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MICROECONOMICS
&
MACROECONOMICS

~ CA DIPESH ARORA

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MICROECONOMICS
1. INTRODUCTION

2. CONSUMER’S EQUILIBRIUM

3. DEMAND

4. ELASTICITY OF DEMAND

5. PRODUCTION FUNCTION

6. COST

7. REVENUE

8. PRODUCER’S EQUILIBRIUM

9. SUPPLY

10. MAIN MARKET FORMS

11. PRICE DETERMINATION WITH SIMPLE APPLICATIONS

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CHAPTER-1

INTRODUCTION
Economy

An economy is a system which provides people, the means to work and earn a living. It is an
organization that provides living to the people. In this task, it makes use of the available resources to
produce those goods and services that people want. For example, Indian economy consists of all sources
of production in agriculture, industry, transport and communication, banking etc.

Vital processes

For the objectives of economy to be fulfilled, it is necessary that every economy should undertake three
economic activities:

1. Production

2. Consumption

3. Investment or capital formation

Scarcity

Scarcity refers to the limitation of supply in relation to the demand for a commodity. It refers to a
situation, when wants exceed the available resources. Scarcity is universal and perpetual i.e. every
individual, organization and economy faces scarcity of resources.

Scarcity of resources calls for economizing of resources. Economizing of resources refers to making
optimum use of the available resources. There is a need to economize, as an economy has to satisfy its
unlimited wants out of limited resources.

Economic Problem

In order to maximize satisfaction, every consumer exercises choice, as to which goods should be
consumed and in what quantity. An economic problem is basically a problem of choice.

Economic problem is a problem of choice involving satisfaction of unlimited wants out of limited
resources having alternative uses.

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Reasons

The three main reasons for existence of economic problem are:

1. Scarcity of resources

Resources are limited in relation to their demand and economy cannot produce all what people want. It
is the basic reason for existence of economic problem in all economies. There would have been no
problem, if resources were not scarce. It is perpetual and universal as well i.e. it applies to all individuals,
organizations and countries.

2. Unlimited Human wants

Human wants are never ending; they can never be fully satisfied. As soon as one want is satisfied,
another new want emerges. We always pine for what is not. Wants of the people are unlimited and
keeps on multiplying and it is not possible to satisfy them all with the limited resources in an economy.

However, these wants always differ in intensities or priorities. If all human wants had been of equal
importance, then it would have become impossible to make choices.

3. Alternate use

Resources are not only scarce, but they can also be put to alternate use also. It makes choices among
resources more important. As a result, an economy has to make choice between the alternative uses of
the given resources.

Features of resources

 They are scarce.

 They have alternative uses.

Features of Human wants

 They are unlimited

 They differ in priorities

Economics

Economics is a social science which studies the way a society choses to use its limited resources, which
have alternate uses, to produce goods and services and to distribute them among different groups of
people.

It is all about making choices in the presence of scarcity. It aims to ensure that the resources are used in
the best possible manner.

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Subject Matter

The subject matter of economics has been studied under two heads:

1. Microeconomics (Price theory)

Microeconomics is that part of economic theory, which studies the behavior of individual units of an
economy. For example, individual income, individual output, price of a commodity etc. its main tools are
demand and supply.

2. Macroeconomics (Income theory)

Macroeconomics is that part of economic theory which studies the behavior of aggregates of the
economy as a whole. For example, national income, aggregate output, aggregate consumption etc. its
main tools are aggregate demand and aggregate supply.

BASIS MICROECONOMICS MACROECONOMICS

Meaning It is that pert of economic theory which It is that part of economic theory which
studies the behavior of individual units studies the behavior of aggregate of the
of an economy. economy as a whole.
Tools Demand and supply Aggregate demand and aggregate supply
Basic objective Its aim is to determine price of a Its aim is to determine income and
commodity or factors of production. employment level of the economy.
Degree of It involves limited degree of It involves the highest degree of
aggregation aggregation aggregation
Basic It assumes all the macro variables to be It assumes all the micro variables to be
assumptions constant constant
Other name It is also known as price theory It is also known as income theory
Example Individual income, individual output National income, national output etc.
etc.

Central problems of an economy

Because of the scarcity of resources, every economy has to decide how to allocate the resources which
are scarce in nature. It leads to the following central problems of an economy:

1. What to produce

This problem involves selection of goods and services to be produced and the quantity to be produced
of each selected commodity. Every economy has limited resources and thus cannot produce all the
goods. More of one good or service will usually means sacrifice of some other good or service.

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On the basis of the importance of various goods, an economy has to decide which goods should be
produced and in what quantities. This is a problem of allocation of resources among different goods.
This problem has two different aspects:

a. What possible commodities to produce

b. How much of that commodities to be produced

The guiding principle is that to allocate the resources in a manner which gives maximum aggregate
satisfaction.

2. How to produce

This problem refers to selection of technique to be used for production of goods and services. A good
can be produced using different techniques of production. Generally there are two different techniques
namely; labor intensive technique of production and capital intensive technique of production.

In labor intensive technique of production, more of labor and less of machineries are used while doing
production of a commodity. While in case of capital intensive technique of production, more of capital
and machinery is used and less of labor is used in the production process.

The Guiding principle is to combine factors of production in such a manner so that maximum output is
produced at minimum cost, using least possible scarce resources.

3. for whom to produce

This problem refer to selection of the category of people who will ultimately consume the goods i.e.
whether to produce goods for more poor and less rich or more poor and less rich.

Goods are produced for those people who have the paying capacity. The capacity of people to pay for
goods depends upon their income level. It means, this problem is basically concerned with the
distribution of income among the factors of production that have helped to produce the goods and
services in the economy.

The guiding principle is to ensure that urgent wants of each productive factor are fulfilled to the
maximum possible extent.

Opportunity cost

Opportunity cost is the cost of next best alternative foregone. For example, suppose, you are working in
a bank at the salary of Rs. 40,000 per month & further suppose, you receive two job offers:

 To work as an executive at Rs. 30,000 per month or;

 To become a journalist at Rs. 35,000 per month

In the given case, the opportunity cost of working in a bank is the cost of next best alternative foregone
i.e. Rs. 35,000/-

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The amount of other goods and services, that must be sacrificed to obtain more of any one good, is
called the opportunity cost of that good.

Production possibility Frontier

Production possibility frontier refers to graphical presentation of possible combination of two goods
that can be produced with given resources and technology. In other words, PPF is the locus of various
possible combinations of two goods that can be produced with given resources and technology.

Synonyms

1. Production possibility curve

2. Production Possibility Boundary

3. Transformation curve

4. Transformation Boundary

5. Transformation frontier

Assumptions

 The amount of resources in an economy is fixed.

 With the help of given resources, only two goods can be produced
 The resources are fully and efficiently employed.
 Resources are not equally efficient in production of all the products.
 The level of technology is assumed to be constant.

PPF schedule

Possibilities Guns (in units) Butter (in units) MOC MRT

A 21 0 - -
B 20 1 1 1:1
C 18 2 2 2:1
D 15 3 3 3:1
E 11 4 4 4:1
F 6 5 5 5:1
G 0 6 6 6:1

Production Possibility curve

fig 1.1

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Marginal opportunity cost

MOC refers to the number of units of a commodity sacrificed to gain one additional unit of another
commodity. In case of PPF, MOC is always increasing, i.e. more and more units of a commodity have to
be sacrificed in order to produce an additional unit of another commodity.

Increasing MOC operates because productivity and efficiency of factors of production decrease as they
are shifted from one use to another.

Marginal rate of Transformation

MRT is the ratio of number of units of a commodity sacrificed to gain an additional unit of another
commodity. MRT = Change in units sacrificed / Change in units gained.

Characteristics of PPF

The two basic characteristics or features or properties of PPF are:

1. PPF slopes downwards

PPF shows that more of one good can be produced only by taking resources away from the production
of another good. As there exist an inverse relationship between change in quantity of one commodity
and change in quantity of another commodity, PPF slopes downward from left to right.

2. PPF is concave shaped

PPF is concave shaped because of increasing marginal opportunity cost, i.e. more and more units of a
commodity is to be sacrificed to gain an additional unit of another commodity.

Attainable combinations

It refers to those combinations at which economy can operate. There can be two attainable options:

1. Optimum utilization of resources

If the resources are used in the best possible manner, then economy will operate at any point like A, B,
C, D on PPF.

2. Inefficient utilization of resources

However, the actual production can fall short of its capabilities. If there is wastage or inefficient
utilization of resources, then economy will operate at any point inside the PPF like E.

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Unattainable combinations

With the given amount of available resources, it is impossible for the economy to produce any
combination more than the given possible combinations i.e. an economy can never operate at any point
outside the PPF.

Fig 1.2

Straight line PPC

PPC can be a straight line if we assume that MRT is constant, i.e. same amount of a commodity is
sacrificed to gain an additional unit of another commodity.

Convex PPC

PPC can be convex to origin if MRT is decreasing, i.e. less and less units of a commodity are sacrificed to
gain an additional unit of another commodity.

Fig 1.4 and fig 1.5

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Change in PPF

The change in PPF can be of two types:

1. Shift in PPF

PPF will shift when there is change in productive capacity with respect to both the goods. The PPF can
shift either right or towards left, when there is change in resources or technology with respect of both
the goods

a. Rightward shift in PPF

When there is advancement of technology or/ and increase in the availability of resources in respect of
both the goods, then PPF will shift to the right.

b. Leftward shift in PPF

When there is degradation of technology or/ and decrease in the availability of resources in respect of
both the goods, then PPF will shift to the right.

Fig 1.7 & fig 1.8

2. Rotation of PPF

It happens when there is change in productive capacity i.e. resources or technology with respect to only
one good. The rotation can be either for the commodity on the X-axis or for the commodity on the Y-
axis.

Fig 1.9 & fig 1.10

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Positive economics

Positive-economics studies the facts of life, i.e., it deals with the things as they are. It deals with what
are the economic problems and how are they actually solved. For example, India is an overpopulated
country or prices are constantly rising.

Positive statements describe what was, what is or what will be under the given state of circumstances.
These statements do not pass any value judgements.

Normative economics

Normative economics tell us what ought to be. Normative economics deals with what ought to be or
how the economic problem should be solved. For example, India should not be an overpopulated
country or prices should not rise.

Normative economics discusses what are desirable things and should be realized and what are
undesirable things and should be avoided. It gives decisions regarding value judgements.

Market economy

Market economy is the one in which the means of production are owned, controlled and operated by
the private sector. This economy is also known as capitalist economy.

Centrally Planned economy

Market economy is the one in which the means of production are owned, controlled and operated by
the government sector. This economy is also known as socialist economy.

Mixed economy

Mixed economy refers to a system in which public and private sector are allotted their respective roles
for solving the central problems of the economy together. It combines the features of both centrally
planned and market economy.

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CHAPTER-2

CONSUMER’S EQUILIBRIUM

Concept of utility
Meaning

Utility refers to want satisfying power of a commodity. It differs from person to person, place to place
and time to time. In other words, utility is the ability of a good to satisfy a want.

Total utility

Total utility refers to the total satisfaction obtained from the consumption of all possible units of a
commodity. It measures the total satisfaction obtained from consumption of all the units of that good.

TUn = U1 + U2 + U3 + ……………+ Un

Marginal utility

Marginal utility is the additional utility derived from the consumption of one more unit of the given
commodity. It is the utility derived from the last unit of a commodity purchased.

MUn = TUn – TUn-1

MU = Change in total utility / Change in number of units.

Relationship between TU and MU

1. TU increases with an increase in consumption of a commodity as long as MU is positive.

2. When TU reaches its maximum, MU becomes zero. This is also known as point of satiety.

3. When consumption is increased beyond the point of satiety, TU starts falling as MU becomes
negative.

Units consumed MU TU
1 20 20
2 16 36
3 10 46
4 4 50
5 0 50
6 -6 44

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Fig 2.1

Law of Diminishing Marginal Utility

Law of diminishing marginal utility (DMU) states that as we consume more and more units of a
commodity, the utility derived from each successive unit goes on decreasing.

This law expresses an important relationship between utility and the quantity consumed of a
commodity. Suppose your father has just come from work and you offer him a glass of juice. The first
glass of juice will give him great satisfaction. The satisfaction from second glass will be relatively lesser.
With further consumption, a stage will come, when he would not need any more glass of juice i.e. when
the marginal utility drops to zero. After that point, if he is forced to consume even one more glass of
juice, it will lead to disutility.

Assumptions

 It is assumed that utility can be measured and a consumer can express his satisfaction in
numbers.
 It is assumed that utility is measurable in monetary terms.
 It is assumed that a reasonable quantity of the commodity is consumed.
 It is assumed that consumption is a continuous process.
 Quality of the commodity consumed is assumed to be uniform.
 The consumer is assumed to be rational.
 It is assumed that all commodities consumed by consumers are independent.

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 As a consumer spends money on the commodity, he is left with lesser money to spend on other
commodities.

This law is also known as fundamental law of satisfaction or fundamental psychological law.

Consumer’s equilibrium
Consumer’s equilibrium refers to the situation when a consumer is having maximum satisfaction with
limited income and has no tendency to change his way of existing expenditure.

Equilibrium means a state of rest or position of no change. It refers to a position of rest, which provides
the maximum benefit or gain under a given situation. A consumer is said to be in equilibrium, when he
does not intend to change his level of consumption i.e. when he derives maximum satisfaction.

Utility analysis

1. Consumer’s equilibrium in case of single commodity

A consumer purchasing a single commodity will be at equilibrium, when he is buying such a quantity of
that commodity, which gives him maximum satisfaction. The number of units to be consumed of the
given commodity by a consumer depends on 2 factors:

a. Price of the given commodity

b. Expected utility from each successive unit.

To determine the equilibrium point, consumer compares the price or cost of the given commodity with
its utility. Being a rational consumer, he will be at equilibrium when marginal utility is equal to price paid
for the commodity.

We know, marginal utility is expressed in utils and price is expressed in terms of money. However,
marginal utility and price can be effectively compared only when both are stated in the same units.
Therefore, marginal utility in utils is expressed in terms of money.

Marginal utility in terms of money = Marginal utility in utils / marginal utility of one rupee

Equilibrium condition

Consumer in consumption of single commodity will be at equilibrium when:

Marginal utility is equal to price paid for the commodity.

MU(x) = P(x)

 MU(x) > P(x)

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If MU(x) is greater than P(x), then consumer is not in equilibrium and he goes on buying because benefit
is greater than cost. As he buys more, MU falls because of operation of law of diminishing marginal
utility. He keeps on consuming commodity X till equilibrium is achieved.

 MU(x) < P(x)

If MU(x) is less than P(x), then also consumer is not in equilibrium as he will have to reduce consumption
of commodity X to raise his total satisfaction till MU becomes equal to price.

So, it can be concluded that a consumer in consumption of single commodity will be at equilibrium when
marginal utility from the commodity is equal to the price paid for the commodity.

Fig 2.3

2. Consumer’s equilibrium in case of two commodities

In case of two commodities, law of equi-marginal utility helps in optimum allocation of his income.
According to the law of equi-marginal utility, a consumer gets maximum satisfaction, when ratio of MU
of two commodities and their respective prices are equal and MU falls as consumption increases.

It means, there are two necessary conditions to attain consumer’s equilibrium in case of two
commodities:

a. The ratio of marginal utility to price is same in case of both the goods

We know, a consumer in consumption of single commodity say X is at equilibrium when

Mux / Px = MUm …… 1

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Similarly, consumer consuming another commodity say Y will be at equilibrium when

MUy / Py = MUm …… 2

Equating 1 and 2

As marginal utility of money is assumed to be constant, the above equilibrium condition can be restated
as:

Mux / Px = MUy / Py OR Mux / MUy = Px / Py

 Suppose Mux / Px > MUy / Py

In this case, the consumer is getting more marginal utility per rupee in case of good X as compared to Y.
therefore he will buy more of X and less of Y. this will lead to fall in Mux and rise in MUy. The consumer
will continue to buy more of X till Mux / Px = MUy / Py.

 Mux / Px < MUy / Py

In this case, the consumer is getting more marginal utility per rupee in case of good Y as compared to X.
therefore he will buy more of Y and less of X. this will lead to fall in Muy and rise in MUx. The consumer
will continue to buy more of Y till Mux / Px = MUy / Py.

b. MU falls as consumption increases

The second condition needed to attain consumer’s equilibrium is that MU of a commodity must fall as
more of it is consumed. If MU does not fall as consumption increases, the consumer will end up buying
only one good which is unrealistic and consumer will never reach the equilibrium position.

Finally, it can be concluded that a consumer in case of two commodities will be at equilibrium when he
spends his limited income in such a way that the ratios of marginal utilities of two commodities and their
respective prices are equal and MU falls as consumption increases.

Indifference curve analysis

Indifference curve

Indifference curve refers to the graphical representation of various alternative combination of bundles
of two goods among which the consumer is indifferent.

In other words, indifference curve is a locus of points that show such combination of two goods which
give the consumer same satisfaction.

Fig 2.4

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Monotonic preferences

Monotonic preferences means that a rational consumer always prefer more of a commodity as it offers
him a higher level of satisfaction. In simple words, monotonic preference implies that as consumption
increases, total utility also increases.

Indifference map

Indifference refers to the family of indifference curves that represent consumer preference over all the
bundles of two goods.

Fig 2.5

Marginal rate of substitution (MRS)

MRS refers to the rate at which the commodities can be substituted with each other, so that total
satisfaction of the consumer remains the same.

