Adigrat University Department of Economics Microeconomics 2011 EC

Chapter five
Monopoly
5. Definition and Characteristics
Monopoly is a market structure in which there is only one firm that produces and sells
a particular commodity or service for which there are no close substitutes. Since the
monopolist is the only seller in the market, the industry is a single firm industry and it
has no direct competitors.

Characteristics of monopoly
1. Single Seller: It is a market structure in which the entire supply is controlled by
one firm, which implies that the firm and industry are same.
2. No close substitutes; There is no close substitute for the goods produced.
3. The monopolist is the price maker: It does not take a price which is determined
by the interaction of market demand and market supply. In order to expand its sale, it
decreases the price of the commodity.
4. Entry Barrier: Entry is blocked in such market structure. The barriers may be
legal, financial, and natural.
5. No Collusion and Competition: Because there is only one firm there is no
competition and no collusion among firms also.
Causes for the existence of the monopoly:
1. Exclusive knowledge of technology.
2. Exclusive ownership/access to strategic raw materials needed for production.
3. Government Policies: Patent Rights.
4. Size of market: The size of the market may not allow more than a single seller.
5. Natural Monopolies: Electricity, telecom etc.,
Demand and Revenue for a Monopoly
The whole market supply is controlled by a single firm. In order to sell more output
the firm reduces price and to increase price the firm reduces its output. Consequently,
output and price decisions are interdependent. So that increasing of one will result in
a reduction of the other and vice versa. As a result, the demand curve of the
monopoly is downward sloping.
Note: The monopoly firm faces the industry demand function which is negatively
slopped.

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Suppose the demand function of the monopoly is given by Q = a – bP.

a 1
Solve for p P  Q
b b
TR = PQ

a 1  a 1 2
 b  b Q Q  b Q  b Q

TR
AR  P
Q
a 1
  QP
b b
At any level of output average revenue and price are the same.

a 1 
dTR d  Q  Q2  a 2
MR  = b b  =  Q
dQ b b
dQ
Comparison of price and marginal revenue will result in having identical vertical
intercepts, but marginal revenue is twice as steeper as the inverse demand.
From TR = PQ, find MR
dTR dQ dP
From MR = P Q
dQ dQ1 dQ
dP
MR = P  Q
dQ
dP dP
P = MR  Q Since is negative. P > MR
dQ dQ

P is always greater than MR. It is so because the firm has to reduce price for all the
units of output to sell additional units of output.
The relationship between Elasticity and Marginal Revenue
 1
MR  P1  
 e
Proof:
dR dQ dP
MR  P Q
dX dQ dQ
dP
MR  P  Q
dQ

Price elasticity of demand is defined as

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Adigrat University Department of Economics Microeconomics 2011 EC

Q P
e
P Q
1 P Q

e Q P
dP 1 P
Solving for 
dQ eQ

Substitute (2) in (1)

 1 P
MR  P  Q  
 e Q
 1
MR  P 1  
 e

Costs: It is similar to competitive firms. ATC, AVC, and MC curves are U shaped
and AFC is rectangular hyperbola. The marginal cost curve is not the supply of the
monopolist as in the case of pure competition.
5.1 Short Run Equilibrium of the monopolist.
The monopolist maximizes his short run profit if the following two conditions are
fulfilled.
1. The marginal cost is equal to the marginal revenue.
2. The slope of marginal cost is greater than the slope of the marginal revenue at
the point of the intersection.
Proof:
The monopolist aims at the maximization of his profit
Π=R–C
(a) The first – order condition for maximum profit Π

0
Q

 R C
  0
Q Q Q

Or
R C

Q Q

That is MR = MC
The second – order condition for maximum profit

2 
0
Q 2

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2   2 R  2C
  0
Q 2 Q 2 Q 2

 2 R  2C
Or 
Q 2 Q 2

[Slope of MR] < [Slope of MC]

