2, at which both quantity demanded and supplied are equal to 4. The algebraic proof (Figure 7) of the equilibrium can also be presented geometrically.

Figure 9 In the figure, AB and OS are the demand and supply curves respectively. The two curves intersect at point E which is an equilibrium point at which price P = 2 and quantity demanded and supplied are both equal (q = 4). At any other price higher than P such as P1, the quantity supplied S1 exceeds the quantity demanded d1 (S1 > d1) and hence at this stage, some sellers remain dissatisfied. On the other hand at any lower price such as P2, quantity demanded d2 exceeds quantity supplied S1 (d2 > S1) and this time some buyers remain dissatisfied. Therefore only at the point of intersection between demand and supply curves can equilibrium be attained. In other words, equilibrium price represents that price at which buyers are willing to buy the good and sellers are willing to sell it. This is the point of satisfaction for both the groups. CHAPTER 3 : MACRO AGGREGATES, UNEMPLOYMENT AND INFLATION 3.1 Macro Aggregates (A) Meaning : We have briefly drawn a distinction between micro and macro economic branches of analysis: microeconomics mainly deals with individual and small units of economic activities, whereas macroeconomics is more concerned with aggregate economic activity at the social and national levels. It deals with aggregative quantities and problems arising out of them, such as supply of money, national consumption, investment, level of effective demand, government spending, proportion of national income saved, annual growth of the economy, foreign trade, balance of payments and rate of exchange. All such macro level transactions are conveniently quantifiable and can be subjected to a mathematical approach. It is concerned not only with a fuller utilization of all existing resources such as labor, power, land, raw materials, machinery and equipment, but also with the increase of all potential resources. All such resources, supply and utilization activities relate to a very long span of time. Expectations of future changes and uncertainties about these components make the whole framework of macroeconomic analysis dynamic in nature. (B) Its Growing Importance :The first half of the twentieth century in the form of the World War I (1914 - 18), the period of the Great Depression (1929-33) and the World War II (1939-44) taught the world an important lesson: that free and private enterprise economy is shaky in its foundations. If left uncontrolled it may cause several problems leading to grave crises and injustices to various sections of the society. Modern public authorities therefore collect large sums of national resources to the extent of about 30 to 35 percent of the national income to be allocated to public expenditure. Such an ever-increasing public expenditure enables public authority to perform a variety of regulatory, welfare-oriented and developmental functions. Some of them can be stated as: i) Regulatory functions include maintenance of stability, high levels of employment, income and effective demand. ii) Welfare functions include redistribution of income, alleviation of inequality and poverty, war and defense expenditure.

iii.

Developmental functions include maintenance of high and steady rate of growth of real national income, avoidance of inflation and compensatory or functional finance policies. Lord Keynes in his General Theory (1936) has made it clear that a free enterprise economy is subject to periodic fluctuations and instability. Hence the undertaking of large-scale public expenditure to maintain high levels of effective demand, output and employment is required. Again a free market economy has a strong tendency towards a biased distribution of national income; more in the favor of the richer sections of society. This needs to be corrected through progressive taxation measures in order to promote social welfare. Finally, the experience of the two menacing wars has led the nations to undertake large-scale defense expenditure and to organize technically superior defense systems. Again maintenance of high levels of effective demand and employment is only a short-term goal. In the long run, it assumes the form of steady growth rates of the economy and of national income. Such a growth rate is expressed in the light of HarrodDomar models in terms of two coefficients. These are the savings - investment ratio (S) and capital - output ratio (C). If the values of these two coefficients are known then the growth rate (g) can be expressed as a ratio of the two coefficients. Thus we have,

If we assume value of S as 20% and value of C as 4% then growth rate will be 5%.

It may be noted that value of 'g' depends directly on S and hence greater the ability of the society to save and invest, greater would be the growth rate. On the contrary, value of 'g' depends inversely upon C i.e. the capital - output ratio or the technical conditions of production. Hence if productive methods are more efficient and if a lower value of the C can be maintained, then the value of growth rate 'g' would be higher. The public authorities have to adopt suitable measures to achieve these ends. Most of the modern governments resort to some sort of planning to achieve these objectives. (C) National Aggregates: National income is the primary macro aggregate. But measurement of national income is a highly complicated activity. This is clear from the definition of national income stated by Alfred Marshall. Accordingly, in a simplified form we have, National income is the money value or market price value of all the goods and services produced by the national citizens of a country during every financial year. Several terms in this definition such as 'money value', 'market price', 'all goods and services', 'national citizens' result into variety of conceptual (related to definition) and practical difficulties. Moreover, the statistical methods employed for the purpose of the measurement of national income are not completely resistant to errors. Consequently what we expect is an approximation and a less exact value of national income than the value of millions of economic activities actually performed by numerous citizens of the country. One way of minimizing the error element is to measure national income employing various approaches and express them in

distinct national aggregates. All these national aggregates are however mutually related and serve the purpose of a self correcting device of aggregative values to make them as accurate as possible. i) GDP and GNP: The first pair of the national aggregates in the form of Gross Domestic Product and Gross National Product values. The value GDP is the result of all productive activities carried out within the country. Therefore GDP is a geographic concept. By and large we are primarily interested in the GDP value. But in modern times there are large-scale international transactions taking place between countries as well. Citizens of a country like technicians, doctors, lawyers, bankers etc. go abroad and earn considerable incomes. This should genuinely form part of the national income of a country. But it is not earned within the territory of the country and hence is not included in the GDP. If we want to compute GNP such income (N) earned abroad will have to be added to GDP. On the contrary foreign citizens may be working inside the country and contributing to the value of the GDP. Since they are not the nationals their contributions (F) will have to be deducted to arrive at an accurate value of the GNP. In other words net of the income earned abroad (N-F) when adjusted to the GDP gives the GNP. GDP + (N -F) = NNP For example, assume the values of GDP, N and F as 1780, 230, 310 respectively. Then, GNP = 1700 GDP + N - F = GNP 1780 + 230 - 310 = 1700 On the other hand, if we begin with GNP then the reverse operation will be necessary. GNP- N+F = GDP 1700 - 230+310 = 1780 Note that GNP will be more or less than GDP according to relative amounts of N and F. If N will be greater than F then GNP would be greater than GDP but if N will be less than F, GNP will be smaller than GDP (Hence GNP < GDP). ii) GNP and GNI: Whereas Gross National Product (GNP) is the total of the market price values of all goods and services, Gross National Income (GNI) is the aggregate income received by all members of the society engaged in productive activities. Whenever goods are produced and sold, the total yield gets distributed among various agents of production. There are theoretically four such categories which contribute to productive activity and receive income. The four shares in the income are profits of the producer (P), wages of the labor (W), rent of the owner of land and natural resources (R) and interest payment on loans and capital transactions (i).

Therefore the value of GNI can be stated as : GNI W + R + P + I For every income generated, there is some corresponding productive activity performed and vice versa. Therefore, the two values GNI and GNP must be conceptually identical. GNI = GNP But in practice there is some disparity between these two aggregates arising out of various causes. There may be some members in society who live on doles and hence earn income without performing any productive functions. On the other hand some part of the goods produced may not be marketed but utilized for self-consumption. Again there may be serious errors in computation or others which may cause some difference in these two values. iii) GNI and NNI: The distinction between Gross and Net values of the national income has both theoretical and practical significance. The adjustment factor is Depreciation charges (D) against the utilization of the services of the stock of capital goods while producing current output. Such capital goods are of longer duration and have to be replaced a few years after their utility is over. Such an allowance for wear and tear of the fixed capital equipment is also known as capital replacement (Cr) cost. The two values (D and Cr) are somewhat different in their computation and purpose. Though it is difficult to accurately predict the future replacement cost of the present capital assets, the usual procedure is to set aside a certain percentage (say 8 to 10 percent) of the national income in the form of depreciation charges. This adjustment is done as follows : GNI - D = NNI In our example, 1700 - 170 = 1530 where D = 170 (10% of 1700) The reverse operation will be: NNI + D = GNI, or 1530 + 170 = 1700 The significance of the depreciation allowance can be explained with the help of a simple example. If a farmer produces 200 quintals of grain every year then the entire produce cannot be marketed or used for his family consumption. He will keep aside say 10 quintals, to be used as seeds for the next harvest. In this case seeds worth 10 quintals is the depreciation allowance in the absence of which no output can be produced in the next harvest. Only after making the adjustment of depreciation charges what remains in the form of NNI is available for current consumption purposes. Hence it should be understood that the term 'national income' in this analysis refers to it in its net form. iv) NNI(MP) - NNI(FC): Another important distinction is between NNI in its market price value and NNI in its factor cost value. When national income value is computed in terms of market

prices, the presence of two elements may not allow for the estimation of the true factor expenditure or cost of production of these goods. These two elements contained in the market price are indirect taxes (IT) such as sales tax, excise duty etc. and subsidy (S) or assistance in cash and kind provided by the government to private producers. The estimate of NNI will exceed the true cost of production to the extent of the IT value. On the other hand the presence of subsidies unduly reduces the correct value than what it would otherwise have been in the form of cost of production. Therefore the value of indirect tax is to be deducted and that of subsidies is to be added to the estimated value of NNI at market prices in order to arrive at the factor cost value of the NNI. With these adjustments we have: NNI(MP) - IT + S = NNI(FC) , or 1530 - 460 + 120 = 1190 where IT = 460 and S = 120 In its reverse form: NNI(FC)+ IT - S = NNI(MP) 1190 + 460 - 120 = 1530 In macroeconomics national income value (NI) is stated in its factor cost version. Therefore unless otherwise stated we will refer to this value as NI (that is National Income at factor cost). v) NI, PI, DI: After the explanation of the process of arriving at the value of NI, two further operations need consideration: these make it possible to arrive at disposable income (DI) and personal income value (PI). These are other important national aggregates in the system of income accounting. Lets begin with personal income (PI) value. In modern times with an increased public expenditure, the government carries undertakes a considerable amount of transfer of incomes in the form of gifts, loans, assistance etc. Some citizens may also receive similar donations from foreign countries. With such gratuities the individuals capacity to spend will be enhanced. However, this additional compensation is not a part of the NI. On the other hand big corporate agencies are subjected to corporate tax to the extent of which national income reduces before it falls in private hands. Some corporate bodies may also set aside part of their profits in an undistributed (UP) form to be utilized for future investment, which further reduces the size of the NI before it becomes Personal Income. Therefore we have: NNI - (CT + UP) + Unearned income = PI 1190 - (80 + 90) + 310 = 1330 where CT = 80, UP = 90 and Unearned income = 310 In a reverse operation we have:

PI - Unearned Income + (CT + UP) = NNI 1330 - 310 + 170 = 1190 While moving on from personal income to disposable income (DI) we need to make some further adjustments. The entire personal income is not available for disposal and for private consumption or investment expenditure. Part of the Personal Income is taxed away in the form of personal income taxation (PT). The value of Disposable Income will be smaller than that of Personal Income to the extent of the tax. We have then: PI - PT = DI 1330 - 130 = 1200, where PT = 130 In its reverse form: DI + PT = PI 1200 + 130 = 1330 vi) Recap of the aggregates: After having defined and explained various national aggregates lets review them. Aggregates are to be interpreted as values in millions or billions in the currency of respective countries such as dollars, pounds, marks, francs, rupees, yens etc. 1. GNP = GNI = 1700 2. GDP = GNP - N + F = 1700 - 230 + 310 = 1780 3. NNP = GNP - D = 1700 - 170 = 1530 4. NNPMP = 1530 NNPFC = NNPMP - IT + S =1530 460 + 120 =1190 5. NNPFC = NI = 1190 PI = NI - (CT + UP) + 4 = 1190 - (170) + 310 = 1330

6. PI = 1330 DI = PI - PT = 1330 - 130 = 1200 (D) Methods of Measurement: Measurement of national income, though important, is a very complex activity. Double counting, omissions, statistical errors etc. may cause considerable inaccuracy in the measurement of income. It was only during the last two decades of the 19th century that systematic attempts were made to measure national income. Since then economists have from time to time introduced various devices to widen the coverage and to reduce the degree of inaccuracy in the process. In particular, the efforts of Nobel laureates like Dr. Richard Stone of the U.K. and Dr. Simon Kuznets of the U.S. are worth mentioning. Dr. V.K.R.V. Rao of India has also carried out useful research in this respect. Yet the complex nature of national income accounting demands three different methods of measurement to ensure the greatest degree of accuracy. These are product, income and expenditure methods. These three methods are complementary to each other and all of them are employed according to convenience. i) Product method: Under this method the market values of all goods and services produced are aggregated to arrive at the national income value. If proper records are maintained of every small and private productive activity then this method should provide satisfactory information. But this method has limited significance since it suffers from certain drawbacks. First, under product method care has to be taken to include values of the final products. The values of intermediate products should be excluded in order to avoid double counting. For instance, if we consider the case of garment manufacturing industry; the raw materials pass through various stages before it is transformed into the final product. These include production of cotton thread, cloth and garments. Therefore we have to include in the national income only the value of the ready-made garments as final products, plus the value of some amount of cotton thread and cloth which might have been used for direct consumption. Second, the product method emphasizes production of tangible goods. Therefore it is possible that useful services such as those of teachers, musicians etc. get excluded or underestimated. Third, under product method, part of the goods produced such as grains, vegetables, fruit etc. may not be marketed at all but used for selfconsumption by the household members of the producers. Evaluating the contribution of nonmarketed products and to add this to the national income becomes a difficult task. Hence the value of this method is limited. ii) Income method: This is the simplest and most convenient method of computing national income. As per convention all possible incomes earned, fall under one of the four categories. These are wages (W), rent (R), profits (P) and interest (i). When these four categories of income are aggregated at the national level and added up, we get the total of the national income. NI = W + R + P + (i)

Though this method is simple it is not quite satisfactory and cannot provide the most accurate information about the value of the national income. Some of the weaknesses that this method suffers from are: a) All possible occasions of earning income are never accurately recorded therefore information available is often incomplete. Government administration, big corporations, factories, semi government organizations etc. maintain their wages, salaries and profit accounts. But large number of small units, self employed persons, small artisans etc. hardly maintain any accounts and even when accounts are maintained they do not supply the requisite information. b) While collecting income information we have to rely upon the statements of the individuals but which may not be necessarily authentic. Some people deliberately understate their income. On the other hand some people overstate their income and make it appear that they are richer than what they are. c) National income value is expected to correspond with national production of goods and services. But when part of the product is not marketed no income will be earned, yet the product value needs to be taken account of. This sort of difficulty arises in all such cases where a part of the goods produced or possessed is used for direct and self-consumption. d) The case is the opposite when unproductive income is earned. There may be some people receiving government transfer earnings in the form of unemployment doles, pension or insurance assistance. Though these are incomes there is no corresponding productive activity and hence need not be included in the national income accounts. The incomes earned illegally by a section of society such as criminals, smugglers etc. should also not find place in the national income accounting. e) Finally, there are some borderline cases. Some sections of the society are either not paid or are underpaid for the services that they render which are otherwise valuable. Housewives, social reformers, voluntary agencies fall under this category. The national income account remains inaccurate to the extent that these services are not accurately evaluated, or no complete information is received about them. iii) Expenditure Method: Both product and income methods have their own limitations. Therefore the expenditure method is often employed as an alternative or as a remedial measure. Lord J.M. Keynes has in his General Theory (1936) introduced highly simplified income and expenditure equations. These are: Y=C+I Income approach Y=C+S Expenditure approach The value of national income (Y) is equal to total income earned either in the form expenditure on the consumption goods (C) on capital goods or investment (I). On the other hand, whatever income earned by the society is spent on purchasing consumption goods (C) or remains unspent

and saved (S). The terms income and expenditure in this respect are relative and flexible. One persons expenditure is anothers income and vice versa. In an over simplified equation as above only private consumption and private investment values have been taken care of. But actually, there are two more categories of expenditure which make significant contributions to national income accounts. These are in the form of public spending or government expenditure (G) and foreign trade. Under the foreign trade sector a variety of to and fro transactions are continuously taking place. These are called imports (M) and exports (X). Whereas imports are liabilities for which the government has to pay to foreign producers, exports are assets for which payments are received. Therefore the value of imports tends to reduce and value of exports tends to enhance the national wealth or income. We therefore take account of the net worth (X - M) of foreign trade and make adjustments in the national income accounts. The expenditure method is a useful device to collect and present information. Under this approach, we are only required to take account of the expenditure of the final products. We have therefore to exclude all such expenditure on intermediate goods and services. In this way double counting of intermediate goods can be avoided because of which, the national income estimate would be highly exaggerated in its value. In this respect, like the earlier two methods, this also has its limitations. a) As noted earlier, those who receive pension, insurance and other benefits contribute to expenditure but do not contribute in a countrys productive activities in any way. All such expenditure will have to be set aside from the national income accounts. b) On the other hand, part of the income genuinely earned may not be spent at all and not even be saved and deposited with the banks. Such a practice is called hoarding of income or of purchasing power. The national income accounts cannot be satisfactory to the extent of such hoarded income. iv) Summary table: Lets present income and expenditure methods of national income accounting in the form of a summary. But before we do so we have to introduce two adjustment factors which we have not taken account of so far. These are in the form of depreciation charges (D) and indirect taxes (IT). Market prices of goods and services are marked to the extent of indirect taxes and depreciation charges. Therefore these values form part of the aggregate expenditure. But they are not present in the aggregate income under the income method of measurement. Therefore in order to strike a balance between the two methods either we have to deduct (D + IT) from the expenditure side or add it to the income side. We have then : Expenditure A/c Consumption Investment Government Expenditure C I G Income A/c Wages Rent Profits W R P

Foreign Trade Minus [ Depreciation Indirect Taxes

(X- M) Interest D + IT ]

OR Expenditure A/c Consumption Investment Government Expenditure Foreign Trade C I G Income A/c Wages Rent Interest W R I

(X-M) Plus [ Depreciation Indirect Taxes D +IT ]

vi) Other Related Concepts a) Inventory goods: A special mention needs to be made of the inventory goods which find an important place in the present national income accounts. This has not been mentioned earlier because it forms part of the current investment expenditure, other than consumption expenditure. It has three distinct elements. These are depreciation charges (D), expenditure on new capital equipment and goods produced or purchased, and inventories. We have already seen that depreciation charges enable replacement of the existing stock of capital. Therefore after excluding depreciation what remains is the net or current investment. But all of which is not the expenditure on the fresh purchase of the capital goods. Very often producers or sellers maintain large stocks of the goods in warehouses. These are not yet marketed but are available for marketing. Such stocks both of finished goods and of raw materials together constitute inventories of the producers. Normally producers have some quantity of inventories which are intended to be so, however sometimes there may also be unintended inventories, when part of the goods remain unsold. In either case these inventory goods form part of the business expenditure and act as a future asset. Therefore these are included in the context of net investment expenditure. At the end of the year each business firm shows its investment account which includes a value of such inventories. b) Real and Nominal Income (Y): An important analytical distinction is to be made between real and nominal values of the national income. By definition national income is the total value

of all goods and services at market price. Thus every year all productive activities are evaluated at current market prices for this purpose. This is however the nominal value of the national income. It is not ordinarily comparable with the national income value of the last or earlier years. This is because of the fact that market prices contain an element of inflation and to that extent actual or real changes in the national income are not accurately recorded by the nominal value. Therefore before any comparison is attempted between the national income estimates of two or more years it is necessary to make the prices uniform and price index applicable to adjust all such values. The process is called conversion of nominal values into real value or conversion of national income from current to constant prices. This process can be applied to all national aggregates uniformly and thus nominal GDP, GNP, NNP, NNI etc. can be converted into their respective real values. Generally, national income is symbolically denoted as Y. For example take Y1 and Y0 as the national income values measured in current prices of respective years (say P1 and P0). In this case Y1 and P1 are national income and price values of the current year and Y0 and P0 are similar values of the base year or of the initial year with which the comparison is to be made. Then when Y1 value is converted into P0 price, such a conversion is known as translating nominal income Y1 (n) into real income Y1 (r). Let us assign numerical values to these variables:

But part of this income is only nominal and not real because of the corresponding rise in the price (from 4 to 5). This is clear if we divide each years nominal income value by the respective prices. In this way we can obtain real or physical variations in the units of goods produced. Thus in the year Y0 physical units of goods produced are Y0/P0 = 1600/4 = 400 and in the year Y1 it is Y1/P1 = 2400/5 = 480. Therefore real or physical increase in the volume of output produced is only 80 over 400 or it is 80/400 100 (that is 20%). This is exactly the extent of increase in the real income shown by Y1 (r).

20 percent is the increase as desired. Therefore conversion of current to constant price or nominal into real income value by multiplying it by P0/P1 ratio makes the comparisons realistic and enables to remove the element of inflationary price rise. The process is also therefore known as deflating current income into constant prices. c) Deflator and rate of inflation: Deflator refers to the extent to which nominal income has been deflated or reduced in its value in order to convert it into its real value. It is a coefficient computed as follows:

In our example the value of the deflator will be,

or the deflator value is 25 percent. This is exactly the same proportion in which the prices of the two years have altered. P1/P0 = 5/4 100 = 125 or 25 percent Hence under the real income computation process we have removed the 25 percent effect of the rise in the price. Since to this extent we have deflated the value of nominal income, if we increase real income by 25 percent, once again we arrive at nominal income. Thus we have 1920 + 25% = 1920 + 480 = 2400. Since real income on multiplication by deflator factor results into nominal income value it can also be called as conversion factor.

Deflator explains the rate of inflation. In the present case it is 25 percent. In a more systematic and general form rate of inflation can be stated as:

In our example the price P1 is higher than P0 and hence there is an inflationary rise in the price level by 25% during Y0 to Y1 years. This is a normal case. But in an exceptional year if the current price is lower than the base year price the deflator value will be less than 100 and the rate of inflation will be negative. In that case it is called rate of deflation. Therefore when the rate of inflation is positive, an inflationary rise in prices has occurred, but if the rate of inflation is negative the price level is said to have deflated. d) Growth rate of Y and P.C.: Computation of annual national income and its conversion into real or constant price value are very important activities. It serves the purpose in analyzing a variety of economic problems on the national scale. One such use of national income statistics is to make comparisons from year to year. When national income in real terms is compared, we get a clear picture of the conditions of the economy. It is a convenient tool to assess whether an economy is making any progress or not and at what rate it has grown. Such a growth rate (g) of the economy is an indicator of economic prosperity of the country. The growth rate can be computed as follows:

This is a ratio of difference in the real national income value of two subsequent years divided by base year real income. On multiplying this ratio by 100 we get the percentage change in the real national income which is the growth rate of the economy. In our earlier example we have,

The economy can be said to have grown by 20 percent over the two periods Y0 and Y1. Comparison of national income and computation of real growth rate, though important, is not a satisfactory indicator. It is only an absolute measure and gives an idea about gross improvements in the countrys wealth. However, it does not explain ultimate improvement in the living standards of the population of the country. This is because while computing the growth rate we

have not related it to the size of the population. If over the same period, the size of the population has also increased from say N0 to N1, then the share of each citizen in the national income must have increased only by a smaller proportion. Such a share of every citizen in the national income is called per capita income (PC) which is obtained as ratio of real national income to the population. Thus over the period Y0 to Y1 per capita income has increased by 5.71 (45.71 - 40). The percentage increase in the P.C. can be stated as:

The symbol is a sign of summation. Therefore CPI is a ratio of sum of the quantity multiplied by the prices of the current year, divided by sum of the quantity multiplied by the prices of the base year. The ratio value is then multiplied by 100 to obtain the percentage change in the CPI value. The quantities are also known as weights. CPI Base Year Current Year

Goods Quantities Prices Total Quantities Prices Total

Exp. q0 A B C 10 8 16 P0 6 10 3 q0 v P0 60 80 48 q1 9 7 15 P1 7 12 3.5

Exp. q1 v P1 63 84 52.5

q0 P0 = 188 The CPI value is therefore:

q1 P1 = 199.5

Therefore CPI value over this period has increased by 6.11 percent. The rise in the CPI is considered the rise in the price level or the rate of inflation. Note that base year expenditure value is equated to 100 therefore the CPI index value for the base year is 100.

It is a matter of both convenience and convention to assume base year value as 100. This enables us to compare with a similar value of any other year and to state the difference as a percentage change. 3.2 Unemployment (A) Types of Unemployment: After the Great Depression (1929-33), two major economic problems that world economies have been facing are Unemployment and Inflation. Therefore the public authority of any nation today has the primary responsibility of minimizing the level of unemployment and aiming for the full employment condition. An equally important task of the public authority is to contain inflation. There are various types or sources of unemployment. These are the contributory causes of unemployment conditions. The main types of unemployment are: i) Frictional Unemployment: Whenever there are frictions or some maladjustment in economic and productive activities, a part of the labor force is likely to be rendered unemployed. The frictions are caused because of a variety of factors. These include changes in the technical

conditions of work, shift in the site of an industrial unit, market imperfections and want of adequate information, failure of adjustments in the supply and demand conditions etc. Normally, frictional unemployment is partial and temporary. It is partial in the sense only a part of the labor force in certain sections of the economy is rendered unemployed. Again it is temporary in the sense once the frictional forces are located and corrected the level of employment can be restored. ii) Structural Unemployment: Whenever an economy undergoes basic structural changes there is the possibility of some part of the labor force being thrown out of employment. The long term process of economic development and growth gives rise to variety of structural changes. Considerable changes in productive activity from traditional agriculture to modern industry; transformation of rural sectors into urban units; replacement of small scale and cottage industries by large scale manufacturing units; introduction of electricity or other sources of commercial energy in place of manual and animal power are some examples of structural changes. The economy under the process of structural changes is in the condition of transition. Some workers are likely to become jobless during the process of transition. Moreover, the duration of such unemployment may also be fairly long depending upon the extent of corrective and restorative measures introduced to restrict the period of unemployment. iii) Voluntary Unemployment: Unemployment is usually defined as a condition under which able bodied members of the working age (about 18 to 60 years) -- do not find it possible to get absorbed at the current market wage rate. But there may be some members of the society who do not satisfy all these conditions and hence remain unemployed. Even when jobs are available at current market wage rate, some may not be willing to work: they may not like the nature of the job or find the rate of wages offered to be inadequate, or they simply prefer leisure to work. In all such cases the members are said to be voluntarily unemployed. Such voluntarily unemployed individuals do not cause any problem to the public authorities. Their size in proportion to the total labor force is likely to be negligible. iv) Involuntary Unemployment: J.M. Keynes has used the term involuntary or forced unemployment in his General Theory. It is also known as cyclical unemployment. Historically, modern capitalist methods of production are highly susceptible to cause periodic cyclical fluctuations. These cycles create changes in the economic activities in the form of prosperity or expansion on the one hand and depression or crisis on the other. During the phase of depression a sizable proportion, sometimes 30 to 40 percent or even more, of the labor force is rendered unemployed. Under such a situation these unemployed workers are willing to accept jobs at whatever wage rate paid to them. But they fail to get employment because of depressed productive activities. It is such involuntary unemployment which is a fundamental and urgent problem that modern public authorities face. Therefore the major purpose of the modern public policy and public expenditure is to reduce or eradicate such unemployment conditions. v) Disguised and Seasonal Unemployment: There are two other sources of unemployment. Disguised unemployment is a situation under which productivity of the working force is very low. This is because an excessive number of workers are employed than what is optimally desirable. If a small plot of land has a maximum capacity to employ six workers then if the actual number of workers attached to land exceeds this limit, some of the workers will be

disgustedly unemployed. It implies that though some of the workers attached to land appear to be employed their service is not being utilized to the optimum. Their productivity is very low and even if they are detached from the land, the total output will remain unaffected. Usually disguised unemployment exists in developing countries, which are characterized by large populations and hence a surplus labor force. Finally, the seasonal unemployment condition is likely to exist in such productive activities which can be undertaken only during specific season. Traditional agrarian economies provide work to agricultural labor mainly during the harvest season. Similarly there are certain industry or trade activities that flourish only during festival or such other seasons. Consequently job opportunities fluctuate and reduce during off-seasons. However, such instances of unemployment do not cause a serious problem since the workers are aware and are prepared to face the situation. (B) Rate of Unemployment: One of the important functions of the modern public authority is to reduce unemployment. This requires large-scale public spending on employment promotion schemes and on the payment of unemployment doles. So that this function can be performed promptly and satisfactorily, it is important that the information about unemployment conditions should be quickly available. This becomes possible with the help of the rate of unemployment. We can compute rate of unemployment as follows:

If we assume total labor force of the size of 40 million workers and those unemployed to be 2 million, then the rate of unemployment will be 5 percent.