MRS = units sacrificed / units gained

Budget line

Budget line is a graphical representation of all possible combinations of two goods which can be
purchased with given income and prices, such that the cost of each of these combinations is equal to the
money income of the consumer. It is also known as price line.

M = Px Qx + Py Qy fig 2.8

Where,

M = money income

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Px = price of commodity X

Qx = quantity of commodity X

Py = price of commodity Y

Qy = quantity of commodity Y

Budget set

Budget set is the set of all possible combinations of the two goods which a consumer can afford, given
his income and prices in the market.

Consumer’s equilibrium

Condition

The consumer’s equilibrium under the indifference curve theory must meet the following two
conditions:

a. MRSxy = Px / Py

Let the two goods be X and Y. the first condition is that MRSxy = Px / Py.

 If MRSxy > Px / Py, it means that the consumer is willing to pay more for X than the price
prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it
becomes equal to the ratio of prices and equilibrium is achieved.
 If MRSxy < Px / Py, it means that the consumer is willing to pay less for X than the price
prevailing in the market. As a result, the consumer buys less of X. As a result, MRS rises till it
becomes equal to the ratio of prices and equilibrium is achieved.

b. MRS continuously falls

The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of
equilibrium i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless
MRS continuously falls, the equilibrium cannot be established.

In the given fig, IC1, IC2and IC3 are the three indifference curves and AB is the budget line. With the
constraint of budget line, the highest indifference curve a consumer can reach is IC 2. The budget line is
tangent to IC2at point E. This the point of equilibrium, where the consumer purchases OM quantity of
commodity X and ON quantity of commodity Y.

Fig 2.12

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Shift in Budget line

1. Effect of a change in the income of consumer

If there is any change in the income, assuming no change in prices of both the commodities, then the
budget line will shift. When income increases, it will shift to its right and vice versa.

2. Effect of change in the relative prices

If there is any change in the prices of the two commodities, assuming no change in the money income of
consumer, then budget line will change. If the price of commodities rises, the budget line will shift to its
left and vice versa.

Properties of Indifference Curves

1. Indifference curves are always convex to origin

An indifference curve is convex to the origin because of diminishing MRS. MRS Declines continuously
because of the law of diminishing marginal utility. It means when a consumer consumes more and more
of a commodity, marginal utility from that good starts falling and he is willing to sacrifice less and less of
another commodity for consuming the commodity.

2. Indifference curves slopes downward

It implies that as a consumer consumes more of one good, he must consume less of the other good. It
happens because if the consumer decides to have more units of one good, he will have to reduce the
number of units of another good, so that total utility remains same.

3. Higher indifference curve represents higher satisfaction

Higher indifference curve represents large bundle of goods, which means more utility because of
monotonic preference. At higher IC, a consumer gets the combination of two goods which gives more
satisfaction than the combinations on lower IC.

4. Indifference curves never intersect each other

As two indifference curves cannot represent the same level of satisfaction, they cannot intersect each
other. It means, only one indifference curve will pass through a given point on an indifference map. If

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two indifference curves intersect each other, then there will be one point common between them which
cannot be possible as satisfaction on two different ICs is different.

CHAPTER-3

DEMAND
Demand

Demand is the quantity of a commodity that a consumer is willing and able to buy at each possible price
during a given period of time.

The definition of demand highlights four essential elements of demand:

a. Quantity of commodity b. Willingness to buy

c. Price of the commodity d. Period of time

Demand for a commodity may be either with respect to an individual or to the entire market.

Individual demand

It refers to the quantity of a commodity that a consumer is willing and able to buy, at each possible price
during a given period of time.

Market demand

It refers to the quantity of a commodity that all consumers are willing and able to buy, at each possible
price during a given period of time.

Determinants of Demand

Demand for a commodity increases or decreases due to number of factors. The various factors affecting
demand are as follows:

1. Price of the given commodity

It is the most important factor affecting demand for the given commodity. Generally, there exist an
inverse relationship between price and quantity demanded. It means, as price increases, quantity

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demanded falls due to decrease in the satisfaction level of consumer. The inverse relation between price
and demand is known as Law of demand.

2. Price of related goods

Demand for the given commodity is also affected by change in price of the related goods. Related goods
are of two types:

a. Substitute goods

Substitute goods are those goods which can be used in place of one another for satisfaction of a
particular want like tea and coffee. An increase in the price of substitute good leads to an increase in the
demand for a given commodity and vice versa. So, demand for a given commodity is directly affected by
change in price of substitute goods.

b. Complementary goods

Complementary goods are those goods which are used together to satisfy a particular want like tea and
sugar. An increase in the price of complementary good leads to decrease in the demand for given
commodity and vice versa. So, demand for a given commodity is inversely affected by change in price of
complementary goods.

3. Income of the consumer

Demand for a commodity is also affected by income of the consumer. However, the effect of change in
income on demand depends on the nature of commodity under consideration.

 If the given commodity is a normal good, then an increase in income leads to rise in its demand,
while a decrease in income reduces the demand.
 If the given commodity is an inferior good, then an increase in income reduces the demand,
while a decrease in income leads to rise in demand.

4. Tastes and preferences

Tastes and preferences of the consumer directly influence the demand for a commodity. They include
changes in fashion, customs, habits etc. if the commodity is in fashion or is preferred by the consumer,
then demand for such a commodity rises and vice versa.

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5. Expectation of change in the price in future

If the price of a certain commodity is expected to increase in near future, then people will buy more of
that commodity than what they normally buy. There exists a direct relationship between expectation of
change in the prices in future and change in demand in the current period.

Determinants of Market demand

Market demand is influenced by all the factors affecting the individual demand for a commodity. In
addition, it is also affected by the following factors:

1. Size and composition of population

Market demand for a commodity is affected by size of population in the country. Increase in the
population raises the market demand, while decrease in population reduces the market demand.

Composition of population i.e. ratio of males, females, children and number of old people in the
population also affects the demand for a commodity.

2. Season and weather

The seasonal and weather conditions also affect the market demand for a commodity. For example,
during winters, demand for woolen clothes and jackets increases, whereas, market demand for raincoat
and umbrellas increases during the rainy reason.

3. Distribution of income

If in the income in the country is equally distributed, then market demand for commodities will be more.
However, if income distribution is uneven, i.e. people are either very rich or very poor, then market
demand will remain at lower level.

Law of Demand

Law of demand states the inverse relationship between price and quantity demanded, keeping other
factors constant (ceteris paribus). This law is also known as the first law of purchase.

Assumptions

1. Prices of substitute goods do not change.

2. Prices of complementary goods remain constant.

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3. Income of the consumer remains the same.

4. There is no expectation of change in the prices in future.

5. Tastes and preferences of the consumer remain the same.

Price (in Rs.) Quantity demanded (in units)

5 1
4 2
3 3
2 4
1 5

Fig3.3

Reasons

1. Law of diminishing marginal utility

Demand for a commodity depends on its utility. If the consumer gets more satisfaction, he will pay
more. As a result, consumer will not be able to pay the same price for additional units of the commodity.
The consumer will buy more units of the commodity only when the price falls.

2. Substitution effect

Substitution effect refers to substituting one commodity in place of other when it becomes relatively
cheaper. When price of the given commodity falls, it becomes relatively cheaper as compared to its
substitute. As a result, demand for the given commodity rises.

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3. Income effects

Income effect refers to the effect on demand when real income of the consumer changes due to change
in price of the given commodity. When price of the given commodity falls, it increases the purchasing
power of the consumer. As a result, he can purchase more of the given commodity with the same
money income.

4. Additional customers

When price of a commodity falls, many new consumers, who were not in a position to buy it earlier due
to high price, starts purchasing in. In addition to new customers, old customers of the commodity starts
demanding more due to its reduced price.

5. Different uses

Some commodities like milk, electricity etc. have several uses, some of which are more important than
the others. When price of such good increases, its uses get restricted to the most important purpose
and demand for less important uses gets reduced and vice versa.

Exceptions to the law of demand

1. Giffen Goods

These are special kind of inferior goods on which the consumer spends a large part of his income and
their demand rise with an increase in price and demand falls with decrease in price. This phenomenon
was first observed by Sir Robert Giffen and it is popularly known as Giffen paradox.

2. Status symbol goods or Goods of ostentation

This exception relates to certain prestige goods which are used as status symbols. For example,
diamonds, gold, antique paintings etc. are brought due to the prestige they confer upon the possessor.
These are wanted by rich persons for prestige and distinction.

3. Fear of shortage

If the consumers expect a shortage or scarcity of a particular commodity in the near future, then they
would start buying more and more of that commodity in the current period even if their prices are
rising.

4. Ignorance

Consumers may buy more of a commodity at a higher price when they are ignorant of the prevailing
prices of the commodity in the market.

5. Fashion related goods

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Goods related to fashion do not follow the law of demand and their demand increases even with the
rise in their prices.

6. Necessities of life

Another exception occurs in the use of such commodities which become necessities of life due to their
constant use.

Change in quantity demanded Vs. Change in demand

Basis Change in qty demanded Change in demand

Meaning When the quantity demanded When the demand changes due
changes due to a change in the to change in any factor other
price, keeping other factors than own price of the
constant, it is known as change commodity, it is termed as
in quantity demanded. change in demand.
Effect on demand curve It leads to a movement along the It leads to a shift in the demand
same demand curve either curve either rightwards or
upwards or or downwards. leftwards.
Reason It occurs due to an increase or It occurs due to change in other
decrease in the price of the given factors except price.
commodity.
Other name Upward movement is known as Rightward shift is known as
contraction in demand curve and increase in demand curve and
downward movement is called leftward shift in demand curve is
extension in demand curve. known as decrease in demand.

Types of demand

1. Price demand

Price demand refers to relationship between the price and demand of a commodity other factors being
constant.

2. Income demand

Income demand relates to a relationship between the income of consumer and the quantity demanded
of a commodity assuming other things being constant.

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3. Cross demand

Cross demand refers to relationship between the demand of a given commodity and the prices of relted
commodities, assuming other things being constant.

4. Joint demand

When two or more goods are demanded simultaneously to satisfy a particular want, then such a
demand is called joint demand.

5. Composite demand

When a commodity can be put to several uses, its demand is known as composite demand.

6. Derived demand

Demand for a commodity which depends on the demand for other goods.

7. Direct demand

When a commodity satisfies the wants directly, its demand is known as direct demand.

8. Alternate demand

Demand is known as alternate demand, when it can be satisfied by different alternatives.

9. Competitive demand

When two goods are close substitutes of each other and increase in demand for one of them will
decrease the demand for the other, then the demand for any one of them is known as competitive
demand.

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CHAPTER-4

ELASTICITY OF DEMAND
Price Elasticity of Demand

Price elasticity of demand means the degree of responsiveness of demand for a commodity with
reference to change in the price of such commodity.

It establishes a quantitative relationship between quantity demanded of a commodity and its price,
while other factors remains constant. Higher the numerical value of elasticity, larger is the effect of a
price change on the quantity demanded.

Price is the most important determinant of demand. So, price elasticity of demand is sometimes
shortened as elasticity of demand.

Methods of measuring price elasticity of demand

1. Percentage Method

It is the most common method of measuring price elasticity of demand (E d). this method is also known
as flux method or proportionate method or mathematical method.

According to this method, elasticity is measured as the ratio of percentage change in the quantity
demanded to percentage change in the price.

Elasticity of demand (Ed) = percentage change in quantity demanded / percentage change in price

Ed = Q X P
P Q

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2. Geometric Method

Geometric method is used to measure the elasticity at a point on the demand curve. When there are
infinitely small changes in price and demand then the geometric method is used. This method is also
known as Graphic method or point method or arc method. Elasticity of demand is different at different
points on the same straight line demand curve.

In order to measure the elasticity at any particular point, lower portion of the curve from that point is
divided by the upper portion of the curve from the same point.

Elasticity of demand = lower segment of demand curve (LS)

Upper segment of demand curve (US)

Fig 4.2

3. Expenditure Method

The price elasticity of demand for a good and the total expenditure made on the good are greatly
related to each other. The responsiveness of demand in relation to change in price determines the
change in expenditure.

a. Elasticity is more than 1. (Ed > 1)

When demand is elastic, a fall in the price of a commodity results in increase in total expenditure on it.
On the other hand, when price increases, total expenditure decreases. In this case, price and
expenditure moves in opposite directions.

b. Elasticity is less than 1 (Ed < 1)

When demand is inelastic, a fall in the price of a commodity, leads to fall in total expenditure on it. On
the other hand, when price increases, total expenditure also increases. In this case, price and
expenditure moves in the same direction.

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c. Elasticity is equal to one (Ed = 1)

When demand is unitary elastic, a fall or rise in the price of commodity does not change the total
expenditure. It means, total expenditure will remain unchanged in case of unitary elastic method.

Fig 4.3

Degrees of elasticities of demand

Price elasticity of demand can be expressed in terms of numerical value, which ranges from zero to
infinity. There are various kinds of price elasticities of demand which are discussed below:

1. Perfectly elastic demand

When there is an infinite demand at a particular price and demand becomes zero with a slight rise in the
price, then demand for such a commodity is said to be perfectly elastic. In such a case, E d = ∞ and
demand curve DD is a horizontal straight line parallel to X-axis.

Price (in Rs.) Demand (in units)

30 100
30 200
30 300
Fig 4.4

2. Perfectly Inelastic Demand

When there is no change in demand with change in price, then demand for such a commodity is said to
be perfectly inelastic. In such a case, E d = 0 and the DD curve is a vertical line parallel to Y-axis.

Price (in Rs.) Demand (in units)

20 100
30 100

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40 100
Fig 4.5

3. Highly Elastic demand

When percentage change in the quantity demanded is more than percentage change in price, then
demand for such a commodity is said to be highly elastic. In such a case, E d > 1. In this case, DD curve is
flatter and its slope is inclined more towards X-axis.

Price (in Rs.) Demand (in units)

20 100
10 200
Fig 4.6

4. Less elastic demand

When percentage change in the quantity demanded is less than percentage change in price, then
demand for such a commodity is said to be less elastic. In such a case, E d < 1. In this case, DD curve is
steeper and its slope is inclined more towards Y-axis.

Price (in Rs.) Demand (in units)

20 100
10 120
Fig 4.7

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5. Unitary Elastic demand

When percentage change in the quantity demanded is equal to percentage change in price, then
demand for such a commodity is said to be unitary elastic. In such a case, E d = 1. In this case, DD curve is
flatter and its slope is inclined more towards X-axis.

Price (in Rs.) Demand (in units)

20 100
10 150
Fig 4.8

Flatter the curve, more is the elasticity

When 2 demand curves intersect each other, then the flatter curve is more elastic at the point of
intersection.

In the given fig, demand curve DD and D1D1 intersect each other at point E. At this point, OQ is quantity
demanded at the price of OP. when price rises from Op to OP1, the quantity demanded falls from OQ to
OQ2 for demand curve DD and from OQ to OQ1 for demand curve D1D1.

With the same change in price PP1, change in demand OQ2 in case of demand curve DD is more than
change in demand OQ1 in case of demand curve D1D1. It means, demand is more elastic in case of
DD(flatter) curve as compared to D1D1(steeper) curve.

Factors affecting price elasticity of demand

1. Nature of commodity

Elasticity of demand of a commodity is influenced by its nature. When a commodity is necessity, its
demand is generally inelastic whereas when a commodity is luxury, its demand is generally more elastic.

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2. Availability of substitutes

Demand for a commodity with large number of substitutes will be more elastic. The reason is that even
a small rise in its price will induce the buyers to go for its substitutes.

3. Income level

Elasticity of demand for any commodity is generally low for higher income level groups in comparison to
people with low incomes. It happens because rich people are not influenced much by changes in the
price of goods.

4. Level of prices

Level of prices also affects the price elasticity of demand. Costly goods have highly elastic demand as
their demand is very sensitive to change in their prices.

5. Postponement of consumption

Commodities like Biscuits, soft drinks etc. whose demand is not urgent, have highly elastic demand as
their consumption can be postponed in case of an increase in their prices.

6. Number of uses

If the commodity under consideration has several uses, then its demand will be elastic. When price of
such commodities increases, then it is generally put to only more urgent uses and as a result, its demand
falls.

7. Time period

Price elasticity of demand is always related to a period of time. It can be a day, a week, a month, a year,
or period of several uses. Elasticity of demand varies directly with the period of time. Demand is
generally inelastic in the short period.

8. Habits

Commodities which have become habitual necessities for the consumers have less elastic demand. It
happens because such a commodity becomes a necessity for the consumer and he continues to
purchase it even if its price rises.

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CHAPTER-5

PRODUCTION FUNCTION

Production function

There exist some relationship between inputs and output of a firm. Such a relationship is known as
production function. Production function is an expression of the technological relation between physical
inputs and output of a good.

Symbolically, Ox = F (L, K, etc.)

Types

1. Short run production function

It studies the effect on output, due to change in variable input, assuming no change in other factors. As
there is change in variable input only, the ratio between different inputs tends to change at different
levels of output. This relation is explained by law of variable proportions.

2. Long run production function

It studies the effect on output, due to change in all factor input, assuming no change in other factors. As
all inputs are variable, the ratio between different inputs tends to remain same at different levels of
output. This relation is explained by law of returns to scale.

Short run and Long run

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1. Short Run

Short run refers to a period in which output can be changed by changing only variable factors. In the
short run, fixed inputs like plant, machinery, building etc. cannot be changed. It means, production can
be raised by increasing variable factors, but till the extent of capacity of fixed factors.

2. Long Run

Long run refers to a period in which output can be changed by changing all the factors of production.
Long run is a period, that is long enough for the firm to adjust all its inputs according to change in the
conditions. In the long run, firm can change its factory size, switch to new techniques of production,
purchase new machinery etc.