A Numerical Example
Given the demand curve of the monopolist
X = 50 – 0.5P
50 – Q = 0.5P
This may be solved for P
P = 100 – 2X
Given the cost function of the monopolist
C = 50 + 40 X
The goal of the monopolist is to maximize profit
Π=R–C
(I) we first find the MR
TR = QP = Q(100-2Q)
Q = 100Q – 2Q2
R
MR = = 100 – 4x
X
(ii) Next find the MC
T C = 50 + 40Q
TC
MC =  40
X
(iii) Equate MR = MC
100 – 4Q = 40
100 – 40 = 4Q
60 = 4Q
Q = 60/4 = 15

(iv)The monopolist’s price is found by substituting Q = 15 into the demand-price equation

P =100 – 2Q = 70
(v) The profit is Π = TR – TC
= PQ –TC = 70(15) – [50 + 40 (15)]

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= 1050 – 650 = 400

This profit is the maximum possible profit, since the second-order condition is satisfied:
 2 R  2C
(a) When 
Q 2 Q 2
MC  ( 40)
 0
Q Q

MR  (100  4Q) 2R

(b) From  =-4 we have  4
Q Q X
Clearly -4 < 0

So we can say output level 15 maximizes profit; and hence it is optimal. Therefore,
we can see that the classical condition for equilibrium of equating the marginal
revenue and marginal cost remained intact, except that price is different from
marginal revenue (unlike the case of perfect competition).
Graphically
The decision for the maximization of the monopolists profit is the equality of his MC
and MR, provided that the marginal cost cuts the marginal revenue curve from below.

P D
SMC SATC

C
P
ATC
B

MC=MR ε
D|

0 Q MR X

Profit = PCBATC

Monopolist supply curve in the short - run

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There is no unique supply curve for the monopolist derived from his MC. Given his
MC the same quantity may be offered at different prices depending on the price
elasticity of demand. Graphically this is shown by the following diagram.

SMC

P2 Qe is sold at P1 for some consumers and

P1 at P2 for others.
D1
D2

0 Qe

MR2 MR1

Similarly, given the Mc of the monopolist, various quantities may be supplied at any
one price, depending on the market demand and the corresponding marginal revenue
curve. Such a situation is depicted in the following figure.

P
SMC

Both Q1 and Q2 are sold at the same price P.

D1
D2
0 Q1 Q2
Q
MR2 MR1

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Since the monopolist can sell the same quantity of output at different prices and can
sell different quantities at the same price, depending on elasticity of demand, there is
no distinct relationship between price and quantity supplied by a monopolist. To
conclude we must say that “the supply curve is not clearly defined.
5.2 Long run Equilibrium of Monopolist
In the long run the monopolist has the time to expand his plant or to use his existing
plant at any level which will maximize his profit. But given entry impossibility into a
monopolist market the firm may not necessarily build the optimal plant size. (That is
to build up his plant until he reaches the minimum point of the LAC).
Given entry barrier, the monopolist will most probably continue to earn super normal
profits even in the long run. However, the size of his plant and the degree of
utilization of any given plant size depend entirely on the market demand.
The monopolist may reach the optimal scale (minimum point of LAC) or remain at
suboptimal scale (falling parts of his LAC) or operate beyond the optimal scale
(expand beyond the minimum LAC) depending on the market condition.
i. Under utilization of capacity (suboptimal scale):- A case in which the market
size and cost conditions lead to maximize profit at lower than optimum size (i.e.
LMC &MR intersects at outputs less than where LAC is at its minimum). For
instance if market might be limited/small that the firm will maintain a sub-optimal
plant and may under utilize the plant.

P
C

SMC LMC
P SAC

E LAC

At long-run equilibrium
D SMC = LMC = MR

0 Q
Q
MR
Fig.1. Monopolist with suboptimal plant and excess capacity.

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Adigrat University Department of Economics Microeconomics 2011 EC

The firm is employing plant size smaller than the optimum and it is under utilizing the
plant (excess capacity).
ii. Over utilization of capacity (over optimum) :- A case where in the market is so
large that it forces the monopolist to maximize profit by over utilizing the capacity
( at outputs greater than where LAC is at its minimum) If the market is so large
relative to the expansion path, the firm may build a production plant larger than
the optimal and may over-utilize the plant. When the market is larger, the
optimum occurs to the right of the minimum point of Long run average cost as at
point Oe. P
C
LMC

A
LAC
P

D
SAC SMC
E
MR
0
Qe Q
. Fig.2 Monopolist operating in a large market: his plant is large than
the optimal (Oe)
e) and it is being over-utilized (at ε|).
iii. Full utilization (Optimum size of the plant):- This is the case in which the
market size and cost conditions allow. The monopolist to maximize long run profit
at exactly equal to the optimum plant. If the market size is just large enough to
permit the monopolist to build the optimal plant, the firm will be operating at
minimum point of LAC.