Usually in every society there is a small percentage of labor force which is always in the condition of unemployment in the sense they are either seeking jobs or they are voluntarily unemployed. Such a percentage (of about 3 to 4 of the total working force) is considered the natural rate of unemployment. Public authority need not introduce any special measures to deal with such unemployment. If we assume 3 percent as a natural rate of unemployment then in the example, above 2 percent (5-3) can be said to be net unemployment of involuntary type and requires quick remedial measures. Though public unemployment programs are primarily targeted against involuntary unemployment, other forms of unemployment may also derive some indirect relief from such activities. iv) Involuntary Unemployment: J.M. Keynes has used the term involuntary or forced unemployment in his General Theory. It is also known as cyclical unemployment. Historically, modern capitalist methods of production are highly susceptible to cause periodic cyclical fluctuations. These cycles create changes in the economic activities in the form of prosperity or expansion on the one hand and depression or crisis on the other. During the phase of depression a sizable proportion, sometimes 30 to 40 percent or even more, of the labor force is rendered

unemployed. Under such a situation these unemployed workers are willing to accept jobs at whatever wage rate paid to them. But they fail to get employment because of depressed productive activities. It is such involuntary unemployment which is a fundamental and urgent problem that modern public authorities face. Therefore the major purpose of the modern public policy and public expenditure is to reduce or eradicate such unemployment conditions. v) Disguised and Seasonal Unemployment: There are two other sources of unemployment. Disguised unemployment is a situation under which productivity of the working force is very low. This is because an excessive number of workers are employed than what is optimally desirable. If a small plot of land has a maximum capacity to employ six workers then if the actual number of workers attached to land exceeds this limit, some of the workers will be disgustedly unemployed. It implies that though some of the workers attached to land appear to be employed their service is not being utilized to the optimum. Their productivity is very low and even if they are detached from the land, the total output will remain unaffected. Usually disguised unemployment exists in developing countries, which are characterized by large populations and hence a surplus labor force. Finally, the seasonal unemployment condition is likely to exist in such productive activities which can be undertaken only during specific season. Traditional agrarian economies provide work to agricultural labor mainly during the harvest season. Similarly there are certain industry or trade activities that flourish only during festival or such other seasons. Consequently job opportunities fluctuate and reduce during off-seasons. However, such instances of unemployment do not cause a serious problem since the workers are aware and are prepared to face the situation. (B) Rate of Unemployment: One of the important functions of the modern public authority is to reduce unemployment. This requires large-scale public spending on employment promotion schemes and on the payment of unemployment doles. So that this function can be performed promptly and satisfactorily, it is important that the information about unemployment conditions should be quickly available. This becomes possible with the help of the rate of unemployment. We can compute rate of unemployment as follows:

If we assume total labor force of the size of 40 million workers and those unemployed to be 2 million, then the rate of unemployment will be 5 percent.

Usually in every society there is a small percentage of labor force which is always in the condition of unemployment in the sense they are either seeking jobs or they are voluntarily unemployed. Such a percentage (of about 3 to 4 of the total working force) is considered the natural rate of unemployment. Public authority need not introduce any special measures to deal with such unemployment. If we assume 3 percent as a natural rate of unemployment then in the

example, above 2 percent (5-3) can be said to be net unemployment of involuntary type and requires quick remedial measures. Though public unemployment programs are primarily targeted against involuntary unemployment, other forms of unemployment may also derive some indirect relief from such activities. 3.3 Inflation This is the second serious problem that worries modern public authorities. Ordinarily inflation is associated with rising price conditions. But to be accurate we can define inflation as a situation under which general level of prices shows tendency of cumulative and continuous upward rise. For rising prices to be considered inflationary, all these three conditions must be satisfied. In the first place, the rising trends of the prices should be general and not sectional. Consumers and producers, goods, raw materials, interest rate, wages, imports and exports prices should all contain an element of inflationary pressure. In the second place, such price changes must be cumulative in the sense that the prices of finished products should have risen because of higher prices of raw materials, or the prices of goods should have risen because of higher wages and vice versa. Finally, inflationary price rise should be continuous. The rounds of rising prices should be repeated month after month and year after year. Inflationary situations in almost all parts of the world have become very common in the post World War II period. A high degree and long phases of inflation are very a complex phenomena. There are a variety of contributory causes. These are the forces active both on the supply (cost of production) and demand (total private and public expenditure) sides of the economy. A section of economists, such as Sir Irving Fisher, A.C. Pigou, Dr. Friedman, known as quantity theorists or monetarists uphold the view that an excessive supply of money, or unexpected changes in the money supply, is the chief cause of inflation. On the contrary, Keynes and his followers held the view that so long as there exist unutilized resources and unemployed labor, an increased money supply will not cause inflation. In a modern economy year after year there is some increase in the supply of the quantity of money in circulation. Normally, the annual increase in the money supply is 3 to 4 percent. This is essential to keep pace with increase in the productivity, increase in the size of the population and changes in some other dynamic forces. Therefore annual rise in the price level to that extent (of the order of 4 percent) is not considered inflationary. Any further rise in the price level in excess of 4 percent will then cause an inflationary pressure on the prices. Suitable measures, such as controlling money supply and public expenditure, regulating prices, improving supply conditions, restricting wage and cost hikes, can be introduced to contain inflation and to restrict price level. Various theories analyzing inflationary price changes have been developed. These are: Cost Push or Demand Pull. Besides internal causes, even international trade activities cause spread of inflation through the imports of goods and services.

********** CHAPTER 4 : AGGREGATE DEMAND AND AGGREGATE SUPPLY 4.1 Aggregate Demand (A) Meaning: Aggregate demand is the total demand made by all members of the society for all goods and services. In macroeconomic analysis such aggregate demand is a function of the general level of prices. Here, the price of any individual good or the demand for it from an individual member is not under consideration. In fact it is the demand for all goods and its dependence on the level of all prices that is being analyzed. Such a general level of prices is in the form of a price index which is usually Consumers Price Index or CPI. The demand on the other hand represents demand for real national income which can be denoted as Yr. Aggregate Demand (AD) is then a function of the price level (P) and the relation between the two can be expressed in the form of a schedule. By scheduled pairs of prices and AD quantities we mean that at arbitrarily given prices, expected quantities demanded are related. On the basis of a demand schedule, as shown below, we can also represent it graphically. CURVE

AD Schedule Price level 6 5 4 3 2 1 AD quantities or Yr 10 12 18 30 44 60

In the AD Schedule we notice an inverse relationship between level of prices and the quantities or real income. As the price level falls (through 6 to 1) Aggregate Demand goes on increasing (from 10 through 60). In the figure, the same information has been presented graphically (in the form of the AD curve). In the figure price has been measured along the vertical and AD quantity along the horizontal axis. The inverse relation between the two is apparent since the AD curve slopes downwards. (B) Inverse Relationship: In case of the individual demand curve the price - quantity relation is inverse and hence the demand curve slopes downwards. This is because of both substitution effect which is negative and income effect which is positive. In such cases we concentrate only on the changes in the price of a single commodity, assuming prices of all the substitute goods to be constant. Therefore the good (say X) for which price rises, becomes relatively dearer, and part of its demand is shifted to other substitutes which are relatively cheaper. Therefore the demand for good X falls. On the other hand, with rise in the price, the consumers real income falls since the purchasing power of his money income decreases (he will have to shell out more money to buy the same amount of good X at its higher price). Hence his demand for good X decreases. Therefore both price and income effects cause demand to fall with a rise in the price of a good. However, in case of changes in aggregate demand and general price level such a simple relation does not hold good. In this case since prices of all the goods are rising simultaneously there cannot be any substitution effect. Moreover, with rising price level money income of labor and other factor owners who provide their services is likely to go up. Therefore, their capacity to spend is likely to increase and demand for goods may actually rise, instead of falling, or may at least remain constant even with a rise in price level. For this reason, the inverse relationship (downward sloping curve) of the aggregate demand curve cannot be explained with the same reasoning as that of the individual demand curve. Yet the price level and aggregate demand continue to hold a negative or inverse relation because of the presence of the three distinct effects. (C) The Three Effects: There are three different effects operating on the aggregate demand as a result of rising price level, or under inflationary conditions. These are Wealth Effect, Rate of interest Effect and Trade Effect. i) Wealth Effect: Professor A.C. Pigou had first stated and analyzed wealth effect under inflationary conditions of the price level changes. With a rise in the price level, value of the given money income of consumers (assuming supply of money to be constant) decreases. With a fall in the purchasing power of their income consumers become poorer and have to reduce their consumption. By way of an example a person with fixed money income of $100 can purchase 25 units of a commodity, price of the commodity being $4. But he can purchase only 20 units of the commodity when price rises to $5. Thus the real income or wealth of a consumer diminishes from 25 to 20 even when his money income is constant. Such a wealth effect results in the consumer reducing his demand with a rising price level. Contrary would be the case under the conditions of deflation and falling prices. In that case his wealth effect will be positive and enable him to purchase larger quantities of all goods and services. Hence the presence of the wealth effect continues to maintain an inverse relation between price level changes and aggregate demand.

ii) Rate of interest Effect: Rate of interest is also a price like all other prices of goods and services. It is the price paid for the use of money or for the use of loanable funds. Rate of interest also shows a tendency to move upward under inflationary conditions or rising prices. With rising price level and with a constant supply of money, there is an increased demand for liquidity or money and credit resources. This is because the rising price level reduces purchasing power of money. Hence a greater quantity of money is needed to carry out a given volume of transactions. Both households and producers create an increased demand for money under conditions of rising price level. Consequently, with constant supply, growing demand for money tends to raise its price in the form of rate of interest. With higher rates of interest, borrowing becomes dearer and the tendency to save rather than consume is induced. Consequently demand for goods and services both from consumers and investors starts declining. Therefore a rising level of prices results in a fall in the aggregate demand due to a rise in the rate of interest. iii) Trade Effect: Rising level of prices finally causes fall in the aggregate demand via foreign trade effect. Under the conditions of inflation domestic prices of goods are higher than international price levels. This makes import of goods attractive since import prices are lower and goods are cheaper than domestic products. Again because of an inflationary rise in the prices of export goods, foreign demand for exported goods declines. Both these processes together reduce demand for domestically produced goods and services. (D) Shifts in Demand: As in the case of the individual demand curve, aggregate demand curve shows a tendency to shift leftward or rightward. The demand curve shifts in this manner when aggregate demand tends to rise without any change in the domestic price level. In other words this occurs when aggregate demand alters for causes other than changes in the price level. There are a variety of such causes contributing to shifts in aggregate demand. When the public authority increases its expenditure, more purchasing power is put in the hands of people who create an increasing demand. If the rates of taxes are reduced then again peoples capacity to spend increases and aggregate demand will rise. International demand and supply conditions may also contribute to shifts in the aggregate demand curve. Rising price level in countries abroad may make exports of a country relatively cheaper and cause an increased demand for exports. On the contrary under such conditions imported goods become relatively dearer, the demand for which declines and this results in a rise in demand for indigenous products. When all these factors are moving in the opposite direction, they will result in a fall in the aggregate demand and rightward shift in the AD curve.

In figure 11, DD is the original demand curve. On this demand curve at a given price level P1 aggregate demand is of the size q1. But when the demand curve shifts rightward or upward, as D1D1 then at the same price level P1 demand increases from q1 to q2. This means that there has been an increase in demand at the same price. If we consider the higher demand curve D1D1 to be the initial demand curve, then the demand curve DD denotes leftward or downward shift. This time it means that at the same price there has been a decrease in demand. 4.2 Aggregate Supply (A) Meaning: Aggregate supply is the total quantity supplied by the producers and sellers. In the scheduled form it is presented through a range of expected quantities supplied at arbitrarily chosen prices.

Aggregate Supply Schedule Price 1 2 3 4 5 6 Quantity supplied 5 15 30 48 58 60

(B) Direct Relationship: Aggregate supply shows a direct relationship with the changes in the price level. As price level rises (from 1 through 6) the quantity supplied goes on increasing (from 5 through 60). The direct relationship between price and aggregate supply is due to the same

reason as in the case of individual supply curve. In both the cases the cost of production goes on increasing with every addition to the goods produced. Therefore more and more supply can be made only when the price level is rising in order to cover rising cost of production. It can be represented graphically in Figure 12.

In figure 12, quantity supplied has been measured along horizontal axis and price level has been shown on the vertical axis. Because of the direct relation between the two, the supply curve OAS is continuously rising upwards. However, there is an important difference in the behavior between individual and aggregate supply curves. An individual supply curve is moderately steep throughout. But in case of aggregate supply curve, two distinct phases are noticeable. Initially the AS curve is flatter and rises upwards only gradually. In the figure ON is such an initial phase. But later on the AS curve becomes steeper and finally becomes a vertical straight line. In the figure, N-AS is such steeper phase. (C) The two phases: The two phases need some explanation. Initially, at the low levels of output produced and supplied, a very small proportion of available resources is utilized. So long as labor, plants and equipment, land etc. are underutilized or unemployed, marginal cost of employing them is relatively low. Therefore more and more output can be produced and supplied with reasonably small rises in the price level. But as resource utilization tends to a fuller level, the marginal cost of employing resources starts rising sharply. Ultimately, when all available resources are exhausted, the condition of no further supply of real goods and services is reached (that is the full employment level). If the price level beyond this point continues to move upward it can no more induce additional production and supply. Rising price level will then be purely inflationary without adding any more to the output level.

Aggregate supply curve may shift upwards (leftward) or downwards (rightward). In figure 13 OAS1 is the original supply curve and AS2 - AS2 is the new upwards or leftwards shifted Aggregate Supply curve. On the new supply curve at a given price P1 aggregate supply has decreased from q1 to q2. If we were to start initially from O-AS1 curve then O-AS would have been a rightward or a downward shifted supply curve showing greater quantity supplied at a given price level. Such shifts in the supply curve are caused by a variety of dynamic changes taking place in the economy. Technological improvements, skill development of labor, innovation, foreign trade prospects are some of examples of it. These factors may cause either favorable or unfavorable effects on the supply conditions. Their unfavorable nature causes an upward shift and favorable effects lead to a downward shift. In the long run, a downward shift in the aggregate supply conditions is normally experienced when an economy has been making progress and development. (D) Short and Long run supply: Earlier we have seen that aggregate supply curve has two phases. Initially on the flatter portion more and more output can be produced with a small rise in the price level. This is possible so long as some resources are unemployed or underemployed. But once the economy reaches a point close to full employment of resources, the supply curve becomes very steep and vertical. These two phases can be associated with short and long run transitions in the aggregate supply conditions as well. The flatter initial phase is a short-term phenomenon whereas steeper vertical portion is experienced in the long run. The distinction is based on the fact that progressive fuller utilization of available resources is a time-consuming activity. Besides there is another contributory factor which causes lapse of time between the two phases. Several resource agents or factors of production are employed on the basis of contracted remuneration. Rate of wages, rent of land and building premises, interest on the loan funds are all examples of contract payments. These contracts last for six months, a year or for a longer period. With an initial rise in the price level contracted factor payments do not rise and quick expansion in the output becomes possible at fairly steady costs. This explains the short run, flatter portion of the supply curve. But after the lapse of time when the contractual period is over the factor agents demand higher remuneration to compensate for the inflationary price rise. This suddenly causes cost of production to rise sharply. The long run supply curve therefore tends to get steeper and gradually attain a vertical shape. But note that both the causes namely fuller utilization of resources and renewal of contracts at higher factor prices together cause steepness and rigidity in the long run supply conditions.

Figure 14 shows relatively flatter short run supply curves while figure 15 shows long run supply curves. Corresponding to the two earlier phases we have here drawn two separate supply curves. 4.3 Equilibrium Given the supply and demand curves in their aggregate form, an equilibrium level can be established at the point of their intersection.

In figure 16, AD and SAS are such short run curves. The two have intersected at point E which is the equilibrium; the price that is commonly offered and received is P and quantity exchanged is Y (P and Y bar). This is only an initial equilibrium and it can alter with a shift in either the demand or supply curves.

In figure 17 such a shift upwards in the aggregate demand curve has been shown. This causes equilibrium position to shift as well from E to E1. In the new equilibrium position price level rises from P to P1 and real output quantity exchanged increases from Y to Y1. Such an increase in the real output becomes possible because between E and E1 we were still operating along the short run supply phase, where some resources were underutilized. But once the point E1 is reached the supply curve becomes steep and vertical. Here the full employment level is reached and no more resources are available for further additions to be made to the real output. Therefore E1Y1 is a vertical full employment long run supply curve (LAS). Points such as E are partial equilibrium under employable points.

Finally in figure 18 we have an interesting case where aggregate demand shifts and increases beyond full employment level. In this case E1 is the original point of equilibrium with AD1 and SAS1 having intersected at this point. However this happens to be the full employment condition and LAS passes through this point which is Y1E1. If aggregate demand further shifts upwards as shown by AD2 then a new point of equilibrium is attained at E2 where AD2 and SAS1 have intersected. The new price level is then P2 and output quantity Y2 . However, since all available

resources were fully employed and exhausted at Y output level, this increase is purely a monetary phenomenon caused by rising price level. Therefore movement from Y1 to Y2 is only an increase in money value of the real output. This becomes possible because contracted agents of production have secured a hike in their wages, rent and interests. As a result of increase in input prices and consequent rise in the cost of production, the supply curve shifts upwards as SAS2. Yet another point of intersection between AD2 and SAS2 becomes possible at a new equilibrium level E3. In this equilibrium position we revert to the old full employment level of output Y1though the price level is now higher than before as P2. Thus in the long run after all adjustments have taken place the economy settles down at the full employment level and only price level rises upwards due to inflationary pressure. **********

CHAPTER 5: OUTPUT-EMPLOYMENT THEORIES (CLASSICAL AND KEYNESIAN) 5.1 Classical Theory (A) Introduction: Employment and output analysis at macro level has become an important part of economic theory only during and after the Second World War period. It was J. M. Keynes who first analyzed the frequent problem of unemployment and fluctuating levels of real output or national income. Before Keynes General Theory (1936) there was hardly any important and serious discussion of the problem of unemployment. However, some underlying issues were discussed by the classical economists. The classical school between 1770 to 1870 mainly includes such leading economists as Adam Smith, David Ricardo, J.B. Say, John Stuart Mill and Karl Marx. The later neo-classical economists like Alfred Marshall (between 1870 to 1930) had hardly anything to add to the classical theory. Professor A. C. Pigou, the contemporary of Keynes strongly justified classical approach and was critical of Keynes new theory. Keynes therefore has regarded all of his predecessors as classical economists in this context. The classical theory is based on the automatic self equilibrating tendency of the economic forces. (B) Says Law: The classical theory of employment rules out the possibility of any general and prolonged unemployment. The classical employment analysis is based on the Market Law of the French economist J. B. Say. The law is simply a description of market exchange activity: "Supply creates its own demand." This apparently simple statement has serious implications. Usually, for an individual good of a smaller seller this statement appears to be a truism. Such a businessman would make suitable adjustments in the price he charges and would clear the market for the supply that he intends to make. If on a particular day he observes that his supply is exceeding demand, then assuming that the good he supplies is extremely perishable (the supply of which cannot be withdrawn or postponed), he will lower the price somewhat and thus create sufficient demand for it. So far so good. However, it is important to remember the classical economists and Says Law were concerned not with a single good and a single supplier of it. The law is a generalization at the macro-level where all varieties of goods and services are supplied. This law in particular meets with serious limitations when an attempt is made to make it applicable to the labor market and to the conditions of employment level. (C) The Classical Approach: If the principle of supply creating its own demand is made applicable to the labor market, one would wonder what its effect would be. The number of workers may be in excess of the available job opportunities and the employers demand for their services. Therefore at the existing or going market rate of wages all available working force cannot be absorbed. Some workers will be rendered superfluous and will remain unemployed. The classical answer to the problem is that like all other goods and their prices workers wage rate should be cut or lowered so that the employers will be induced to employ more number of workers. The condition of full employment can then be restored if workers are agreed upon the wage cut solution. Thus flexible rate of wages is a classical approach to solve the problem of unemployment.

It is possible that some workers may resist a cut in the wage rate and may remain unemployed. But according to the classical viewpoint such unemployment is only voluntary in nature. Moreover individual employers face excess supply of labor conditions. Therefore such unemployment is only temporary and partial in nature. With the acceptance of the law: "Supply creates its own demand", there cannot be any prolonged, involuntary and general unemployment situation in the economy. The classical theory therefore rules out any general or widespread kind of unemployment. This sort of classical assertion is a result of the typical approach of the classicists to the capitalist free enterprise system. They believed in the self-equilibrating nature of such an economy. Even if there are any disturbances in the initial equilibrium conditions these are temporary and minor. Moreover, these can be cured automatically and spontaneously. There is an in-built flexibility in the supply and demand forces which leads the economy towards restoration of the equilibrium condition. Therefore general equilibrium in such a private and free economy is a rule and any disturbance or disequilibrium is only a momentary exception. (D) Classical Solution Illustrated: The classical solution to overcome temporary and marginal gaps between demand and supply: forces is in the form of flexible wage rates and flexible prices. This can be illustrated. At the macro level of economic operations the prices include a variety of prices of goods and services, wage rates, interest rates, rent of land etc. Lets therefore illustrate it with the movements in the rate of interest. This should however be treated as of symbolic importance. What is true about rate of interest is equally true under the classical system about wage rates of all other prices. Lets assume that for some reason the consumers decide not to spend the whole of their income. This would cause a fall in the demand. With such a shrinking in the consumers aggregate demand all the goods and services offered for sale in the market cannot be sold. In the market there would exist the condition of excess supply. The producers would be worried that this may eventually cause a fall in the price level and thereby a fall in their profit margin. Therefore the firms would be inclined to restrict their production and reduce their particular demand for factor services. Hence an initial fall in the consumers demand ultimately results into the unemployment condition. But in view of self-equilibrating nature of the economic activities, at this point one can bring in the flexible price solution of the classical argument. We illustrate this with the help of a figure which shows the aggregate savings and aggregate investment curves. In this case with a fall in the aggregate demand for consumption goods, a compensating increase in investment expenditure takes place, with appropriate changes in the rate of interest.

In figure 19, SS and II are the initial savings and investment curves respectively. The point of intersection of these curves is E which represents the initial equilibrium position. At point E the rate of interest is r and amount of savings equal to investment is L. When consumers decide to spend less their unspent portion of the income results in an increased level of savings. This has been shown by a shift in the supply curve of savings from SS to S1S1. With increased amount of savings, the rate of interest starts reducing. It falls from r to r1. With reduction in the rate of interest, the price paid for borrowed loanable funds reduces. This induces producers to invest more to reach a new point of equilibrium E1. This is a point at which S1S1, the saving supply curve intersects the investment demand curve. Once again savings are equal to investment at higher level of loanable funds L1. Therefore in the new equilibrium position a fall in the rate of interest causes a rise in the amount of investment of the size L1. This compensates for the fall in the consumption demand for goods and services. As a result of such an increase in the investment demand, the level of aggregate demand is restored. Any danger of large-scale unemployment has thus been avoided. The classical economists have also depended on similar adjustments in the level of prices and wage rates. Hence flexible rates of interest, prices and wage rates together ensure full employment in the loanable funds, commodity and labor markets. Such a self-equilibrating process prevents any dangers of prolonged and general unemployment conditions. The total equilibrium has been shown below in figure 20. (E) Full Equilibrium: The classical flexible interest, price, wage rate solution automatically leads the economy back to the full employment level. Therefore the effect of a fall in consumer demand on the levels of output and employment is only temporary. In figure 20, AD1 and SAS1 are original aggregate demand and aggregate supply curves respectively. The two curves have intersected at point E.