Basis Short run Long run

Meaning Short run refers to a period in Long run refers to a period in
which output can be changed by which output can be changed by
changing only variable factor. changing all factors of
production.
Classification Factors are classified as variable All factors are variable in the
and fixed factors in short run. long run.
Price determination In the short run, demand is more In the long run, both demand
active in price determination as and supply play equal role in
supply cannot be increased price determination as both can
immediately. be changed accordingly.

Variable factors and fixed factors

Variable factors

Variable factors are those factors, which can be changed in the short run. For example, raw material,
casual labor, power, fuel etc.

Variable factors vary directly with the level of output. As output increases, requirement for variable
factors also rises and also vice versa.

Fixed Factors

Fixed factors refer to those factors, which cannot be changed in the short run. For example, plant and
machinery, building, land etc.

The quantity of fixed factors remain same in the short run irrespective of level of output i.e. they do not
change, whether the level of output rises, falls or becomes zero.

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Basis Variable factors Fixed factors
Meaning Variable factors refer to those Fixed factors refer to those
factors which can be changed in factors which cannot be changed
the short run. in the short run.
Relation with output They vary directly with output. They do not vary directly with
output.
Example Raw material, casual labor, Building, plant and machinery,
power, fuel etc. permanent staff etc.

Product

Meaning

Product or output refers to the volume of goods produced by a firm or an industry during a specified
period of time.

Total Product

Total product refers to total quantity of goods produced by a firm during a given period of time with
given number of outputs. For example, if 10 labors produce 60 kg of rice, then total product is 60 Kg. it is
also known as Total Physical Product or Total return or Total output.

TPn = MP1 + MP2 + ……. + MPn

Average Product

Average product refers to output per unit of variable input. For example, if total product is 60 Kg,
produced by 10 labors, then average product will be 60 / 10 = 6 Kg.

AP is obtained by dividing TP by units of variable factor.

Average Product = Total Product / Units of variable factor

Marginal Product

Marginal product refers to addition to total products, when one more unit of variable factor is
employed.

MPn = TPn – TPn-1

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For example, if 10 labors make 60 Kg of rice and 11 labors make 67 Kg of rice, then MP of 11 th labor is 7
Kg.

MP = Change in TP / Change in units of variable factors

Relation between TP and MP

The relationship between TP and MP can be summarized as follows:

1. As long as TP increases at an increasing. MP also increases. Fig 5.3

2. When TP increases at a diminishing rate, MP decreases.

3. When TP reaches its maximum point, MP becomes zero.

4. When TP starts decreasing, MP becomes negative.

Relation between AP and MP

1. As long as MP is more than AP, AP rises.

2. When MP is equal to AP, AP is at its maximum.

3. When MP is less than AP, AP falls.

4. Thereafter, both AP and MP fall, but MP becomes negative, whereas AP remains positive.

Fig 5.4

Law of Variable Proportions

Statement

Law of variable proportion states that as we increase quantity of only one input keeping other inputs
fixed, Total product initially increases, at an increasing rate, then at decreasing rate and finally at a
negative rate.

Assumptions

1. It operates in the short run.

2. The law applies to all fixed factors including land.

3. Under law of variable proportions, different units of variable factor can be combined with fixed
factors.

4. This law applies to the field of production only.

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5. The effect of change in output due to change in variable factor can be easily determined.

6. It is assumed that, factors of production become imperfect substitutes of each others beyond a
certain limit.

7. The state of technology is assumed to be constant during the operation of this law.

8. It is assumed that all the variable factors are equally efficient.

Fixed factor Variable factor TP MP Phase

1 1 10 10 Ist
1 2 30 20 Phase
1 3 45 15 2nd
1 4 52 7 Phase
1 5 52 0 3rd
1 6 48 -4 Phase

Fig 5.1

Phases

Phase 1: Increasing returns to a factor

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In the first phase, every additional variable factor adds more and more to the total output. It means TP
increases at an increasing rate and MP of each variable factor rises. In the given fig, TP increases at
increasing rate till point Q and MP phase ends till it reaches its maximum point P, which marks the end
of first phase.

Phase 2: Diminishing returns to a factor

In the second phase, every additional variable factor adds lesser and lesser amount of output. It means
TP increases at a diminishing rate and MP falls with increase in variable factor. That is why; this phase is
known as diminishing returns to a factor. The second point ends at point S, when MP is zero and TP is
maximum at point M.

Phase 3: Negative returns to a factor

In the third phase, the employment of additional variable factor causes TP to decline, MP now becomes
negative. Therefore, this phase is known as negative returns to a factor. This phase starts after point S
on MP curve and point M on TP curve. MP of each variable factor is negative in the 3 rd phase.

Stages of operation

A rational producer will always operate in the second phase. In the 1 st phase, employment of every
additional unit of variable factor gives more and more output. In the third phase, marginal product of
each variable factor is negative.

This brings us to the conclusion that a producer will aim to operate in the second phase as TP is
maximum and MP of each variable factor is positive.

Reasons for law of variable proportions

1. Reasons for increasing returns to a factor

a. Better utilization of fixed factors

In the first phase, when variable factors are increased and combined with fixed factor, then fixed factor
is better utilized and output increases at an increasing rate.

b. Increased efficiency of variable factor

When variable factors are increased and combined with fixed factors, then variable factor becomes
more efficient with greater cooperation and high degree of specialization.

c. Indivisibility of Fixed factors

Generally, once an investment is made in an indivisible fixed factor, then addition of more and more
units of variable factor, improves the utilization of fixed factors.

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2. Reasons for Diminishing returns

a. Optimum combination of factors

Among the different combinations between variable and fixed factor, there is one optimum
combination, at which total product is maximum. After making the optimum use of fixed factor, the
marginal return of variable factor begins to diminish.

b. Imperfect substitutes

It also occurs because fixed and variable factors are imperfect substitutes of one another. There is a limit
to the extent of which one factor of production can be substituted for another.

3. Reasons for negative returns to a factor

1. Limitation of fixed factor

The negative returns to a factor apply because some factors of production are of fixed nature, which
cannot be increased with increase in variable factor in the short run.

2. Poor coordination between variable and fixed factor

When variable factor becomes too excessive in relation to fixed factors, then they obstruct each other. It
leads to poor coordination between variable and fixed factor. As a result, total output falls.

3. Decrease in efficiency of variable factor

With continuous increase in variable factor, the advantage of specialization and division of labor starts
diminishing. It results in inefficiencies of variable factor, which is another reason for negative returns.

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CHAPTER – 6

COST
Meaning

Cost is the total expenditure incurred in producing a commodity. It is the sum total of explicit and
implicit cost.

Explicit cost

It is the actual money expenditure on inputs or payment made to outsiders for hiring their factor
services. For example, wages paid to the employees.

Implicit cost

It is the estimated value of the inputs supplied by the owners including normal profit. For example,
interest on own capital etc.

So, the cost in the economic sense includes actual expenditure on inputs and imputed value of the
inputs supplied by the owners.

Basis Explicit cost Implicit cost

Meaning It is the payment made to It is the cost of self supplied
outsiders for hiring factor factors.
services.

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Money payment It involves actual money It involves imputed value of
payment on buying and hiring factors owned by the firm. There
inputs. is no money payment involved.
Example Payment of wages, rent, Interest on capital, rent of own
insurance premium etc. land etc.

Cost Function

The relation between cost and output is known as cost function. Cost function refers to the functional
relationship between cost and output. It is expressed as : C = f (q)

Opportunity Cost

Opportunity cost is the cost of the next best alternative foregone.

Money cost

Money cost refers to the total money expense incurred by a firm for producing a commodity.

Real cost

Real cost refers to the pain, sacrifices, discomfort and disutility involved in providing factor services to
produce a commodity.

Private cost

Private cost refers to the cost of production incurred by an individual firm in producing a commodity.

Social cost

Social cost includes the disadvantages suffered by the society due to the production of a commodity.

Short run costs

In the short run, there are some factors which are fixed, while others are variable. Short run costs are
divided in to two kinds of costs:

1. Total fixed costs

Fixed cost refers to those costs which do not vary directly with the level of output. For example, rent of
premises, interest on loan, salary of permanent staff etc.

It is also known as supplementary cost or overhead cost or indirect cost or general cost or unavoidable
cost. It is incurred on fixed factors like machinery, land, building etc. the payment to these factors
remains fixed irrespective of the level of output. It remains same, even if the output is zero.

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Output TFC Fig 6.1
0 12
1 12 2. Total variable costs
2 12
3 12 Variable costs refer to those cost which vary directly
4 12 with the level of output. For example, payment for
5 12 raw material, power, fuel, etc.

These costs are incurred on variable factors like raw material, direct labor, power etc. which changes
with change in the level of output. Such costs are incurred till there is production and become zero at
zero level of output. These cost are also known as prime cost or direct cost or avoidable cost.

Output TFC
0 0
1 6 Fig 6.2
2 10
3 15
4 24
5 35

Basis Total variable cost Total fixed cost

Meaning This cost refers to those cost which These costs refer to those cost which do
vary directly with the level of output. not vary directly with the level of output.
Time period It can be changed in the short run It cannot be changed in the short run
Cost at zero level It is zero when there is no production It can never be zero even if there is no
of output production
Factors of It is incurred on variable factors like It is incurred on fixed factors like land,
production labor, raw materials etc. building etc.
Shape of the TVC is inversely S-shaped. TFC is horizontal straight line parallel to
curve X-axis.
Example Wages for casual labor, payment of raw Salary of permanent staff, insurance
material etc. premium etc.

Relationship between TC, TFC and TVC

1. TFC curve is a horizontal straight line parallel to X-axis as it remains constant at all level of output.

2. TC and TVC curves are inversely S-shaped because they rise initially at a decreasing rate, then at a
constant rate and finally, at an increasing rate.

3. At zero output, TC is equal to TFC because there is no variable cost at zero level of output.

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4. The vertical distance between TFC curve and Tc curve is equal to TVC. As TVC increases, there is also
an increase in the distance between TFC and TC curve.

5. TC and TVC curve are parallel to each other and the vertical distance between them represents TFC,
which remains constant at all levels of output.

Fig 6.3

Average costs

1. Average fixed cost

Average fixed cost refers to the per unit fixed cost of production. It is calculated by dividing TFC by total
output. AFC falls with increase in output as TFC remain same at all levels of output.

AFC = TFC / Q

2. Average Variable cost

Average variable cost refers to the per unit variable cost of production. It is calculated by dividing TVC by
total output. AVC initially falls with increase in output and after reaching its minimum level, it starts
rising.

AFC = TVC / Q

3. Average Total Cost

Average cost refers to the per unit total cost of production. It is calculated by dividing TC by total output.
It is also defined as the sum of average fixed cost and average variable cost.

AC = TC / Q OR ATC = AFC + AVC

Marginal costs

Marginal cost refers to addition to total cost when one more unit of output is produced.

MCn = TVCn – TVCn-1

OR

MC = change in total cost / change in units of output

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Relationship between AC and MC

1. When MC is less than AC, AC falls with increase in the output.

2. When MC is equal to AC, AC is constant and at its minimum point.

3. When MC is more than AC, AC rises with increase in output.

4. Thereafter, both AC and MC rise, but MC increases at a faster rate as compared to AC.

Fig 6.9

Relationship between AVC and MC

1. When MC is less than AVC, AVC falls with increase in the output.

2. When MC is equal to AVC, AVC is constant and at its minimum point.

3. When MC is more than AVC, AVC rises with increase in output.

4. Thereafter, both AVC and MC rise, but MC increases at a faster rate as compared to AVC.

Fig 6.10

Relationship between AC, AFC and AVC

1. AC is greater than AVC by the amount of AFC.

2. The vertical distance between AC and AVC curves continues to fall with increase in output because
the gap between them is AFC which continues to decline.

3. AC and AVC curves never intersect each other as AFC can never be zero.

4. Both AC and AVC curves are U-shaped due to law of variable proportion.

5. MC curve cuts AVC and AC curves at their minimum points.

Fig 6.11

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CHAPTER – 7

REVENUE
Meaning

Revenue refers to the amount received by a firm from the sale of a given quantity of commodity in the
market. Revenue is directly influenced by sales level, i.e. as sales increases, revenue also increases.

Total Revenue

Total revenue refers to the total receipts from the sale of the given quantity of a commodity. It is the
total income of a firm. Total revenue is obtained by multiplying the quantity of commodity sold with the
price of the commodity.

Total revenue = quantity X price

For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the total revenue will be Rs.
1600/-

Average Revenue

Average revenue refers to revenue per unit of output sold. It is obtained by dividing the total revenue by
the number of units sold.

Average revenue = Total revenue / quantity.

For example, if total revenue from the sale of 10 chairs @ Rs. 160/- per chair is Rs, 1600/-, then average
revenue will be 1600 / 10 = Rs. 160/-

*AR and Price are the same

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TR = q X p

AR = TR / Quantity = P X Q / Q = P

Marginal revenue

Marginal revenue is the additional revenue generated from the sale of an additional unit of output. It is
the change in TR from the sale of one more unit of a commodity.

MRn = TRn – TRn-1

For example, if total revenue realized from sale of 10 chairs is Rs. 1600/- and that from sale of 11 chairs
Rs. 1780/-, then MR of the 11th chair will be Rs. 180/-

Relationship between TR and MR

 When price remains constant

 When price falls with rise in output

When price remains constant

When price remains constant at all the levels of output, then Price = AR= MR. Therefore, price line is the
same as MR curve. Also, TR = ∑MR. so the area under MR curve or price line will be equal to TR. In this
case, TR will be equal to area under Price line.

Fig 7.3

When price falls with rise in output

Bot h MR and AR falls with increase in output. However, fall in MR is double than that in AR, i.e. MR falls
at a rate twice the rate of fall in AR. As a result, MR curve is steeper than the AR curve because MR is

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limited to one unit, whereas, AR is derived by all the units. It leads to comparatively lesser fall in AR than
fall in MR.

Fig 7.4

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General Relationship between AR and MR

 AR increases with as long as MR is higher than AR.

 AR is maximum and constant when MR is equal to AR.
 AR falls when MR is less than AR.

Fig 7.5

Break-even point

Break-even point refers to the point where the total revenue is equal to the total cost. At break-even
point, firm is able to meet all its cost.

 As seen in the diagram, E is the breakeven point at this point, TR = TC.

 Point E is the situation of normal profits which is also known as No profit or No loss.
 Any point below E indicates abnormal losses, whereas, any point above E shows abnormal
profits.

Fig 7.9

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Shut down point

Shut down point refers to a situation when a firm is able to cover its variable costs only. In other words,
it is a situation when total revenue received from sale of goods is just equal to total variable cost of
production.

TR = TVC

Or TR / Q = TVC / Q

Or AR = AVC

At the shut-down point, firm incurs loss of fixed cost. The firm does not stop the production as fixed cost
will still be incurred. However, if AR further falls and is unable to meet even AVC, then firm will shut
down, the operations.

Fig 7.11

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CHAPTER- 8

PRODUCER’S EQUILIBRIUM

Producer’s Equilibrium (MR-MC Approach)

According to MR-MC approach, producer’s equilibrium refers to the stage of that output level at which

 MC=MR: As long as MC is less than MR, it is profitable for the producer to go on producing more
and more because it adds to its profits. He stops producing more only when MC becomes equal
to MR.
 MC is greater than MR after MC = MR output level: when MC is greater than MR after
equilibrium, it means producing more will lead to decline in profits.

Both the conditions are needed for producer’s equilibrium:

1. MC = MR

We know MR in addition to TR from sale of one more unit of output and MC in addition to TC for
increasing production by one unit. Every producer aims to maximize their total profits. For this, a firm
compares it’s MR with its MC. Profits will increase as long as MR exceeds MC and profits will fall if MR is
less than MC. So equilibrium is achieved when MR = MC.

2. MC is greater than MR after MC = MR output level

MC = MR is a necessary condition, but not sufficient enough to ensure equilibrium. It is because MC =

MR may occur at more than one level of output. However, out of these, only that output level is the
equilibrium output when MC becomes greater than MR after the equilibrium. It is because if MC is
greater than MR, then producing beyond MC = MR output will reduce profits. On the other hand, if MC
is less than MR beyond MC = MR output, it is possible to add to profits by producing more. So, first
condition must be supplemented with the second condition to attain producer’s equilibrium.

There can be two cases here:

 When price remains constant

Output is shown on the X-axis and revenue and cost on the Y-axis. Both AR and MR curves are straight
lines parallel to the X-axis. MC curve is U-shaped. Producer’s equilibrium will be determined at OQ level
of output corresponding to point K because only at point K, the following two conditions are met:

a. MC = MR

b. MC is greater than MR after MR = MC output level.

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Fig 8.3

 When price falls with rise in output

In the given fig, output is shown on the X-axis and revenue and cost on the Y-axis. Producer’s
equilibrium will be determined at OM level of output corresponding to point E because at this, following
two conditions are met:

a. MC = MR

b. MC is greater than MR after MR = MC output level.

Fig 8.4

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CHAPTER – 9

SUPPLY

Meaning

Supply refers to quantity of commodity that a firm is willing and able to offer for sale at a given price
during a given period of time. This highlights 4 essential elements:

a. Quantity of a commodity

b. Willingness to sell

c. Price of the commodity

d. Period of time

Like demand, supply also can be either for a single seller or for all the sellers:

Individual supply

It refers to quantity of commodity that an individual firm is willing and able to offer for sale at a given
price during a given period of time.