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Adigrat University Department of Economics Microeconomics 2011 EC

P
C

LMC
SMC
LAC
P SAC

0 Qε Q

Fig: Monopolist operating at his optimal plant size (Full capacity

utilization)
If the monopolist is at his optimal plant size SMC = LMC = SAC =MR at minimum
of LAC.
Note: The firm still earns supernormal profit because price is greater than the
marginal revenue (profits in the shaded area).
5.3 Price Discrimination
Price discrimination exists when the same product is sold at different prices to
different buyers or to different groups of individuals or else to different localities. A
producer, mostly likely a monopolist need not always charge a single price to his
customers since he is the only producer in the market, he has a control over the supply
of the product. He can charge different prices to different consumers or in different
markets. Thus when the same product is sold at different price to different consumers,
it is called price discrimination. The two most important points to note about the
definition of price discrimination are: first, exactly the same products must have
different prices. A trip from Bahir Dar to Gondar is not the same as a trip from Bahir
Dar to Dessie because transportation costs are different and this difference raises the
price of the trip. Second, in order for price discrimination to exist, production costs
must be equal. If costs are different, a profit maximizing firm who sets MR=MC will
usually charge different price for a product. This price difference is also due total cost
difference not discrimination.

Consumers are discriminated in respect of price on the basis of their incomes,

geographical location, Age, sex, quantity they purchase, frequency of visits to the

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Adigrat University Department of Economics Microeconomics 2011 EC

shop etc. For instance, price discrimination on the basis of age in airways, railways,
Cinema shows, Musical concerts, charging lower price for teenagers. Doctors has
charged different price for rich and poor persons. But to implement price
discrimination effectively the following conditions has to be full filled.
Some of the necessary conditions for the firm to practice price discrimination are as
follows:
1. The monopolist must distinguish between more price elastic consumer and
less price elastic consumer. (The market must be divided into sub markets
with different price elasticity.)
2. There must be effective separation of the sub markets, (no reselling can take
place from a low price market to a high price market). Eg., Services like
transport, a show, services of doctor, electricity supply etc.,
By practicing price discrimination the monopolist can increase revenue and hence
profit by selling the optimal output (where MR = MC) at different prices in different
markets.
The main objective of price discrimination is to maximize profit more than that the
firm could obtain by charging the same price defined by the equation of his MC and
MR. The degree of price discrimination, therefore, refers to the extent to which a
seller can divide the market and can take advantage of it in extracting the consumers
surplus. Accordingly there are three degrees of price discrimination practiced by
monopolists
a. First degree price discrimination

The discriminatory pricing that attempts to take away the entire consumer surplus is
called first-degree discrimination. Under first price discrimination, the firm treats each
individual's demand separately and each consumer is assumed as a separate market in
accordance to their ability to pay (reservation price). In this case, the firm might
negotiate price with every consumer to charge him/her the maximum price he/she can
pay. It extracts the entire consumer’s surplus and it is called first degree price
discrimination.

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b. Second -Degree price Discrimination.