In this equilibrium position original price level is P and real output or national income level is Y. This is full employment equilibrium since the long run supply curve LAS passes through this point. When the consumers reduce their demand for consumption goods the aggregate demand curve then shifts as AD2. The new AD2 curve and original SAS1 curve have intersected at point E1 which is a short run partial equilibrium condition. At E1 the price level falls to P1 and real output level reduces to Y1. Thus a fall in the real output causes some unemployment of labor and other resources. But due to equilibrating forces at work, such as a fall in the rate of interest and a cut in the wage rates, a fresh demand for investment goods is generated. A fall in the wage rates

reduces cost of production which induces producers to employ more workers. As a result of these adjustments the economy moves from E1 to a new equilibrium point E2. At this point AD2 intersects the new supply curve SAS2 which has shifted downwards. Such a shift in the supply curve shows a fall in the cost of production due to a cut in the wage rates. At point E2 the original equilibrium level of output Y can be produced which is the full employment level of output. The price level has now fallen to P2. Thus with a fall in the rate of interest, price level and wage rate, the restoration of full employment equilibrium level becomes possible. 5.2 Keynes Employment Theory (A) Keynesian Revolution: It was in the year 1936 that Lord John Maynard Keynes General Theory of Employment, Income and Rate of Interest was first published. It is the first ever full account of macroeconomic activities. Keynes theory is an outstanding piece of analysis, which is considered a landmark in the history of economic science. It contains a variety of novel scientific ideas. It is a major breakthrough in the classical tradition and an entry into a modern Keynesian school of economics. His followers Harrod, Domar, Kaldor, Mrs. Robinson, Solow etc. have ever since widened the scope of macroeconomic analysis. After the publication of the General Theory both economic practice and policy making have changed fundamentally. It is not without reason that the theory has come to be known as 'Keynesian Revolution'. The revolutionary impact of the theory has been variously demonstrated. Keynes has introduced a variety of new tools of analysis. His equations of income and expenditure, consumption function, law of marginal propensity to consume (MPC), multiplier operations, investment function and marginal efficiency of capital (MEC), identity between savings and investment, and his pure monetary liquidity preference theory of interest accompanied by speculative motive for demand for money are some of his new contributions. Keynes denied the classical belief that the free enterprise system is a self regulating one and asserted that such a system requires periodic intervention of the public authority to avoid fluctuations and instability in economic activities. Besides, Keynes replaced the classical partial equilibrium by a more general equilibrium to ensure the full employment level of output and employment. Keynes was building an entirely new structure of economic analysis to study and redress the problem of unemployment. It was therefore essential for him to bring out weaknesses and inadequacies of the classical approach to the problem of unemployment. (B) Critique of Says Law: Keynes criticism of the classical theory in general and Says Law in particular is the first step in the direction of the new theory. Says Law of the markets is a truism only under barter economic system. In that case whatever goods are produced are either sold in the market or are utilized for self-consumption. Hence supply and demand are always equated. There cannot be a general surplus or glut of the goods. Though this works well under barter conditions it is no more true in a modern economy where almost every transaction is carried out with money in the form of currency or credit. In such an economy buyers and producers or even sellers are not directly collecting together to carry out the exchange activity but messages are sent through the medium of money. The classical approach is essentially partial and a microeconomic piece of analysis. It looks at the problem of employment and unemployment from the perspective of an individual producer

and employer. Therefore it regards unemployment only as a temporary and voluntary condition. It rules out any possibility of large-scale involuntary condition of general unemployment. But in reality one noticed frequent occasions of economic fluctuations and widespread unemployment conditions throughout the 19th century and early 20th century. The latest example of it is in the form of the period of the Great Depression (1929-33) which rendered 40 percent or more of the labor force unemployed in western countries and other parts of the world. All these events make it evident that the classical theory was far from the reality. This is essentially true because the problem of unemployment is not partial but general, not voluntary but involuntary and not micro but macro in its nature. Therefore it needs to be analyzed in its proper perspective and handled differently. Unemployment, as we understand today, was not a problem for classics which is unfortunately not true. Moreover, the classical solution to tackle unemployment, in whatever form they conceived it, is totally inadequate and unsatisfactory. They have relied entirely on a cut in the rate of interest and wage rates. These are self-defeating polices. Any cut in wage rates will result in widening the gap of unemployment instead of correcting it in modern times. This is because of the fact that any attempt to cut wage rates at the bottom of the depression period will cause a considerable portion of the aggregate or effective demand to reduce further causing a more severe unemployment situation. This can be illustrated with the help of a simple example: Lets assume that a small fruit seller sells 20kg of fruit at a market price of $10 on a daily basis. Thus his daily turnover is $200 (20 v 10) of which the only cost of production is in the form of wage rate. If he employs 10 laborers at a daily rate of $15, then the total wage payment is $150 (10 v 15). The fruit seller therefore earns a daily profit of $50 (200 - 150). If for some reason the demand for fruit that he sells reduces, then he will have to reduce the price say from $10 to $8. In this new situation his total daily turnover goes down to $160 and at the old cost of production, his profit margin declines to $10 (160-150). The fruit seller is not satisfied with this. Therefore he may reduce the number of his workers from 10 to 8 and bring down the cost of production from $150 to $120 (8 v 15). The two workers are then rendered unemployed. If the unemployed laborers insist on their re-employment, the producer will lay down the condition that wage rate of all the workers will be reduced from $15 to $11. If the workers accept this then the total wage bill will be $110 (10 v 11) which restores the sellers profit of $50 (160 - 110) as before. It appears that even with reduced demand and fall in the price of fruit, unemployment of workers has been avoided with the help of a cut in the wage rate. But this in only a momentary and superficial solution. The workers total income has now reduced from $150 to $110 as a result of which they can spend less and reduce demand for every other commodity that they consume. Therefore initially the problem of depressed demand and unemployment which was faced by a single seller will eventually become a general and wider problem faced by all other dealers. Instead of curbing it, the wage cut solution will therefore increase the problem of unemployment. Though this example is oversimplified and hypothetical yet it helps to bring out gist of the Keynes Criticism of Classical theory. Keynes further asserts that the classical wage cut solution is unsatisfactory both in theory as well as practice. In modern times trade unions and political parties have been strongly supporting the cause of the working class. Therefore even if wage cut may make good economic sense, it makes

bad political sense. But Keynes at once proves that it makes bad economic sense as well. In order that the wage cut solution should be effective, not only is a cut in the rate of monetary wages required; it is necessary that real wage rates should also fall. This is in view of the fact that levels of output and employment are real variables and therefore these can be altered only when the real cost of production goes down. Hence a fall in the rate of monetary wages must be accompanied by constant general level of prices (CPI). But this scarcely becomes possible because economic actions are strongly interdependent. Falling rates of monetary wages are invariably accompanied by a falling price level. In that case real rates of wages will be unaltered. Thus Keynes has found faults with the classical analysis in every respect. He then proceeds to present his own theory of employment. (C) Effective Demand: The prospects of high levels of output and employment depend upon size of the effective demand and not the rate of wages. Effective demand is the total monetary expenditure of the community and is therefore a price. It depends upon two other variables, namely, aggregate demand (ADP) and aggregate supply price (ASP). Effective demand (ED) is then an equilibrium value determined at the point of intersection of the ADP and ASP schedules. These have been defined by Keynes as follows: 'ADP is that money value of all goods and services which producers actually receive.' ASP is that money value of all goods and services which producers expect to realize in the market. Thus producers plan their output and employment decisions on the basis of value of the ASP that they expect. But in reality what falls in their hand is the total expenditure or ADP that consumers are prepared to undertake. If ADP value satisfies ASP value then the producers continue to produce as before and employ as many workers as before. But if ADP falls short of the ASP then producers expectations are not fully satisfied and they are induced to reduce output and demand for labor. This causes unemployment. Therefore the cause of unemployment has been detected. It is then deficiency in the effective demand that is the culprit which results in unemployment. Lets illustrate this with the help of a figure. It will also help to draw a distinction between classical partial equilibrium and Keynes general equilibrium analysis.

In figure 21, units of employment have been shown on the horizontal axis and levels of real income have been shown on the vertical axis. AD1 , AD2 and AD3 are the levels of aggregate demand. Note the demand curves in this case are seen as upward functions and not downward sloping as normal demand curves. This is because demand curves (AD1, AD2 and AD3) here are functions of the level of income and not of the price level. The relationship between level of income and demand is direct, suggesting that the richer a person gets, the more would be his demand for all goods and services. OZ curve is a continuous upward function representing ASP and producers expectations. Since ASP is related to the cost of production it behaves in the same manner as a usual aggregate supply curve. The points of intersection between the two have been marked as E1, E2 and E1 which are all equilibrium points. At every equilibrium position the simultaneous values of real income and level of employment are determined. At points E1, E2 and E3 these are Y1, Y2, Y3 and N1, N2, N3 respectively. Moreover the points of equilibrium decide effective demand on different AD curves. Though every point on the individual AD is a point on the Schedule, only one point on it is effective, in the sense reflecting the willingness of consumers to actually spend a part of their income. Lets distinguish between Classical and Keynesian approaches. As we notice in the figure with a given aggregate supply curve higher levels of effective demand help to generate more employment opportunities and lead towards the full employment level. Lets assume that the economy is initially at point E2 with employment level as N2 and level of national income as Y2. At this stage some amount of the workforce is unemployed. If the classical solution of wage cut is applied then the economy is likely to move downwards in the direction of point E1. This will cause a further reduction in the effective demand, level of employment and real income. Therefore wage cut solution is self-defeating and intensifies the unemployment condition. What is needed at point E2 is the organization of the public expenditure program and the boosting the level of effective demand so as to move from E2 to E1. Such a movement ensures a higher level of employment and leads the economy closer to the full employment point. This proves that the level of employment is not a function of the rate of wages but it is a function of effective demand and size of the total expenditure in the economy. CHAPTER 6 : MONEY AND BANKING 6.1 Money (A) Definition and Meaning: Money is today popularly used in performing almost all economic transactions i.e. activities which includes the transfer of goods or services from one person or organization to another. It may be in the form of cash and currency or bank credit, bank papers like cheques, deposits, drafts, or in other near money forms such as bonds, shares, securities etc. Presently we will begin with officially supplied money in the form of currency notes. Money has a long history and has passed through several evolutionary forms such as wealth in the form of sheep, coins, gold and silver metals and has finally arrived at paper currency stage. Metallic money or coins is called commodity money while paper currency is known as paper money or fiat money. Another category is bank money which includes the credit that banks offer to depositors.

Paper currency has been increasingly issued and circulated in the present century. It has several advantages over money in the form of gold or silver. It saves the use of precious metals and is less risky to hold. Further, one finds it more convenient to transact with the help of paper currency in small or large quantities. But an even more important feature of the paper currency is its flexibility. Its supply is no more rigidly tied up with the availability of gold and silver. In most countries that use paper currency, some fiduciary principle is followed by the monetary authorities. (If something is fiduciary it is said to enjoy the support and confidence of the public.) Under proportional fiduciary the amount of paper currency can be conveniently altered whenever a certain proportion, say 40 percent, of gold reserves are maintained. The minimum fiduciary system is even more flexible. It requires monetary authority to possess some minimum gold reserves (say 500 kg of gold) to supply any quantity of paper currency. In either case it is clear that in modern times actual supply or issue of paper currency is much in excess and is never fully backed by gold reserves. Therefore modern currency system is also known as fiat money system. The value of fiat money is actually much less than what it represents. Money is general purchasing power. It can buy anything and anywhere against itself. In order that money should perform this role as general purchasing power, it must be universally acceptable. This can be possible only when its value is fairly stable and it is not subjected to disorder frequently. In reality, however, because of its excess and flexible supply possibility, the value of money is likely to fluctuate, particularly because paper currency is worth less in its intrinsic (natural) value. Therefore the modern monetary agencies hold a considerable responsibility of maintaining the value of money to keep it as stable as possible. The attempt to achieve this is by carefully controlling the supply of it. Money as general purchasing power is used as a means of exchange. Money is not normally demanded for itself but for using as a means or medium in buying and selling activities. Therefore money is judged as reliable and trustworthy or otherwise to the extent that it can perform its own functions. Therefore money is commonly defined in terms of its functions. Professor Walkers simple definition clearly brings out these functions: "Money is a matter of functions four, Medium, Measure, Standard, Store." Another definition based on its functions can be stated as, 'Money is what money does.' (B) Functions of money: As per Walkers definition money has to perform four major functions. If in reality money is found to be performing any additional function then it is directly or indirectly connected with these four functions. The first two of these functions medium and measure are known as 'M' or original functions of money. It is due to the fact that money was originally invented to perform these functions. The other two are S functions to act as a standard and store; these are its derived functions. Once the money was in use it could prove itself capable of performing these functions as well. Now lets look at the functions of money more closely.

i) Medium of Exchange: Money is used as a common medium or means of buying and selling all goods and services. In the absence of money exchange activity used to take place in the barter form. Barter exchange means the direct exchange of goods against goods. Cloth is sold in exchange of sugar (which is therefore bought) or sugar is sold in terms of fruit (which is again being purchased) etc. But under such a system of exchange various inconveniences crop up. The major problem is of double coincidence of wants. Further, it becomes necessary that buyers and sellers of all such goods demanded must meet together at a particular place every time to perform the exchange. With the use of money only currency is needed to act as a medium between two or more buyers. Another basic advantage of the use of money is the wide extension of markets. Barter activity can be performed only locally among small traders. But with economic progress, markets go on expanding. Both the number of goods exchanged and geographic distances of markets widen. The markets extend from village to city and to regional, national and international levels. All this is facilitated by the use of money. ii) Measure of value: The second important function that money performs is to act as a common measure of values of all goods and services. In this form money acts as a unit of account. Under barter exchange buying and selling was difficult or even impossible in case of large variety of goods. This is because several goods are quite dissimilar. Hence to decide and compare their values is inconvenient. For instance, one would possibly not be able to compare the value of some pounds of wheat with a few ounces of milk or of a piece of land with number of cows. But with the use of money as a commonly accepted standard value of all goods and services can be expressed and compared in it. iii) Standard: In modern times money acts as a means of deferred payments. We may purchase an automobile or a TV set today and pay back in installments over a few months or years ahead. We can avail of a doctors services today and conveniently pay him later on. Businessmen may purchase raw materials or machines today and pay their charges when the goods are produced and sold. All these are called credit or loan transactions. Money can suitably be used for this purpose. The only difference may be in the present and future valuation for which a small additional amount is paid or received by way of premium, discount or interest charges. By acting as a standard of deferred payments, the size of the markets and exchange activities is not only widened but also multiplied several times. iv) Store of value: Goods and services are perishable. These must be consumed or utilized immediately or within short interval whenever they are supplied. Fruit, vegetables, fish, milk or services of teachers, workers, musicians must be used within a very short span of time. These goods and their values cannot be stored up for future use. Even when it is possible (in case of some durable goods) to preserve them, there is always a danger of their damage or loss of value. But with the presence of money all these inconveniences can be avoided. Excess grains produced by farmers can be sold at market price and the money received can be deposited in the bank. As a matter of fact, money can store values for future use or transactions because money in paper currency or in the form of bank deposits is a transferable and a durable commodity. Its capacity to store values and wealth enables it to act as a standard of deferred payments.

On the other hand, it may be pointed out that money may not be the sure shot way as a store of value. After all it may even devaluate over a period of time. At the same time, nevertheless, it may be regarded as the most liquid asset as it is easily accepted universally. (C) Demand for Money: The demand for money is made in the form of currency or cash possessed or in the form of checkable and quickly withdrawable saving deposits. All such demands are mainly meant for carrying out a variety of activities. There are household demands for purchasing several consumption goods, for payment of services of doctors, teachers, for purchasing durable goods like property or automobiles etc. A firm or a trader demands money for purchasing raw materials or plant and machinery, for the payment of wages, salaries and other factor payments etc. Besides such a demand for money in order to carry out various transactions, some people demand it for hoarding or holding wealth in liquid form. It can conveniently be used according to variations in the market conditions. Each of these purposes is called motive for demanding money. There are three chief motives for which money is demanded. These are transactions, precaution and speculation. The first two motives are traditional and classical economists made use of them. The third motive of speculation is modern; Keynes has introduced and analyzed this particular motive. i) Transactions Motive: Money is demanded to perform variety of regular economic transactions. Both households and firms have to carry out a variety of transactions for which they need money. Even an individual member going out to school, college or the workplace has to spend on transport, buying beverages, snacks etc. for which he needs some money. Throughout the day millions of transactions are taking place for which money is paid or received. The demand for money on account of the transactions motive is fairly stable. It is related to the size of the income and type of activities performed by individuals, households and firms. Since the size of the income does not change suddenly and significantly, the demand for money for this purpose is normally constant in the short run. Demand for money to satisfy transactions motive is about 50 percent of the size of an individual or household income. ii) Precautionary motive: Money demanded to satisfy the precautionary motive is for meant for unforeseen circumstances. This amount of money kept aside can be used during times of uncertainty or emergency. An individual or a household creates such demand to face future possibility of accident, sickness, unemployment, old age, education of the children etc. The firms, corporate bodies and governmental agencies also demand money to meet the precautionary motive. Fluctuating economic conditions, future uncertainties, sudden needs of expenditure, failure of expectations are some of the examples which necessitate such demand for money. Even this type of demand for money is more or less steady in its amount. It depends mainly on the size and responsibilities of the family and size of the income. In the short run these factors remain constant and hence demand for money also remains nearly constant. iii) Speculative motive: Keynes was the first economist to admit the role of speculative activities in modern economy and that of demand for money made by speculators. Such demand is made to invest in capital market for buying shares, bonds, securities etc. when their prices are low. But speculators quickly dispose of their securities when their prices are sufficiently high. They make capital gains from such transactions. In order to carry out this activity, speculators create demand

for money on a large scale. Keeping money in this idle form is known as hoarding of money. Keynes has shown that speculative demand for money is highly fluctuating. It all depends upon fluctuating prices and market conditions for securities. Therefore total demand for money or liquidity can be classified into two parts: Total demand for money = L = L1 + L2 L1 is that part of money or liquidity demanded to satisfy transactions and precautionary motives. This is more or less stable in size. Keynes calls this the demand for Active Cash balances or money. The second part L2 is money demanded made to satisfy the speculative motive. Such demand for money is highly unstable and fluctuating. Keynes has called this as demand for Passive Cash balances or money. Speculative demand depends upon the prices of securities but these prices are highly sensitive to the rate of interest. Therefore small variations in the rate of interest or even expected changes in the rate or interest can create large variations in speculative demand for money. (D) Supply of Money: Supply of money is carried out and regulated by a monetary authority. Generally such a monetary agency is in the form of a central bank (Federal Reserve Bank, Bank of England, Reserve Bank of India etc.) and the Finance Minister or such other government agency. The supply of money is institutional and part of a policy decision. It does not depend upon the economic behavior of individuals of firms. Therefore the supply of money remains stable in the short run. In a modern economy besides official currency there is a variety of other resources which act as near money and perform similar functions as medium of exchange. Some of them are convertible into currency after a lapse of time and with some inconvenience. These include checkable deposits, current deposits, savings and fixed deposits, very long-term deposits with postal or insurance agencies, certificate deposits etc. All these forms of money make up for the total supply of money. With the inclusion of some or more varieties of these kinds of money the total supply can be classified into four categories. These are as follows: M1 = Total currency, coins and notes, checkable or current M2 = M1 + Saving and fixed (time) deposits M3 = M2 + Insurance company and postal bank deposits M4 = M3 + very long-term deposits, certificate deposits etc. deposits

According to the context of this discussion, supply of money can be stated in terms of one or the other category. When monetary authority directly attempts to alter money supply or quantity then it is of M1 the type. But generally, money supply is of the M3 type. 6.2 Banking (A) Commercial Banks i. Nature and Functions: Modern commercial banks have been functioning for over two centuries. They perform a variety of functions. They accept money deposits, lend money,

transfer money, issue checks and drafts, provide safe deposit vault facilities, act as trustees, act as financial agents, finance agriculture, industry and foreign trade etc. Modern bankers mainly act as middlemen between lenders and borrowers. Their deposits are collected out by the small savings of households and firms. Their borrowers are usually investors and businessmen or needy households asking for consumption loans. The loans are normally made by discounting bills. Money that banks receive creates liabilities on their part for future repayment. Money that they lend is their asset which they will get back sometime in the future. Tabular arrangement of the accounts of a banker is called a Balance Sheet. The loans issued by banks are also known as advances. Balance sheet Liabilities 1) Share Capital Assets 500 1) Reserves with Central Bank and Cash in hand 1000 2) Call Money 3500 3) Bills Discounted 4000 4) Investments, Loans, Advances 1000 5) Premises, Property etc. 10,000 Total 1200

2) Reserve Fund 3) Saving (Demand) Deposits 4) Fixed (Time) Deposits 5) Borrowing from other banks Total

1500 4300

2200

800

10,000

The Balance sheet of a banker always balances. This is because it is only a technical device of equating assets with liabilities. ii. Creation and supply of credit: Modern commercial banking is a profit making activity. It appears that their profits arise out of the difference in the rate of interest that they pay to the depositors and the rate of interest that they charge on their loans or advances. But a major source of their profit is creation and supply of credit money. Such transactions in credit money are much in excess of the original cash deposits that the bankers receive. The ability of a banker to satisfy all its depositors by paying them cash is called 'liquidity' of a banker. But because bankers create credit and liabilities much in excess of their cash holding, no banker is ever fully liquid. The banking business is therefore an activity colored with risk. Hence commercial banks have to operate under some control of the central banking agency in the interest of the public. The central banks have legal authority to require commercial banks to maintain certain reserves with it. Such reserve funds maintained by the central bank can be useful in the event of an emergency.

In their credit creation activity commercial banks go by the saving habits of their depositors. If the depositors are known to demand about 10 percent of their total amount deposited then the remaining 90 percent of the amount is available for credit creation and the issue of loans. For example, if the total deposit amount received by the banker is $10,000 then 10 percent of this is set aside. This is also the proportion of the reserve fund that is required to be maintained with the central bank. After maintaining a reserve of $1000 the remaining amount of $9000 can be issued as credit or advance. But the borrower of a banker is also its own depositor since bankers issue advances in the form of a fresh bank account in the name of the borrower. This explains the chief principle on which the banking activity is based. It can be stated as: 'Every advance creates a deposit'. Therefore in the example above $9,000 becomes a fresh deposit of which 10 percent or $900 is set aside and the remaining amount of $8,100 is lent in the same manner to yet another borrower. Again this becomes a deposit of which 10 percent or $810 is set aside and the remaining $7,290 is available to be loaned to the third borrower. The chain of borrowing and depositing continues until finally all resources are exhausted. But by that time the total transactions of a banker add up to $100,000 i.e. the amount exactly ten times as large as the original cash deposits of $10,000. The final tally is made up of $10,000 total reserves plus $90,000 total credit and advances. This has been summarized in the table below: Credit creation by banks Serial No. 1 2 3 4 Final Total Deposits 10,000 9,000 8,100 7,290 100,000 Reserves 1000 900 810 729 100,000 Advances 9,000 8,100 7,290 6,561 100,000

In the example above with the depositors are in the habit of demanding 10 percent and the same requirement of the central banks to maintain reserves, the net creation of credit money is $90,000 against original deposits of $10,000. This is 9 times larger the amount. However, this is the potential capacity of a banker to multiply his credit supply activity. In reality no individual banker will ever indulge in such a large proportion of the supply of credit. In reality bankers normally create credit to the extent of 5 to 6 times of their original deposits (500 to 600 percent). This is determined by a variety of factors such as convention, permission of the central bank, general market conditions and demand for loans, alternative sources of issuing financial resources etc.

There is also leakage in the credit creation activity, for example if the borrower of the loan immediately demands payment of it in cash, or if depositors change their habits during festive seasons etc. or if the central bank reserve requirement is altered or if bankers themselves want to play safe and maintain cash reserves in larger proportions, then to that extent the capacity of the bankers to create and supply credit reduces. (B) Central Banks i) Importance of central banks: Today in every country wherever commercial banks exist, a central bank is a must. Central banks have been established and have come into prominence in the present century. With the progress of the banking business, central banks acquire an essential role. Modern central banks, like the Federal Reserve Bank, the Bank of England, the Reserve Bank of India etc. perform a variety of functions. These functions are placed under three categories: a. To act as a banker to the government,

b. To function as a bankers bank, and

c. To control the credit supply activity. As a banker to the government the central bank performs a variety of functions. It acts as a government agent in making payments and receiving money on its (the governments) behalf. It is in charge of supplying currency and maintaining fiduciary reserves and foreign exchange reserves. It is the only financial agency that can issue currency. It also has to control the rate of exchange of the currency in foreign trade and maintain the value of currency internally. It needs to provide financial and loan resources and maintain these accounts for the government. As a bankers bank it acts exactly in the manner that commercial bankers act with their customers. It accepts deposits in the form of statutory reserves from banks. It rediscounts bankers bills and provides financial assistance to them. It supervises and advises commercial bankers in various respects. Another fundamental function is to control credit created by commercial banks. ii) The Federal Reserve Bank: The central bank of the U.S., the Federal Reserve Bank (or Fed as it is usually referred to), is in charge of issuing all the currency of the country i.e. the Federal Reserve Notes. The commercial banks keep their share of bank reserves with the Fed. As the Fed is the clearing house i.e. the place where all the transactions between the banks can take place (say the clearing of checks), the commercial banks maintain a section of their required reserves with it. Now consider the Balance Sheet of the Fed. Any Balance Sheet would list the Assets on the left side and the Liabilities on the right. The Assets section of the Balance Sheet of the Fed consists of a huge amount of government debt that is present in the form of U.S. government bonds. The

U.S. Treasury issues these bonds in order to pay for the deficits of the present as well as past governments. Now the Liabilities section of the Balance Sheet of the Fed comprises of all the Federal Reserve Notes (U.S. currency) in circulation as well as all reserves held with the Fed, which are actually private bank deposits. An important thing to remember is that the Feds total liabilities will always equal its total assets. iii) Credit control: Commercial bankers are profit making agencies. For them creation and supply of credit is a source of profits. The total credit money supply is much in excess and a certain multiple of the cash deposits that they possess. Therefore commercial banks are likely to run into difficulties whenever their depositors suddenly increase demand for money. If the bankers are unable to satisfy the needs of their depositors then they are likely to fail and go bankrupt. But for the central bank it is a matter of prestige that every bank should operate successfully and come over its difficulties. Therefore the central bank keeps a severe control on the credit supply activities of the banks. In order to achieve its goals the central bank uses two devices. These are quantitative and qualitative methods of credit control. a) Quantitative Control: Through this kind of control, attempts are made by the central bank to restrict the quantity or size of credit supply. There are three quantitative instruments used by central banks. These are: a. Bank Rate Policy,

b. Open Market Operations and

c. Variable Reserve Ratios (i) Bank Rate Policy: The Bank Rate is the official rate of interest declared by the central bank. It is that rate which the central bank charges on the rediscount facility and assistance that it provides commercial banks. The rate of interest charged by commercial banks is somewhat higher than the bank rate. Therefore whenever, the central bank lowers or raises the bank rate all other banks also have to lower or raise their respective interest rates. This makes credit or loan finance cheaper (when it is lowered) or dearer (when it is raised). This procedure helps in the expansion or the contraction of credit whenever necessary. (ii) Open Market policy: The central bank enters the capital market and sells or buys securities to contract or expand credit supply. When securities are sold, these are purchased by individual members or by the bankers. In either case the deposits or cash reserves of the banks reduce to that extent. This diminishes the capacity of bankers to create credit and there is fall in the credit supply to the extent of some multiple of the amount of securities sold. On the other hand, when the central bank buys the security, it puts money in the hands of people or banks and it enables bankers to expand their credit supply.