Market supply

It refers to of a commodity that all the firms are willing and able to offer for sale at a given price during a
given period of time.

Supply and Stock

 Supply refers to the quantity, which a producer is willing to offer for sale, which changes with
change in price, whereas, stock indicates a fixed quantity.
 Supply relates to a period of time, whereas, stock relates to a particular point of time.

Determinants of supply

Some of the important factors affecting supply are as follows:

1. Price of the given commodity

The most important factor determining the supply of a commodity is its price. As a general rule, price of
commodity and its supply are directly related. It means, as price increases, the quantity supplied of the
given commodity also rises and vice versa. It happens because at higher prices, there are greater
chances of making profit.

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2. Prices of other goods

As resources have alternatives uses, the quantity supplied of a commodity depends not only on its price,
but also on the price of other goods. Increase in the prices of other goods makes them more profitable
in comparison to the given commodity. As a result, the firm shifts its limited resources from production
of the given commodity to production of other goods.

3. Prices of Factors of production

When the amount payable to factors of production and cost of inputs increases, the cost of production
also increases. This decreases the profitability. As a result, seller reduces the supply of the commodity.
On the other hand, decrease in price of factors of production or inputs, increases the supply due to
reduction in overall cost.

4. State of technology

Technological changes influence the supply of a commodity. Advanced and improved technology
reduces the cost of production, which raises the profit margin. It induces the seller to increase the
supply. However, technological degradation or complex and outdated technology will increase the cost
of production and it will lead to decrease in supply

5. Government policy

Increase in taxes raises the cost of production and thus, reduces the supply, due to lower profit margin.
On the other hand, tax concessions and subsidies increase the supply as they make it more profitable for
the firms to supply goods.

6. Goals or objectives of the firm

Generally, supply of a commodity increases only at higher prices as it fulfills the objectives of profit
maximization. However, with change in trend, some firms are willing to supply more even at those
prices, which do not maximize their profits.

Determinants of Market supply

1. Number of firms in the market

When the number of firms in the industry increases, market supply also increases due to large number
of producers producing that commodity. However, market supply will decrease, if some of the firms
start leaving the industry due to losses.

2. Future expectation regarding price

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If sellers expect a rise in the prices in near future, then current market supply will decrease in order to
raise the supply in future at higher prices. However, if the sellers fear that the prices will fall in the
future, then they will increase the present supply to avoid losses in future.

3. Means of transportation and communication

Proper infrastructural developments like improvements in the means of transportation and

communication help in maintaining adequate supply of the commodity.

Law of Supply

Law of supply states the direct relationship between price and quantity supplied, keeping other factors
constant. (Ceteris paribus)

Assumptions

 Price of other goods are constant

 There is no change in the state of technology
 Prices of factors of production remain the same.
 There is no change in the taxation policy.
 Goals of the producer remain the same.

Supply schedule

Price (in Rs.) Quantity (in units) Fig 9.3

1 10
2 20
3 30 Reasons
4 40
5 50 1. Profit motive

The basic aim of producers, while supplying a commodity, is to secure maximum profits. When price of a
commodity increases, without any change in costs, it raises their profits.

2. Change in the number of firms

A rise in the price induces the prospective producers to enter in to the market to produce the given
commodity so as to earn higher profits. Increase in number of firms raises the market supply.

3. Change in stock

When the price of a good increases, the sellers are ready to supply more goods from their stocks.
However, at a relatively lower price, the producers do not release the big quantities from their stocks.

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Exceptions

1. Future expectations

If sellers expect a fall in the price in future, then the law of supply may not hold true. In this situation,
the sellers will be willing to sell more even at a lower price and vice versa.

2. Agricultural Goods

The law of supply does not apply to agricultural goods as their production depends on climatic
conditions. If, due to unforeseen changes in weather, the production of agricultural products is low,
which in turn reduce the supply.

3. Perishable goods

In case of perishable goods, like vegetables, fruits etc. sellers will be ready to sell more even if the prices
are falling. It happens because sellers cannot hold such goods for long.

4. Rare articles

Rare, artistic and precious articles are also outside the scope of law of supply.

5. Backward countries

In economically backward countries, production and supply cannot be increased with the rise in price
due to shortage of resources.

Difference between change in quantity supplied and change in supply

Basis Change in quantity supplied Change in supply

Meaning When the quantity supplied changes When the quantity supplied changes due
due to change in price, keeping other to change in factors other than price, it is
factors constant, it is known as change known as change in supply.
in quantity supplied.
Effect on supply It leads to movement along a supply It leads to shift in supply curve.
curve curve.
Reason It occurs due to increase or decrease in It occurs due to change in factors other
price of the given commodity. than price of the commodity.
Other name Upward movement is known as Rightward shift in supply curve is known
extension in supply curve and as increase in supply whereas leftward
downward movement is called shift in supply curve means decrease in
contraction of supply curve. supply.

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Price elasticity of supply

Meaning

Price elasticity of supply refers to degree of responsiveness of supply of a commodity with reference to
change in the price of such commodity.

Methods

1. Percentage method

According to this method, elasticity is measured as the ratio of percentage change in the quantity
supplied to percentage change in the price.

Es = percentage change in quantity supplied / percentage change in price

OR

Es = Q/ pXP/Q

2. Geometric method

According to the geometric method, elasticity is measured at a given point on the supply curve. This
method is also known as Arc method or Point method. The measurement of elasticity of supply for the
supply curve SS is:

Es = Intercept on X-axis / quantity supplied at that price

Fig 9.20

Types

1. Perfectly elastic supply

When there is an infinite supply at a particular price and the supply becomes zero with a slight fall in
price, then the supply of such a commodity is said to be perfectly elastic. In such a case, E s =∞ and the
supply curve is a horizontal straight line parallel to X-axis.

Price Supply Fig 9.23

30 100
30 200
30 300

2. Perfectly inelastic supply

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When the supply does not change with change in price, then the supply of such a commodity is said to
be perfectly inelastic. In such a case, E s = 0 and the supply curve is a vertical straight line parallel to Y-axis.

Price Supply Fig 9.24

20 20
30 20
40 20

3. Highly elastic supply

When percentage change in quantity supplied is more than percentage change in price, then supply of
such a commodity is said to be highly elastic. In such a case, E s > 1and the supply curve has an intercept
on the Y-axis.

Price Supply Fig 9.25

10 100
15 200

4. Less elastic supply

When percentage change in quantity supplied is less than percentage change in price, then supply of
such a commodity is said to be less elastic. In such a case, E s < 1, and the supply curve has an intercept
on X-axis.

Price Supply Fig 9.26

10 100
15 120

5. Unitary elastic supply

When percentage change in quantity supplied is equal to percentage change in price, then supply of
such a commodity is unitary elastic. In such a case, E s = 1 and supply curve is a straight line passing
through origin.

Price Supply Fig 9.27

10 100
15 150

Factors affecting elasticity of supply

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1. Nature of commodity

On the basis of nature, commodities may be classified as perishable and durable goods. Durable goods
have elastic supply as they can be stored and their supply can be changed according to changes in their
prices whereas on the other hand perishable goods have inelastic supply.

2. Cost of production

If cost of production rises rapidly with increase in output, then there is less incentive to raise the supply
with increase in supply. In such cases, supply will be inelastic.

3. Time period

In the market period, supply of commodity is perfectly inelastic as supply cannot be changed
immediately with change in price. In the short period, supply is relatively less elastic as frim can change
the supply by changing the variable factors.

4. Technique of production

Supply is generally elastic for commodities which involve simple technique of production. However,
supply is inelastic for commodities, which involves complex techniques of production. Output of such
goods cannot be increased rapidly.

5. Nature of inputs used

Elasticity of supply depends on the nature of inputs used in the process of production. If raw materials
are easily available, then supply will be less elastic as supply cannot be easily changed with change in
prices.

CHAPTER – 10
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MAIN MARKET FORMS
Market

Market refers to the whole region where buyers and sellers of commodity are in contact with each other
to effect purchase and sale of the commodity.

The essential elements of a market can be summarized as follows:

1. Area

It spreads over an area. The area becomes the point of contact between buyers and sellers.

2. Buyers and sellers

Buyers and sellers should be in contact with each other. However, contact does not necessarily mean
physical presence.

3. Commodity

For the existence of market, there must be a commodity which will be sold and purchased among
buyers and sellers.

4. Competition

The existence of competition among buyers and sellers is also an essential condition for the existence of
a market, otherwise different prices may be charged for the same commodity.

Forms of market structure

On the basis of main factors, which determine the market structure, the main forms of market structure
are shown in the following chart:

1. Perfect competition

2. Imperfect competition

a. Monopoly

b. Monopolistic competition

c. Oligopoly

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Perfect competition
Perfect competition refers to a market situation where there are very large number of buyers and sellers
dealing in a homogeneous product at a price fixed by the market. In the perfectly competitive market,
sellers sell a homogeneous product at a single uniform price. The price is not determined by a particular
firm but by the industry.

Features:

1. Very large number of buyers and sellers

In a perfectly competitive market, there are very large number of buyers and sellers.

Implication of very large number of buyer and sellers is that the number of sellers is so large that the
share of each seller is insignificant in the total supply. Hence, an individual seller cannot influence the
market price. Similarly, a single buyer’s share in total purchase is so insignificant that they cnnot
influence the price.

2. Homogeneous Product

The product offered for sale in the market are homogeneous i.e. the product sold is identical in all
respects like size, shape, quality, color etc. since each firm produces 100% identical products, their
products can be readily substituted for each other.

Implication of homogeneous product is that buyers treat the products as identical. Therefore the buyers
are willing to pay only the same price for the products of all the firms in the industry. It also implies that
no individual firm is in a position to charge a higher price for its product.

3. Freedom of entry and exit

Every seller has the freedom to enter or exit the industry. There are no artificial or natural barriers for
entry of new firms and exit of existing firms. It ensures absence of abnormal profits and abnormal losses
in the long run.

Implication of freedom of entry and exit is that all firms will earn only normal profits in the long run. A
firm can earn abnormal profits or losses in the short run as firms are not in a position to enter or leave
the industry. But in the long run, any abnormal profits, induces new firms to enter the market. It
increases the total supply and reduces the market price. This trend continues till the profits are reduced
to normal profits.

4. Perfect knowledge about buyers and sellers

Perfect knowledge means that both buyers and sellers are fully informed about the market price. Its
implication is that no firm is in a position to charge a different price and no buyer will pay a higher price.
As a result, a uniform price prevails in the market.

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5. Perfect mobility of factors of production

The factors of production i.e. land; labor, capital and entrepreneurship are perfectly mobile. There is no
geographical or occupational restriction on their movement.

6. Absence of transportation cost

In order to ensure uniform price in the market, it is assumed that transportation cost are zero. A
producer can sell his product at any place and a buyer can buy it from the place he likes.

7. Absence of selling cost

Selling cost refers to cost of advertisement of the product. In perfect competition, there are no selling
cost because of perfect knowledge amongst buyers and sellers.

Firm is a price maker and industry is price maker

Price taker means that an individual firm has no option but to sell at a price determined by the industry.
Under perfect competition, an individual firm cannot influence the price on its own as its share in total
market supply is negligible.

Therefore, a firm plays no role in price determination. It can affect neither supply nor the demand in the
market. So firm is a price taker and industry is the price maker. Each firm has to accept the price as
determined by market forces of demand and supply. Price is determined at the point where market
demand curve intersects the market supply curve of the commodity.

Fig 10.1

In the given fig, the market demand curve DD and supply curve SS intersects at point E, at which OP
price is determined. The price OP is adopted by the price taker firm and the firm is free to sell any
quantity at this price. This makes the AR curve perfectly elastic and thus parallel to X-axis. According to
AR and MR relationship, when AR is constant, MR = AR. So, in this situation, P =AR = MR.

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Monopoly
Monopoly refers to a market situation where there is a single seller selling a product which has no close
substitutes. For example, Railways in India.

Features:

1. Single seller

Under monopoly, there is a single seller selling the product. As a result, the monopoly firm and industry
is one and the same thing and the monopolist has the full control over the supply and price of the
product.

2. No close substitutes

The product produced by the monopolist has no close substitutes. So, the monopoly firm has no fear of
competition from new or existing products. For example, there is no close substitutes of electricity
services provided by NDPL.

3. Restrictions on entry and exit

There exist strong barriers to entry of new firms and exit of existing firms. As a result, a monopoly firm
can earn abnormal profits and losses in the long run. These barriers may be due to legal restrictions like
licensing, or patent rights or due to restrictions created by firms in the form of cartel.

4. Price determination

A monopolist may charge different prices for his product from different sets of consumers at the same
time. It is known as price discrimination.

5. Price maker

In case of monopoly, firm and industry is one and the same thing. So, firm has complete control over the
industry output. As a result, monopolist is a price maker and fixes its own price. It can influence the
market price by changing the supply of the product.

6. Demand curve under monopoly

Demand of the product is not in the control of monopoly. In order to increase the output to be sold,
monopolist will have to reduce the price. Therefore, monopoly firm faces a downward sloping demand
curve. In the given fig, output is measured along the X-axis and price and revenue along the Y-axis. At
price OP, a seller can sell OQ quantity. Demand rises to OQ 1, if the price is reduced to OP1. So, demand
curve under monopoly is negatively as more quantity can be sold only at a lower price.

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Fig 10.3

Monopolistic competition
Monopolistic competition refers to a market situation in which there are large numbers of firms which
sell closely related but differentiated products. Market of products like soap, toothpaste, AC etc. is
examples of monopolistic competition.

Features:

1. Large number of sellers

There are large numbers of firms selling closely related, but not homogeneous products. Each firm acts
independently and has a limited share of the market. So, an individual firm has a limited control over the
market price. It leads to competition in the market.

2. Product differentiation

Each firm is in a position to exercise some degree of monopoly in spite of large number of sellers
through product differentiation. Product differentiation refers to differentiating the product on the basis
of brand, size, color, shape etc.

3. Selling costs

Under monopolistic competition, products are differentiated and these differences are made known to
the buyers through selling cost. Selling cost refers to the expenses incurred on marketing, sales
promotion and advertising of the product. Such cost are incurred to persuade the buyers to buy a
particular brand of the product in preference to competitor’s brand.

4. Freedom of entry and exit

Under this competition, firms are free to enter in to or exit from the industry at any time they wish. It
ensures that there are neither abnormal profits nor any abnormal losses to a firm in the long run. But it
is not as easy as under perfect competition.

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5. Lack of perfect knowledge

Buyers and sellers do not have perfect knowledge about the market conditions. Selling cost create
artificial superiority in the minds of the consumers and it becomes very difficult for a consumer to
evaluate different products available in the market.

6. Pricing decisions

A firm under monopolistic competition is neither a price maker and nor a price taker. However, by
producing a unique product or establishing a particular reputation, each firm has partial control over the
price. The extent of power or command over the price is determined by the brand name of the
producer.

7. Demand curve

Under this competition, large number of firms selling closely related but differentiated products makes
the demand curve downward sloping. It implies that a firm can sell more output only by lowering the
price of its product.

Fig 10.4

Comparison of demand curve under monopoly and monopolistic competition

The demand curve of monopolistic competition looks exactly like that of monopoly as both faces
downward sloping demand curves. However, demand curve under monopolistic competition is more
elastic as compared to demand curve under monopoly. This happens because differentiated products
under monopolistic competition have close substitutes, whereas there are no close substitutes in case of
monopoly.

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Oligopoly
Oligopoly refers to a market situation in which there are few firms selling homogeneous or
differentiated products. It is sometimes also known as competition among the few as there are few
firms’ sellers in the market and every seller influences and is influenced by the behavior of other firms.

For example, in India, markets for automobiles, cement, steel, aluminum etc.

Features:

1. Few firms

Under oligopoly, there are few large firms. The exact number of firms is not defined. Each firm produces
a significant portion of the total output. There exist severe competition among different firms and each
firm try to manipulate both prices and volume of production to outsmart each other.

2. Interdependence

Interdependence means action of one firm affect the actions of the other firms. A firm considers the
action and reaction of the rival firms while determining its price and output levels. A change in the
output or price by one firm evokes reactions from other firms operating in the market.

3. Non-price competition

Under oligopoly, firms are in a position to influence the prices. However, they try to avoid price
competition for the fear of the price war. They follow the policy of price rigidity. Price rigidity is a
situation in which price tends to stay fixed irrespective of changes in demand and supply conditions.
Firms use other methods to compete with each other like advertising, better services to customers etc.

4. Barriers of entry of firms

Patents, requirement of large capital, control over crucial raw material etc. are some of the reasons,
which prevent new firms from entering in to the industry. Only those firms enter in to the industries
which are able to cross these barriers.

5. Role of selling cost

Due to severe competition and interdependence of the firms, various sales promotion techniques are
used to promote sales of the product. Advertisement in a full swing under oligopoly and many a times
advertisement can become a matter of life and death.

6. Group behavior

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Group behavior means that firms tend to behave as if they were a single firm even though individually
they retain their independence. Instead of independent price and output strategy, oligopoly firms prefer
group decisions that will protect the interest of all the firms.

7. Indeterminate demand curve

Under oligopoly, the exact behavior pattern of a producer cannot be determined with certainty. So,
demand curve faced by an oligopolist is indeterminate or uncertain. As firms are interdependent, a firm
cannot ignore the reaction of the rival firm.

Types:

1. Pure or perfect oligopoly

If the firms produce homogeneous products, then it is called pure or perfect oligopoly. Though it is rare
to find pure oligopoly situation yet some industries like cement, steel etc. approach pure oligopoly.