First-degree price discrimination is expense to implement. Because dealing each

individual demand curve needs vast information and it is costly. Second degree price
discrimination is somewhat simpler because it requires the firm to consider groups of
consumers. This is discrimination on the basis of quantity purchased and intends to
take only the major part of consumer surplus rather than the entire.

c. Third degree Price discrimination

Selling the same product with different price in different markets having demand
curves with different elasticity is called third degree price discrimination. Profit in
each market would be maximum only when his MR=MC in each market. The
monopolist therefore divides his output between the markets and in all markets his
MR=MC.
In this case suppose that the monopolist has to sell his product in only two markets A
and B. As a result, the monopolist must allocate output between the two markets in
such proportion that the necessary condition for profit maximization (i.e. MR = MC)
is satisfied. The equilibrium condition is satisfied where MC=MRa =MR b (common
MC)
Price discrimination and the price elasticity of demand
Note that the firm that practice price discrimination charge higher price when
elasticity is lower and lower prices where elasticity of demand is higher.
 1
Initially we have established that MR  P1  
 e

In the case of price discrimination we have

 1  1
MR1  P1 1   MR2  P2 1   At equilibrium MR1 = MR2 = MC
 e1   e2 

 1
1  
 1  1  P1  e2 
P1 1    P2 1   
 e1   e2  P2  1
1  
 e1 
P1
If e1 = e2 the ratio of prices is equal to unity.  1  P1  P2
P2

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Adigrat University Department of Economics Microeconomics 2011 EC

This implies that when elasticity is same, price discrimination is not possible. The
monopolist will charge uniform price for his product.
But if elasticity are different
 1  1 
P1 1    P2 1  
 e1   e2 

 1  1 
If e1 > e2, then 1    1   this means P1 < P2
 e1   e2 
The market with higher elasticity will have the lower price.
Exercise:
1) Consider a monopolist that takes a market which can be divided into two
submarkets with demand functions.
Q1 = 100 –P1 Q = Q1+Q2
Q2 = 100-2P2 Q = 200 – 3P
If MC is constant at $10 calculate the prices that must be charged in the two markets
and quantities if the firm practices price discrimination.
Solution:
First change the direct demand factions in to inverse demand functions.
Q1 = 100 – P1 Q2 = 100 – 2P2
P1 = 100 – Q1 P2 = 50 – ½ Q2

R1 = P1Q1 R2 = P2.Q2
Q1 [100-Q1] Q2[50-1/2 Q2]
100Q1-Q12 50Q2-1/2 Q22
MR1 = 100-2Q1 MR2 = 50 – Q2
Set MR in each market with MC
MR1 = MR2 =MC
100 – 2Q1 = 10 50 – Q2 = 10
100 – 10 = 2Q1 50 – 10 = Q2
Q1 = 90/2 =45 40 = Q2
Q1 = 100 – P1 = 45 Q2 = 100 – 2P2 = 40
P1 = 100 – 45 =55 = 100 - 40 = 2P2
P2 = 60/2 = 30

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Adigrat University Department of Economics Microeconomics 2011 EC

The Elasticity in each market is

Q1 P1 55 11
e1    1   1.2
P1 Q1 45 9
Q2 P2 30 2
e2    2   1.5
P2 Q2 40 3
e1>e2, thus P1 < P2
2) Given total demand function Q = 50 – 0.5P. Assume further that the market is sub-
divided into two.
Q1 = 32 – 0.4P1
Q2 = 18 – 0.1P2 Where Q1+Q2 = Q
C = 50 + 40 Q [C = 50 + 40 (Q1+Q2)]
(a) Find Price levels of the two markets.
(b) Find Q1 and Q2
(c) Compare the profits obtained by the firm when it practices price
discrimination and without discrimination.
(d) Proof that at higher elasticity the firm charges lower price.
5.4 Multi-plant Monopolist
So far we have analyzed the equilibrium of a monopoly firm which owns and
produces with only one plant. Suppose now a monopolist produces out put in more
than one plant, with different cost strictures. How such a firm would allocate a given
level of output among these plants to maximize his profit?
In order to produce the profit maximization output, the monopoly firm will operate
each plant in such a manner that MC in each plant is equal to the common MR. For
the sake of simplicity, we assume
i. The firm has two plants
ii. The firm is aware of its AR and MR curves.
Then how a profit maximizing monopolist determines its total output and price is
illustrated in the figure below.