The fact that the Fed can alter the composition of its Balance Sheet enables it to regulate the money supply in the economy. For instance, the Fed may want to increase the supply of money. In this case, the Fed would purchase government bonds from bondholders and private banks. The direct result of this move would be that the reserves with banks would increase by exactly that amount (by which the bonds were bought) and thus there will be an increase in the process of deposit expansion. On the other hand, the Fed may plan to decrease the amount of money supply and therefore sell the government bonds it holds. The direct result of this would be that the amount of money available to private banks for the purpose of deposit expansion (i.e. reserves) will decrease proportionately. (iii) Variable Reserve Ratio: The central bank can also vary the cash reserves requirement of the bankers. It may be pointed out here that the money multiplier is inversely proportionate to the reserve requirement or ratio (refer the section: (C) Money Multiplier). If the reserves are increased (say from 10 to 15 percent), the money multiplier would be decreased and the capacity of the bankers to create credit will reduce to that extent. And therefore the supply of money would also decrease. But when the reserve requirement is reduced (say from 10 to 8 percent) by the central bank, the money multiplier would increase and the capacity for credit expansion would be enhanced. And hence the supply of money would also increase. This is how the Fed can control the supply of money in the economy. b) Qualitative Credit Control: Sometimes quantitative credit control measures are inadequate or are likely to be harmful. Quantitative methods apply uniformly and to the same extent to all bankers. But if the central bank finds that only a few or specific bankers are misbehaving then it has to apply qualitative methods to individual bankers. These may be in the form of special reserve requirement, moral appeal and advise or even direct action against defaulting bankers. (C) Money Multiplier: It has been observed in a previous section that commercial banks can make total credit supply which is a certain multiple of the original cash deposits. The extent to which such an expansion of credit can be made is called money multiplier. It is a reciprocal of the reserve requirement (which represents the tendency of people to withdraw cash). If the reserve requirement (RR) is 10 percent, the multiplier value is 10, and if RR = 8 percent, the multiplier value will be 12.5. Similarly, when RR=12 percent, the multiplier will be 8.33 Money Multiplier = 1/RR = 1/0.1 = 10, 1/0.08 = 12.6, 1/0.12 = 8.3.

Money multiplier thus varies inversely with the value of RR. ********** CHAPTER 7 : FISCAL AND MONETARY POLICIES 7.1 Fiscal Policy (A) Meaning and Importance of Fiscal Policy

i) Introduction: Fiscal and monetary policies are the two important instruments in the hands of the modern public authority. During and after the Second World War period these have gained ever-increasing importance in macroeconomic analysis and policy. It was Keynes who first recognized the need of regulating private enterprise economy. In his General Theory (1936) he asserted that large-scale public expenditure is to be made from time to time to avoid cyclical fluctuations in economic activities and to maintain high levels of employment and income. Since then fiscal policy has come into prominence. Almost all modern governments today collect resources to the extent of 30 percent or more of the national income and spend this on a variety of economic activities. Classical economists before Keynes were opposed to large-scale fiscal policy and government expenditure. They held a simple belief: "That government is best which taxes the least or which spends the least." This is because they were of the view that government spending causes unnecessary intervention in private economic activities. They believed that the free enterprise system is a self-equilibrating one and public intervention will only cause disturbances in its smooth working. But Keynes opposed such a view. He pointed out that throughout the 19th century, western free enterprise economies have suffered frequent problems of cyclical fluctuation. The recent experience during the Great Depression (1929-33) is a flagrant example of it. During the Depression, output and employment levels fell by 40 percent for a prolonged time. The modern public authority has a responsibility of promoting public welfare. It cannot play a passive role during such major economic crises. Again the classical school generally suggested that if there is any problem of inflation or deflation then public authority instead of directly intervening in the form of fiscal policy can use monetary policy. This basically concerns the regulation of money supply. It may be said that the economy can be kept in order with the help of the monetary policy which operates indirectly. Keynes, however, opposes this argument. It can neither be effective nor adequate during the periods of widespread unemployment and such other major crises. ii) Budgetary Policy: This relates to two important implements: government expenditure and taxes. The idea of collecting taxes is so that the government can carry out expenditure on various public facilities. a) Revenue and Capital accounts: Modern public authorities have been popularly making use of fiscal policy. It is planned and implemented through annual budgets of the governments. A budget is an estimated or anticipated account of government receipts and expenditure in the next financial year. It is discussed and voted (for or against) in the legislature, in the Congress or Parliament. It is implemented by executives such as ministers or secretaries. The budget has two components. These are revenue or current account and capital or debt account. The revenue account displays receipts from tax collection and from other sources of public income during the course of the year. The capital account shows all debt liabilities and payments of interest on loans. Government loans may be internal in the form of borrowing from the people, banks or the central bank. It may also be in the form of external debt from international agencies like the International Monetary Fund (IMF) or International Bank for Reconstruction and Development (IBRD).

b) Budgetary Surplus or Deficit: If the current or revenue account receipts are exactly equal to proposed expenditure, then the budget is said to balanced. If the revenue receipts fall short of the proposed expenditure then it is a case of a deficit budget. On the other hand if revenue receipts exceed the proposed expenditure then it is called Surplus budget. In order to avoid public intervention in economic activities the classical economists used to favor balanced budgets i.e. when the government expenditure is exactly equal to the tax revenues. In case of a deficit budget, the government expenditure has exceeded receipts. Therefore, the government intends to spend more and increase the size of the aggregate or effective demand. This can be done by raising fresh debts to finance extra expenditure. Alternatively, the tax rates can also be reduced in order to enable people to spend more. The case of surplus budget is exactly the opposite. Here, public revenue exceeds public expenditure. It then becomes possible for the government to repay some debt burden. It is also possible to raise tax rates and to withdraw some purchasing power from circulation. c) Expansionary and Contractionary policies: Fiscal policy becomes meaningful when budgets either show deficits or surpluses. The deficit budget is also known as an expansionary policy. This is because through deficits and enhanced public spending, the overall level of effective demand can be expanded. Such a policy is pursued during the period of deflation. Under such conditions the price level is depressed, the output level is falling and the level of unemployment is increasing. Therefore the rising level of effective demand is expected to act as a remedy. On the other hand a surplus budget (which is also known as contractionary) policy is useful under inflationary conditions. During inflation, the general price level shows a strong tendency to move sharply upwards. Therefore such a situation can be corrected by withdrawing some purchasing power from the people. This helps to bring down the level of effective demand. As is mentioned above, classical economists generally favored a balanced budget. It is only Keynes and his followers who have popularized expansionary and contractionary policies. However, here again the Keynesians emphasize expansionary policies. It is only in exceptional situations of running away conditions of inflation that the contractionary policy may be called in. Both expansionary and contractionary policies can be illustrated. (B) Fiscal Policy at work i) During Unemployment: Fiscal policy has been strongly recommended by Keynes and his followers under the conditions of depression. Though the fiscal policy can take both expansionary and contractionary forms, it is the expansionary fiscal policy and deficit financing that has dominated the post Second World War period. It intends to maintain a high and growing size of the effective demand. Keynesians are of the view that only such policies can cure unemployment, stabilize the economy and help in maintaining high levels of output and employment. The classical opponents of Keynes however uphold the price and wage-cut policy that leaves out public intervention in economic activities. Those who follow the classical view also fear that government expenditure and its attempts to increase effective demand may cause

inflation. Keynesians counter argue that if a choice is to be made between inflation and unemployment then the former should be preferred. Inflation is a lesser evil than unemployment. The classicists further state that without any government spending, natural full employment equilibrium can be established with the help of a price-wage cut in the long run after a lapse of time. But Keynes himself had made the witty statement: "In the long run all of us are dead." This suggests that even if long run equilibrium is possible with a cut in the wage-rate, it is not advisable to follow. Labor is an extremely perishable commodity. Every day in the workmans life matters. It is improper to ask thousands or millions of workers to wait for few months or years before the economic situation can be improved and jobs can be made available. The controversy between the two view points can conveniently be explained with the help of a figure.

Figure 24 Level of Real Income / Employment In figure 24 we find that levels of real income and employment have been shown on the horizontal axis and various price levels appear on the vertical axis. AD1 and AD2 are aggregate or effective demand curves and SAS1 and SAS2 are short run aggregate supply curves. The vertical line Y2e3 e2Ls is the long run supply curve. It stands for natural or full employment level of resources and output. Lets begin with initial demand and supply conditions along AD1 and SAS1. The two curves have intersected at point e1 which is an equilibrium position. At point e1 level of output (or real income) and employment is Y1and level of price is P1. This is however not a full employment equilibrium. Since Y2 is a long run full employment and output level, there is still some labor unemployed at Y1. Now one is faced with the problem of how to overcome this amount of unemployment. The classical writers assert that if price level is lowered and if wage rates are cut the cost of production will reduce. Employers will be induced to invest more and employ the workers who are unemployed. This will bring about a downward shift in the aggregate supply curve which will now be SAS2. The new supply curve intersects AD1 at point e3. This equilibrium point is on the long run supply curve and therefore ensures full employment. In this equilibrium position output level is Y2 and price level is P3. It has become possible to attain the condition of full employment without any government spending, simply by cutting wage rate. This is the classical solution.

Keynes rejects this proposition. For him such an equilibrium is unattainable. Laborers, with the backing of their trade unions, will not accept a cut in wages. The wage rates are downward sticky or rigid. Therefore the supply curve cannot shift downwards. Yet unemployment can be cured. The only requirement here is to make adjustments on the demand side. If the government undertakes fiscal policy and increases public spending, effective demand will increase. This will cause aggregate demand curve to shift upwards as AD2. The new demand curve intersects both the old supply curve SAS1 as well as the long run supply curve at point e2. Therefore this is the full employment equilibrium. At this point output and employment levels are Y2 and price level is P2. Therefore though the price level P2 is somewhat higher, the problem of unemployment has been solved immediately. ii. During Inflation: Keynesian expansionary policy helps to overcome the problem of unemployment with an upward shift in the effective demand level. Similarly, his contractionary policy can be used to mitigate an inflationary rise in the price level. In this case what is needed is a downward shift in the effective demand and a reduction in public spending. This has been shown in figure 25.

Figure 25 Level of Real Income and Employment The levels of income are shown on the horizontal and that of price are shown on the vertical axis. AD1 and AD2 are the two demand curves while SAS1 and SAS2 are two supply curves. The only change this time is an upward shift of the supply curve in the form of SAS2. The initial full employment equilibrium occurs at point e1 with Y1 as the level of income and P1 as the price level. The point e1 is the point of intersection between AD1 and SAS1. If now aggregate demand increases and shifts upward as AD2 then a new equilibrium position is established at e2. This is the point of intersection between AD2 and SAS1. At this point, the level of income is Y2 and the price level is P2. Both income and prices appear to have risen because of the shift in the demand curve. However, increase of income (Y1 to Y2) is purely nominal or monetary in form. Since level Y1 represents the full employment output level, there are no further resources to be employed. Hence there cannot be any real additions to the output (or real income) and income. Again e2 point of equilibrium is not stable. Due to the rising price level, workers and other resource owners will demand a rise in wages and remuneration. With this kind of an increase in the cost of production, the supply curve will shift upwards as SAS2. The new supply curve

SAS2 intersects the new demand curve AD2 at point e3, establishing a fresh equilibrium position. At e3 the income level has fallen back to full employment level Y1. But the price level has sharply risen to P3. The point e3 is a stable equilibrium point since it is on the long run full employment supply curve LS Y1. But at e3 the net inflationary rise in the price level is P1 to P3. If the inflation is to be removed and price level is to be restored as P1 then the effective demand will have to be contracted. With a fall in public expenditure, the aggregate demand curve will shift down from AD2 to AD1. The economy will then revert to the old equilibrium point e1. Thus the contractionary policy of reducing public expenditure is helpful during periods of inflation. This is however not a full employment equilibrium. Since Y2 is a long run full employment and output level, there is still some labor unemployed at Y1. Now one is faced with the problem of how to overcome this amount of unemployment. The classical writers assert that if price level is lowered and if wage rates are cut the cost of production will reduce. Employers will be induced to invest more and employ the workers who are unemployed. This will bring about a downward shift in the aggregate supply curve which will now be SAS2. The new supply curve intersects AD1 at point e3. This equilibrium point is on the long run supply curve and therefore ensures full employment. In this equilibrium position output level is Y2 and price level is P3. It has become possible to attain the condition of full employment without any government spending, simply by cutting wage rate. This is the classical solution. Keynes rejects this proposition. For him such an equilibrium is unattainable. Laborers, with the backing of their trade unions, will not accept a cut in wages. The wage rates are downward sticky or rigid. Therefore the supply curve cannot shift downwards. Yet unemployment can be cured. The only requirement here is to make adjustments on the demand side. If the government undertakes fiscal policy and increases public spending, effective demand will increase. This will cause aggregate demand curve to shift upwards as AD2. The new demand curve intersects both the old supply curve SAS1 as well as the long run supply curve at point e2. Therefore this is the full employment equilibrium. At this point output and employment levels are Y2 and price level is P2. Therefore though the price level P2 is somewhat higher, the problem of unemployment has been solved immediately. ii. During Inflation: Keynesian expansionary policy helps to overcome the problem of unemployment with an upward shift in the effective demand level. Similarly, his contractionary policy can be used to mitigate an inflationary rise in the price level. In this case what is needed is a downward shift in the effective demand and a reduction in public spending. This has been shown in figure 25.

Figure 25 Level of Real Income and Employment The levels of income are shown on the horizontal and that of price are shown on the vertical axis. AD1 and AD2 are the two demand curves while SAS1 and SAS2 are two supply curves. The only change this time is an upward shift of the supply curve in the form of SAS2. The initial full employment equilibrium occurs at point e1 with Y1 as the level of income and P1 as the price level. The point e1 is the point of intersection between AD1 and SAS1. If now aggregate demand increases and shifts upward as AD2 then a new equilibrium position is established at e2. This is the point of intersection between AD2 and SAS1. At this point, the level of income is Y2 and the price level is P2. Both income and prices appear to have risen because of the shift in the demand curve. However, increase of income (Y1 to Y2) is purely nominal or monetary in form. Since level Y1 represents the full employment output level, there are no further resources to be employed. Hence there cannot be any real additions to the output (or real income) and income. Again e2 point of equilibrium is not stable. Due to the rising price level, workers and other resource owners will demand a rise in wages and remuneration. With this kind of an increase in the cost of production, the supply curve will shift upwards as SAS2. The new supply curve SAS2 intersects the new demand curve AD2 at point e3, establishing a fresh equilibrium position. At e3 the income level has fallen back to full employment level Y1. But the price level has sharply risen to P3. The point e3 is a stable equilibrium point since it is on the long run full employment supply curve LS Y1. But at e3 the net inflationary rise in the price level is P1 to P3. If the inflation is to be removed and price level is to be restored as P1 then the effective demand will have to be contracted. With a fall in public expenditure, the aggregate demand curve will shift down from AD2 to AD1. The economy will then revert to the old equilibrium point e1. Thus the contractionary policy of reducing public expenditure is helpful during periods of inflation. 7.2 Monetary Policy (A) Equation of Exchange: Monetary policy, like fiscal policy, can also be used either as an alternative or a complementary measure. It can be used for its expansionary or contractionary effects. The classical economists would rely more on the monetary policy. This is because it operates only indirectly and helps to avoid direct intervention of the public authority in economic activities. But before we go on to analyze monetary policy, it would not be out of context to consider the equation of exchange.

In the early present century Sir Irving Fisher introduced an equation of exchange. This briefly summarizes classical position in this respect. The equation of exchange can be stated as : MV = PT or MV = PY There are four terms in the equation; two each on the left and right sides. On the left hand side of the equation we have total supply of money which is M multiplied by V. The letter M stands for total quantity of money in the form of coins and currency issued by the central bank as the supreme monetary agency. However, total supply of money is much larger than this because each unit of money is transferable and capable of changing hands frequently. The total function of money supply as a medium of exchange therefore will depend upon the average number of times a unit changes hands. This is called velocity or frequency of using money units. Lets illustrate this: if an individual consumer starts off with a currency note of $10 in the morning, he may spend it on purchasing sugar. The sugar merchant later on may purchase fruit against the same bill. The fruit seller in his turn may buy milk with the same note. Finally, the note rests with the milkman. During the course of the day the note of $10 has performed four exchange activities. $10 worth sugar + $10 fruit + $10 milk + $10 income of milkman = $40. Thus a single note or quantity (M) of $10 has performed $40 worth total exchange activity which is the total supply of money. If this is divided by the quantity 'M' what we get is velocity or the average number of times a particular unit of currency has been used to purchase final goods and services over a year. Total exchange or supply (= 40) M (the quantity = 10) = V

Normally, value of 'V' settles itself between 3 and 4. It is only during highly inflationary conditions that it moves above 4, and under deflationary conditions it falls below 3. On the right hand side of the equation the two important terms are 'P', the average price level or index number of prices and 'T', the volume of trade or transactions. The total volume of all the goods and services is traded at the national level and hence it can also be symbolized as real national income 'Y'. This equation of exchange, therefore, may be viewed as an identity: the market value of all goods and services must be equal to the supply of money multiplied by the velocity of the circulation of one unit of currency.

Fisher has also presented an extended version of the equation of exchange. For this purpose he had introduced bank money or credit (M1) and its velocity or circulation (V1). The equation of exchange in its full form can then be stated as: MV + M1V1 = PT But it can be assumed that MV includes both currency and credit money and hence it can be stated in its simplified form: MV = PT (B) Value of money: The equation of exchange is used by classical economists mainly for explaining fluctuations in the value of money. Otherwise in its original form the equation is a truism or an identity. It simply explains total money supply (MV) is equal to total monetary expenditure (PT). While using it for explaining transitions in the value of money two fundamental assumptions are made. These are related to the behavior of 'V' and 'T'. It is assumed that: i) 'V', the velocity of circulation of the currency depends upon consumption patterns of the people and the size of their income. Both these things are not likely to alter significantly in the short run with any changes in the quantity (M) of money. Therefore over a short interval 'V' can be assumed to be constant. ii) The trade volume (T) or level of real income (Y) depends upon the availability of resource supplies and technological conditions. These factors are not likely to alter in the short run with the variations in the quantity of money (M). If these two assumptions are granted then the only dependent variable that remains in the equation is the price level 'P'. Hence the conclusion at once follows: with 'V' and 'T' remaining constant, 'P' will vary directly and proportionately with 'M'. This can be illustrated : Let M = 300, V = 4, T = 600 the P will be equal to 2.

But since 'V' and 'T' are constant 'M' and 'P' must vary directly and proportionately. If M is doubled P will also be doubled.

Similarly when 'M' is halved P is also halved,

According to the followers of the equation of exchange, the price level directly and proportionately depends upon quantity of money. But price level is inversely related to the value of money. Hence value of money is inversely proportional to the quantity of money. Money is general purchasing power. Therefore the capacity of a unit of money to purchase more or less goods will depend upon the level of prices. By way of example if the price of chocolates is 20 cents per piece then a dollar can purchase 5 chocolates but if its price rises to 25 cents per piece the same dollar can purchase only 4 pieces of chocolates. Therefore with the rise in the price, the value of the dollar falls. Similarly with a fall in the price level, the value of the currency rises. We can relate this to the variations in the quantity of money. Increase in M pRise in P p Fall in value of M Decrease in M p Fall in P p Rise in value of M This relationship forms the basis of the monetary policy. (C) Monetary Management: Monetary authority in the form of the central bank and some government agency together control money supply. Monetary management is either to expand or contract supply of currency and credit from time to time according to the needs of the economy. For this purpose the central bank can employ both quantitative and qualitative measures. Quantitative control occurs in the form of: i. Variable Reserve Ratios (VRR),

ii.

Open Market operations (OMO) and

iii.

Bank Rate (BR) or Discount Rate.

The central bank can use one or all the three measures as the situation may demand. If the central bank proposes to follow cheap money or expansionary policy then it can either reduce reserve ratio requirement (say from 10 to 8 percent), or buy the securities from banks and individuals, or reduce the bank rate or introduce all the three measures. By reducing RR i.e. the reserve requirement of commercial banks, their capacity to create credit increases. By buying the securities or bonds, the central bank puts more money in the hands of people and bankers. This helps in the expansion of credit. A fall in the Bank Rate makes central bank assistance cheaper. The bankers are therefore induced to borrow more from the central bank and supply more credit. The rate of interest charged by bankers also falls, as it is related to the bank rate. Therefore investment demand for bank credit increases.

In the opposite case, the central bank can undertake exactly contrary measures to contract the credit supply. It can increase reserves requirement, sell the securities and raise the bank rate. All these steps reduce capacity of the bankers to supply credit and also make credit resources dearer. Therefore investors demand for bank credit tends to fall. During periods of inflation when price level is rising sharply the central bank follows a contractionary policy. However, during periods of deflation when price level is low and declining and output and employment levels are below full employment capacity, the central bank follows expansionary policy. (D) Effectiveness of the monetary policy: Keynes and his followers have strongly criticized this policy and pointed out several limitations of it. Monetary policy is both inadequate and ineffective to solve fundamental problems of fluctuations and disequilibrium in employment and income levels. Some of the important criticisms are: i) Monetary policy operates only on the supply side of the economy. It attempts to control the supply of currency and credit. But leaves demand side outside its scope altogether. As a result, such a one-sided approach has no chance of achieving any significant success in solving major issues. ii) Even on the supply side, the monetary policy faces various difficulties. It is expected that whenever the central bank wants to expand or contract credit supply, the bankers should act accordingly. But this need not be the case. Bankers are likely to be affected by the central bank policies only through their reserve funds positions. But many bankers play safe and are cautious in credit supply activity. They often maintain larger cash reserves than the minimum limits set by the central bank. In such cases bankers can continue to expand or contract credit supply even when the central bank does not desire them to do so. iii) Bank credit supply activity and investors demand for it depends upon general market conditions. If the central bank reading about the market behavior is not correct then its policy will be a failure. Even when it intends to make credit supply the unwilling investors will wish to utilize credit resources. On the other hand if investors strongly wish to borrow and invest then any attempt to raise bank rate and to make credit dearer will not prevent them to do so. iv) Monetary policy suffers from time lags. There are usual administrative delays in making the decision. Then it is published and made known to the bankers. Before the bankers take official note of it and make adjustments in their current transactions there may be further time lapses. There is usually 4 to 6 months or even a longer interval of time lag between the original decision of the monetary authority and its final impact. In the meantime the original economic situation might have altered significantly. Therefore the monetary policy then becomes irrelevant. v) Monetary policy is based on the functioning of the equation of exchange. The equation is based on two basic assumptions. It presumes both the velocity of circulation (V) and the trade volume or level of real income (T) to remain constant, despite changes in the supply of money. But none of these assumptions are realistic. During periods of inflation, when money is losing its value, people show a greater tendency to quickly convert money into stock of real goods. This tends to reduce the value of (V) the velocity of circulation. On the contrary, during a deflationary phase, when the value of money is increasing, people reduce consumption and prefer to hold on

to money. This causes a rise in the value of (V) the velocity. The second assumption about constancy of (T) trade volume is also not correct. At the most one can say that the equation of exchange works under full employment conditions. But in reality, the economic conditions are frequently fluctuating. This results in a situation where some resources are kept unemployed or underemployed. So long as the resources are unemployed, the equation of exchange cannot hold good. Variations in the supply of money cannot simply raise or lower the price level. It is incorrect therefore, to believe that money supply has no real effects on the levels of output and employment. In modern times money cannot remain a neutral medium. It does influence real economic activities. vi) Monetary policy operates only to bring about variations in the fluctuating price level. But this is a highly unsatisfactory approach. Price level is only a superficial part of the deeper economic phenomenon. When price level is in disorder there is something fundamentally wrong with the real economic processes. Therefore mere changes in the supply of money, intending to correct price level, cannot achieve anything substantial. It is more important to detect real causes of disequilibrium on the supply and demand sides of money and to correct them . vii) Monetary policy attempts to operate through the supply of credit and rate of interest. Keynesian economists agree that higher or lower rates of interest may have some indirect effect on the marginal efficiency of capital (MEC). This may influence investment behavior to some extent. But the ability of monetary policy to alter the rate of interest significantly is itself a matter of doubt. Keynes concept of liquidity trap shows that rate of interest is always positive and it never falls below a certain minimum level. Therefore monetary policy ceases to be of any effect beyond such a point. (E) Monetarists views i) Demand for money: The classical viewpoint in opposition to the Keynesian analysis has been put forth in the recent past by the monetarists. After 1954, Professor Milton Friedman and his followers have repeatedly contributed to such monetarist arguments. Their views are significantly modified and more realistic than the traditional rigid outlook. Before arriving at their reaction to monetary policy, it would be appropriate to consider the demand for money. Demand for money is the opposite of the velocity of circulation of money. It is the reciprocal of velocity in its value. If (V) is velocity and (d) is demand for money then,

This is an obvious relationship. Velocity is speed or frequency of rotating units of money and its value can be increased only by restricting spending. An individual possessing a $100 bill can either spend it or hold a part of it. If he spends $90, he can only hold $10 of it. But if he spends $70 he can hold only $30 in cash. Therefore spending more is demanding less and demanding more is spending less of money possessed.