2. Imperfect oligopoly

If the firms produce differentiated products, then it is called differentiated or imperfect oligopoly. For
example, passenger cars, cigarettes etc.

3. Collusive oligopoly

If the firms cooperate with each other in determining price or output or both, it is called collusive or
cooperative oligopoly.

4. Non-collusive oligopoly

If firms in an oligopoly market compete with each other, it is called a non-collusive or non-cooperative
oligopoly.

Difference

Basis Perfect Monopoly Monopolistic Oligopoly

competition competition
Number of sellers Very large number Single seller Large number of Few big sellers
of sellers sellers
Nature of product Homogeneous No close Closely related but Homogeneous or
products substituted differentiated differentiated
products depending upon
the type of
oligopoly
Entry and exit of Freedom of entry Restricted entry Freedom of entry Restriction on
firms and exit and exit and exit entry and exit
Demand curve Perfectly elastic Less elastic More elastic Indeterminate
demand curve downward sloping downward sloping demand curve

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demand curve demand curve
Price Uniform price as Firm is a price Firm has partial Price rigidity due
each firm is a price maker control over the to fear of price
taker price war
Selling cost No selling cost Only informative High selling cost Huge selling cost
CHAPTER – 11

PRICE DETERMINATION
Market equilibrium

Equilibrium refers to a state of balance. It means, under perfect competition, market equilibrium is
determined when market demand is equal to market supply. Both market demand and market supply is
counteracting forces, which move in the opposite direction. Market equilibrium is determined when the
quantity demanded of a commodity becomes equal to the quantity supplied. The price determined
corresponding to market equilibrium is known as equilibrium price and quantity determined at that level
is known as equilibrium quantity.

Fig 11.1

Important points

 Each firm is a price taker and industry is the price maker

 Each firm earns only normal profits in the long run
 Decision of consumers and producers in the market are coordinated through free flow of prices
know as price mechanism.
 It is assumed that both law of demand and supply will operate.
 At equilibrium, there is neither shortage nor excess of demand and supply.

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Excess demand

Excess demand refers to a situation when quantity demanded is more than quantity supplied at the
prevailing market prices. Under this situation, market price is less than the equilibrium price.

In the given fig, market equilibrium is determined at point E at which OQ is the equilibrium quantity and
OP is the equilibrium price. However, if the market price is OP 1, then market demand of OQ1 is more
than market supply of OQ2. This situation is termed as excess demand.

 The excess demand will lead to competition amongst the buyers as each buyer wants to have
the commodity.
 Buyers would be ready to pay higher price to meet their demand, which will lead to rise in price.
 With increase in price, market demand will fall, due to law of demand and market supply will
rise due to law of supply.
 The price will continue to rise till excess demand is wiped out.

Fig 11.2

Excess supply

Excess supply refers to a situation, when the quantity supplied is more than the quantity demanded at
the prevailing market price. Under this situation, market price is more than equilibrium price. In the fig,
if market price is OP1, then market supply of OQ1 is more than the market demand of OQ 2. This situation
is termed as excess supply.

 Excess supply will lead to competition between sellers as each seller wants to sell his product.

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 Sellers would be ready to charge lower price to sell the excess stock, which will,lead to fall in
price.
 With decrease in price, market supply will fall due to law of supply and market demand will rise
due to law of demand.
 The price will continue to fall till excess supply is wiped out.

Fig 11.3

Viable industry

Viable industry refers to an industry for which supply curve and the demand curve intersect each
other in positive axis. In the viable industry, supply and demand curve must intersect at some
positive point as shown in the given fig.

Fig 11.4

Non-viable industry

Non-viable industry refers to an industry for which supply curve and demand curve never intersect
each other in the positive axes. In a non-viable industry, supply curve lies above the demand curve
as price is too high for the consumers. It happens when the price at which the producer are ready to
produce is so high that the customers are not willing to buy even a single unit. As a result, the
product is not produced.

Fig 11.5

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Effects of changes in demand and supply on market equilibrium

This topic will be discussed in class.

Price ceiling

Price ceiling refers to fixing the maximum price of a commodity at a level lower than the equilibrium
price.

Fig 11.30

In the diagram, demand curve DD and supply curve SS of a commodity intersect each other at point
E and as a result, equilibrium price of OP is obtained.

 Suppose the equilibrium price of OP is very high and many poor people are unable to afford
commodity at this price.
 Now government interferes and fixes the maximum price known as price ceiling at OP 1 which is
less than the equilibrium price OP.
 At this controlled price, the quantity demanded exceeds the quantity supplied.
 It creates a shortage of MN and some consumers of commodity go unsatisfied. To meet this
excess demand, government may enforce the rationing system.
 Rationing is a technique adopted by the government to sell a minimum quota of essential
commodities at a price less than equilibrium price to supply goods to the poor community at a
cheaper price.

But price ceiling through rationing system has following drawbacks:

a. Black markets

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A black market is any market in which the commodities are sold at a price higher than the maximum
price fixed by the government. Black markets exist because consumers are ready to pay a price more
than the price fixed by the government to get more of the limited amount of commodity available.

b. Difficulty in obtaining goods from ration shops

Consumers have to stand in long queues to buy goods from ration shops. Sometimes, commodities are
not available in the ration shops or goods are of inferior quality.

Price Floor or Minimum support Price (MSP)

Price floor refers to the minimum price above the equilibrium price, fixed by the government, which the
producers must be paid for their produce.

When government feels that the price fixed by the forces of demand and supply is not remunerative
from the producer’s point of view, then it fixes a price known as price floor which is more than the
equilibrium price.

Fig 11.31

In the diagram, demand curve DD and supply curve SS of a commodity intersect each other at point E
and as a result, equilibrium price of OP is obtained.

 Suppose to protect the producer’s interest and to provide incentive for further production,
government declares OP2 as the minimum price known as price floor which is more than the
equilibrium price of OP.
 At this support price, the quantity supplied exceeds the quantity demanded.
 This creates a situation of surplus in the market which is equivalent to MN in the diagram. The
excess supply may be purchased by the government either to increase its buffer stocks or for
exports.

Example:

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Under minimum wage legislation, the government aims to ensure that wage rate of labor does not fall
below a particular level and the minimum wages are set above the equilibrium wage level.

MACROECONOMICS
1. CIRCULAR FLOW OF INCOME

2. BASIC CONCEPTS OF MACROECONOMICS

3. NATIONAL INCOME AND RELATED AGGREGATES

4. MEASUREMENT OF NATIONAL INCOME

5. MONEY

6. BANKING

7. AGGREGATE DEMAND AND RELATED CONCEPTS

8. INCOME DETERMINATION AND MULTIPLIER

9. EXCESS DEMAND AND DEFICIENT DEMAND

10. GOVERNMENT BUDGET AND THE ECONOMY

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11. FOREIGN EXCHANGE RATE

12. BALANCE OF PAYMENTS

CHAPTER-1

CIRCULAR FLOW OF INCOME

Meaning

It refers to cycle of generation of income in the production process, its distribution among the factors of
production and finally, its circulation from households to firms in the form of consumption expenditure
on goods and services produced by them.

Stock and Flow

Stock

Stock variable refers to that variable, which is measured at a particular point of time. For example, stock
of goods in the godowns as on 31st march, 2011. It means stock variable are not time dimensional.

Flow

Flow variable refers to that variable, which is measured over a period of time. For example, production
done of goods during the month of January, 2011. The period of time could be a day, week, month or an
year. It means flows are time dimensional as they are measured over a period of time.

Basis Stock Flow

Meaning Stock variable refers to that Flow variable refers to that
variable which is measured at a variable which is measured over
particular point of time. a period of time.
Time dimension It does not have a time It has a time dimension.
dimension
Nature of concept It is a static concept. It is a dynamic concept.
Examples Population of India as on Number of births during 2009.
31/03/2009

Types of circular flow

Real Flow

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Real flow refers to the flow of factors services from households to firms and the corresponding flow of
goods and services from to households. It is also known as physical flows. There is only exchange of
goods and services between the two sectors without involvement of any money. It determines the
magnitude of growth process in an economy.

Money flow

Money flow refers to flow of factor payments from firms to households for their factor services and
corresponding flow of consumption expenditure from households to firms for purchase of goods and
services produced by the firms. It is also known as nominal flow. It involves exchange of money between
the two sectors.

Basis Real flow Money flow

Meaning It is the flow of goods and It is the flow of money between
services between firms and firms and households.
households.
Kinds of exchange It involves exchange of goods It involves exchange of money.
and services.
Difficulty in exchange There may be difficulties of There is no such difficulty in case
barter system in exchange of of money flow.
goods and factor services.
Alternative name It is also known as physical flow. It is also known as nominal flow.

Circular flow of income (two sector economy)

A simple economy assumes the existence of only two sectors i.e. household sector and firm sector.
Households are the owners of factors of production and consumers of goods and services .Firms
produce goods and services and sell them to households. It is the simplest form of closed economy in
which there is no government sector and foreign trade.

Assumptions

 There are only two sectors in the economy.

 There is no government and foreign trade
 Household sector supplies services to only firms and firms hire factor services from households.
 Firms produce goods and services and sell their entire output to the households.
 Household receive factor incomes for their services and spend the entire amount on
consumption of goods and services.
 There are no savings in the economy.

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Fig 1.4

The outer loop of the diagram shows the real flows i.e. the flow of factor services from household to
firms and corresponding flow of goods and services from firms to households.

The inner loop shows the money flow i.e. flow of factor payments from firms to households and the
corresponding flow of consumption expenditure from households to firms.

In the circular flow of income, production generates factor income, which is converted in to
expenditure. This flow of income continues as production is a continuous activity due to never ending
human wants. It makes the flow of income circular.

Injections and leakages

Leakages

Leakages refer to withdrawal of money from the circular flow. When household and firm save a part of
their incomes, it leads to leakages from the circular flow of income. Thus, it reduces the flow of income.

Injections

Injections refer to the introduction of income in to the circular flow. When household and firm borrows
money from external sources like financial institutions, it adds to their incomes. Thus, it increases the
flow of income.

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CHAPTER-2

BASIC CONCEPTS OF MACROECONOMICS

Domestic territory or economic territory

Domestic territory means the political frontiers of the country. However for the purpose of national
income accounting, it is used in a wider sense.

It Includes

1. Ships and aircrafts owned and operated by normal residents between two or more countries.

2. Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of the country
in the international waters where they have exclusive rights of operation.

3. Embassies, consulates and military establishments of a country located abroad.

It does not include

1. Embassies, consulates and military establishments of a foreign country.

2. International organizations like UNO, WHO, etc. are located within the geographical boundaries of the
country.

Normal Residents

Normal resident of a country refers to an individual or an institution who ordinarily resides in the
country and whose center of economic interest also lies in that country. It includes both individuals and
institutions. It does not include

1. Foreign tourists and visitors who visit a country for recreation, holidays, medical treatment, study etc.

2. Foreign staff of embassies, officials, diplomats and members of the armed forces of a foreign country
located in the given country.

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3. International organizations like UNO, WHO etc. are not considered as normal residents of the country
in which they operate.

4. Employees of international organizations are considered as residents of countries to which they

belong and not of the international area.

5. Crew members of foreign vessels, commercial travelers and seasonal workers provided their stay is
less than one year.

6. Border workers who live near the international borders and cross the border for working in other
countries are considered the residents of the countries in which they reside.

Factor income and transfer income

Factor income

Factor income refers to income received by factors of production for rendering factor services in the
production process. It is received for providing factor services of land, labor, capital and enterprise.

Transfer incomes

Transfer income refers to income received without rendering any productive service in return. It is a
unilateral or one sided concept.

Basis Factor income Transfer income

Meaning It refers to income received by It refers to income received
factors of production for without rendering any
rendering factor services in the productive service in return.
production process.
Nature It is included in both national It is neither included in national
income and domestic income. income nor it is included in
national income.
Concept It is an earning concept It is a receipt concept
Recipient It is received by factors of It is generally received by
production. households and the government
Example Rent, wages, interest and profit Scholarship, old age pension,
unemployment allowance etc.

Final goods and intermediate goods

Final goods

Final goods refer to those goods which are used either for consumption or for investment purpose.

Intermediate goods

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Intermediate goods refer to those goods which are used either for resale or for further production in the
same year.

Basis Final goods Intermediate goods

Meaning These refer to those goods which These refer to those goods which
are used either for consumption are used either for resale or for
or for investment further production in the same
year.
Nature They are included in both They are neither included in
domestic and national income. national income nor in domestic
income.
Demand They have a direct demand as They have a derived demand sa
they satisfy the wants directly their demand depends on final
goods.
Value addition They are ready for use by their They are not ready to use as
final users. some value has to be added to
them.
Production boundary They have crossed the They are still within the
production boundary. production boundary.
Example Milk purchased by household for Milk used in dairy shop for
consumption. resale.

Consumption and capital goods

Consumption goods

Consumption goods refer to those goods which satisfy the wants of the consumers. For example, bread,
butter, shirts, pens, televisions, furniture etc.

Capital goods

Capital goods are those final goods which help in production of other goods and services. For example,
plant and machinery, equipment’s etc.

Basis Consumption goods Capital goods

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Satisfaction of human wants These goods satisfy human Such goods satisfy human wants
wants directly. So, such goods indirectly. So, such goods have
have direct demand. indirect demand.
Production capacity They do not promote production They help in raising production
capacity. capacity.
Expected life Most of the consumption goods Capital goods generally have an
have limited expected life. expected life of more than one
year.

Gross investment, Net investment and Depreciation

Gross investment

The total addition made to the capital stock of economy in a given period is termed as Gross investment.
Capital stock consists of fixed assets and unsold stock. So, Gross investment is the expenditure on
purchase of fixed assets and unsold stock during the accounting year.

Net Investment

The actual addition made to the capital stock of an economy in a given period is termed as Net
investment.

Net investment = Gross investment – Depreciation

Depreciation

Depreciation refers to a fall in the value of fixed assets due to normal wear and tear, passage of time or
expected obsolescence. It is due to the following reasons:

 Normal wear and tear

 Passage of time
 Expected obsolescence

Net indirect taxes, market price and factor cost

Net indirect taxes refer to the difference between indirect taxes and subsidies.

Net Indirect Taxes = Indirect taxes – subsidies

Indirect taxes

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Indirect tax refers to those taxes which are imposed by the government on production and sale of goods
and services. Sales tax, excise duty, custom duty etc. are some of the indirect taxes.

Subsidies

Subsidies refer to the financial assistance given by the government to an enterprise on the production of
a certain commodity. In India, LPG cylinder is sold at subsidized rates.

Factor Cost

It refers to the amount paid to factors of production for their contribution in the production process.

Market price

It refers to the price at which product is actually sold in the market.

Symbolically, Market price = Factor Cost + Indirect taxes

Net Factor Income From Abroad

It refers to the difference between factor income received from the rest of the world and factor income
paid to the rest of the world.

NFIA = factor income earned from abroad – factor income paid to abroad

Significance

NFIA is significant to differentiate between domestic income and national income.

NFIA = National Income – Domestic Income

NFIA cab be positive, negative or zero

 NFIA is positive when income earned from abroad is greater than income paid to abroad.
 NFIA is negative when income earned from abroad is less than income paid to abroad.
 NFIA is zero when income earned from abroad is equal to income paid to abroad.

Components

There are three main components of NFIA:

1. Net Compensation to Employees

It refers to the difference between income from work received by resident workers living or employed
abroad for less than one year and similar payments made to non-residents workers staying or located
within the domestic territory of the country for less than one year.

2. Net income from property and entrepreneurship

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It refers to the difference between income from property and entrepreneurship received by residents of
the country and similar payments made to the non-residents.

3. Net retained earnings

It refers to the difference between retained earnings of resident companies located abroad and retained
earnings of non-resident companies located within the domestic territory of the country.

CHAPTER-3

NATIONAL INCOME AND RELATED AGGREGATES

Gross Domestic Product at Market price (GDPmp)

It refers to gross market value of all final goods and services produced within the domestic territory of a
country during a period of one year.

Gross Domestic Product at Factor cost (GDPfc)

It refers to gross value of all the final goods and services produced with in the domestic territory of a
country during a period of one year.

GDPfc = GDPmp – dep

Net Domestic Product at Factor Cost (NDPfc)

It refers to net money value of all the final goods and services produced within the domestic territory of
a country during a period of one year.

NDPfc = GDPmp – dep – NIT

Gross National Product at Market Price (GNPmp)

It refers to gross market value of all the final goods and services produced by normal residents of a
country during a period of one year.

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GNPmp = GDPmp + NFIA

Gross National Product at Factor Cost (GNPfc)

It refers to gross money value of all the final goods and services produced by normal residents of a
country during a period of one year.

GNPmp = GDPmp + NFIA – NIT

Net National Product at Market Price (NNPmp)

It refers to gross market value of all the final goods and services produced by normal residents of a
country during a period of one year.

NNPmp = GDPmp + NFIA – dep

Net National Product at Factor Cost (GNPfc)

It refers to gross money value of all the final goods and services produced by normal residents of a
country during a period of one year.

NNPfc = GDPmp + NFIA – NIT – dep

Basis Domestic income National income

Nature of concept It is a territorial concept as it It is a national concept as it
includes the value of final goods includes the value of final goods
and services produced within the and services produced in the
domestic territory of the entire world.
country.
Category of producers It considers all producers within It considers all producers who
the domestic territory of the are normal residents of the
country. country.
NFIA It does not include NFIA It includes NFIA

Private income

Private income refers to the income which accrues to private sector from all the sources within and
outside the country.