Total Market
Plant A Plant B

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Adigrat University Department of Economics Microeconomics 2011 EC

The total MC (indicated in total market) is the horizontal summation of the MC

curves of the individual plants. I.e. MC = MCa = MC b i.e, the firm should transfer
output of the higher cost plant in the lower cost plant. For example, if the last unit
produced in plant B costs birr 10, but one more unit produced in A adds only birr 7 to
A's cost, that unit should be transferred from B to A. this process continuous until
marginal cost of A equals marginal cost of B i.e. MCa=MCb
The total profit maximizing output & is defined by the intersection of MC and MR
curves. And the profit maximizing output, therefore can be obtained by drawing a line
parallel to x-axis until it intersects the individual MCa and MCb which is equal to the
common MR (MC=MCa =MCb =MR)
Numerical Example:
Given the monopolist’s cost and demand curve
Q = 200 -2P or P = 100 – 0.5Q
C1 = 10Q1 C2 = 0.25Q22,
Find Q, Q1, and Q2, P Where Q = Q1 + Q2.
P = 100 – 0.5Q
TR = P. Q = 100.Q – 0.5Q2
MR = 100 – Q
= 100 – Q1 – Q2
TC1 = 10Q1
MC1= 10
TC2 = 0.25 Q22
MC2 = 0.5Q2
MC1 = MR 10 = 100 – Q1 – Q2
MC2 = MR 0.5Q2 = 100 – Q1 – Q2
Q1 + Q2 = 90
1.5Q2 + Q1 = 100
-Q1 – Q2 =- 90
1.5Q2 + Q1 = 100
0.5Q2 = 10
Q2 = 20
Q1 + Q2 = 90
Q1 = 90 – 20 = 70
P = 100 – 0.5 (90) = 100 – 45 =55

Monopolist profit   R  C1  C 2
= 4950 – 10(70) – 0.25 (400) = 4150
SOCIAL COSTS OF MONOPOLY

So far we have seen how output and price is determined in the case of perfect
competition and monopoly. And we have examined the quantity supplied under
perfect competition & monopoly; the price charged by a perfectly competitive and

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Adigrat University Department of Economics Microeconomics 2011 EC

monopolistic firm. Economists always criticizes monopoly firm in that it is less

efficient than competitive firms and it causes social welfare loss and distortions in
resource allocation.
The most common reason for criticism of monopoly is that price is higher and output
is lower than in a perfectly competitive market. Therefore, we compare the long run
price and output under monopoly and perfect competition using the following
graphical analysis assuming a constant cost industry ( so that LAC =LMC)
0 q1 q2

LAC=LMC=MR=AR
=DD perfect

Price and out put under monopoly & perfect competition

As it is prevailed in the above figure given the cost and revenue conditions, the
perfectly competitive industry will produce Oq2 at which is LAC = LMC= AR. Its
Price will be OP1.
On the other hand, the monopoly firm produces an output where LMC = MR.
Monopoly firm produces Oq1 and charges price OP2. Thus, if both monopoly and
competitive industries are faced with identical cost conditions, the output under
competitive condition is higher than under monopoly (0q2 >0q1), and price in the
competitive industry is lower than in monopoly (OP1<OP2). Perfect competition is
therefore more desirable from social welfare angle. The loss of social welfare is
measured in terms of loss of consumer surplus. The total consumer surplus equals the
difference between the total utility which a society gains from and the total price
which he pays for a given quantity of goods.

 Consumer surplus under competitive market

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Adigrat University Department of Economics Microeconomics 2011 EC

- The total utility from oq2 = area OALq2

- Total price paid by the society = area OP1Lq2
- Consumer surplus = area OALq2 = area OP1Lq2
= area ALP1
 Consumer surplus under monopoly
- Total utility from Oq1 = area OAJq1
- Total price paid by them society = OP2Jq1
- Consumer surplus = area OAJq1-areaOP2q1
= area AJP2
 Thus loss of consumer surplus under monopoly equals
Area ALP1 -Area AJP2 = P2JLP1

Of this total loss of consumer surplus (P2JLP1), P2JkP1 is extracted by the

monopolist as profit, the remaining JKL goes to none and it is termed as dead weight
loss to the society.