ii. Monetarists and monetary policy: The monetarists point out that demand for money, as a proportion of the total income is stable. Therefore during the expansionary phase when a greater amount of money income is received, people tend to spend the surplus income quickly. Such spending causes aggregate or effective demand to increase and the curve to shift upwards. Moreover in the short run some resources may be underutilized or unemployed. In that case such extra expenditure induces some increase in employment. But once the full employment condition is established, there is no further scope for real output and employment to increase. If the expansionary policy persists and monetary expenditure continues to increase, then it will cause a pure inflationary rise in the price level. Thus in the short run monetary policy may have an impact on the real economic activities but in the long run the equation of exchange holds good. iii) Abuse of monetary policy: Monetarists further argue that it is not monetary policy as such but the abuse of it that is objectionable. Such abuse arises out of rigid and incorrect judgments of monetary authority about market conditions. During the period of the Great Depression, the deflationary policy was pursued; this was a wrong move that had accentuated the crisis. Moreover, the average man as a consumer or a firm goes by 'expectations' about future changes in the monetary policy. Normally the average annual growth rate of price level is said to be permissible and desirable to the extent of 4 percent. This can compensate for real growth rate of income (GDP). But if people expect higher or lower rate of inflation in the future then their reactions alter and cause disturbances in the economy. Therefore the best thing for the monetary authority to do is to maintain a steady growth rate of money supply and maintain steady rate of inflation. The monetarists believed that the monetary policy should be able to allow for a rise in the growth rate and at the same time not result in either inflation or deflation. ********** CHAPTER 8 : THEORY OF THE CONSUMER 8.1 Nature of the Consumer (A) Meaning of Microeconomics: The term micro suggests an infinitesimally minute quantity. Microeconomics deals with the smallest economic units. It is concerned with the behavior of an individual consumer or an individual household or an individual business firm. There are other interesting features of the micro branch of economics. It attempts to analyze the behavior of consumers and producers as they tend to optimize on their transactions. Optimization means simultaneous maximization and minimization. As a consumer one attempts to maximize utility or satisfaction and minimize expenditure. As a producer one attempts to maximize profits and minimize cost of production. Microeconomics is a static approach in the sense it concentrates on individual behavior in a very short period of time. It analyzes instant changes in behavior. It avoids taking account of long term and external effects on such behavior. Since economic life is highly complex and interdependent, such a simple approach requires the help of strong assumptions. These assumptions are together stated in the form of the ceteris paribus clause. It implies that the analysis operates under the condition "other things are equal or constant or remain unchanged"

when individual behavior alters. Other things include income of the individual, number of members of a family, price of substitutes, taste of a consumer, technical conditions of production, supply of labor, land, capital and other resources, fiscal and monetary policies of the government, etc. Microeconomics makes use of marginal methods for analyzing economic problems. Marginal changes arise out of small adjustments in economic activities. The concept of margin is equivalent to the first derivative method of mathematics. Finally, microeconomics is essentially a price level analysis. It attempts to study the effect of small variations in prices on individual behavior. It avoids the problem of long-term shifts in the total economic conditions, such as in the levels of real national income. Microeconomics makes assumptions about the constancy of the size of national income and employment. As a result of this, microeconomics becomes a partial equilibrium analysis. Microeconomics is also alternatively known as neoclassical economic analysis. It has been developed since 1870 onwards by Jevons, Walras, Menger, Marshall, Pareto, Hicks, Samuelson and others. Though microeconomics is highly restrictive because of its assumptions, it is a simple yet important part of economic theory. In the present chapter the behavior of a consumer will be our main concern. A similar analysis of the behavior of a firm will follow in the next chapter. (B) Utility and Preferences: We continuously experience a large variety of wants. The wants are unlimited and recurring. Though wants are numerous no individual can ever satisfy all of his wants since the satisfaction of wants needs some resources or means to be spent. Resources may be in the form of money, time, intelligence, physical strength, goodwill etc. Such resources are always limited or scarce. Therefore every individual has to spend his resources carefully and wisely. Such behavior is called rational or economic behavior. When one behaves economically he has to make a choice and decide his preference while spending his limited resources. The satisfaction of wants is an objective of economic activity. A person with a limited income of $10 may have multiple wants. He may want to spend on food, garments, entertainment, cosmetics etc. But his limited income does not allow him to acquire all these. Therefore he has to make a choice about one or more of his needs which can be satisfied immediately. The decision is rationally based on the urgency and importance of a particular want or end. Once the choice is made the necessary goods are bought and consumed. The act of consumption brings satisfaction or utility to a consumer. Some goods like fruit or snacks can be consumed only once but durable goods can be used repeatedly. A wristwatch, garments, furniture etc. are durable goods. When in use they are considered to be consumed. This is because of the fact that consumption of a good leads to reduction or destruction of its utility. What can be consumed is the utility of a good. (C) Relative and subjective nature of utility: Wants are satisfied with the help of various goods. The want satisfying quality of goods is called their utility. The quality of food to satisfy

hunger and that of water to satisfy thirst are therefore their respective utilities. But utility is not an absolute or objective quality of any good. This is because wants are satiable. Therefore utility of a good is relative and subjective. Utility is relative to a person and his wants. Cigarettes have utility for a smoker or medicines are useful for someone ill. This means that for a nonsmoker or a healthy person these goods can bring no utility. Again for the same individual a cup of tea is highly refreshing in the morning, less refreshing in the evening and totally useless late at night. Therefore utility is subjective and depends upon person to person as well as the state of mind of a person at different times. 8.2 Equilibrium of a consumer (A) Law of Marginal Utility: The law of marginal utility was stated and developed by Menger, Marshall and others. It is the first and simplest attempt to analyze consumer behavior and to determine equilibrium: the most satisfying condition for a consumer where he can maximize his utility considering the limitations of price and income. The law suggests that the utility that a person gains from several units of the same good goes on falling because utility is subjective. The law is based on the satiability characteristic of wants. This is called the Diminishing Marginal Utility (DMU) principle. Marshall has stated the DMU as follows: 1) As the stock of commodity that a person already possesses, 2) increases, 3) the additional benefit that a person receives, 4) will increase but not as fast as the stock itself. The four important parts of the principle of DMU as stated above have been presented in four separate lines. The implication of the DMU principle will be clear with the help of a numerical example. The example helps to bring out the basic principle underlying the law. Four columns need to be drawn which should include the following information: I. Total stock or number of units offered to and consumed by a person, II. Every unit brings some utility which is progressively added to make up for Total utility, III. Marginal or additional utility as the difference between Total utility of two succeeding units; such as 35 - 20 = 15, 44 - 35 = 9 etc. [Refer to the table below.] IV. Finally in the last column, an evaluation of marginal utility in money units assuming that one unit of utility equals two cents. I Stock or Units II Total Utility III Marginal Utility IV Money value u =2c

1 2 3 4 5

20 35 44 48 49

20 15 9 4 1

40 30 8 8 2

The columns in the table correspond with the four lines of the statement of the law. The first column shows progressive increase in the stock or units of the good as 1, 2, 3...etc. The second column shows how the total utility or satisfaction that a consumer derives behaves with every increase in the stock. The total utility has been continuously or absolutely increasing as 20, 35, 44etc. The third column shows the difference in the utilities of two successive units. This is the additional benefit or marginal utility. One would notice that marginal utility falls progressively (20, 15, 9...etc.) as the stock increases. This is the diminishing marginal utility tendency. It is also known as a relative fall in utility. This kind of a reduction is due to the progressive satisfaction of wants. As the utility of the good increases, the succeeding units are less intensely and less urgently needed by the consumer. Finally, in the fourth column marginal utility has been converted in money units with the conversion rule 1u = 2c. (B) Equilibrium and the Law of Demand: Once the law of marginal utility is granted, both, the equilibrium of a consumer and the law of demand follow automatically. The equilibrium rule is that the consumer must equate marginal utility with market price of a good in order to maximize his satisfaction. In the example above, Mu = Price for Maximum satisfaction If the price of a good (consider a chocolate), is 40 cents per unit then the consumer can buy one unit since, Mu1 = 40 = price When the market price is 30, he can buy 2 units and, at market price 18, he can buy 3 units since, Mu2 = 30 = price Or, Mu3 = 18 = price Variations in the number of units consumed at varying prices help to establish the law of demand. As the price of a good falls from 40c to 2c the demand for that good rises from 1 to 5. On the other hand, as the price of a good rises from 1c through 20c the demand for that good goes on falling from 5 through 1. Therefore the inverse relationship between price and quantity of a good demanded at once follows, once the DMU principle is accepted and applied. (C) Law of Equimarginal Utility: The principle of diminishing marginal utility brings about the law of demand simply by equating market price with marginal utility. If a consumer stops consuming earlier and purchases a unit less than the equilibrium units, then his marginal utility

will exceed market price. He has therefore not yet maximized his utility. If he purchases more units than the quantity at equilibrium, then his marginal utility will fall short of the market price and his total utility will be smaller than that at equilibrium, as compared to his total expenditure. The DMU principle is applicable only in the case of a single commodity. In reality a consumer has to purchase multiple goods. He has therefore to compare the marginal utilities of all such goods that he purchases with the relative prices of these goods. With the limited income that the consumer possesses he may not be able to reach the point of equality between marginal utility and price of each commodity. He may have to stop before such a point is reached and start spending on some other good. How a consumer can attain equilibrium in such a situation is an important question that arises at this point. Even here in the case of multiple goods, the marginal utility principle remains applicable but in a different form. It is called the equimarginal utility principle. What the consumer now attempts is to equate the marginal utility of various goods that he intends to purchase. Since the goods have different prices, the consumer has to equate the ratios of marginal utility and price of all the goods that he desires to purchase. If X, Y, Z etc. are the goods and Px, Py, Pz etc. are their prices respectively then the equilibrium rule can be stated as,

For utility maximization This can be illustrated with the help of a simple example of two goods. Let X and Y be the goods a consumer wants to consume. Their prices are Px = $4 and Py = $2 respectively. The consumers allowance or budget is $10. He must spend the entire income so as to maximize his satisfaction from the two goods. His marginal utilities for the two goods and corresponding Mu/P ratios are shown in the table below:

Units of good X

Mu of X

Mux/Px (Px = $4)

Units of good Y

Mu of Y

Muy/Py (Py = $2)

1 2 3 4

48 36 24 12

12 9 6 3

1 2 3 4

18 16 12 6

9 8 6 3

(Equimarginal utility = 102, Total budget = $10) In order to reach equilibrium and to maximize satisfaction the consumer has to equate Mu/P ratios for the two goods. This happens when he purchases and consumes two units of good X and one unit of good Y. This equilibrium combination has been highlighted in the table. The total

expenditure of a consumer is $8 on good X for two units and $2 for one unit of Y. Therefore the total expenditure of $10 coincides exactly with the supposed allowance of the consumer. The total utility that the consumer derives from this combination is 48 + 36 = 84 of X units, and 18 of Y units i.e. 102 units from the entire combination. This is the highest level of satisfaction under the given price-income conditions. Any other combination cannot help the consumer to increase his utility further. For instance, if the consumer decides to purchase only one unit of X and decides to spend $4 on it he will attain utility of 48 units from it. The remaining $6 he can then spend on Y to purchase three units of it. From good Y the total utility he attains will be 18 + 16 + 12 = 46 units. From such a combination the consumers total utility from the two goods will be: 48 + 46 = 94 units. This is obviously lower than 102 units of utility from the equilibrium combination. It would be a similar case for any other combination. (D) Variation in the price: The equimarginal or equiproportional rule helps to establish equilibrium for a consumer-maximizing utility. Such an equilibrium holds good only under the given market conditions. If the price of one of the goods alters the consumer will have to make a readjustment and change the combination. Let us assume that the price of good Y remains the same (Py = $2) as before, but the price of good X rises (from $4 to $6). The consumer will have to readjust the equilibrium. Units of good X 1 2 3 4 Mu Mux/Px Units of of good (Px = X $6) Y 48 36 24 12 8 6 4 2 1 2 3 4 Mu of Y 18 16 12 6 Muy/Py (Py = $2) 9 8 6 3

(Equimarginal utility = 82, Total budget = $10) With the rise in the price of good X and the price of good Y remaining constant a new equilibrium position has been established. In this equilibrium position, the consumer reduces the consumption of good X, which has become dearer. Instead of 2 units, only 1 unit of X is

purchased and $6 are spent on good X. The remaining $4 are now spent on purchasing two units of good Y. Once again the Mu/P ratio for the two goods has been equated with its value 8 for the new combination. The consumer who is continually maximizing his utility keeps on making such readjustments whenever the market price of goods changes. (E) Substitution Principle: The law of equimarginal utility as the basis of consumer equilibrium can be extended to cover any number of goods. In its general form, the law can be stated as

This law is also known as the principle of substitution. In order to maximize satisfaction the law requires the substitution of units of one good in place of the other so long as the ratio is not brought into equality. This can be illustrated with the help of two goods. Let us begin with an initial equilibrium position of Mux = 8, Px = 4, Muy = 12 and Py = 6,

If the price of X falls to $2 and the price of Y is constant then,

Therefore the Mu/P ratio for good X whose price has fallen is now greater than the similar ratio for good Y whose price has not fallen. According to the rule, there will be an increase in the consumption of the cheaper good (X) and a decrease in the consumption of the dearer good (Y). With every increase in the units of good X consumed, the marginal utility for good X (Mux) will start falling. And with every decrease in the good Y consumed Muy will start rising. Continue the process until the two ratios are equated. If price of X remains constant but that of Y falls then the value of the first ratio will be smaller than that of the second. In this case an increase in the consumption of Y and a decrease in the consumption of X will help to reestablish the equilibrium. This principle of substitution is the basis of consumer equilibrium. We will later study a golden rule based on the principle of substitution. (F) Substitution and Income effects: Marginal utility, equimarginal utility or law of demand in general, help to analyze consumer behavior. Price and the quantity of a good are generally inversely related. This means that the consumption or demand of a good increases if its price falls and the consumption or demand of a good decreases if its price rises. There are two distinct effects that underlie such an inverse tendency. They are known as substitution and income effects. Substitution effect means the tendency of a consumer to reduce the consumption of a relatively dearer good and to increase the consumption of a relatively cheaper good. As a result of this, the consumption or demand of a good whose price has fallen, increases. For example: let

a consumer spend a total amount of $10 in equal proportion of $5 each on two brands of soap. Both varieties of soap perform the same function and therefore are substitutes of each other. If the price of one of the brands falls, it becomes cheaper. The consumer may then spend more (say $7) on it and increase the demand for the cheaper brand?. On the other hand, he is left with only $3 which he spends on the second brand. The demand for the second brand which is relatively dearer, therefore decreases. Such an act of shifting demand from a dearer to a cheaper good is called the substitution effect. This kind of an effect works in the inverse direction: a fall in price results in a rise in demand and is therefore negative in its influence. There is another cause for increase in demand of a good of which price falls. It is in the form of an income effect. As a result of a fall in the price of a commodity, a consumer becomes richer and his income increases. Let us suppose that a consumer has a sum of $12 to spend on a certain good, the price of which is $4 per unit. With his income he can purchase 3 units of the good. When the price of the good falls from $4 to $3 and if he continues to buy 3 units as before then $9 would be enough. He is now left with $3 of additional allowance. This is the income effect. If he decides to spend these additional $3 on the same good his total demand will increase from 3 to 4 units. The income effect further enables a consumer to increase his demand for cheaper goods. Note that a rise or fall that occurs with a change in the price of a good is not an increase in the money income of a consumer (which is constant as $12) but it is an increase in the real income of a consumer. Since an increase in income and an increase in consumption are changes in the same direction, the income effect is said to be direct and positive. The income effect is generally positive for normal goods. Only in the case of exceptional type of inferior goods the income effect becomes negative. (G) Consumers Surplus: Marshall has analyzed consumers surplus as a part of demand behavior. Such a surplus of utility that a consumer enjoys is a result of the law of diminishing marginal utility. While utility that a consumer experiences from every additional unit consumed goes on falling, the market price that he has to pay for all the units is uniform. Hence actual money expenditure (which is objective) and the utility received (which is subjective) do not add up to the same value. The extra utility that a consumer enjoys is called Consumers Surplus. This concept can be described variously. It is the difference in consumer satisfaction arising out of his subjective and objective evaluations. It may also be described as the extra satisfaction that the intra-marginal units bring to a consumer. It can also be explained as the area under the demand curve. This can be illustrated as: No. of MU Price units consumed 1 2 3 4 5 4 3 2 2 2 2 2 Consumers Surplus (Mu-P) 3 2 1 0

5 6

1 0

2 2

6 (Total CS)

In the example we have 6 units of a good. The marginal utility that a consumer enjoys from these units, goes on falling as5, 4, 3, 2, 1 and 0. The market price is $2 per unit. Assuming each of the utility units to be worth a dollar, the consumer will equate Mu with price. Consumer equilibrium occurs at the fourth unit where Mu = Price = 2 which maximizes the consumers total satisfaction. For purchasing 4 units of the good he has to spend $8 (an objective evaluation) but he actually receives a total utility of 14 units (5 + 4 + 3 + 2) from the four units he purchases. Thus he receives 6 units of extra satisfaction (14 - 8 = 6): this is the consumers surplus. This arises from the fact that though the consumer equates utility (the marginal units) with the price, the earlier or intra-marginal units are more valuable (a subjective valuation) for him, in terms of utility enjoyed. This has further been explained in Figure 26.

In the figure, DD1 is the demand curve. Units of the good have been shown on the horizontal axis and price is shown on the vertical axis. At price OP (i.e. $2) there is consumer equilibrium. The consumer purchases OQ (4) units. His total expenditure is $8 (4 x 2) which is equal to the area of the rectangle OPRQ. The total utility that the consumer enjoys from the four units purchased is equal to the area DRQO. The difference between the two areas would be the area of the triangle DRP (DRQO - PRQO = DRP). This is the surplus satisfaction that the consumer enjoys. The numerical value of the consumers surplus in our example is 6 units. However, the geometrical measure of the surplus is somewhat larger. It is equal to the area of the triangle DRP (half the base into altitude) = (PR x PD). PR = OQ = 4 and PD = OD - OP = 6 - 2 = 4. The geometric value of consumers surplus is (4 x 4) = 8 which is larger than 6. Consumers Surplus is considered a somewhat hypothetical or imaginary concept. It has considerable importance in framing practical policies such as those of taxation, foreign trade, welfare promotion etc.

(H) Market Demand Curve: So far we have discussed marginal utility, equilibrium and demand of a single consumer. The actual market as such has numerous consumers. An interesting question arises regarding the construction of such a market demand curve and its behavior.

Figure 27 shows the method of construction of a demand curve for the entire market. We have two consumers A and B with two demand curves which have different slopes. Consumer A demands 2 units of a good when price is $4 but he demands 4 units of a good when the price is $2. Consumer B has no demand for the good at price of $4 but he demands 2 units of the good when its price falls to $2. The market demand curve shows the total demand of the two consumers as 2 units at price $4 (2 + 0) and as 6 units (4 + 2 = 6) when price is $2. Such a geometric addition of demand curves is also known as lateral summation of demand. The market demand curve is flatter or more flexible than the individual demand curve. This is because of the fact that at every price the total demand in the market is much larger than that of any individual. ********** CHAPTER 9 : EQUILIBRIUM OF A FIRM 9.1 Concept of a Firm A firm is the smallest unit of production or sale. Microeconomic theory is an equilibrium analysis. It is concerned with the behavior of demand and supply forces. Marshall is reported to have said that demand and supply are like two blades of a pair of scissors. Demand is a result of the utility-maximizing behavior of a consumer in rational bounds. Similarly supply is an outcome of the profit-maximizing behavior of a firm, again in rational bounds. Firms may have different organizational forms. A firm may be an individual enterprise, a partnership, a joint stock company, a corporate body, a cooperative enterprise or a public utility agency. Again a firm may be a producer, seller, trader, exporter or a financier. In any one of these capacities, firms show similar basic tendencies. In order to maximize its profits a firm has to maintain as large a difference between what it spends on resources or cost of production and what it earns by selling goods in the form of revenue or returns. The difference between the two is the firms profit. So the firm has to keep its cost of production as low as possible. On the other

hand, it has to charge a high price and sell as much quantity of products as possible. In this respect, the firms actions are related to the behavior of consumers. Besides the limitation of cost of production, the capacity of a firm to charge a suitable price is restricted by the consumers willingness to pay. 9.2 Factors of Production and Product Output (A) Fixed and Variable factors: In the act of production a firm uses a variety of goods and services called factors of production or inputs. These factors and services include plant and machinery, factory premises, tools and equipment, land, raw materials, labor etc. Some of these factors are fixed in size. A machine or manager has to be employed in its full capacity, irrespective of the volume of the output. Other factors like labor and raw materials can be employed in small or large units according to the varying quantity of output. These are variable factors of production. Fixed factors are indivisible while variable factors are divisible into small units. Fixed factors are supplementary in nature. Machines make productive activity more convenient and efficient. However, even in their absence, output of some volume can be produced. Variable factors are called prime factors without which no output can be produced. The distinction between the two types of factors is the basis of cost analysis and the law of returns. If all the factors of production were perfectly divisible and variable, the cost of production would have increased in the exact proportion of the output. As this is not the case, a special cost analysis becomes important. The classification of costs can be summarized as follows:

Fixed Cost Indivisible large units Supplementary: Even in their absence some amount of production can be carried out. Plant, machinery, manager, land, factory premises etc.

Variable Cost Divisible small units Without these factors no production can be carried out. Labor, raw materials, transport, freight etc.

(B) Total and Marginal Output: In the act of production, a progressive increase in the input results in a similar increase in the output. There is a significant difference in the composition of input and its effect on the output. In the short run, the total employment of fixed factors of production remains constant as regards quantity and quality. Fixed inputs are lumpy in the sense they are to be employed in a single big unit that may be available. Let us assume that machines, factory premises and the manager together make up for a lumpy unit of fixed factors. So long as variable factors are not employed no output can be produced. Since variable factors are divisible

into small units, they can be employed and increased in small doses. Let us assume one worker and a small quantity of raw materials together form a variable input unit. With every increase in the variable unit, output will increase simultaneously. This increase will appear in the total output. Such an increase in the total output is not exactly proportional. Every additional variable unit may make a different contribution to the firms total output. Such additions, of individual variable units, are called the marginal product. It is important to note that the marginal product is essentially an outcome of the functioning of variable input units. This is because fixed inputs are not themselves capable of producing any output. In this sense fixed inputs are supplementary while variable units are prime in their contributions. This can be illustrated with the help of a numerical example. The entire process of productive activity in the example is subject to the law of variable returns. (C) Production Function and the Law of Returns: The relation between input and output is called the production function: Q = f (L, K) It states that the output produced (Q) is functionally dependent on the units of input: labor (L) and capital (K). Though in the simplified form of the function, only two inputs have been shown, the relation can be extended to a range of input quantities and qualities. Labor (L) in general symbolizes all types of human services utilized in productive activity. Similarly capital (K) symbolizes different types of material or physical agents of production. Fixed Production Input Units Units 1 2 3 4 5 6 7 1 1 1 1 1 1 1 Variable Input Units 1 2 3 4 5 6 Total Output Output 4 11 18 23 25 26

Marginal 4 7 IMR 7 CMR 5 2 1

In the example given above the complete picture of production function or the process of productive activity has been presented. The entire process is carried out in 7 different units. The first unit has fixed inputs but no variable inputs; so no output is produced. In the second unit one dose or unit of variable input is applied and the output produced is 4 units. For the third production unit the second unit of variable input is applied and the output is more than double. It has increased from 4 to 11. Marginal output is 7 (11 - 4 = 7) units. For production unit 4, the third unit of variable input is applied and the output increases to 18 units. Marginal output is again 7 units (18 - 11 = 7). Hereafter with every additional application of variable inputs total output goes on increasing from 18 to 23 to 25 to 26. Marginal output continuously decreases from 7 to 5 to 2 to 1. Three phases of the production function have been marked in the table. The

output increases more than proportionately for the first two variable units. This is the phase of Increasing Marginal Returns (IMR). Then between the second and third variable units marginal addition is constant at 7 units. This is the stage of Constant Marginal Returns (CMR). From the third unit of variable input right upto the sixth unit there is a continuous fall in the marginal output produced. This is the stage of Diminishing Marginal Returns (DMR). The three phases of productive activity together make up for the Law of Variable Returns, which is stated below. (D) The Law of Variable Proportions or Returns: In the act of production, with constant units of fixed inputs, but progressively increasing units of variable inputs, the output will increase but not in the same proportion. Initially it will increase at an increasing rate (IMR), then at a constant rate (CMR) and finally, at a continuously diminishing rate (DMR). There are various causes responsible for the variable behavior of output. These include internal and external economies and varying utilization of the capacity of fixed factors. For a single firm, in the short run, external economies are not important. Such a firm may enjoy internal economies in the form of more efficient use of machines and managerial skills, better supervision, avoidance of wastage etc. The chief cause, however, is the degree of utilization of fixed inputs. These lumpy fixed inputs possess optimum capacity of production. For instance, a printing press may turn out 5000 pages of books per day or a manager may supervise 800 workers. So long as this capacity is under utilized the output will increase at an increasing rate. Once the capacity is fully or optimally utilized the output will increase at a constant rate. When the capacity is utilized beyond optimum level output starts increasing at a diminishing rate. Thus the three phases of the production function are closely associated with under utilization, optimum utilization and over utilization of the fixed factors of production. 9.3 Cost and Profit (A) A Firms objective: Production and sale of goods is a commercial activity; it is a profit motivated activity or behavior. A firm will produce a particular quantity of output and will sell it at a particular price which will help maximize profit. Profit is the difference between Total Revenue (TR) and Total Cost (TC) of the firm. By revenue we mean money value of the output at market price. Similarly total cost is in money units at the market price of inputs. Profit = (TR TC)max A firm attempts to maximize the difference between TR and TC by maximizing the value of TR or minimizing the value of TC or by doing both. (B) Explicit and Implicit Costs: In the act of production a variety of inputs are used and a variety of services employed. Inputs such as labor, land, building premises, raw material, transport charges etc. are paid their remuneration by way of wages, rent, profits, interest etc. All these costs incurred are of explicit nature. Actual payments are made from time to time out of the revenue or capital of the firm.