Personal Income

Personal income is the sum total of all the incomes that are actually received by households from all the
sources.

Personal Disposable Income

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Personal disposable income refers to that part of personal income which is actually available at the
disposal of households.

Net national disposable Income

National disposable income refers to the income which is available to the whole country for disposal.

Gross national Disposable Income

When depreciation is added to the Net national disposable income, we get Gross national disposable
income.

CHAPTER – 4

MEASUREMENT OF NATIONAL INCOME

VALUE ADDED METHOD

Meaning

Value added refers to the addition of value to the raw materials (intermediate goods) by a firm, by
virtue of its productive activities. It is calculated as the difference between value of output and value of
intermediate consumption.

Intermediate consumption

Use of intermediate goods in the production process is termed as intermediate consumption and
expenditure on them is termed as intermediate consumption expenditure.

Value of Output

Value of output refers to market value of all goods and services produced during a period of one year.

Steps

 The first step is to identify and classify all the producing enterprise of an economy in to primary,
secondary and tertiary sectors.
 In the second step, Gross Value added at market price of each sector is calculated and sum total
of GVA of all sectors give GDPmp.

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 By subtracting the amount of depreciation and net indirect taxes from GDPmp, we get domestic
income.
 In the final step, NFIA is added to domestic income to arrive at national income.

Precautions

 Intermediate goods are not included in the national income.

 Sale and purchase of second-hand goods is not included.
 Any commission or brokerage on sale or purchase of such goods will be included.
 Production of services for self-consumption is not included.
 Production of goods for self-consumption will be included.
 Imputed value of owner-occupied houses should be included.
 Change in stock of goods will be included.

Problem of double counting

In measuring the national income, the value of only final goods and services is to be included. However,
the problem of double counting arises when value of intermediate goods is also included along with the
value of final goods. Double counting refers to counting of an output more than once while passing
through various stages of production.

Let us understand it through the famous example of farmer, miler and baker:

 Farmer: suppose, farmer produces 50 Kg of wheat and sells it for Rs. 500 to miller.
 Miller: for miller, wheat is an intermediate good. Miller converts wheat in to flour and sells it for
Rs. 700 to a baker.
 Baker: for baker, flour is an intermediate good. Baker manufactures bread from flour and sells
the entire bread for Rs. 1000.

In the given example, wheat is a final product for farmer, flour for miller and bread for baker. As a
general practice, every producer treats his commodity as the final output. It means, total output will be
500+700+1000 = 2200.

As a result, the value of wheat and flour are counted more than once. This causes the problem of double
counting. It leads to over-estimation of value of goods and services produced.

Avoiding double counting

There are two alternatives to avoid double counting:

a. Final output method

According to this method, value of only final goods should be added to determine the national income.

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b. Value added method

According to this method, sum total of the value added by each producing unit should be taken in the
national income.

INCOME METHOD
Meaning

According to this method, all the incomes that accrue to the factors of production by way of wages,
profits, rent and interest etc. are summed up to obtain the national income.

Components

a. Compensation of employees

COE refers to amount paid to employees by employer for rendering productive services. It includes all
the payments and benefits, which the employee receives, directly or indirectly, from the employer.

b. Rent and royalty

Rent is that part of national income which arises from ownership of land and building. It includes both
actual rent as well as imputed rent. Royalty refers to income received for granting leasing rights for sub-
soil assets.

c. Interest

Interest refers to amount received for lending funds to a production unit. It includes interest on loans
taken for productive purposes only.

d. Profits

Profit is the reward to the entrepreneur for his contribution to the production of goods and services. It is
the residual income, which an entrepreneur earns after paying all the other factors of production. It is
used for three purposes: corporate tax, dividend and retained earnings.

e. Mixed income

It is the income generated by own-account workers and unincorporated enterprises. It is the term used
for any income that has elements of more than one type of factor income.

Steps

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 Identify and classify all the production units.
 Estimate the factor incomes paid by each sector.
 When the factor incomes of all the sectors are summed up, we get domestic income.
 In the final step, NFIA is added to domestic income to arrive at National Income.

Precautions

 Transfer incomes like scholarships; donations etc. are not included in national income.
 Income from sale of second-hand goods shall not be included.
 Any brokerage or commission paid on sale of second hand goods is to be included.
 Income from sale of shares, bonds and debentures will not be included.
 Windfall gains are not included in national income.
 Payments out of past savings are not included in national income.
 Indirect taxes are not included in national income at factor cost.

EXPENDITURE METHOD
Meaning

Factor income earned by factors of production is spent in the form of expenditure on purchase of goods
and services produced by firms.

Components

1. Private Final Consumption Expenditure

It refers to expenditure incurred by households and private non-profit institutions serving households on
all types of consumer goods i.e. durable, semi-durable, non-durable goods and services.

2. Government final consumption expenditure

It refers to the expenditure incurred by general government on various administrative services like
defense, law and order, education etc.

3. Gross domestic Capital Formation

It refers to the addition to capital stock of the economy. It represents the expenditure incurred on
acquiring goods for investment by the production units located within the domestic territory.

4. Net exports

It refers to the difference between exports and imports of a country during a period of one year.

Steps

 Identify the economic units incurring the final expenditure.

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 The sum total of four components of final expenditure of all the economic units gives Gross
domestic Product at market price.
 By subtracting the amount of depreciation and net indirect taxes form GDPmp, we get domestic
income.
 In the final step, NFIA is added to domestic income to get national income.

Precautions

 Expenditure on intermediate goods will not be included in the national income.

 Transfer payments are not included as such payments are not connected with any productive
activity.
 Purchase of second-hand goods will not be included.
 Purchase of financial assets will not be included.
 Expenditure on own account production will be included in the national income.

National Income at current income and constant prices

1. National income at current price

It is the money value of final goods and services produced by normal residents of a country in a year,
measured at the prices of the current year.

2. National income at constant price

It is the money value of final goods and services produced by normal residents of a country in a year,
measured at the base year price.

Basis National income at current price National income at constant

price
Meaning It refers to money value of final It refers to money value of final
goods and services produced by goods and services produced by
normal residents of a country in normal residents of a country in
a year measured at current a year, measured at prices of the
prices. base year.
Index of economic growth It is not a good tool for It is a better tool for measuring
measuring the economic growth the economic growth of a
of the country. country.
Cause of change It is affected by change in both It is affected by change in the
price and quantity. quantity only
Comparison It is not suitable tool for It is generally used for comparing
comparing the national income the national income for different
of different years. years.
Calculation Current price X current quantity Base year price X current
quantity

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Alternative name It is also known as Nominal It is also known as Real national
national income. income.

GDP and related concepts

Nominal GDP

When GDP of a given year is estimated on the basis of price the same year, it is called nominal GDP.

Real GDP

When GDP of a given year is estimated on the basis of price the base year, it is called real GDP.

GDP deflator

GDP deflator measures the average level of prices of all the goods and services that make up GDP.

GDP deflator = Nominal GDP / Real GDP X 100

GDP and Welfare

GDP is often considered as an index of welfare of the people. Welfare means sense of material well-
being among the people. So, higher GDP is generally taken as greater welfare of people.

However, this generalization may not be correct due to following limitations or reasons:

1. Distribution of GDP

GDP shows the total goods and services produced in the country. However, it does not exhibit the
structure of the product. If the increase in GDP is mainly due to increased production of war equipment
and ammunitions, then such an increase cannot be associated with any improvement in economic
welfare.

2. Change in prices

If increase in GDP is due to rise in prices and not due to increase in physical output, then it will not be a
reliable index of economic welfare.

3. Non-monetary exchanges

Many activities in the economy are not evaluated in monetary terms. For example, non-market
transactions like services of housewife, kitchen gardening, leisure time activities etc. are not included in
GDP, due to non-availability of data.

4. Externalities

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Externalities refer to benefits or harms of an activity caused by a firm or an individual, for which they are
not paid or penalized. For example, environmental pollution caused by industrial plants. As such,
external effects do not form part of GDP.

5. Rate of population growth

GDP does not consider the changes in the population of a country. If rate of population is higher than
rate of growth of GDP, then it will decrease the per capita availability of goods and services, which will
adversely affect the economic welfare.

Conclusion:

Finally, it can be concluded that GDP may not be taken as a satisfactory measure of economic welfare
due to above mentioned limitations, yet it does reflect index of economic welfare.

Green GNP

Green GNP measures national income or output adjusted for the depletion of natural resources and
degradation of the environment. It will help to attain a sustainable use of natural environment and
equitable distribution of benefits of development.

CHAPTER -5

MONEY
Barter System

Barter exchange refers to exchange of goods for goods. An economy, where there is a direct barter of
goods and services is called barter economy or C-C-economy.

For example, when a farmer gets wheat and gets cloth from the weaver in return, it is known as barter
exchange.

Limitations

1. Lack of Double co-incidence of wants

Barter system can work only when both buyer and seller are ready to exchange each other’s goods. For
example, A can exchange goods with B only when A has what B wants and B has what A wants.
However, such co-incidence was very rare.

2. Lack of common measure of value

In the barter system, all commodities are not of equal value and there is no common measure of value
of goods and services, in which exchange ratios can be expressed. For example, if A has wheat and B has
rice, then it is difficult to decide, how much wheat is needed to exchange with one kilogram of rice.

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3. Lack of standard of deferred payment

Under barter system, contracts involving future payments or credit transactions cannot take place with
ease because of following reasons:

 The borrower may not be able to arrange goods of exactly same quality at the time of
repayment.
 There may be conflicts regarding which specific commodity is to be used for repayment.
 The commodity to be repaid may lose or gain its value the time of repayment.

So, it is very difficult to make deferred payments in the form of goods.

4. Lack of store of value

Under barter system, it is difficult for people to store wealth for future use because:

 Most of the goods do not possess durability i.e. their quality deteriorates with passage of time.
 Storage of goods requires time and efforts.

As a result, goods cannot be used to store the earnings for a long period.

Functions of Money

The functions of money can be classified in to two categories:

1. Primary functions

Primary functions include the most important functions of money, which it must perform in every
country. These are:

a. Medium of exchange

Money, as a medium of exchange, means that it can be used to make payments for all transactions for
goods and services. It is the most essential function of money. Money has the quality of general
acceptability. So, all exchanges take place in terms of money. Money has no power to satisfy human
wants, but it commands power to purchase those things, which have utility to satisfy human wants.

b. Measure of value

Money as a measure of value means that money works as a common denomination, in which value of all
goods and services are expressed. By reducing the value of all goods and services to a single unit i.e.
price, it becomes very easy to find out the exchange ratios between them and comparing their prices.
This function facilitates maintenance of business accounts, which would be otherwise impossible.

2. Secondary function

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These refer to those functions of money which are supplementary to the primary functions. These
functions are derived from primary functions and therefore they are also known as derivative functions.

a. Standard of Deferred of payments

Money as a standard of deferred payments means that money acts as a standard for payments, which
are to be made in future. Every day, millions of transactions take place in which payments are not made
immediately. Money encourages such transactions and helps in capital formation and economic
development of the economy.

b. Store of value

Money as a store of value means that money can be used to transfer purchasing power from present to
future. Although, wealth can be stored in other forms also, but money is the most economical and
convenient way. It provides security to individuals, to meet contingencies, unpredictable emergencies
and to pay future debts.

c. Transfer of value

Money also performs the function of transfer of value. By transfer of value, we mean transferring the
value of durable and immovable goods from one place to another. Through money, anybody can sell his
immovable property at any particular place and buy property at any other place.

Definition of Money

Money is anything which is generally accepted as a medium of exchange, measure of value, store of
value and means of standard of deferred payments.

Money is a matter of function four:

A medium, a measure, a standard and a store

Related definitions

1. Legal tender money

Money which can be legally used to make payments of debts and other obligations is termed as legal
tender money. A creditor is obliged by law to receive such money in payment of debt due to him.

2. Full bodied money

Any unit of money, whose face value and intrinsic value are equal, is known as full bodied money. For
example, during the British period, one rupee coin was made of silver and its value as money was same
as its value as a commodity.

3. Credit money

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Credit money refers to the money whose intrinsic value as a commodity is much lower than its face
value i.e. money value > commodity value. For example, the value of Rs. 100 note is Rs. 100, but we
would get a much lower value if we sell the note as a piece of paper.

4. High powered money

High powered money is the money produced by the R.B.I and the government. It consist of two things:

a. Currency held by the public

b. Cash reserves with the banks.

Money supply

Money supply refers to total volume of money held by public at a particular point of time in an
economy. It includes money held by public only which includes individuals and business firms. It is a
stock concept i.e. it is concerned with a particular point of time.

Measures of money supply

In India, R.B.I uses four alternative measures of money supply which are as under:

1. M1

It is the first and basic measure of money supply. It is also known as Transaction money as it can be
directly used for making transactions.

M1 = currency and coins with public + demand deposits of commercial banks + other deposits with R.B.I

2. M2

It is a broader concept of money supply as compared to M1. In addition to M1, it also includes saving
deposits with post office saving bank.

M2 = M1 + saving deposits with post office saving bank

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3. M3

This concept is broader as compared to M1. In addition to M1, it also includes net time deposits.

M3 = M1 + net time deposits with banks

4. M4

This measure includes total deposits with post office saving bank in addition to M3.

M4 = M3 + total deposits with post office saving bank

Important facts

 The four measures of money supply represents different degrees of liquidity, which M1 being
the most liquid and M4 being the least liquid.
 M3 is widely used as a measure of money supply and it is also known as aggregate monetary
resource of the society.
 M1 and M2 are generally known as narrow measure of money supply whereas, M3 and M4 are
known as broad measure of money supply.

CHAPTER – 6

BANKING
Commercial Bank
Commercial bank is an institution which performs the functions of accepting deposits, granting loans
and making investments, with the aim of earning profits. State bank of India, Punjab National Bank,
Allahabad Bank, Canara bank are some examples of commercial banks in India.

Functions

1. Accepting of deposits

It is the most important function of commercial banks. They accept deposits in several forms according
to requirements of different sections of society. The main kinds of deposits are:

a. Current account

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These deposits refer to those deposits which are repayable by the banks on demand. Such deposits are
generally maintained by businessman with the intention of making transactions with such deposits. They
can be drawn upon by a cheque without any restriction. Banks do not pay any interest on it.

b. Fixed deposits

Fixed deposits refer to those deposits, in which the amount is deposited with the bank for a fixed period
of time. Such deposits do not enjoy chequable facility. These deposits carry a high rate of interest.

c. Saving deposits

These deposits combine features of both current account deposits and fixed deposits. The depositors
are given the facility to withdraw money from their account with some restrictions along it. They carry a
rate of interest which is less than interest rate on fixed deposits.

2. Advancing of loans

The deposits received by banks are not allowed to remain idle. So, after keeping certain cash reserves,
the balance is given to needy borrowers and interest is charged from them, which is the main source of
income for these banks. Different types of loans advanced by commercial banks are as under:

a. Cash credit

Cash credit refers to a loan given to the borrower against his current assets like shares, Bonds, stock etc.
a credit limit is sanctioned and the amount is credited in his account. Interest is charged on the amount
actually withdrawn.

b. Demand loans

Demand loans refer to those loans which can be recalled on demand by the bank at any time. The entire
sum of demand loan is credited to the account and interest is payable on the entire sum.

c. Short-term loans

They are given as personal loans against some collateral security. The money is credited to the account
of borrower and the borrower can withdraw money from his account and interest is payable on the
entire sum of loan granted.

3. Overdraft facility

It refers to a facility in which a customer is allowed to overdraw his current account up to an agreed
limit. This facility is generally given to respectable and reliable customers for a short period. Customers
have to pay interest to the bank on the amount overdrawn by them.

4. Discounting bills of exchange

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It refers to a facility in which the holder of a bill of exchange can get the bill discounted with bank before
the maturity. After deducting the commission, bank pays the balance to the holder. On maturity, bank
gets payment from the party which had accepted the bill.

5. Agency functions

These banks also perform some agency functions for their customers which are as follows:

a. Transfer of funds

Banks provide the facility of economical and easy remittance of funds from place-to-place with the help
of instruments like demand drafts, mail transfers etc.

b. Collection and payment of various items

Commercial banks collect cheques, bills, interest, dividends etc. and also make payment of taxes,
insurance premium etc. on behalf of their clients.

c. Purchase and sale of foreign exchange

Some commercial banks are authorized by the central bank to deal in foreign exchange. They buy and
sell foreign exchange on behalf of their clients.

d. Purchase and sale of securities

Commercial banks buy and sell stocks and shares of private companies as well as government securities
on behalf of their customers.

6. General utility functions

 Locker facility
 Traveler’s cheque
 Letter of credit
 Underwriting securities
 Collection of statistics

Money creation or credit creation by commercial banks

Through the process of money creation, commercial banks are able to create credit, which is in far
excess of the initial deposits. The process can be better understood by making two assumptions:

a. The entire commercial banking system is one unit and termed as ‘Banks’.

b. All receipts and payments in economy are routed through banks.

The deposits held by banks are used for giving loans. However, bank cannot use the whole deposit for
lending. It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as

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reserves. The fraction is called the Legal reserve Ratio (LRR) and is fixed by the central bank. Banks do
not keep 100 % reserves against the deposits. They keep reserves only to the extent indicated by the
Central bank.