Short & Simple 18 – Income

Determination in a Closed Economy
Posted on 26 August 2017
In this and upcoming parts of the series, we will look in a little more
detail at the ‘income-expenditure model’. The foundations of the model
have been introduced in the previous two parts (here and here).
We have seen that, within the model, equilibrium output is determined
by two main factors:

1. the level of autonomous expenditure (denoted A);

2. the marginal propensity to leak (denoted α).
The expenditure multiplier k is 1/α. Equilibrium output is a multiple of
autonomous spending, kA.

By delving a little more deeply into the components of both A and α,

the model can help us to explore various connections between
government policy, private spending behavior, income distribution and
other factors. To keep things relatively simple, for now a closed
economy is considered. A closed economy is one that does not
interact with any sector external to itself. The most important example
is the global economy as a whole. In contrast, an open economy, such
as an individual trading nation, does interact with an external sector.
We will return to an open economy later in the series.
In a closed economy, we can distinguish between three main
categories of spending: private consumption (C), private investment (I)
and government spending (G). By accounting identity, total output and
income (Y) equal total spending:

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Adigrat University Department of Economics Microeconomics 2011 EC

Y=C+I+G

We can also distinguish three main uses of income. As we saw in part

5, some income goes to taxes (T), some is consumed (C) and some is
saved (S):
Y=C+S+T

If we set the right-hand sides of these two identities equal to each

other (since they both equal Y), we find that:

I+G=S+T

Private investment and government spending are known as injections.

An injection is an expenditure that is not made by (domestic)
households and is autonomous of income. We have already seen in
earlier parts that saving and taxes are leakages. So the last identity
says that:
Total Injections = Total Leakages

Now, the expressions considered above are simply identities. In

themselves, they do not say anything about behavior. The income-
expenditure model combines identities with particular behavioral
assumptions.

In the determination of equilibrium output, the focus is

on planned spending, not actual spending (this distinction was
discussed in part 17). The model makes certain assumptions about
planned spending behavior.
Private consumption is considered to be largely induced by income, but
there is also a role for autonomous private consumption. These
assumptions are embodied in the following consumption function:
C = C + c(Y – T)
P 0

This says that planned private consumption (C ) is positively related to

P

disposable income (income Y minus taxes T). A ‘P’ subscript is used to

represent planned variables.
C is autonomous consumption. A ‘0’ subscript indicates an
0

autonomous variable. Autonomous consumption is unrelated to

income.
Induced consumption is represented by the term c(Y – T). In this term, c
is the marginal propensity to consume. It is the fraction of an
additional dollar of disposable income that goes to consumption. The
fraction is always between 0 and 1. Private consumption increases with
disposable income because of the extra consumption this induces,
represented by c(Y – T).
If we suppose that taxes T are simply a constant fraction t of income
(that is, T = tY), the consumption function can be written:

C = C + c(Y – tY)
P 0

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Adigrat University Department of Economics Microeconomics 2011 EC

The fraction t is known as the marginal propensity to tax.

All other categories of spending (the injections) are assumed to be

autonomous of income: I = I and G = G .
P 0 P 0

Equilibrium output is equal to the sum of planned expenditures (Y =

C + I + G ). Substituting the expressions for each category of
P P P

spending, we have:
Y = C + c(Y – tY) + I + G
0 0 0

We can group together on the left-hand side terms involving Y, then

factorize:

Y – cY + ctY = C + I + G
0 0 0

(1 – c + ct)Y = C + I + G
0 0 0

Solving for equilibrium output gives:

The ‘e’ subscript says that the level of income is consistent with
equilibrium. The result accords with what we have observed in previous
posts. In particular, equilibrium income is a multiple of the sum of
autonomous expenditures C , I and G . The expenditure multiplier k is:
0 0 0

In the formulas for output and the multiplier, 1 – c + ct (= α) is the

marginal propensity to leak. It is the fraction of an additional dollar of
income that leaks to saving and taxes.