There are certain inputs or services utilized in the act of production which are not paid or are not adequately remunerated. These are the implicit costs of the firm. Consider the case of a small producer carrying out productive activity: he may provide tea and snacks to the workers; or the owner-manager of a firm may carry goods to the market in his own motor car; or the owner may visit the factory even on Sundays and holidays and may work for extra hours. All these contributions are unpaid cost items in the act of production. These are implicit costs of production. Explicit inputs are obvious and receive full cash compensation; implicit inputs are not obvious and do not receive full value for their contribution. (C) Profits - Accounting, Economic, Normal: A firm intends to maximize profits by maintaining as large a difference between total revenue and total cost as possible. The profits of a firm may appear in different forms. i) Accounting Profits: First there are accounting profits. These are the profits calculated as the difference between total revenue and total explicit costs of a firm. Only such costs are deducted from the revenue which have been fully paid out. Accounting Profits = Total Revenue - Explicit Costs ii) Economic Profits: These are smaller in value. In determining economic profit, explicit as well as implicit costs are deducted from total revenue. Economic profits are therefore smaller in value than accounting profits. Economic profits = Total Revenue (Explicit + Implicit Costs) iii) Normal Profits: The concept of normal profit is of analytical or theoretical nature. Ordinarily it can be stated that a normal profit condition is one in which economic profits are zero. Such a situation will arise when total revenue of a firm is equal to its total cost. Marshall has stated that normal profit is that rate of minimum profit which a firm must earn in order to survive in the market. Depending upon actual market conditions a firm may earn Super Normal (more than normal), Normal (Just normal), or Sub Normal (less than normal) profits. By way of an example, consider a firm which expects a minimum profit of 8 percent over the costs of production. If the actual profit it earns is 10 percent then the firm makes Super normal profit. If the firm earns exactly 8 percent then it is said to be making normal profit. However, if the actual profit of a firm is only 6 percent then it is suffering sub normal profit (loss). In a competitive market, super normal profits are competed with and eliminated. Firms suffering subnormal profits may have to close down in the long run. The competitive rule permits only normal profits to all the firms in the long run. Profit = TR - TC When TR = 100 and TC = 80 Profit = 100 - 80 = 20 Super Normal When TR = 100 and TC = 100 Profit = 100 -100 = 0 Normal When TR = 100 and TC = 120 Profit = 100 -120 = -20 Sub Normal

Normal profit rate is governed by the general expectations of a firm. It is usually equal to current market rate of interest. In that sense it is an opportunity cost of capital resources. 9.4 Cost Analysis (A) Behavior of costs: Cost of production is a function of the volume of output produced. Total cost is made up of two components. Some of the inputs are fixed and indivisible. Their aggregate cost remains constant and hence goes on falling in an average proportion as output increases. Other factors of production are variable and go on increasing with the level of output produced. Hence the variable cost of production continuously increases but in different proportions. The behavior of the total cost of production is a mixture of these two influences. Like the law of returns there are similar laws for cost behavior. The cost behaves exactly in an opposite manner as compared to the behavior of the returns or the output. If input worth $1 produces 3 units of output, then per unit of good, cost of production is 33 cents. If output produced decreases to 2 units per dollar, cost increases to 50 cents per unit and if the output produced increases to 4 units per dollar, cost decreases to 25 cents per unit of output.

Cost of Input $1 $1 $1

Output Produced 2 3 4

Cost per Unit 50 cents 33 cents 25 cents

The phase of Increasing Marginal Returns corresponds with Diminishing Marginal Cost. The Diminishing Marginal Returns phase corresponds with Increasing Marginal Cost and Constant Marginal Returns are equivalent to Constant Marginal Cost. This is diagrammatically represented asReturns Behavior IMR CMR DMR p p p Costs Behavior DMC CMC IMC

(B) Numerical Example: In Cost Analysis, mainly marginal costs and average costs, which are among other variants of cost, need to be studied. Average costs are of three types: average total cost, average fixed cost and average variable cost. We will begin with marginal cost and then proceed to average costs.

i) Marginal cost: Let us assume that fixed costs are of the value of $40. This amount will remain constant throughout the act of production. Let the variable cost be $10 per unit. As the variable units go on increasing this cost will continuously increase as a multiple of 10.

.asp I II III IV V VI Fixed Marginal Cost Production Cost Variable Marginal Total Cost II + (MVC ? M output) Output III 40 2.5 (10 ? DMC 4) 1.42 (10 ? 7) 1.42 (10 ? CMC 7) 2.00 (10 ? 5) 5.00 (10 ? IMC 2) 10.00 (10 ? 1)

Units 1

40

Cost -

40

10

50

40

20

60

40

30

70

40

40

80

40

50

90

40

60

100

Column I shows the Units of Production. In column II we have $40 as Fixed Cost. This remains constant throughout the act of production. Column III explains Variable Cost of production at the rate of $10 per unit of variable inputs. In column IV Marginal Output changes have been shown from our earlier example. In column V we find Total Cost as a sum of fixed and variable costs. Column VI has the Marginal Cost per unit of output produced. This is a ratio of marginal or additional variable cost (which is 10) divided by marginal units of output produced. Accordingly marginal cost is 10 z 4 = 2.5, 10 z 7 = 1.42 etc. Marginal cost behavior shows three phases of change. Initially from 2 units of production to 3 units of production the marginal cost decreases from 2.5 to 1.42. Then between 3 to 4 units of

production it remains constant. Finally, from unit 4 onwards marginal cost continuously increases from 1.42 to 10. The three phases marked as DMC, CMC and IMC exactly correspond with IMR CMR and DMR on the output or returns side. As we have seen earlier, where returns diminish, costs increase and both are constant for the same units of output. ii) Average costs: Average cost is a ratio of Total Cost to Total Output units produced. Since total cost has fixed and variable costs as two components, we have three types of average costs. These are average fixed cost, average variable cost and average total cost. I II III (TFC TO) IV (TVC TO) = AVC 2.5 1.82 1.67 1.73 2 2.3 V (TC TO) = (III+IV) = ATC 12.5 5.45 3.89 3.46 3.6 3.84

Production Total units 1 2 3 4 5 6 7

output = AFC 4 11 18 23 25 26 10 3.63 2.22 1.73 1.6 1.54

In the table, column I shows Production Units 1 to 7. Total Output is shown in column II as 4,1126. In column III we find AFC which is a ratio of Total Fixed Cost to Total Output (TFCz TO). Therefore it is determined as 40 z 4 = 10, 40 z 11 = 3.63etc. Column IV reads Average Variable Cost. It is a ratio of Total Variable Cost to Total Output (TVC z TO). It is obtained as 10 z 4 = 2.5, 20 z 11 = 1.82...etc. Finally, in column V we notice Average Total Cost for different units. It is a ratio of Total Cost to Total Output. (TC z TO). Therefore, it is determined as 50 z4, 60 z11etc. Note that ATC is exactly equal to AFC + AVC. The alternate method of computing ATC is to add the values in columns III and IV. The behavior of the three average cost varieties is an interesting and important part of Cost Analysis. We are mainly interested in the behavior of ATC (column V) which has two components, AFC and AVC. The behavior of ATC is jointly determined by AFC and AVC. AFC continuously falls. Therefore AFC tends to pull AFC in its own direction and causes its fall. AFC falls sharply in the initial stage from 10 to 3.63 but it slows down in its rate of fall towards the end such as from 1.60 to 1.54. The effect of the fall in AFC is the progressive reduction in the value of ATC. AVC initially decreases from 2.5 to 1.82 to 1.7 but it subsequently rises from 1.67 to 1.73 to 2 to 2.30. The effect of AVC on ATC is initially reductive but when it starts rising, it attempts to pull ATC in its own direction. ATC initially falls sharply from 12.5 to 5.45 to 3.89 when both AFC and AVC reduce in value. Then it becomes moderate in its fall us present the cost curves with the help of diagrams to gain further familiarity with them.

iii) Total Cost Curves: Let us begin with a picture of Total Cost, Total Fixed Cost and Total Variable Cost Curves. This is simpler and easier to understand. With increasing units of output: 4, 11, 18, 23, 25 and 26, Total Fixed Cost remains constant at $40. Total Variable Cost increases proportionately as 10, 20, 30, 40, 50 and 60. The Total Cost as a sum of the two (Total Fixed and Total Variable Costs) increases as 50, 60, 70, 80, 90 and 100. In the figure three cost curves have been drawn accordingly.

Total Output Units have been measured along the horizontal axis and Total Costs have been shown on the vertical axis. At a distance of 40 units we find T - FC as a line parallel to OX axis. This shows that even at zero output level TC is equivalent to FC. From here onwards TC rises continuously and in the same proportion as VC. Therefore VC and TC are parallel curves. iv) Marginal, AVC, AFC, ATC, curves: Let us now turn to the slightly complex nature of the marginal and average cost curves.

a) Marginal and Average Cost Curves: In Figure 29 we have once again shown varying output units on the horizontal axis and different cost amounts on the vertical axis. All the four cost curves have been drawn on the basis of respective values in the tables above. Marginal Cost varies as 2.5, 1.42, 1.42, 2.0, 5.0 and 10.0. Accordingly the Marginal Cost Curve has been drawn. It shows an initial downward trend but a subsequent sharp rise. AFC is based on the values 10, 3.63, 2.22, 1.73, 1.60, 1.54 therefore it is seen to be continuously falling. However, initially it falls sharply and then with a slower tempo. AFC first falls sharply and then its curve becomes flatter. AVC is based on the cost values 2.5, 1.82, 1.67, 1.73, 2.0 and 2.33. Therefore AVC initially falls moderately and then it rises continuously but moderately. Since ATC is combination of both AFC and AVC, it has a mixed behavior. It is based on the values 12.5, 5.45, 3.89, 3.46, 3.60 and 3.80. The behavior of ATC is to be explained in terms of the joint behavior of AFC and ATC. It is necessary to analyze ATC more carefully. Let us workout its features. b) Behavior of ATC: Certain features of the ATC are worth analyzing. These are as follows:
y ATC shows three distinct phases. Between C1C2 the curve slopes downward. At C2 the curve

reaches a minimum point. From C2 to C3 the curve starts continuously rising upwards. It is also called Short Run (SAC) U Shaped Cost Curve.
y The two components of ATC are noticeable. At output level Q1 value of ATC = C1Q1 which is

equal to F1Q1 the Fixed Cost Component and V1Q1 the Variable Cost Component. This is true for any point on ATC. C1Q1 = F1Q1 + V1Q1
y The lowest point on ATC is C2. Around this point ATC remains constant for a moment. To the left of C2 ATC falls (C1C2) and to its right ATC rises (C2C3). ATC thus shows the three

stages of cost behavior, namely, the Diminishing, the Minimum (Constant) and the Increasing Cost Phases.
y

The lowest point on ATC is C2 2 the point of Minimum, the Marginal Cost Curve MC intersects ATC. This is essential since MC is in addition to Variable Cost. So long as MC rises but remains below ATC the ATC falls. When MC crosses ATC and is above ATC it causes a rise in the value of ATC as well as an upward shift in the curve.

c)Causes of ATC behavior: ATC passes through three stages. Initially it falls, then it reaches a minimum and is nearly constant; finally it starts increasing. The explanation of such behavior of the ATC runs is as in the case of the laws of variable returns. In the short run, internal economies such as better and efficient performance of machine and manager, better supervision and avoidance of waste, etc. are examples of internal economies. The shape of ATC also depends on the different nature of the fixed and variable inputs. So long as fixed and indivisible factors are not used to their fullest capacity (C1C2) the ATC keeps on falling. Once the fixed capacity is fully utilized the ATC reaches a minimum point (C2). This is the point of optimum utilization of fixed factors. If the output continues to increase beyond this point the fixed factors get over utilized and cause ATC to rise. tical concept. These is no fixed limit on the number of years to distinguish between short run and long run. For each variety of fixed factors, its long run depends upon its life span. Let us assume that a firm employs three factors of production with their life span given as Machine = 6 years, Manager = 10 years and Factory building = 15 years. Then for machine replacement 7 years is the long run, for replacement of manager 11 years is the long run and after 15 years all the three factors become perfectly variable or replaceable. Depending upon length of the long period, the long run cost curve will behave in one way or the other. If all the factors are perfectly variable and there are no fixed factors at all then the long run Average Cost Curve will be a horizontal line parallel to OX axis. If some of the fixed factors have an unlimited capacity to produce then the long run Average Cost Curve will continuously fall downward. If some of the factors are variable while a few other factors continue to be fixed even in the long run then LAC will be U shaped but flatter than SAC. Let us present a graph of the LAC. vi) LAC, LMC and scale of production: Besides internal economies that a firm enjoys in the short run, it has the advantage of the scale economies in the long run. Each fixed factor with its given life span constitutes a scale of production which in the short run cannot be altered. With the passage of time each of these factors can be altered and replaced. This permits change in the scale of production. An old machine can be replaced by a new one which has better capacity, a manager can be replaced at the end of the contract period with another more qualified and experienced person. Such changes make productive activities more efficient and hence are called economies (advantages) of the scale. Since the long run goes on combining such individual advantages it is also called a chain of the short runs. In Figure 30 we find Long run Average cost Curve (LAC) represented by a chain of three short run cost curves SAC1, SAC2 and SAC3. In between them there may be many more SACs. We have also drawn LMC which is the Long run Marginal cost Curve. It intersects LAC at the minimum point of LAC which is N2 at output level Q2.

Let us summarize the features of the behavior of the LAC. LAC is also known as an envelope curve. It passes from outside the SACs. At least one of the SACs is tangential to LAC. This is essential because the advantages available in the long run must be relevant to the respective short run possibilities. None of the SACs can ever intersect LAC. This is because of the fact that if SAC intersects LAC then some portion of SAC will lie below LAC. It would suggest some advantages that firm can enjoy in the short run are not available to it in the long run. This is absurd since LAC is a chain of SACs. LAC is also U shaped, showing the falling, the minimum and the rising phases. It is less pronounced or flatter than SACs. This is because more factors become divisible and variable in the long run. Some of the factors may still continue to be fixed even in the long run to make it fall and rise. LMC (like SMC) intersects LAC at the minimum point of the LAC. The reason for such behavior is similar to that in the short run. The three phases of the LAC mark variations in the scale economies. Initially between the N1N2 points on LAC and for output levels Q1Q2 we find the falling phase of LAC. The cost decreases and the returns increase. This is the phase of Economies or increasing returns. Then at point L2 for output level Q2 LAC is almost constant. Therefore cost is constant and returns are also constant. This is the Stage of Optimum Utilization of Scale Advantages. Beyond this point between N2N3 we notice LAC rising upwards. The cost now increases and returns decreases. This is the phase of diseconomies of the scale. Under these long run conditions no further output can be advantageously produced beyond Q2. The economies of scale are at the disposal of a firm only in the long run when fixed factors become variable and replaceable.

********** CHAPTER 10 : PERFECT COMPETITION 10.1 Features of Competition (A) Introduction: A firm is the smallest unit of production. The objective of a firm is to maximize profits. This it can achieve by minimizing cost of production, or maximizing total revenue (i.e. Price v Output). The prospects of profit for a firm are further guided by market conditions. In a market where a firm has to sell its output there may be competitive, monopolistic or oligopolistic conditions. Each market type has a different impact on the price and quantity sold by the firm. All these market types will be analyzed in the present and following chapters. Besides the difference in the number of firms under competition and monopoly there are also qualitative distinctions. In modern markets the popular practice of Product Differentiation exists. All this will be studied under different forms of the market. Let us begin with a discussion on the nature of a competitive market. (B) Features: Traditionally perfect competition is considered as an ideal form of market. For classical writers, perfect and pure competition is a golden rule. Only under exceptional conditions, this rule may not be satisfied. In that case monopolistic elements may be present in the market. As it is understood today, the Classical Competitive Model is hypothetical in nature; it is not based on actual market conditions. Such a competitive market is supposed to provide maximum justice to a maximum number of buyers and sellers. Competition is said to be Pure and Perfect when six basic characteristics are satisfied (three characteristics each associated with Pure and Perfect competition). i) Pure Competition: The market is said to be pure when i) There is a large number of buyers and sellers; ii) Goods produced and sold are homogeneous, and iii) There is Free Entry or Exit for any producer or seller. The three conditions together ensure that an individual firm can have no control over market conditions of price and quantity supplied. The first condition ensures there are several competitive firms in the market. Each firm has a small and insignificant share in the market supply. Therefore, even if a firm doubles or completely withdraws its share from the market its actions will not affect market conditions. Further, each firm produces homogeneous products. The goods produced are physically and chemically identical in their qualities. This further takes away the influencing capacity of firms. Finally, there is complete freedom to enter or exit the market. So long as a firm finds existing market conditions beneficial, it will continue to produce and sell.

ii) Perfect Competition: Competitive market is supposed to be perfect in every respect. For this three conditions must be satisfied: i) Perfect knowledge on the part of the buyers and sellers about market conditions, ii) Perfect mobility of the factors of production, and iii) Proximity to the market. This further consolidates competitive force and rules out the influencing capacity of individual firms. When market conditions are perfectly understood there is no chance of a higher price being charged or paid. When factors of production are freely mobile, entry or exit of firms is facilitated. Proximity to the market further ensures that there is no extra transport cost, which may otherwise cause a small variation in the price. (C) Analytical Gains: The analytical outcome of a competitive market is derived from the six characteristics of competition. Thus, analytically, Price Uniformity and Horizontal Demand Curve, and Normal Profits are the attributes of competition. i) Uniform Prices: In a competitive market, an individual firm has no capacity to influence market conditions. Therefore it has to take market price as given, constant and uniform in nature. The price of a good is also known as the Average Revenue of the firm.

This is because Total Revenue of a firm is Price (P) vOutput (Q) sold. Hence, Price is Total Revenue divided by Quantity Sold which is Average Revenue. TR = P v Q, hence TR = P = Average Revenue Q

Since Average Revenue or Price and Marginal Revenue are identical, when the former is constant the latter is also constant. Moreover, the Average Revenue curve of a firm is the same as the individual demand curve. Hence, the competitive demand curve is a horizontal straight line parallel to the OX axis. This has been shown in Figure 31. The quantity of Output produced and sold is shown on the OX axis and Price is measured along the OY axis. Competitive market price OP is given and fixed for an individual firm. At this price the firm has freedom to produce any small or large quantity such as Q1, Q2, Q3 etc. The firm cannot charge a higher or lower price than the OP. If it attempts to charge a somewhat higher price like OP1 assuming competition, the firm will be able to sell nothing. On the other hand, if it charges a somewhat lower price OP2 the firm will unnecessarily suffer losses.

ii) Horizontal Demand Curve: With constant market price an individual firms demand curve is perfectly flexible. It assumes the form of a horizontal straight line. Such a demand curve is also the Average and Marginal Revenue curve of a firm. In Figure 31, P - AR = MR is the demand curve of a firm. Earlier we studied the nature of a demand curve which is downward sloping. In a competitive market as well, there is a downward sloping demand curve. It is applicable to the entire market or the industry. Such a demand curve has been shown as DD in Figure 32. The relation between a firms demand curve and market demand curve can be explained in two ways. When there are innumerable firms under competition each firms demand quantity appears as a dot or a point (f1, f2...fn) on the market demand curve. Again with each addition of a firm to the market the industry demand curve becomes more flexible; structurally it gets flatter. It starts moving in the direction of DD p DD1 p DD2 and ultimately assumes the form of a horizontal straight line. Therefore there is no contradiction between the horizontal demand curve of a firm and the downward sloping demand curve of a market or industry. iii) Normal Profits and Price Takers: Finally, though the price is fixed and a firm has to accept it as given, such price ensures normal profits for the firm. These profits are economic profits and enable a firm to cover all its explicit and implicit costs. In the short run more efficient firms may make Super Normal profits but these will not continue in the long run. On the other hand, if some firms are suffering Sub Normal profits or losses they will have to quit or exit and discontinue production in the long run. All firms in a competitive market make only normal profits in the long run. Because of fixed and uniform price and normal price conditions,

individual firms are called Price Takers. They have to accept the market price as given. Therefore, they are not Price Makers. 10.2 Competitive Equilibrium (A) MR = MC rule: Equilibrium of a firm is a condition where profits are maximized. The analytical condition of equilibrium is stated as a point of equality between Marginal Revenue and Marginal Cost. It ensures the profit as Profitmax = TR - TCmax where MR = MC i.e. the difference between Total Revenue and Total Cost. (TR - TC) is maximized automatically when this condition is satisfied. This MR = MC rule is equally applicable to a competitive or monopolistic or oligopolistic or any other form of the market. This can be explained with the help of a figure.

In Figure 33, P - AR = MR is the demand or Average and Marginal Revenue curve. AC is the Average Cost curve and MC the Marginal Cost curve. Point e is the point of intersection of AC and MC; hence at the minimum point on AC there is equality between MR and MC. Therefore e is the point of equilibrium where profits are maximized. At the equilibrium point market price is P and output produced is Q. For any other output level, profits cannot be further increased. For a smaller output level Q1 the point on the Marginal Revenue curve R1 is above the point e1 on the Marginal Cost curve. Hence to the left of point e so long as MR > MC a firm can gain more profits by increasing output and by moving in the direction of point e. On the other hand, if a firm tries to produce a larger output Q2 then Marginal Cost C2 exceeds Marginal Revenue R2 (MC > MR) and the firm makes some losses. These losses can be avoided only by restricting output and by moving in the direction of point e. Hence we conclude that e is the point of equilibrium which alone can help to maximize the profits of a firm. Note that the firm is operating under competitive market conditions. It earns only normal profits which are included in the average cost of the production curve AC. We have therefore marked AC as AC + NP curve. In a competitive market, a firm will be in equilibrium at a point e where all the four variables are equal.

MR = MC = AR = AC. A firm in such equilibrium earns only normal profit. AC = AC + NP (B) Numerical Example: The profit maximization of a firm with equality between Marginal Revenue and Marginal Cost can be illustrated with the help of a numerical example: Production Output TC MR=AR=P=$5 TR MC ATC Profits (II * (V Units Produced V) II) 1 40 -40 2 4 50 5 20 2.5 12.5 -30 3 11 60 5 55 1.42 5.45 -5 4 18 70 5 90 1.42 3.89 +20 5 23 80 5 115 2 3.46 +35 6 25 90 5 125 5 3.6 +35 7 26 100 5 130 10 3.84 +30 In the example, output units produced have been shown in column II as 4, 11...etc. Total Cost appears in column III as 40, 50...etc. In column IV we find Marginal Revenue which is assumed to be $5 and which remains constant. This is because the firm is operating under competition. If we assume market price as $5 per unit then AR = MR = 5 which remains fixed. In column V we have Total Revenue as Output v Price or Marginal Revenue. Hence these values are 4 v 5 = 20, 11v 5 = 55...etc. In columns VI and VII the values of Marginal and Average Total Cost are stated (respectively). Column VIII shows the total profits of the firm. Profits are the difference between Total Revenue and Total Cost. Hence profits are seen to be 0 - 40 = - 40, 20 - 50 = - 30, 55 - 60 = -5, 90  70 = 20, 115 - 80 = 35, 125 - 90 = 35 and 130 100 = 30.

Initially for the first three units of productive activity, TC exceeds TR and profits are negative. From the 4th unit onwards, profits become positive. Between the 5th and the 6th units, profits are maximum and profit value is $35. Beyond this output level, the profit starts falling again. The equilibrium position has been marked in the table. It is between the 5th and the 6th units. It is clear that when a firm attains equilibrium its Marginal Revenue is equal to Marginal Cost. Again, MR = MC = 5. Between these output units, the Average Total Cost of production is minimum i.e. between 3.46 to 3.60. Every requirement of a firms equilibrium under competition has been satisfied at an output level of 6 units. 10.3 Short Run Equilibrium (A) Three Possibilities: In a competitive market, price is fixed and given for an individual firm. Moreover, every firm should earn only normal profits as included in its Average Cost of production. However, in the short run, different firms may have a varying degree of efficiency. Their cost structures may differ. More efficient firms may temporarily earn extra or Super Normal profits. Less efficient firms may earn Sub Normal profits (losses) and only optimum efficiency firms will earn normal profits. This is because of the fact that though equilibrium of a firm depends upon the MR = MC condition, its profits depend upon the difference between firms Average Revenue (Price) and Average Cost (AR AC) condition. This leaves us with three possibilities. In an equilibrium with MR = MC, either i) AR > AC = Super Normal profits ii) AR < AC = Sub Normal profits, and iii) AR = AC = Normal profits. In the long run the presence of Super Normal profits will attract new firms. As new firms enter the market extra profits will be competed away. Similarly inefficient firms with higher costs will start exiting in search of some other opportunity. In the long run, after all adjustments are over only normal profits will be earned by all the firms. In that case not only the MR = MC but the AR = AC condition will also be satisfied by all firms. (B) Short run equilibrium explained: Let us study three short run possibilities with varying profits with the help of a figure.

In Figure 34 we have OP the fixed market price with MR = AR for the three types of firms. The cost structures of the firms are different. Let us begin with the first firm which is more efficient. Its Average Cost curve AC1 passes from below the MR = AR curve. The point e1 marks its equilibrium position where MR = MC. The firm produces Q1 output. The Total Revenue of the firm is then, Similarly the Total Cost of producing this output is, TC = Output v Average Cost = OQ1 vQ1C1 = OQ1C1R1 Therefore, Profit = TR - TC = OQ1e1P OQ1F1R = R1C1e1P This is the Super Normal profit of the firm. The second firm with AC2 as its Average Cost curve is a less efficient firm. Its Average Cost curve passes from above the MR = AR curve. In an equilibrium point e2 we find MR = MC and output level is Q2. For this output level the firm receives Total Revenue as, TR = Output v Price = OQ2e2P Total Cost of the firm in equilibrium is, TC = Output vAC = OQ2C2R2 Hence profits of the firms are, OQ2C2P - OQ2C2R2 = - Pe2C2R2 which are negative or subnormal profits. This is because the area of Total Cost is larger than the area of total profits for the second firm.

Finally, there is a third firm with optimum efficiency. In this case AC3 the average cost curve of the firm is neither above nor below the MR = AR curve. The two are just tangential at point e3. The Marginal Cost curve also passes from this point and hence MR = MC. Equilibrium output is Q3. For this output level both Total Revenue and Total Costs are equal. Hence profits of the firm are zero. TR = TC = OQ3e3P, TR - TC = Profits = 0 The firm is therefore making only normal profit. Note that in the case of an optimum firm in equilibrium not only MR = MC but also AR = AC. Hence in the long run, full equilibrium condition of a competitive market is that all firms should be of optimum efficiency and should make only normal profits. 10.4 Long Run Equilibrium (A) Firm and Industry: A competitive market is made up of a large number of firms with complete freedom of entry. Such firms together are called competitive industry. An industry can be defined as a group of firms producing homogeneous products with freedom of entry and exit and which earn only normal profits. Hence the concept of an industry is applicable only under competitive conditions. There is no fixed size of an industry though the analytical stability of an industry can be stated. An industry is said to be stable and in equilibrium when in the long run all adjustments have been made and there is neither tendency for outside firms to enter nor tendency for inside firms to exit; hence each firm makes only normal profits. (B) Market Supply Curve: Before we analyze the long run market equilibrium of a competitive industry let us begin with the demand and supply curves. The market demand curve under competitive industry conditions is downward sloping. Its supply curve is governed by the cost structure.

In Figure 35 we have Average and Marginal Cost curves of a firm. Marginal Cost curve intersects Average Total Cost curve at a minimum point. A rational profit maximizing firm is supposed to arrive at a point such as S and produce output Q. Since for smaller output levels Average Cost is still falling and for larger output levels Average Cost is rising, at initial point S Average Cost C1 = Price P. At price P a firms supply is Q. If a firm is required to make

additional supply such as Q1 it will expect to cover its additional or Marginal Cost as S1 = C1. Supply will increase only when C1 = price P1 in the market i.aspsing. The law of supply is therefore a direct relation between price and supply. Higher the price (P1) greater the supply. A firms supply curve is equiv.aspt to its Marginal Cost curve. To construct market supply curves of a firm we have to make a lateral summation of the supply of firms. Therefore the market supply curve is much more flexible and flatter than the supply curves of individual firms.