Let us understand the process of money creation through an example:

 Suppose, initial deposits in banks is Rs. 1000 and LRR is 20%. It means, banks are required to
keep only Rs. 200 as cash reserve and are free to lend Rs. 800.
 Suppose they lend Rs.800 but banks do not lend this money by giving amount in cash. Rather,
they open the accounts in the names of the borrowers, who are free to withdraw the amount
whenever they like.
 Suppose borrowers withdraw the entire amount of Rs. 800 for making payments. The money
spent by the borrower comes back in to the banks in the form of deposit accounts of those who
have received this payment.
 With new deposits of Rs. 800, banks keep 20% as cash reserves and lend the balance of Rs. 640.
 The deposits keep on increasing in each round by 80% of the last round deposits. At the same
time, cash reserves also go on increasing, each time by 80% of the last cash reserves.
 Deposit creation comes to an end when total cash reserves becomes equal to the initial
deposits.

Deposits Loans Cash reserves (20%)

Initial deposits 1000 800 200
Round I 800 640 160
Round II 640 512 128
- - - -
Total 5000 4000 1000
As seen in the table, banks are able to create total deposits of Rs. 5000 with the initial deposit of just Rs.
1000. It means, total deposits became five times of the initial deposits. Five times is nothing but the
value of Money Multiplier.

Money multiplier = Initial deposit / LRR

Central banks
Central bank is an apex body that controls, operates, regulates and directs the entire banking and
monetary structure of the country. All the financially developed countries have their central banks. In
India, central bank is the Reserve bank of India.

Functions

1. Currency authority

In India, Reserve bank of India has the sole right of issuing paper currency notes except one rupee notes
and coins, which are issued by Ministry of Finance. All the currency issued by the central bank is its
monetary liability i.e. central bank is obliged to back the currency with assets of equal value.

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Advantages

 It leads to uniformity in note circulation.

 It gives central bank power to influence money supply.
 It enables the government to have supervision and control over the commercial banks.
 It ensures public faith in the currency system.
 It helps in stabilization of internal and external value of currency.

2. Banker to the government

The Reserve bank of India acts as a banker, agent and financial advisor to the central government and all
the state government except the state of Jammu and Kashmir. As a banker, it carries out the following
functions:

 It maintains a current account for keeping their cash balances

 It accepts receipts and make payments for the government
 It also gives loans and advances to the government for temporary periods.

3. Banker’s bank and supervisor

There are number of commercial banks in a country. There should be some agency to regulate and
supervise their proper functioning. As the banker to banks, the central bank performs in three
capacities:

a. Custodian of cash reserves

Commercial banks are required to keep a certain proportion of their deposits with the central banks. In
this way, central bank acts as a custodian of cash reserves of commercial banks.

b. Lender of last resort

When commercial banks fail to meet their financial requirements from other sources, they approach the
Central bank to give loans and advances as a lender of the last resort. Central bank assists these banks
through discounting of approved securities and bills of exchanges.

c. Clearing house

All commercial banks have their accounts with the central bank. Therefore the central bank can easily
settle claims of various commercial banks against each other by making debit and credit entries in their
accounts.

4. Controller of credit supply and money

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Due to economic fluctuations, the central bank i.e. R.B.I controls the credit supply and money in the best
interest of the country. For this R.B.I makes use of the following methods of credit control:

a. Repo rate

Repo rate is the rate at which the central bank of a country lends money to commercial banks in the
event of any shortfall of funds. The central bank advances loans against approved securities or eligible
bills of exchange.

b. Bank rate

Repo rate and bank rate are almost similar except the following differences: repo rate is applicable for
short term lending whereas bank rate is applicable for long term lending and is governed by long term
interest rates.

c. Reverse repo rate

Reverse repo rate is the rate at which Reserve bank of India borrows money from commercial banks. RBI
makes use of this tool when there is excess money supply in the economy. Banks are always happy to
lend money to RBI as their money is in safe hands with a good interest.

d. Open market operations

Open market operations refer to buying and selling of government securities by the central bank fro/to
the public and commercial banks. It does not matter whether the securities are bought or sold to the
public or banks because ultimately the amounts will be deposited or transferred from some bank.

e. Legal Reserve Requirements

According to legal reserve requirements, commercial banks are obliged to maintain reserves. The
reserves can be of two types:

 Cash reserve ratio (CRR)

It refers to the minimum percentage of net demand and time liabilities, to be kept by commercial banks
with the central bank. A change in CRR affects the ability of commercial banks to create the credit.

 Statutory Liquidity Ratio (SLR)

It refers to minimum percentage of net demand and time liabilities which commercial banks are
required to maintain with themselves. SLR is maintained in the form of designated liquid assets.

f. Margin requirements

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Margin is the difference between the amount of loan and market value of security offered by the
borrower against the loan. If the margin fixed by the central bank is 40%, then commercial banks are
allowed to give a loan only up to 60% of the value of security.

g. Moral suasion

This is a combination of persuasion and pressure that central bank applies on other banks in order to get
them act, in a manner, in line with its policy.

h. Selective credit control

Under selective credit control, the RBI gives directions to other banks to give or not to give credit for
certain purposes to particular sectors. This method can be applied in both positive and negative manner.

5. Custodian of foreign exchange reserves

The central bank also acts a custodian of the country’s stock of gold and reserves of foreign exchange.
This function enables the central bank to exercise a reasonable control on foreign exchange. According
to regulations of foreign exchange, all foreign exchange transactions must be routed through RBI.

Basis Central bank Commercial bank

Meaning Central bank is an apex bank that Commercial bank is an institution which
controls, operates, regulates and directs performs the function of accepting
the entire banking and monetary deposits, granting loans and making
structure of the country. investments with the objective of earning
profits.
Status It is the apex institution in the money It is merely a unit in the banking structure
market. of the country and operates under the
control of central bank.
Ownership It is generally owned and governed by It can be owned and governed by the
the government. government or private sector.
Objective It operates in public interest without It aims to maximize profits.
profit motive
Issue of It has sole monopoly in issue of currency. It has no power to issue currency.
currency
Public dealing It does not deal directly with the public It deals directly with the public

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Number of There is only one central bank in a There are number of commercial banks in a
banks country. country.

CHAPTER-7

AGGREGATE DEMAND AND RELATED CONCEPTS

Aggregate Demand

Meaning

Aggregate demand refers to the total value of final goods and services which all the sectors of an
economy are planning to buy at a given level of income during a period of one accounting year.

It is important to consider that aggregate demand refers to the planned expenditure and not the actual
expenditure. So, AD is the total expenditure that all the households, firms and the government are
planning to incur during a given period of time.

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Components

1. Private consumption expenditure (C)’

It refers to the total expenditure incurred by the households on purchase of goods and services during
an accounting year. Generally, consumption expenditure is directly influenced by the level of disposable
income i.e. higher the disposable income. Higher will be the consumption expenditure and vice versa.

2. Investment expenditure (I)

It refers to the total expenditure incurred by all the private firms on capital goods. It includes addition to
the stock of physical capital assets such as machinery, equipment, building etc. and change in inventory.
It is assumed to be autonomous, i.e. investments are not influenced by the level of income.

3. Government expenditure (G)

It refers to the total expenditure incurred by the government on consumer goods to satisfy the common
needs of the economy. It means, government incurs expenditure on consumption as well as investment.
Level of government expenditure is determined by the policy of the government, which is generally
guided by the social welfare.

4. Net Exports (X-M)

Exports indicate the demand for goods produced within the domestic territory of a country by rest of
the world. Imports refer to the demands of the residents of the country for the goods that have been
produced abroad. The difference between exports and imports is called net exports.

AD = C + I + G + (X-M)

Fig 7.1

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Aggregate Supply

Meaning

Aggregate supply refers to money value of goods and services that all producers are willing to supply in
an economy in a given time period.

Aggregate supply = National Income

When AS is expressed in physical terms, it refers to total output of goods and services in an economy
which is distributed in the form of rent, wages, interest and profit. The sum total of these factor incomes
is known as National income. So, we can say that Aggregate supply and national income are one and the
same thing.

Components

The major portion of national income is spent on consumption of goods and services and the balance is
saved. It means, Income is either is consumed or saved.

So, National income (Y) = Consumption (C)’ + Saving (S)

Y = AS = C + S

Fig 7.2

Consumption Function(propensity to consume)

Consumption expenditure refers to that portion of income which is spent on the purchase of goods and
services at the given level of income. Consumption function refers to functional relationship between
consumption and national income.

C = f(y)

Where,

C = Consumption; Y = national income; f=functional relationship

Relationship

The relationship between consumption and income is shown in the given table and diagram:

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Income Consumption Fig 7.3
0 40
100 120
200 200 Important observations
300 280
400 360  Consumption curve starts from point C on the Y-axis.
500 440 This implies that there is autonomous consumption
600 520 even when the national income is zero.
 CC has a positive slope, which indicates that as income increase, consumption also rises.
However, proportionate rise in consumption is less than that of income.
 When income is less than consumption, the gap is covered by dis savings.
 At OM level of income, consumption becomes equal to income and savings is zero. The point E
is known as Break-even point.
 At points to the right of E, income is more than consumption. Excess of income leads to savings.

Types

1. Average propensity to consume (APC)

Average propensity to consume refers to the ratio of consumption expenditure to the corresponding
level of income.

APC = Consumption / Income

Important points

 As long as consumption is more than income, APC is more than 1.

 At the break-even point, consumption is equal to the national income.
 Beyond the break-even point, consumption is less than income.
 APC falls continuously with increase in income.
 APC can never be zero even if income is zero as minimum consumption is required for basic
survival in life.

2. Marginal propensity to consume (MPC)

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Marginal propensity to consume refers to the ratio of change in consumption expenditure to change in
total income.

MPC = change in consumption / change in income

Important points

 Value of MPC varies between 0 and 1.

 MPC of poor is more than that of rich.
 MPC falls with successive increase in income.

Saving function (propensity to save)

Like consumption, saving is also a function of income i.e. saving also depends on the level of income.
Saving is the excess of income over consumption expenditure. Saving function refers to the functional
relationship between saving and national income.

S = f(y)

Where, S = saving, Y = national income, f = functional relationship

Relationship

The relationship between saving and income is illustrated in the given schedule and figure:

Income Consumption Saving Fig 7.5

0 40 -40
100 120 -20
200 200 0 Important observation
300 280 20
400 360 40  Saving curve starts from point
500 440 60 S on the Y-axis, indicating that
600 520 80 there is negative saving when
national income is zero.
 SS has a positive slope, which indicates the positive relationship between saving and income.
 Saving curve crosses the X-axis at point R, which is known as Break-even as at this point, saving
is zero.
 After the break-even point, saving is positive.

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Types

Propensities to save are of two types:

1. Average propensity to save (APS)

Average propensity to save refers to the ratio of savings to the corresponding level of income.

APS = Savings / Income

Important points

 APS can never be 1 or more than 1.

 APS can be zero.
 APS can be negative or less than 1.
 APS rises with rise in income.

2. Marginal propensity to save (MPS)

Marginal propensity to save refers to the ratio of change in savings to change in total income.

MPS = change in savings / change in income

Important points:

 If the entire additional income is saved, then MPS = 1.

 However, if the entire additional income is consumed, then MPS =0.
 Usually, value of MPS varies between 0 and 1.

Relationship between APC and APS

We know that,

Y=C+S

Y/Y = C/Y + S/Y

1 = APC + APS

Relationship between MPC and MPS

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Y= C+ S

Y/ Y = C/ Y+ S/ Y

1 = MPS + MPC

Derivation of saving curve from consumption curve

As seen in the diagram, CC is the consumption and 45 0line OY represents the income curve.

 At zero level of income, autonomous consumption is equal to OC. It means, saving at zero level
of income will be OS. As a result, the saving curve will start from point S on the negative Y-axis.
 Consumption curve CC intersects income curve OY at point E. this is the break-even point. At
point E, consumption = income i.e. APC = 1 and saving is zero. It means, saving curve will
intersect X-axis at point R. By joining the points S and R and extending it further, we get the
saving curve SS.

Fig 7.9

Derivation of Consumption curve from Savings curve

In the given diagram, SS’ is the saving curve which shows negative savings equal to OS at zero level of
income and zero savings at OA level of income.

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 At zero level of income, consumption expenditure is equal to OC which is equal to negative
savings of OS at that level of income. So, C is the starting point of consumption curve.
 Savings are zero at OA level of income as the whole of income is spent. So, at OA level of
income, consumption expenditure must be equal to OD = OA. This gives a point B on the
consumption curve.

By joining C and B and extending it further, we get consumption curve. At point B on the consumption
curve, total consumption expenditure is equal to total income.

Fig :

Investment function

Investment refers to the expenditure incurred on creation of new capital assets. It includes the
expenditure incurred on assets like machinery, building, raw material etc. which lead to the increase in
the production capacity of an economy.

It can be classified under two heads:

1. Induced Investment

Induced investment refers to the investment which depends on the profit expectations and is directly
influenced by income-level. It is income elastic, i.e. it increases with the increase in income and vice-
versa.

Fig 7.10

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2. Autonomous investment

Autonomous investment refers to the investment which is not affected by changes in the level of
income and is not induced solely by profit motive. It is income inelastic i.e. it is not influenced by the
level of income.

Fig 7.11

Basis Induced investment Autonomous investment

Motive It is driven by profit motive. It is done for social welfare and not for
profit.
Income It is income elastic. It is income inelastic.
elasticity
Investment Its curve slopes upwards as it is income Its curve is parallel to X-axis as it is income
curve elastic. inelastic.
Sector It is generally done by the private sector. It is generally done by the government
sector.
Determining Besides income, it also depends on It depends on socio-economic and political
factors innovations, technology, government conditions of the country.
policy etc.

Determinants

The decision to invest in a particular project depends on two factors:

1. Marginal efficiency of investment

MEC refers to the expected rate of return from an additional investment. MEI is determined by two
factors:

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a. Supply Price

It refers to the cost of producing a new asset of that kind. It is the cost at which new asset can be
purchased or the old one can be replaced.

b. Prospective yield

It refers to net return expected from the capital assets over its lifetime.

2. Rate of interest

It refers to the cost of borrowing money for financing the investment. There exists an inverse
relationship between ROI and the volume of investment.

Comparison of MEI with ROI

The profitability of an investment can be worked out by comparing MEI with ROI. If MEI > ROI, then
investment is profitable.

Important concepts

1. Ex-ante savings

It refers to the mount of saving which households plan to save at different levels of income in the
economy.

2. Ex-ante Investment

It refers to the amount of investment which firm plans to invest at different levels of income in the
economy.

3. Ex-post saving

It refers to the actual or realized savings in the economy during a year.

4. Ex-post Investment

It refers to the realized or actual investment in an economy during a given year.

5. Full employment

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It refers to a situation in which all those people, who are willing and able to work at the existing wage
rate, get work without any undue difficulty.

6. Involuntary unemployment

It refers to an unemployment in which all those people, who are willing and able to work at the existing
wage rate, do not get work.

CHAPTER – 8

INCOME DETERMINATION AND MULTIPLIER

There are two approaches for determination of equilibrium level of income:

1. AD-AS approach
2. Saving-Investment approach

Aggregate demand and Aggregate supply approach (AD-AS approach)

The equilibrium of income in an economy is determined when aggregate demand represented by C+I
curve is equal to the total output i.e. aggregate supply.

The determination of equilibrium level of income can be better understood with the help of following
schedule and diagram:

Employment Income AD AS
0 0 80 0
10 100 160 100

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20 200 240 200
30 300 320 300
40 400 400 400
50 500 480 500
60 600 560 600

Fig 8.1

In the given fig, the AD curve shows the desired level of expenditure by consumers and firms
corresponding to each level of income. The economy is in equilibrium at point E, where C+I curve
intersects 450line.

 E is the equilibrium point as at this point, the level of desired spending on consumption and
investment exactly equals the level of total output.
 OY is the equilibrium level of output corresponding to point E.
 It is a situation of effective demand. It becomes effective because it is equal to AS.
a. When AD is more than AS

When planned spending (AD) is more than planned output (AS), then Ad curve lies above the AS curve. It
means that consumers and firms together would be buying more goods than the firms are willing to
produce. As a result, planned inventory would fall below the desired level.

To bring the inventory back to the desired level, firms would resort to increase in employment and
output until the economy is back at output level OY, where AD becomes equal to AS and there is no
further tendency to change.

b. When AD is less than AS

When AD is less than AS, the Ad curve lies below the AS curve. It means that consumers and firms
together would be buying fewer goods than the firms are willing to produce. As a result, the planned
inventory would rise.

To clear the unwanted increase in inventory, firms plan to decrease the employment and output until
the economy is back at the output level OY, where AD becomes equal to AS and there is no further
tendency to change.

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Saving-Investment Approach (S-I Approach)

According to this approach, the equilibrium level of income is determined at a level, when planned
saving is equal to planned investment.

Let us understand the same with the help of schedule and diagram:

Income Consumption Savings Investment

0 40 -40 40
100 120 -20 40
200 200 0 40
300 280 20 40
400 360 40 40
500 440 60 40
600 520 80 40
Fig 8.2 sirf neeche wali bnani hai

In the given fig, investment curve is parallel to X-axis because of the autonomous character of
investments. The saving curve slopes upwards showing that as income rises, saving also rises.

 The economy is in equilibrium at point E, where saving and investment curves intersesct each
other.
 At point E, ex-ante saving is equal to ex-ante investment.
 OY is the equilibrium level of output corresponding to point E.

a. When Saving is more than Investment

If planned saving is more than planned investment, i.e. after point E, it means that households are not
consuming as much as the firms expecting them to. As a result, the inventory rises above the desired
level.

To clear the unwanted increase in inventory, firms would plan to reduce the production till saving and
investment become equal to each other.

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b. When investment is more than saving

If planned savings is less than planned investment, i.e. before point E, it means that households are
consuming more and saving less than what the firms expecting them to. As a result, planned inventory
would fall below the desired level.