This is perhaps made clearer if we rewrite the expression, making use

of the fact that the marginal propensity to save s = 1 – c. The
expression can then be written s + (1 – s)t, which if expanded and re-
factorized with s now taken as a common factor, can be written s(1 – t)
+ t. Since s is the fraction saved out of extra disposable income, s(1 –
t) is the fraction saved out of extra income. So we have the fraction of
extra income going to saving, s(1 – t), plus the fraction of extra income
going to taxes, t. This hopefully makes clear that s(1 – t) + t, which is
equivalent to 1 – c + ct, is the marginal propensity to leak out of
income (α).
Another way of seeing this is to rewrite 1 – c + ct as 1 – c(1 – t). Since c
is the fraction consumed out of an extra dollar of disposable income,
c(1 – t) is the fraction consumed out of an extra dollar of income.
Therefore, 1 – c(1 – t) is the fraction of an extra dollar of income that
does not go to consumption. Any income that does not go to

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Adigrat University Department of Economics Microeconomics 2011 EC

consumption goes to taxes and saving, which again makes clear that
the term 1 – c + ct represents the marginal propensity to leak out of
income.
As expected, we have reached the same basic conclusion that output
depends upon autonomous expenditure and the marginal propensity to
leak. However, we can now notice things that were not so obvious in
our simpler version of the model.

One observation concerns distribution. The expenditure multiplier (k) is

bigger when the marginal propensity to save (s = 1 – c) and the
marginal propensity to tax (t) are small. Because high-income
households tend to save a higher proportion of their income than low
and middle-income households, the marginal propensity to save will
tend to be smaller when the distribution of income is more equal.
Accordingly, a more equal distribution of income implies a bigger
expenditure multiplier (k). A given level of autonomous spending (A =
C + I + G ) will result in a higher level of equilibrium income when
0 0 0

there is greater equality of income.

We could also say more about the sectoral balances, but we will leave
this till next time.

Brief notes on four

broad approaches of
money supply
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Economists are not in agreement on the question of

definition of money supply. There are four broad
approaches of money supply. They are as follows:

1. Traditional Approach:
The traditional approach emphasises the medium of
exchange function of money. According to this

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Adigrat University Department of Economics Microeconomics 2011 EC

approach, money supply is defined as currency with

public and demand deposits with commercial banks.
Demand deposits are the current accounts of
depositors in a commercial bank.

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The traditional approach is analytically superior

because it provides the most liquid and exact measure
of money supply.

The central bank can have better control over the

money supply if it includes currency and demand
deposits of banks alone. But, this approach limits
money supply to a very narrow area.

2. Monetarist Approach:
The Chicago School led by Milton Friedman includes in
money supply currency plus demand deposits plus
time deposits. Time deposits are fixed deposits of the
banks which earn a fixed rate of interest depending
upon the period for which the amount is deposited.

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According to Friedman money is defined as “anything

that serves the function of providing a temporary
abode of purchasing power.”

Money can act as a temporary abode of purchasing

power if it is kept in the form of cash, demand deposits

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Adigrat University Department of Economics Microeconomics 2011 EC

or any other asset which is close to currency, i.e., time

deposits. This approach lays emphasis on the store of
value function of money and provides a broader
measure of money.

3. Gurley and Shaw Approach:

Gurley and Shaw further widened the scope of money
supply by including in its constituents currency plus
demand and time deposits of banks plus the liabilities
of non-banking intermediaries. The liabilities of non-
banking intermediaries cover saving bank deposits,
shares, bonds, etc. and are close substitutes to money.

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4. Radcliffe Committee Approach:

Radcliffe Committee approach or liquidity approach
provides much wider view of the concept of money
supply. In this approach, the concept of money supply
is viewed in terms of general liquidity of the economy.

Money supply covers “the whole liquidity position that

is relevant to spending decisions.” The spending is not
limited to the amount of money in existence. It is
related to the amount of money people think they can
get hold of whether by receipts of income, by disposal
of assets or by borrowing.

Thus, according to this approach, money supply

includes cash, all kinds of bank deposits, deposits with

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Adigrat University Department of Economics Microeconomics 2011 EC

other institutions, near-money assets and the

borrowing facilities available to the people.

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The practical difficulty with this liquidity approach is

that the money supply in this wider sense cannot be
successfully measured because the degree of liquidity
of different constituents of money supply varies
considerably.

Moreover, most of the constituents remain outside the

control of central bank and thus restrict the effective
implementation of monetary policy.

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