.aspnter> In Figure 36 we have DD and SS as industry demand and supply curves respectively. Their point of intersection is e where equilibrium is established. This is short run equilibrium under which Q is the qua.aspy bought and sold and P is the price charged. If the demand condition suddenly changes then the demand curve will shift upwards as D1D1. In the short run on the old supply curve SS a new equilibrium p.asp.asp.asp e1 is established. In this equilibrium quantity exchanged increases to Q1 and the price rises as P1. With a rise in price the same firms start earning Super Normal profits. Therefore outside firms are attracted and start entering the industry. In the long run industry supply curve is shifted downwards as S1S1. A new point of equilibrium e2 is established where D2D2 and S2S1 have intersected. In the new equilibrium position a larger quantity Q1 is exchanged at the same old price P. The firms again earn only normal profits. The long run equilibrium price will depend upon the cost structures of the new and old firms. The price may take any one of the three forms in the long run. Normal possibility is that either the price will remain constant or it will be slightly higher than that in the short run. 10.5 Exit or Shutdown point Firms in a competitive industry have freedom to enter or exit. With the presence of Super Normal profits, outside firms start entering the industry. If, however, some firms are suffering Sub Normal profits or losses, they will not take the decision to withdraw from the market immediately in the short run. They will prefer to wait and find out whether market conditions improve to their advantage. If they continue to make losses even in the long run the firms will have ultimately to leave the industry. This decision is governed by the behavior of the firms

Average Variable Cost curve (AVC). So long as market price is above AVC the firm will cover all its variable costs and the same fixed costs as well. If the price falls below AVC the firm will have to close down and to stop productive activity. This is because variable cost is current expenditure which a firm must expect to cover at market price. If it is unable to cover fixed costs the firm can wait and hope to cover them in the long run.

In Figure 37 when price is as high as P the firm makes normal profits. If the price falls to P1 then the firm still covers all its variable costs plus part of the fixed costs. If the price further falls to P2 the firm cannot cover even its variable costs. It is then advisable that the firm should close down. Therefore Shutdown point for a firm is one where price is just equal to its Average Variable Cost or below AVC. ********** CHAPTER 11 : MONOPOLY 11.1 Nature and Sources (A) Features of Monopoly: Monopoly is another traditional form of market. It is an extreme form, opposed to a competitive market structure. As against this, a competitive market is one with a large number of firms or producers. Monopoly is a case where there is only a single seller in the market. This, however, is a theoretical concept. In reality, a market with a few producers assumes the form of a monopoly. The second important feature of a monopoly market is the absence of substitutes for the goods produced and sold by the monopolists. Buyers have no other option except to purchase goods from the monopolist at whatever price he charges. This results in a situation in which the monopolist has complete control over market conditions. He can decide his own price and earn profits without any fear of competition from his rivals. Yet a monopolist has certain constraints arising out of demand and technical conditions. (B) Limits to the Monopoly Power: Though a monopolist has complete freedom in determining his own price, there are some limits to his power. These are listed below: i) The demand curve of a monopolist slopes downwards.

This is shown as demand curve DD of the monopolist in Figure 38. On such a curve, a monopolist cannot choose both Price and Output to be sold. He has to determine one of these quantities. If he chooses higher price P1 he has to be satisfied with smaller sales of quantity Q1. If he prefers larger output Q2 he will have to charge lower price P2. ii) The second constraint on monopoly power arises out of the income and willingness of consumers. If the monopolist attempts to charge a price as high as Pn his sales fall to zero. So even though a monopolist has complete freedom to charge any high price this freedom is restricted by the consumers ability to purchase goods. iii) Finally, monopoly power also depends upon elasticity of the demand curve. If the demand curve is rigid or less elastic the monopolist has a greater degree of control. As the demand curve becomes more flexible or flatter the monopolists control starts declining.

This can be explained with the help of Figure 39. In the figure there are two demand curves. DD1 is rigid or less flexible showing greater monopoly control. DD2 is flatter or more flexible and depicts a lower degree of monopoly control. On rigid demand curve DD1 if the monopolist increases the price from P to P1 the fall in the quantity sold is as small as QQ1 . On the flatter demand curve DD2 with the same rise in price, a fall in the quantity sold is as large as NN1 . In case of a flexible demand curve there is a danger that even at a higher price, the total revenue of a monopolist may be smaller. This has been further explained in the table below:

Rigid Total Flexible Total Price Demand Revenue Demand Revenue D1 TR1 D2 TR2 2 4 6 6 5 4 12 20 24 20 8 5 40 32 30

A monopolist attempts to raise his price from 2 to 4 to 6. As a result of this quantity demanded goes on falling. Yet in the case of Rigid Demand D1, with a fall in the demand from 6 to 5 to 4 Total Revenue TR1 increases from 12 to 20 to 24. With the Flexible Demand condition D2 the quantity demanded falls sharply from 20 to 8 to 5 causing Total Revenue TR2 to fall from 40 to 32 to 30. Hence the slope or the degree of flexibility of the demand curve governs the degree of monopoly power. (C) Sources of Monopoly: Traditionally monopoly is considered as an evil form of market. It stands in the way of economic justice. Restrictive practices of the monopolist cause prices to be higher and supply of goods to be smaller than what would normally be available. Monopoly is decried and disliked by buyers or consumers, by government agencies and by other fellow producers. Yet monopoly always exists in some form or the other. It has simply to be tolerated. Monopoly is unavoidable under certain circumstances. These circumstances are called sources of monopoly. They are listed below: i) There are some natural resources such as land, mines, oil deposits, fields, etc. the supply of each of which is absolutely limited. When such products are essential and not available anywhere else the owners of the resources automatically acquire natural monopoly powers. ii) In some enterprises, large amount of capital is required to be invested right from the beginning. Steel production, railway construction etc. are examples of such enterprises. Those who possess such capital resources enjoy monopoly powers. Other small investors cannot compete with them and the monopoly survives unrivaled. iii) In certain enterprises, specialized technical resources are required to be employed. Ship building, aeronautics, space research are examples of these enterprises. Those who possess such technical resources will have monopoly power. iv) In modern times certain legal provisions create monopoly rights. These are in the form of copyright norms, patent norms, standardization, etc. leading to monopoly power. v) Finally there are monopolies in the form of public utilities. Road construction, postal services, water supply, telecommunications, etc. are some of the examples. In the case of such services it is necessary to maintain a high quality and a uniformity of products or services. This results in monopoly power.

In all such cases monopoly form of the market becomes unavoidable. Though there are certain evils of the monopoly system these have to be suffered and tolerated. In absence of monopoly production and supply of these goods and services the society will be totally deprived of certain benefits. 11.2 Monopoly Demand Curve (A) Downward Sloping Curve D: In case of a competitive firm, price is given and fixed. Demand or Average Revenue curve is perfectly flexible and is a horizontal straight line. A monopolist has the freedom to charge a higher or lower price. With a change in the price, the quantity demanded also alters. Again a monopolist is a single seller. He himself is a firm as well as an industry. Hence market demand curve is in itself the demand curve of the monopolist. As a result of this the demand curve of a monopolist is downward sloping.

This has been shown in Figure 40. DD in the figure is the Demand or Average Revenue curve of a monopolist. When the Average Revenue curve falls, the corresponding Marginal Revenue curve also falls and is below the AR curve. The usual law about the behavior of average and marginal quantities governs such a relation between AR and MR. (B) AR-MR Relationship: The relation between Average and Marginal Revenue is similar to that of the behavior of average and marginal quantities in general, such as costs, wages etc. When the marginal quantity is constant, average quantity is also constant and the two values are identical. When the marginal quantity increases, the average quantity likewise increases and is lower than the marginal quantity. On the other hand, when the marginal quantity decreases the average quantity falls but is above or greater than the marginal value. This has been illustrated in the table below. Click to view the Table The table makes the MR-AR relationship clear. In part I where total quantity increases from 10 to 20 to 30 marginal quantity remains constant at 10 (20 0 = 10, 30 - 20 = 10). Average quantity is also constant and equal to 10 (20 z2 = 10, 30 z 3 = 10). When the marginal quantity increases as 10, 15, 20 though the average quantity increases it is smaller in value and is below the marginal quantity. When the marginal value falls as 10, 8, 6 the average value also tends to

fall as 10, 9, 8. In this case, average value is more than and above marginal value. This has further been made clear with an arrow diagram in Figure 41.

Here A the average quantity and M the marginal quantity are equal when the two are constant. When A rises, M1 is above A and when A falls, M2 is below A. This relationship is applicable to all forms of markets and for all average marginal quantities. The reason for such behavior is simple. It is Marginal Change which makes the average quantity behave one way or the other. Marginal Change is a single unit change whereas average value gets distributed over all previous units. When M increases from 10 to 15, 5 is added to M. This value is distributed over two units to produce Average Change of 5 z 2 = 2.5; hence the rise from 10 to 12.5. 11.3 Monopoly Equilibrium (A) Monopoly Supply Curve: The behavior of the monopoly demand curve is distinct from the demand curve under competition. The supply curve of a monopolist is similar to that of a competitive firm. Supply is governed by the technical conditions of production. There is no reason why these should be different for a monopolist. Hence supply curve of a monopolist depends upon the behavior of the usual average and marginal cost of production. With such cost curves and a downward sloping demand curve let us attempt an equilibrium analysis of a monopolist. (B) Monopoly Equilibrium: In order to study equilibrium under monopoly let us draw the demand and supply or cost curves of a monopolist.

In Figure 42 AR and MR are the demand and marginal revenue curves of a monopolist. AC and MC are the respective cost or supply curves. The usual equilibrium of MR=MC is equally applicable to the monopolist. In the figure MR and MC have intersected at point e which is the equilibrium point. At this point the monopolist produces and supplies output quantity Q. This is the only profit-maximizing condition for the monopolist. Under the given demand-cost structure no other level of output can help to enhance his profit. In an equilibrium the monopolist charges price P which is determined by a corresponding point R on the average revenue curve. The total revenue of the monopolist is then, TR = OQ v P = OQRP Similarly the total cost of the monopolist is governed by a point on the average cost curve. S or C is the average cost of producing output Q in which the total cost will be TC = OQ v AC = OQSC The profits of the monopolist as the difference between TR and TC are, Profits = TR - TC = OQRP - OQSC = CSRP Hence CSRP are the monopoly profits. These profits look similar to Super Normal profits under competition. Monopoly profits differ in two respects: i) Monopoly profits are permanent and enjoyed in the short as well as long run. There is no fear of monopoly profits being competed away. ii) Monopoly profits arise out of control over conditions in the market. The monopolist follows restrictive policies and charges a higher price. This is the source of his profits. It is made clear by a downward sloping demand curve. Competitive Super Normal profits, on the other hand, are the result of more efficient and favorable conditions of production. Whether a monopolist will always earn extra profits or be satisfied with normal profits depends upon the technical cost conditions of a monopolist and the flexibility of the demand curve. By nature, a monopolist is not likely to allow his profits to fall. He will maintain some positive profits through restrictive practices. 11.4 Evils and Wastage of Monopoly Monopoly market is restrictive and hence considered as an evil form of market. Monopoly is also a source of wastage. It underutilizes productive capacity and reduces Consumers Surplus. Underutilization of capacity may cause some workers to remain unemployed. These and other shortcomings can be analyzed and explained with the help of a comparative diagram in Figure 43. We find both competitive and monopoly equilibrium positions marketed by point e1 and e2 respectively. A competitive firm produces output Q1 and sells at price P1. A monopolist produces

smaller output Q2 (Q2<Q1) and charges higher price P2 (P2>P1). Competition allows only normal profits to a firm as part of the average cost of production. A monopolist earns extra monopoly profits of the size CSRP2. Under competition output is produced at point e1 which is the lowest point on the average cost line. Therefore competition makes fuller utilization of the productive capacity. Under monopoly output is produced at point S which is on the falling phase of AC. This shows underutilization of the productive capacity. Finally, the size of the Consumers Surplus under competition is as large as De1P1 while that under monopoly is only DRP2. Hence under monopoly there is higher price, lower output, underutilization of productive capacity or wastage of resources and reduction in Consumers Surplus. Such evils or wastage under monopoly are also present more or less in every other imperfect market with a lower degree of competition. ********** CHAPTER 12 : OLIGOPOLY MARKET 12.1 Oligopoly (A) Oligopoly Problem: Monopoly and Competition are two extreme forms of market under traditional analysis. Between these two forms there are other possibilities such as Oligopoly and Duopoly. When there are only a few producers or sellers the market is said to be an oligopoly. With one or more requirements of perfect competition missing or weak the market assumes a certain degree of imperfection. The number of firms may not be sufficiently large or the freedom of entry may not be fully available or knowledge about the market conditions may be inadequate or the factors of production may not be fully mobile. All such causes create market imperfections. Oligopoly and Duopoly are the result of a small number of producers. This is Quantitative Imperfection. Economic theory finds it difficult to find a solution to oligopoly or duopoly markets. This is because of the fact that with the presence of a few producers there is bound to be stiff rivalry among producers. This may cause endless price-cutting tendencies. As a result of this stable equilibrium solution may not be possible. Such a suspicion is unfounded since in reality oligopolists and duopolists do exist and perform successfully. (B) Renewed Efforts: Though some economists fear instability in oligopolistic markets, efforts are made from time to time to analyze them. The earliest work in this respect is that of French economist, Cournot (1834). Since then Bertrand, Edgeworth, Stackelberg, Hall-Hitch, Chamberlin and others have produced different equilibrium models. The main difficulty that arises in this respect is about appropriate assumptions about behaviors and reactions of the rivals. Economists do not have adequate information on this subject. The latest work in this respect is that of Paul Sweezy. His model is based on a new tool of analysis that he has introduced. It is in the form of a Kinked Demand Curve. This has become a popular part of oligopoly analysis. (C) Kinked Demand Curve: The demand or average revenue curve used in this analysis is Kinked. It has a Kink or a knot. The demand curve is not a smooth straight line but has two segments with a varying degree of flexibility or slope. Before we present the Kinked Demand

Curve let us begin with its underlying assumptions. Sweezy has made the following two assumptions: i) If the firm reduces its price the producer expects other competitors to introduce a similar price cut; the market demand will increase but the share of the firm will remain unaltered. ii) If the firm raises the price then other competing firms will not follow the price rise. There will be a very small rise in demand but a significant reduction in the sales of the firm. The two assumptions suggest that neither a fall nor a rise in price would benefit the firm. Oligopoly price is rigidly fixed. Moreover, such a price rigidity causes a Kink in the demand curve with its lower segment steeper or inelastic and its upper segment flatter and more flexible. Consequently there is no incentive to alter price under oligopoly. This will be clearer when explained with the help of a figure.

In Figure 44, there are two demand curves, DED, which is flatter and more flexible and D1ED1, which is steeper and less flexible. The two demand curves interest at point E which itself is a point of Kink. The upper portion of the flatter demand curve DE and the lower portion of the steeper demand curve ED1 together make up the Kinked Demand Curve. Under the above stated assumptions the lower portion of the flatter demand curve ED and the upper portion of the steeper demand curve D1E are not operative. Taking into account only relevant segments of the two demand curves a Kinked demand curve DED1 has been formed and presented in Figure 45.

Once we locate the point of Kink there is no further problem in oligopoly analysis. The point of Kink, E, is itself an equilibrium point. At such a point equilibrium output produced is Q and price charged is P. (D) Oligopoly Equilibrium: Once a Kink in the demand curve is known and given, oligopoly equilibrium automatically follows. The point of Kink such as E is itself an equilibrium point. Moreover, such an equilibrium is rigid and stable. There is no incentive on the part of the oligopolist to move away from the point of Kink. Any attempt on his part either to lower or raise the price will not be to his advantage. This can be explained with the help of Figure 46.

The lower segment ED1 of the demand curve is steeper. Even with a significant fall in price from P to P1 increase in the quantity demanded QQ1 is very small. Reduction in price will then result in a smaller total revenue for the firm. On the other hand, any attempt to cause a small rise in price as PP2 on the flatter portion ED of the demand curve causes a significant fall in the quantity demanded from Q to Q2. This again will cause total revenue of the oligopolist to be smaller at higher price. The oligopolist is rigidly fixed at E, the point of Kink with P as the price. This therefore is also called sticky price solution. Oligopoly analysis (such as the above) has been carried out exclusively in terms of demand or average revenue curve. So long as oligopolists find the average revenue higher than the average cost of producing equilibrium output, they will make profits. Any reference to the marginal cost of a firm is not necessary in such an analysis. Therefore it is also called Full Cost (not marginal cost) Oligopoly Equilibrium Solution. Even if we desire to bring in the marginal revenue and the marginal cost curves into the discussion that does not alter the equilibrium attainment of the firm. This can be seen in Figure 47.

We have two marginal revenue curves MR and MR1 corresponding to the average revenue curve segments DE and ED1 respectively. The two marginal revenue curves are broken and the broken portion is along the vertical line EQ. Marginal cost curve of the firm passes from the broken portion of the marginal revenue curve. The equality between MR=MC is also fulfilled for the same output level Q and price P. The Kinked demand curve appears to be satisfactory in every respect. However, the Kinked demand curve solution has also come under some criticism. Sweezy's behavioral assumptions are doubted. Once the Kink position is known the rest of the analysis follows; however, how to determine the Kink is not stated. 12.2 Cartel (A) Meaning of Cartel: By Cartel we mean a combination of several firms into a group sharing an identical interest. When a large number of firms or industries join hands they enjoy extra power. They can exert considerable influence on the market conditions. They can charge exorbitantly high prices and exploit consumers. For this reason, cartels are normally banned in various nations. In some implicit or explicit forms cartels do exist in different parts of the world. Generally cartel organizations take undue advantages of the loopholes in the legal provisions. Cartels are theoretically akin to monopolies but in practice are far more menacing and damaging in effect. The best and most notorious example of cartels in the recent past is that of OPEC - Oil Producing and Exporting Countries. Saudi Arabia and other countries after 1973 formed a cartel. As a result of this petroleum prices rose exorbitantly, twice in the period between 1973 and 1978. The price hike of petroleum products was more than 500 percent during the period. It rose from $6 per barrel to $32 per barrel or more. This caused a tremendous rise in the cost of production all over the world. It led to a prolonged recessionary phase in economic activities. Some other developing countries producing and exporting products such as tobacco and cotton have also thought of forming cartels. This has not been realized so far. (B) Cartel Equilibrium: Cartel is a monopoly organization. Equilibrium under Cartel and monopoly is identical in nature. Cartel equilibrium has been represented in Figure 48. Average and marginal cost curves are similar to that of the monopolist. Similarly average and marginal revenue curves of a Cartel are downward sloping like those of a monopolist.

The cartel attains equilibrium at point e with MR = MC where quantity sold is Q and price charged is P. The profits of the cartel are of the Size CSRP. Cartel is a dangerous form of market. It may possibly not survive as long as monopoly. This is because the monopolist is a single producer while a cartel is a group of firms. Rivalry among cartel members and certain underhand practices on their part may cause troubles. ********** 12.2 Cartel (A) Meaning of Cartel: By Cartel we mean a combination of several firms into a group sharing an identical interest. When a large number of firms or industries join hands they enjoy extra power. They can exert considerable influence on the market conditions. They can charge exorbitantly high prices and exploit consumers. For this reason, cartels are normally banned in various nations. In some implicit or explicit forms cartels do exist in different parts of the world. Generally cartel organizations take undue advantages of the loopholes in the legal provisions. Cartels are theoretically akin to monopolies but in practice are far more menacing and damaging in effect. The best and most notorious example of cartels in the recent past is that of OPEC - Oil Producing and Exporting Countries. Saudi Arabia and other countries after 1973 formed a cartel. As a result of this petroleum prices rose exorbitantly, twice in the period between 1973 and 1978. The price hike of petroleum products was more than 500 percent during the period. It rose from $6 per barrel to $32 per barrel or more. This caused a tremendous rise in the cost of production all over the world. It led to a prolonged recessionary phase in economic activities. Some other developing countries producing and exporting products such as tobacco and cotton have also thought of forming cartels. This has not been realized so far. (B) Cartel Equilibrium: Cartel is a monopoly organization. Equilibrium under Cartel and monopoly is identical in nature. Cartel equilibrium has been represented in Figure 48. Average and marginal cost curves are similar to that of the monopolist. Similarly average and marginal revenue curves of a Cartel are downward sloping like those of a monopolist.

The cartel attains equilibrium at point e with MR = MC where quantity sold is Q and price charged is P. The profits of the cartel are of the Size CSRP. Cartel is a dangerous form of market. It may possibly not survive as long as monopoly. This is because the monopolist is a single producer while a cartel is a group of firms. Rivalry among cartel members and certain underhand practices on their part may cause troubles. ********** CHAPTER 13 : MONOPOLISTIC COMPETITION 13.1 Market Imperfection (A) Quantitative and Qualitative Differences: Traditionally a competitive market is considered an ideal form of market. As a rule almost all markets are competitive in nature. Only in exceptional cases certain market imperfections may cause departure from competition. Such exceptions to competition are in the form of monopoly, oligopoly or duopoly. However, all these forms are numerically and quantitatively dissimilar to competition. Traditional analysis does not take account of qualitative differences. The number of firms may remain fairly large to make the market appear competitive. Yet there may be noticeable varieties in the price charged and the profits earned by individual firms. This can be explained thus: such modern markets have started emerging in the 1920s. Traditional competitive analysis could not explain them. The conclusion drawn was that modern competitive firms deliberately create qualitative differences in their products and in their selling activities. In other words, modern firms differentiate their products. Firms producing biscuits, soaps, chocolates, stereo systems and TV sets are all examples of product differentiating firms. This new trend among producers demands a different approach to analyze their behavior. Two young economists Joan Robinson in England and Prof. E. H. Chamberlin in the U.S presented their respective theories on Imperfect Competition and Monopolistic Competition in the earlier half of the 20th century. We will presently review monopolistic competition. (B) Main Features of Monopolistic Competition: Monopolistic competition is a modern form of the market. A large variety of goods are sold in such a market. Its main features can be stated as follows:

i) Large Number: The number of firms operating under monopolistic competition is sufficiently large. Moreover there is freedom of entry. There are no quantitative restrictions or differences in market conditions. However, each firm differs from its rivals in some qualitative respect. ii) Close Substitutes: In case of a monopoly there are no substitutes available. Under monopolistic competition firms produce very close substitutes. Chocolates of one company may serve a similar purpose as that of some other firm. The only difference may be of some variation in the quality of the product. iii) Group: Firms under monopolistic competition together form a group. They cannot be called an industry. This is because their products are somewhat dissimilar and not homogenous as under competitive industry. iv) Product Differentiation: Under monopolistic competition products are differentiated. This is the outstanding feature of this form of market. Otherwise monopolistic competition closely resembles perfect competition. The fundamental difference between the two is that products are no more homogenous. Goods produced are deliberately differentiated. By differentiation we mean the goods are made to appear somewhat different and superior to those produced by other firms. Product differentiation may be real or apparent. By real differentiation we mean that a difference is maintained in some physical or chemical composition of a product or in the taste and appearance of that product. This is easily done with the help of attractive packaging; or some extra services are rendered. A product can also be marketed as superior using local advantage. When products are differentiated more buyers are likely to be attracted. Thereby the firm gains extra control over demand and market conditions. The demand curve of a firm will then alter to the advantage of a firm. It will become more flexible and shift upwards. A firms capacity to alter the demand curve for its own product is the chief analytical feature of monopolistic competition. Under no other form of market do producers attempt to influence the demand which is entirely based on consumer behavior. Gains of product differentiation have been shown in Figure 49. In the figure dd is the original demand curve that the firm faces before product differentiation.

On this demand curve at market price P the firm sells output Q. When the firm differentiates its product successfully its demand curve alters and is now d1d1. On the new demand curve the firm at point R1 can charge a price as high as P1 and sell old output Q. It could also charge the same price P and sell a very large output Q1 at point R3. Or then the firm could choose a somewhat

higher price (higher than P1 but lower than P2) P2 at point R2 and sell a somewhat larger quantity Q2. (v) Selling (Advertising) Cost: Selling Cost (SC) is another outstanding feature of a monopolistic competitive market. This in the form of advertisement expenditure. Selling Cost and Product Differentiation together enable the producer to maintain some control over market conditions and influence the shape of the demand curve. Both features are interdependent. Whenever a product is differentiated it is necessary to inform buyers; and advertisement is the only medium through which buyers can be told about superiority of that product. Selling Cost by itself is apparent product differentiation. When a product does not contain any genuine qualitative difference, buyers can be made to treat a product differently through advertisements. So whenever products are differentiated and advertised, the market becomes a monopolistic competition. These are the hallmarks of this form of market. The presence of selling cost increases the firms cost of production. In order to recover it, firms have to charge a higher price. The net effect of a monopolistic competitive market is pricing goods at a higher rate. Consumers have to bear this extra expenditure. 13.2 Equilibrium under Monopolistic Competition (A) Chamberlins assumptions: Since products are differentiated under monopolistic competition, the demand curve for a firm alters. The price of an individual firm may be higher and its sales larger. All this calls for stiff reaction on the part of other rival firms. Moreover under monopolistic competition there is freedom of entry and the products are close substitutes. All this makes the market situation highly complex through continuous actions and reactions of the firms. In order to simplify the analysis under such a market, Chamberlin has made certain assumptions. Two of these assumptions deserve special reference. Chamberlin has called them Heroic assumptions. i) Uniformity Assumption: Both demand conditions and cost conditions, and demand and supply curves are uniform throughout the group for all products produced. This ensures that the ability of a firm to influence buyers is not caused by a difference in the demand or cost structures of the firm. The influence of the firm must arise purely out of its ability to differentiate products. ii) Symmetry Assumption: Any adjustment made in the price or the product by an individual firm spreads its influence over a large number of competitors. The impact of such adjustments is significant. The net effect of these two assumptions is on the demand curve of a product differentiating firm. Before we proceed with equilibrium analysis let us summarize the monopolistic and competitive elements in this market. Chamberlin has called this market one of monopolistic competition because of the blending of the features of both competition and monopoly.

Positive: It is a competition because of the presence of i) a large number of firms and, ii) freedom of entry Negative: It is not a pure competition because i) the products are not homogenous but differentiated and, ii) the Price is not uniform.

It is a monopoly because each firm has some control over market conditions.

It is not a monopoly because the producer is not a single individual. There is no restriction on entry, and the goods are close substitutes.

(B) Equilibrium and Profits: When the product is differentiated an individual firm has some capacity to influence market conditions. It can exert a degree of control over price and output sold. Equilibrium of a firm has been explained in Figure 50.

In the figure, we notice two demand curves dd and DD which need some explanation. Both are demand or average revenue curves. They differ in certain respects which are as follows: i) dd is the demand curve of a firm which differentiates its product. As a result of this the firm expects to sell a larger quantity. The dd curve is flatter and more flexible. However, the firms expectations may not be fulfilled.

ii) In the market the firm faces competition from its rivals. Its actual share in the market is smaller than what it had expected. Such a market share of the firm is shown by the DD curve. This curve is steeper and less flexible. The firm attains equilibrium at a point e which is a point of intersection of the dd and DD curves. In the equilibrium position a firm sells output Q at price P. The total revenue of the firm is equal to the area OQeP. In order to find the profit of the firm we have to introduce the cost curve and work out the total cost of production. For this purpose, Chamberlin has used LAC, the Long run Average cost Curve of the firm. This is because of the fact that the firms adjustments and the rivals reaction process is time-consuming. It can be completed only in the long run. The vertical line eQ intersects the cost curve at point S which determines average cost of producing output Q. The total cost that the firm has to bear in producing output Q units is equal to the area OQSC. The difference between total revenue and total cost shows extra profits that the firm earns. These are equal to the area CSeP. OQSC = CSePProfits TR - TC = OQeP Under monopolistic competition the conditions that matter are the demand curve and the average revenue of the firm. Any reference to marginal revenue and marginal cost is not necessary for such equilibrium. (C) Long run Normal Profits: When a firm has differentiated its product successfully it earns extra profits by selling more output and charging a higher price. These profits may not continue in the long run. The reason is: when one firm makes extra profits other firms are also induced to differentiate their products. Moreover, outside firms will also start entering the market. Such reactions on the part of the rivals cause a firms demand curve dd to slide downwards as d1d1in Figure 51.

It will continue to slide until it becomes tangential to LAC at point e1 as seen in Figure 51. This is a new long run equilibrium point. Market share demand curve also shifts to the left from DD to D1D1 and passes through point e1. In this new equilibrium position the firm sells a smaller output Q1 at a lower price P1. Its total revenue and total cost are both equal and of the size OQ1e1P1. Thus extra profits have been competed with. Still this may not be a stable equilibrium solution because individual firms are free to undertake fresh rounds of product differentiation. This may renew the whole process. ********** CHAPTER 14 : LABOR MARKET 14.1 Demand and Supply (A) Demand for Inputs: Firms produce output and bring it to the market. The whole activity is carried out with the intention of earning profits. In order to achieve this, firms have to maximize their returns or revenue and minimize their cost of production. Their ability to control cost of production will depend upon supply and demand conditions in the input market. There is a large variety of raw materials, land, capital, equipment, and labor services employed by the firm. Though demand for such inputs is important in theory, there is a special significance concerning the demand for labor. This is because labor is a human factor of production. Labor is not only a means but also an end of all economic activities. Moreover, labor is a perishable commodity. Every moment in the life span of a worker is precious. Once lost, it is forever irretrievable. Labor as a human factor of production further shows considerable dissimilarity in its quality, experience, age composition, educational and technical skills, degree of mobility, aptitude and preferences etc. This makes the labor market problem highly complex. We will presently take account of some aspects of the demand for labor. (B) Supply of inputs: The cost of a firm in employing resources also depends upon the supply conditions of the inputs. If we concentrate only on the labor supply problems several difficulties are likely to emerge. Supply of labor normally depends upon the size of the population and the age composition of the working population. This refers only to the quantitative supply of labor power. If we take an account of physical and mental efficiency, educational achievements, technical training etc. there is a variety of dissimilarities in the labor supply conditions. Traditionally classical writers throughout the 19th century assumed perfect competition in the labor market. In such a market at a fixed rate of wages any number of workers are freely available. Moreover, even a fixed competition wage rate was supposed to be equal to the subsistence needs of an average worker. This is no longer held as true in modern labor markets where strong trade unions are present. Both on the demand and supply sides, the labor market is not governed by purely economic considerations. There are social, ethical and political aspects of labor market which often form part of the discussion. Meanwhile we will restrict ourselves mainly to economic considerations leading to demand for and supply of labor. 14.2 Marginal Productivity Theory

(A) MPP and MRP: Just as demand and supply forces together determine prices and quantities of goods exchanged in the product market similar rules operate in the factor market. If the labor market is assumed to be competitive then the rate of wages will be fixed and uniform. At such a competitive wage rate a firm has to decide how many workers it can profitably employ. In other words, a firm has to determine its own demand for labor. The productive contribution of an additional or marginal worker governs such a demand for labor since labor is a productive service. A firm is guided in this respect by the marginal productivity rule. The most important principle determining demand for labor is called Marginal Productivity Theory. It attempts to relate marginal contribution to the output produced and the rate of wages required to be paid to the marginal worker. Wages are paid in cash or money units while the product is measured in physical units. To make the comparison convenient Marginal Physical Product (MPP) is converted into Marginal Revenue Product (MRP). For this purpose, MRP is multiplied by the marginal revenue earned by a firm in the curve. If a firm is operating under a competitive product market then the price or the average revenue and marginal revenue values are identical. MRP is Price v MPP under competition. This same value is MR v MPP under imperfect markets. MRP = MPP vPrice p Competition MRP = MPP v MR p Monopoly, Oligopoly etc. (B) A Firms Demand Curve: Let us begin with the simple case of a competitive market. There is competition both in the labor market and the product market. Price of the product is assumed to be $5. The firm has to determine its demand under the following productivity conditions: Marginal Revenue Product (MPP $5) 25 35 30 20 15

No. of workers Employed 1 2 3 4 5

Total Physical Product 5 12 18 22 25

Marginal Physical Product 5 7 6 4 3

In the example, the number of workers employed increases progressively from 1 to 5. With more workers employed total output continuously increases from 5 to 12to 25 units. Marginal product initially rises from 5 to 7 (12-5=7) but subsequently falls from 7 to 6, 4, and then 3. Under competitive product market MRP or money value of the MPP at a fixed price of $5 will be 25, 35, 30, 20 and 15. The firm will decide how many workers need to be employed depending on the present market rate of wages. If the rate of wages is as high as $35 per worker, the firm can employ only two workers. With the wage rate as low as $15 the firm can employ five workers. If we assume that the actual competitive labor market wage rate is $20 the firm can employ 4 workers and remain in equilibrium. At this wage rate the demand and supply forces have been equated.

In Figure 52, we have MRP, the demand curve for labor. This is the downward sloping curve showing a progressive fall in the productivity of labor. It enables the firm to employ more workers only at a lower wage rate. The labor market is competitive and $20 is the fixed uniform rate of wages. At this wage rate any number of workers will offer services. Therefore the labor supply curve is perfectly flexible. It is represented by the horizontal straight line WS (AW = MW) curve. The rate of wages as a price of labor is equal to both the average wage and the marginal wage per worker. The demand and supply curves intersect at the point of equilibrium e. At this point a firm employs N = 4 workers and pays W = $20 as wages. This is a profitable situation for the firm. 14.3 Supply Curve of Labor (A) Backward Sloping Supply: The labor supply curve of a single worker may not be smooth and straight. It is likely to be backward bending or sloping in nature. On such a labor supply curve, a worker will initially increase the supply of a number of hours of work with a rise in the rate of wages. Once his estimated need of wage income is satisfied he is likely to prefer leisure or rest from work. Leisure is an attractive alternative to work and hence it is the opportunity cost at further hikes in the wage rate. This has been shown in Figure 53.

In the figure the number of hours of labor supplied have been measured along OX axis and the rate of wages along OY axis. When the initial wage rate is as low as W a worker supplies N hours of labor. With a rise in the rate of wages to W1 he has an incentive to work longer and to earn a higher income. Therefore the worker offers more hours of labor (N1). The labor supply curve SS1 slopes upwards as is normally expected. Beyond W1 if the wage rises further as W2 the worker may withdraw some hours of labor. He may prefer more leisure than work. Therefore supply of labor drops to fewer hours as N2. The supply curve S1S2 bends backward. This is the typical nature of the labor supply curve. This can be explained both with the help of income and substitution effects. Beyond point S1 and wage rate W1 the worker feels that an adequate income has already been earned by him. Therefore beyond this point he prefers leisure to income. This is termed the negative income effect. Also, more work and more income, on the one hand, and more leisure, on the other, are substitutes of each other. About 10 or 12 hours of work leisure may be given up in preference to income but, beyond that, leisure is considered more valuable. Therefore it is substituted in place of work and income. (B) Market Demand and Supply Curves for Labor: Under a perfect competitive market both demand and supply curves are likely to be normal in behavior. Demand curve for labor will then be downward sloping. In a market numerous firms operate; so the demand curve will be more flexible than in the case of individual firms. Labor supply curve will be composed of the additions of labor supplied by individuals. This is likely to slope upwards. It indicates that both labor of a higher quality and skills are supplied only at a rising rate of wages. Under competition, with a very large number of workers and with less significant personal differences, the supply curve will be highly flexible tending to be a horizontal straight line. Given the demand and supply schedules or curves competitive market equilibrium can be determined.

In Figure 54, DD and SS represent the competitive labor demand curve and the competitive supply curve respectively. The two curves intersect at point e which is a point of equilibrium. Under equilibrium condition, N number of workers offer supply of labor and receive the wage rate W. If labor market shows a greater homogeneity and if the qualitative variations are very few then the supply curve will be more flexible as represented by S1S1. With such a supply curve under the given demand conditions, a new point of equilibrium e1 is established. At this point more workers N1 offer services at a lower wage rate W1. Thus demand and supply conditions together determine level of employment and rate of wages in a competitive market. 14.4 Monopsony and Exploitation of Labor (A) Monopsony: Monopoly in the product market is a condition where only one producer or seller operates. Similarly when only one employer is buying labor he enjoys monopsony power in the labor market. The workers have no option but to work with the monopsonist and to accept whatever wage rate is offered by him. The presence of monopsony causes a lower rate of wages than what the workers ordinarily deserve. Such a situation results in exploitation of labor. By exploitation, we mean that a smaller wage remuneration is paid to the workers than what they are entitled to receive under competitive rule. There are two possible cases of exploitation. In one case, monopoly power is enjoyed only in the labor market. In the other case, the producer is a monopolist both in the labor and the product markets. (B) Monopsony and Competition: A producer has monopsony power only in the labor market. In the product market he faces competition with other firms. In Figure 55 we notice such a situation.

In a competitive commodity market the demand curve of the producer is at once both the Marginal Revenue Product and the Average Revenue Product (MRP = ARP) curve. Because of uniform product price both values are identical. In the labor market, however, he has control over the labor supply. Therefore the supply curve slopes upwards. The value of Marginal Wage (MW) differs from Average Wage (AW). Both the MW and AW curves slope upward but MW is above AW. The firm is in equilibrium at point e with MRP = MW. In equilibrium position, N number of workers are employed and the price of the product is P. The total revenue of the firm is OPeN. The actual rate of wages paid is decided by the point of intersection L on the AW curve. The average wage of N workers is NL = OW. The total wage payment is of the size OWLN. The difference between the two areas is the value of exploitation of labor. Exploitation = Total Revenue - Total wage cost = OPeN - OWLN = WPeL (C) Monopsony and Monopoly: Besides being a monopsonist if the producer happens to be a monopolist in the product market as well then his surplus will be further enlarged.

In Figure 56, we find that the producer enjoys monopoly power in both markets. Being a monopsonist in the labor market his MW AW curves slope upwards as in the earlier case. Since he is a monopolist in the product market as well his marginal and average revenue product curves slope down and are distinct. MRP is below ARP. Once again the producer strikes equilibrium at point e where MRP = MW. At this point, N number of workers are employed. The price of the product is determined by a relevant point R on the AR curve. The price is NR = OP.

At this price, total revenue of the firm is OPRN. Wage rate is determined by the value of the average wage. It is therefore NL = OW. At this wage rate, the total wage payment is OWLN. The difference between the areas is the no profit surplus of the producer. Net Profit Surplus = OPRN - OWLN = WPRL The entire surplus is split into two parts: i) SPRe as surplus due to monopoly power in the producer market. ii) WSeL as exploitation of labor due to monopsony power in the labor market. The presence of monopsony has similar undesirable effects such as high price, low level of output, underutilization of capacity of production and loss of consumer surplus.

********** CHAPTER 15 : CAPITAL MARKET 15.1 Basic Concepts (A) Meaning and Importance: Capital is the second important factor of production. Whereas labor is a human agent, capital is a material agent of production. Capital is, however, a controversial factor. This is because capital is composed of a large variety of heterogeneous goods. There are no uniform units for its measurement. It is difficult to determine the productivity of capital. Leaving aside such issues we will attempt to collect useful information about this chief agent of production. It is also difficult to find an accurate definition of capital. This is because capital is not confined to any set of goods as such; capital is a function that the goods perform. In the early 20th century, the Austrian economist, Bohm Bawerk defined capital as a produced means of production. Two things are remarkable in this definition. i) Capital is an already produced means or factor of production. Machines, factory buildings, railway wagons etc. are examples of Capital. This suggests that capital, unlike land or labor, is not a natural agent of production. Since land and labor are used to generate capital, capital is said to be a result of past land plus labor (because land and labor are spent in producing capital). Therefore capital is sometimes called dead labor or past labor. ii) Capital is also a means of production. There are a variety of produced goods such as sugar, milk, cloth, steel, electricity etc. which may not all be capital goods. All produced goods together constitute wealth. Total wealth can be used only in one of the two ways. It can be consumed immediately for the present satisfaction of wants or part of the wealth may be saved and used in further acts of production. When it is used in the second form wealth becomes capital. This makes it clear that it is not the goods themselves which are capital but it is the use of these goods

that makes it capital. In this sense, capital refers to a function of goods rather than the goods per se. (B) Investment Savings: Capital is a valuable agent of production. It tremendously enhances productive capacity. For instance, a fisherman, who can catch 10 fish per day with his own hands, can collect 50 or more fish with the use of a net. The use of a net thus enhances the fishermans catch. Modern machines play a similar role by enhancing productive efficiency in ever increasing proportions. This requires careful development of the supply of capital. The whole process is called capital formation. It begins with the act of saving. Right from the days of Adam Smith (1776) economists have recognized the importance of savings. They have often called it thrift. In order to make capital goods available, society must protect or set aside part of the wealth from being presently consumed. Since in modern times economic activities are carried out in money or currency units part of the income is to be saved. Such individual savings are collected by banks and other financial agencies. These collective savings are passed on to businessmen for the purpose of investment. The investors make use of borrowed savings either to purchase or construct new capital goods. Finally, such goods are used in productive activity. The entire process makes up for capital formation activity. Any flaw or delay in the process reduces final outcome of capital goods. (C) Types of Capital: Capital is a functional concept and is not restricted to a specific set of goods. Therefore a variety of goods and services assumes the role of capital. i) In the first place, there is physical capital and financial capital. All material agents of production such as plants and machinery, tools and equipment, power or energy resources, transport vehicles, etc. are physical forms of capital. When all economic activities are widely monetized there is an equivalent stream of financial or monetary capital. This takes a variety of forms. Financial investments can be made in time deposits of commercial banks or through purchase of bonds, shares, debentures (loan certificates), purchase of government securities, etc. All such investments are together known as portfolio investments. Share capital of companies or corporations is called equity investment. Households undertake such investment with a view to earn attractive interest or dividend income. Paper investment by itself must not be regarded as the final generation of capital goods. It is merely a step in that direction. Complete paper investment may not necessarily get converted into physical capital. Still it is an important part of the process of capital formation. ii) A useful distinction is also made between physical capital and human capital. Just as investment is made in physical goods to enhance their productive capacity similar investment can be made in human beings to promote their efficiency. Over the past few decades the role of human capital has been specially emphasized. Prof. Schultz defines investment thus: Any expenditure on the upkeep and development of the physical and spiritual qualities of human members of society is called investment. It performs a similar function of improving future productive resources of society. It is also suggested that human capital and investment activity is superior and in the long run produces permanent gain to a greater extent. Health, education, nutrition, training, etc. are the types of facilities contributing to human capital development. The whole process is known as Human Resource Development (HRD) activity.

15.2 Productivity of Capital (A) Physical and Value Productivity: Capital is a productive agent; so it must result into an enhanced productive efficiency in the act of production. The result of employment of machines should lead to a sizable increase in the total output produced. If a handloom factory produces 300 yards of cloth daily then, with the introduction of the powerloom, there must be net improvement in the cloth output produced such as of about 400 to 500 yards. This is termed physical productivity of capital. According to Bohm Bawerk, there must also be value productivity (in terms of future utilities) of capital. This is necessary because in the act of capital formation there is considerable time lapse. Human valuation of present goods or their present consumption opportunity is relatively larger than similar but uncertainopportunities in the future. Therefore future enhanced size of goods must also compensate for such value differences. This compensation is called agio or discounting process. (B) Stock and Flow: The concept of capital is essentially a stock concept. Such a stock of goods produces income for future consumption opportunities. A house purchased with an investment of $15,000 today will bring in rent for the future 20 years or so. Investment in the house is the stock and future rent is an income flow. Sir Irving Fisher has spoken in terms of a cherry tree which is the stock and cherries that are collected every day as the flow of income. Flow comes only when stock is present. Therefore in order to enrich future income one has to build the stock and improve it from time to time. (C) Net Investment and Depreciation: Capital formation is not a once for all activity. It needs to be continuously sustained and improved. This can be possible only when the stock of capital grows in size in the long run. Fresh addition made to the stock annually or from time to time is called net investment. However, total annual investment activity may not be fully realized in the form of increase in the stock of capital. This is because part of the present capital is likely to depreciate. Hence, additional investment expenditure over and above depreciation charges makes for the net investment and capital formation activity. As an illustration, let a company that produces goods possess a total stock of capital goods worth $10,000. These capital goods such as machinery, tools etc. may have an average life span of 5 years. Therefore after 5 years the entire capital stock will be exhausted and no further productive activity will be possible. In order to replace the present stock after 5 years some amount of current income has to be set aside. Such an allowance is called depreciation charge or alternatively capital consumption or replacement charge. In the above example, the firm has to set aside 1/5 or 20 percent of the value of the stock every year. Hence the firms depreciation charges will be $2000 per year (10,000 z 5 = 2000). If the annual investment activity of the firm is $3000 then it can add to the stock as well. In this case $3000 is the gross investment. Out of this amount $2000 are required for depreciation purposes; the remainder $1000 is the firms net investment. We can conclude that the firms net investment or capital formation activity will be positive and its stock of capital will increase when its gross investment exceeds depreciation requirement. If gross investment falls short of the depreciation allowance then net investment will be negative. GI - D = NE 3000 - 2000 = 1000 Positive GI D = NE 2000 - 2000 = 0 Nil

GI D = NE 1500 2000 = - 500 Negative (D) Interest and Discount: Capital goods are productive and they increase the future stock of goods. Therefore capital is said to be an asset which brings net return or additional income in the future course of time. Such net return on capital is called its rate of interest. Rate of interest may be both real as well as monetary in form. If we lend 500 quintals of wheat to a farmer during the planting season to be used as seeds, he may promise to return 550 quintals after the harvest season. The additional 50 quintals he returns is the real interest on the capital lent. The rate of interest in this case is 10 percent. Since almost all economic transactions today are performed in currency units the rate of interest is charged and paid in monetary units. The farmer in the above example may approach a banker for a loan of $1000 with a promise to return $1100 after a year. In this case the farmer pays an interest of $100 which is 10 percent of the loan but in monetary units. It is easier and more convenient to compute and charge interest in the form of money. This is because loan transactions are carried out over a long number of years in which case, the compound interest to be charged also increases in value. As in the example above, if a bank lends an amount of $1000 at 10% rate of interest after one year the total amount repayable will be $1100 of which the capital or principal amount is $1000 and the interest amounts to $100. Further if we suppose the loan is extended over the second year the amount to be repaid will be more than $1200 because at the end of the first year $1100 were repayable and hence have been renewed as loan for the second year. 10% of 1100 will be equal to $110. Therefore at the end of the second year, the borrower would have to repay $1210. 1000 (principal) + 100 (first years interest) + 110 (second years interest) = 1210 This process is called compounding of interest charges. As the number of years of the borrowing period increase the compounded interest goes on increasing. In general, for n number of years, the mathematical formula used for compounding purposes is as follows: V = K(l + r)n [V = K(l + r)1, K(l + r)2, K(l + r)n] V is the final value of the loan plus interest, K is the capital or principal amount borrowed, r is the rate of interest and n is the number of years of borrowing. In our example, V = 1210, K = 1000, r = 10% or 0.10 and n = 2 Discounting is an opposite process. The interest rate enhances the present value of the principal in the future course of time. On the other hand, the discounting method reduces future incomes or values at a certain rate to determine their worth under present valuation. Since the future is uncertain, price levels and other conditions may alter and therefore the lender considers the future value to be lower under present valuation. The rate of discount is calculated as the extent of difference in valuation. Normally the rate of interest also acts as a rate of discount. In the above example the amount of $1100 an year ahead is equivalent to $1000 today. This way, the present value of the future income has been discounted by 10 percent. 15.3 Market Rate of Interest

Borrowing and lending are capital transactions. Savings or bank credits are supplied as loanable funds. Borrowers pay the extra charges of interest or discount for the use of loanable funds. Therefore the rate of interest is the price of borrowing loanable funds. Matters like the interest rate being positive, or then how high (or low) an interest should be charged are determined in the same manner like other commodity prices. It is the supply of savings and the demand for loanable funds which together determine the rate of interest. If the number of savers and their amount of saving exceeds the needs of the borrowers then the rate of interest will be relatively low. But if the loanable funds supplied are smaller in size than the needs of the borrowers the rate of interest will be relatively higher. Demand for funds borrowed increases with every fall in the rate of interest. Therefore supply of savings or loanable funds is an upward sloping curve. Demand and supply schedules in the capital market together determine the rate of interest.

In Figure 57 DD is the downward sloping demand curve for loanable funds. The supply curve of loanable funds SS is upward sloping showing an increased savings effort with every rise in the rate of interest. The two curves have intersected at point e which is an equilibrium position in the capital market. At point e the quantity of loanable funds exchanged is L and the rate of interest is r. If the rate of interest is somewhat higher, for instance, like r1, then supply of saving s1 will exceed demand for loanable funds d1 (s1 > d1). Therefore some savers will try to push down the rate of interest and move in the direction of the point e. On the other hand, if the actual rate of interest is lower (r2) then the demand for loanable funds, d2, exceeds supply of savings s2 (d2 > s2). Some of the borrowers will then remain unsatisfied and will try to push the rate of interest upwards by moving in the direction of the point e. Thus r is the only stable equilibrium rate of interest. 15.4 Investment Decisions (A) Discounting: One important but difficult part in the process of transactions in the capital market is about appropriate investment decisions. How does one decide whether a certain type of investment will be profitable or not? Let us continue with our earlier example: A lender who gives a loan of $1000 receives $1100 after a year and $1210 after two years when the rate of interest is 10 percent. These future values of present lending are determined by the compounding process. Future Value V = K (1 + r)1 = 1000(1 + 0 .10) 1 = 1000(1 .1) = 1100

V = K (1 + r)2 = 1000(1 .10)2 = 1000 (1.21) = 1210 In this example, K is the present lending value and V, the future value. Since we already know the expected future income, to arrive at its equivalent present value, we need to reverse the process or discount the future values at the rate of the current interest rate.

(B) Investment Decisions: There is a similar method employed for discounting future streams of income which is applicable in making appropriate investment decisions. Let us assume that a taxi driver wants to purchase his own car and to use it as a taxi for earning regular income. Suppose the present market price of the taxi cab is $1000. The present rate of interest (discount) is 10 percent. The life of the taxi is likely to be four years. During these years the taxi driver expects to earn an average annual income of $3000. At the end of the fourth year the vehicle cannot any more be used as a taxi but can be sold out as scrap at a value of $1000. Keeping this in mind the driver has to decide if it will be worth purchasing the car. At a glance it appears that the taxi will bring a total income of $12000 (3000 v 4) plus scrap value of $1000. The sum of $13000 as future income on the present investment is attractive. However, other factors must also be considered. The expected income streams in the future have to be discounted at the rate of 10 percent because the market rate of interest acts as an opportunity cost. The taxi owner could have earned this much by depositing $10000 with the bank if he were to possess such resources. Otherwise he could have borrowed $10000 from the bank and promised to pay interest charges. The present discounted value of these expected incomes would be as follows:

In the present case the discounted value of 10509.59 exceeds the investment value of $10,000 by $509.59. Therefore the investment decision is profitable. If the present value were lower than the total investment, and subsequently, if the difference were negative then the investment decision would not have been profitable.

Let us assume that the market rate of interest is as high as 15 percent but retain the initial investment amount of $10,000 and the final scrap value of $1000. The present discount value of the capital asset will be negative and it will not be worth while to invest in it. Discounted values of the expected incomes in this case are as follows:

Since the net addition to the income is negative, an investment decision will not be profitable. Let us briefly summarize the two cases. Case 1: Profitable Case 2: Net Profitable

Initial Investment $10000 Initial Investment $10,000 Rate of Interest 10% ; Scrap value $1000 Rate of Interest 15% Scrap value $1000

Sr. No. 1 2 3 4

Net Value

Expected Discounted Expected Discounted Annual Present Annual Present Income Value Income Value 3000 2727.27 3000 2608.7 3000 2479.34 3000 2268.43 3000 2253.94 3000 1972.52 3000 2049.04 3000 1715.26 1000 2040.04 1000 10509.59 9564.91 -10000 -10000 +509.59 Net -435.09 Value

(C) Practical Difficulties: A decision regarding investment is a complex and difficult activity. To compute discounted values and to compare them with expected income is a formidable task. The method explained above is quite similar to the Keynesian concept of Marginal Efficiency of Capital (MEC). In actual decision making there are further risks involved. We have assumed fixed average future expected returns. We have also assumed uniform constant rate of interest. Both these expectations are likely to go wrong. Such conditions of uncertainty take away the possibility of accurate investment decision making. The only conclusion we can draw is that investment decisions are likely to be more profitable at a relatively lower rate of interest and less profitable at a relatively higher rate of interest. Therefore a lower rate of interest which simultaneously falls is more favorable to investment activity.

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