To bring the inventory back to the desired level, firms would plan to increase the production till saving
and investment becomes equal to each other.

Important concepts

1. Full employment equilibrium

It refers to a situation when the aggregate demand is equal to the aggregate supply at full employment
level. At this level of output, all those who are willing to work at the prevailing wage rate, are able to
find employment i.e. there is no involuntary unemployment.

2. Underemployment equilibrium

It refers to a situation when the aggregate demand is equal to the aggregate supply when the resources
are not fully employed.

3. Over employment equilibrium

It refers to a situation when AD is equal to AS beyond the full employment level. It occurs after the full
employment equilibrium level.

Investment Multiplier

Multiplier expresses the relationship between an initial increment in investment and the resulting
increase in aggregate income.

Multiplier is the ratio of increase in national income due to increase in investment.

K = change in income / change in investment

K = 1 / 1 – MPC or 1 / MPS

The value of K ranges from 1 to infinity.

The value of multiplier depends upon the value of MPC. Multiplier and MPC are directly related i.e.
when MPC is more, K is more and vice-versa. On the contrary, higher the MPS, lower will be the value of
multiplier and vice-versa.

Working

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The working of multiplier is based on the fact that one person’s expenditure is another person’s income.
When an additional investment is made, then income increases many times more than the increase in
investment. Let us understand through an example:

 Suppose, an additional investment of Rs.100 crores is made to construct a flyover. This extra
investment will generate an extra income of Rs. 100 crores in the first round. But this is not the
end of the story.
 If MPC is assumed to be 0.90, then recipients of this additional income will spend 90% of Rs.
100 crores as consumption expenditure and the remaining amount will be saved. It will increase
the income by Rs. 90 crores in the second round.
 This multiplier will go on and the consumption expenditure in every round will be 0.90 times of
the additional income received from the previous round.

Round Increase in investment Increase in income Increase in

consumption
1st 100 100 90
2nd 90 81
3rd 81 72.90
4th 72.9 65.61
5th 65.61 -
- - -
- - -
Total 100 1000 900

Diagrammatic presentation

Fig 8.7

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CHAPTER-9

EXCESS DEMAND AND DEFICIENT DEMAND

Excess demand

Excess demand refers to the situation when aggregate demand is more than the aggregate supply
corresponding to full employment level of output in the economy. It gives rise to inflationary gap.

Inflationary gap refers to the gap which actual aggregate demand exceeds the aggregate demand
required to establish full employment equilibrium.

The concepts of excess demand and inflationary gap are illustrated in the given fig

Fig 9.1

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Reasons

 Excess demand may arise because of the increase in the consumption expenditure due to rise in
propensity to consume.
 It may also occur due to increase in disposable income caused by reduction in taxes.
 Rise in government demand for goods and services due to increase in public expenditure.
 Decrease in imports due to high international prices in comparison to domestic prices.
 It may be cause due to increase in the money supply caused by deficit financing.

Impact

 Effect on output: excess demand does not affect the level of output because economy is already
at full employment level and there is no idle capacity in the economy.
 Effect on employment: there will be no change in the level of employment as the economy is
already operating at full employment equilibrium.
 Effect on general price level: excess demand leads to increase in general price level as aggregate
demand is more than aggregate supply.

Deficient Demand

Deficient demand refers to the situation when aggregate demand is less than the aggregate supply
corresponding to the full employment level of output in the economy. It gives rise to deflationary gap.

Deflationary gap refers to the gap by which actual aggregate demand falls short of aggregate demand
required to establish full employment equilibrium.

The concept of deficient demand and deflationary gap is shown in the given fig

Fig 9.2

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Reasons

 A decrease in consumption expenditure due to fall in propensity to consume.

 AD may also fall short due to imposition of higher taxes which leads to decrease in disposable
income.
 When government reduces its demand for goods and services due to fall in government
expenditure.
 When international prices are comparatively less than the domestic prices, then it may lead to
rise in imports implying a cut in aggregate demand.

Impact

 Effect on output: due to lack of sufficient aggregate demand, there will be an increase in the
inventory stock. It will force the firms to reduce their consumption.
 Effect on employment: deficient demand causes involuntary unemployment in the economy
due to the fall in planned output.
 Effect on general price level: deficient demand causes the general price level to fall due to lack
of demand for goods and services in the economy.

Measures to correct excess demand or deficient demand

1. Government spending

It is a part of the fiscal policy. Government spends huge amount on infrastructural and administrative
activities.

To control the situation of excess demand, government should reduce its expenditure to the maximum
possible extent. More emphasis should be placed to reduce expenditure on defense and unproductive
woks as they rarely help in growth of the country.

During deficient demand, the government should increase expenditure on public works like construction
of flyovers, buildings etc. with a view to provide additional income to the people. This will increase the
aggregate demand and will help to correct the situation of deficient demand.

2. Availability of credit

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In the situation of excess demand, the central bank aims to reduce availability of credit in the economy
through its monetary policy. And in the situation of deficient demand, the central bank aims to ensure
easy availability of credit in the economy.

Two major instruments of monetary policy are:

a. Quantitative instruments
 Bank rate

The term bank rate refers to the rate at which central bank lends money to commercial banks as the
lender of last resort.

During excess demand, central bank increases the bank rate, which raises the cost of borrowing from
the central bank. It forces the commercial banks to increase their lending rates, which discourages
borrowers from taking loans.

During deficient demand, the central bank reduces the bank rate in order to expand credit in the
economy. It leads to fall in the market rate of interest which induces the public to borrow more funds.

 Open market operations

Open market operations refer to sale and purchase of securities in the open market by the central bank.
It directly influences the money supply in the economy.

During inflation, central bank offers its securities for sale. It reduces the reserves of the commercial
banks. It adversely affects the bank’s ability to create credit.

During deficient demand, the central bank starts purchasing securities from the open market. It
increases the money supply and enhances the purchasing power capacity in the economy.

 Legal reserve requirements

Commercial banks are obliged to maintain legal reserves. An increase in such reserves is a direct method
to reduce the availability of credit whereas decrease in these reserves will increase the availability of
credit in the economy. There are two types of reserves:

i. Cash reserve ratio (CRR)

It is the minimum percentage of net demand and time liabilities, to be kept by the commercial banks
with the central banks.

ii. Statutory liquidity ratio (SLR)

It is the minimum percentage of net demand and time liabilities, to be kept by the commercial banks
with themselves.

b. Qualitative instruments

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 Margin requirements

Margin requirement refers to difference between the market value of security offered and the value of
amount lent. When the economy is suffering from excess demand, central bank increases the margin,
which restricts the credit creating power of banks. During deficient demand, central bank reduces the
margin which enhances the credit creating power of banks.

 Moral suasion

This is a combination of persuasion and pressure that central bank applies on other banks in order to get
them act, in a manner, in line with its policy. It is exercised through discussions, letters, speeches and
hints to banks.

During excess demand, the central bank advices, requests and persuades the commercial banks not to
advance credit for speculative or non-speculative activities. It helps to reduce availability of credit and
aggregate demand.

During deficient demand, the central bank advices, requests and persuades the commercial bank to
encourage credit. It helps to raise availability of credit and aggregate demand.

CHAPTER – 10

GOVERNMENT BUDGET AND THE ECONOMY

Meaning of government budget

Government budget is an annual statement, showing item wise estimates of receipts and expenditures
during a fiscal year. The receipts and expenditure, shown in the budget are not actual figures but the
estimated values for the coming fiscal year.

Objectives of government budget

Government prepares the budget for fulfilling certain objectives. The various objectives of government
budget are as under:

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1. Reallocation of resources

Through the budgetary policy, government aims to reallocate resources in accordance with the
economic and social priorities in the country. Government can influence allocation of resources through:

i. Tax concessions or subsidies

To encourage investment, government can give tax concessions, subsidies etc. to the producers.

ii. Directly producing goods and services

If private sector does not take interest, government can directly undertake the production.

2. Reducing inequalities in income and wealth

Economic inequality is an inherent part of every economic system. Government aims to reduce such
inequalities of income and wealth, through its budgetary policy. Government aims to influence
distribution of income by imposing taxes on the rich and spending more on the welfare of the poor.

3. Economic stability

Government budget is used to prevent business fluctuations of inflation or deflation to achieve the
objective of economic stability. The government aims to control the different phases of business
fluctuations through its budgetary policy.

4. Management of public enterprises

There are large numbers of public sector industries especially natural monopolies which are established
and managed for social welfare of the public. Budget is prepared with the objective of making various
provisions for managing such enterprises and providing them financial help.

5. Economic growth

The growth rate of a country depends on the rate of saving and investment. For this purpose, budgetary
policy aims to mobilize sufficient resources for investment in the public sector. Therefore, the
government makes various provisions in the budget to raise overall rate of savings and investment in the
economy.

6. Reducing the regional disparity

The government budget aims to reduce regional disparities through its taxation and expenditure policy
for encouraging setting up of production units in economically backward regions.

Components of Government Budget

1. Budget Receipts

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Budget receipts refer to the estimated money receipts of the government from all sources during a
given fiscal year. Budget receipts may be further classified as : (i) Revenue receipts and (ii) capital
receipts.

a. Revenue receipts

Revenue receipts refer to those receipts which neither create any liability nor cause any reduction in the
assets of the government. They are regular and recurring in nature and government receives them in its
normal course of activities.

 The receipt must not create a liability for the government.

 The receipt must not cause decrease in the assets.

Sources

(i) Tax Revenue

Tax revenue refers to sum total of receipts from taxes and other duties imposed by the government. Tax
is a compulsory payment made by people and companies to the government without reference to any
direct benefit in return. Tax revenue can be further classified as direct taxes and indirect taxes.

 Direct tax: Direct tax refers to taxes that are imposed on property and income of individuals and
companies and are paid directly by them to government.
 Indirect tax: indirect taxes are those taxes which affect the income and property of individuals
and companies through their consumption expenditure. They are imposed on goods and
services.
(ii) Non-tax revenue

Non tax revenue refers to receipts of the government from all sources other than those of tax receipts.
The main sources of tax revenue are:

 Interest: Government receives interest on loans given by it to state governments, union

territories, private enterprises and general public. Interest receipts from these loans are an
important source of non-tax revenue.
 Profits and dividends: Government earns profits through public sector undertakings like Indian
railways, LIC, BHEL etc. it earns profit from the sale proceeds of the products from such public
enterprise.
 Fees: Fees refer to charges imposed by the government to grant permission for something.
 Fines and penalties: They refer to those payments which are imposed on law breakers. For
example, fine for jumping red light.
 Escheats: It refers to claim of the government on the property of a person who dies without
leaving behind any legal heir or a will.

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 Gifts and Grants: Government receives gifts and grants from foreign governments and
international organizations. Sometimes, individuals and companies also voluntarily gift money
to the government.
 Special Assessment: It refers to the payment made by owners of those properties whose value
has appreciated due to developmental activities of the government.

b. Capital Receipts

Capital receipts refer to those receipts which either create a liability or cause a reduction in the assets of
the government. They are non-recurring and non-routine in nature.

 The receipts must create a liability for the government

 The receipts must cause a decrease in the assets.

Sources

(i) Borrowings

Borrowings are the funds raised by the government to meet excess expenditure. Government borrow
funds from open market, Reserve bank of India, Foreign Governments and international institutions.

(ii) Recovery of Loans

Government grants various loans to state governments or union territories. Recovery of such loans is a
capital receipts as it reduces the assets of the government.

(iii) Other receipts

These include:

 Disinvestment: disinvestment refers to the act of selling a part or the whole of shares of
selected public sector undertakings (PSU) held by the government. They are termed as the
capital receipts as they reduce the assets of the government.
 Small savings: Small savings refer to funds raised from the public in the form of Post office
deposits, national saving certificates, Kisan Vikas patras etc. They are treated as capital receipts
as they lead to an increase in liability.

Basis Revenue receipts Capital receipts

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Meaning They neither create any liability nor They either create any liability nor reduce
reduce any asset of the government. any asset of the government.
Nature They are regular and recurring in They are irregular and non-recurring in
nature. nature.
Future There is no future obligation to return In case of certain capital receipts, there is
obligation the amount. future obligation to return the amount along
with interest.
Examples Tax revenue and non-tax revenue Borrowings, disinvestments etc.

2. Budget expenditure

Budget expenditure refers to the estimated expenditure of the government during a given fiscal year.
The budget expenditure can be classified as:

a. Revenue Expenditure

Revenue expenditure refers to the expenditure which neither creates any assets nor reduces any liability
of the government.

 It is recurring in nature
 It is incurred for normal functioning of the government
 The expenditure must not create an asset of the government.
 The expenditure must not cause decrease in any liability.

b. Capital expenditure

Capital expenditure refers to the expenditure which either creates an asset or causes a reduction in the
liabilities of the government.

 It is non-recurring in nature
 It adds to the capital stock of the economy
 The expenditure must create an asset of the government.
 The expenditure must cause a decrease in the liabilities.

Basis Revenue expenditure Capital expenditure

Meaning Revenue expenditure neither Capital expenditure either
creates any asset nor reduces creates an asset or reduces a
any liability of the government. liability of the government.
Purpose It is incurred for normal It is incurred mainly for
running of government acquisition of assets and
departments and provision of granting of loans and advances.
various services.
Nature It is recurring in nature. It is non-recurring in nature.
Example Salary, pension etc. Repayment of borrowings,
expenditure on acquisition of

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capital asset etc.

Important concepts

1. Plan expenditure

Plan expenditure refers to the expenditure that is incurred on the programs detailed in the current five
year plans.

2. Non-plan expenditure

Non-plan expenditure refers to the expenditure other than the expenditure related to the current five
year plans.

3. Developmental expenditure

Developmental expenditure refers to the expenditure which is directly related to the economic and
social development of the country.

4. Non-developmental expenditure

Non-developmental expenditure refers to the expenditure which is incurred on the essential general
services of the government.

Measures of government deficit

Budgetary deficit is defined as the excess of total estimated expenditure over total estimated revenue.
When the government spends more than it collects, then it incurs a budgetary deficit. Budget deficit can
be of three types:

1. Revenue deficit

Revenue deficit refers to excess of revenue expenditure over revenue receipts during the given fiscal
year. It signifies that government’s own revenue is insufficient to meet the expenditure on normal
functioning of the government departments.

Revenue deficit = revenue expenditure – revenue receipts

Implications

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 It indicates the inability of the government to meet its regular and recurring expenditure in the
proposed budget.
 It implies that government is dissaving.
 It also implies that the government has to make up this deficit from capital receipts.
 Use of capital receipts for meeting extra consumption expenditure leads to an inflationary
situation in the economy.
 A high revenue deficit gives a warning signal to the government to either curtail its expenditure
or increases its revenue.

Measures

 Government should take serious steps to reduce its expenditure and avoid unproductive or
unnecessary expenditure.
 Government should increase its receipts from various sources of tax and non-tax revenue.

2. Fiscal Deficit

Fiscal deficit refers to the excess of total expenditure over total receipts during a given fiscal year.

Fiscal deficit = total expenditure – total receipts excluding borrowings.

Implications

 Debt trap: fiscal deficit indicates the total borrowing requirements of the government.
Borrowing not only involves repayment of principal amount, but also requires payment of
interest. It increases the revenue expenditure which leads to revenue deficit. As a result,
country is caught in a debt trap.
 Inflation: Government mainly borrows from RBI to meet its fiscal deficit. RBI prints new
currency notes to meet the deficit requirements. It increases the money supply which leads to
inflation.
 Foreign dependence: Government also borrows from rest of the world, which raises its
dependence on other countries.
 Hampers the future growth: It increases the financial burden of future generations.

Measures

 Borrowings: fiscal deficit can be met by borrowings from the internal sources or the external
sources.
 Deficit financing: Government may borrow from RBI against its securities to meet the fiscal
deficit. RBI issues new currency for this purpose. This process is known as deficit financing.

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3. Primary deficit

Primary deficit refers to difference between fiscal deficit of the current year and interest payments on
the previous borrowings.

Primary deficit = fiscal deficit – Interest Payments

CHAPTER – 8

FOREIGN EXCHANGE RATE

Meaning

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Foreign exchange refers to the rate at which one currency is exchanged for the other. It represents the
price of one currency in terms of another currency. For example, if $1 can be exchanged for Rs. 50, then
value of Re. 1 will be $ 0.20.

The exchange rate can fluctuate from year-to-year or even day-to-day. Like many other prices, exchange
rate is determined by the forces of demand and supply.

Currency depreciation and appreciation

Currency depreciation

Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency.
It makes the domestic currency less valuable and more of it is required to buy the foreign currency.

With same amount of foreign currency, more goods can be purchased from India i.e. exports to foreign
country will increase as they will become cheaper.

Currency depreciation

Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency.
It makes the domestic currency more valuable and less of it is required to buy the foreign currency.

With same amount of home currency, more goods can be purchased from foreign country i.e. imports
from foreign country will increase as they will become cheaper.

Basis Devaluation Depreciation

Meaning Devaluation refers to reduction in price Deprecation refers to fall in market price of
of domestic currency in terms of all domestic currency in terms of a foreign
foreign currency under fixed exchange currency under flexible exchange rate
rate system. system.
Occurrence It takes place due to government It takes place due to market forces of
demand and supply.
Exchange rate It takes place under fixed exchange rate It takes place under flexible exchange rate
system system. system.

Types of foreign exchange rate

1. Fixed exchange rate system

Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by the
government. The basic purpose of adopting this system is to ensure stability in foreign trade and capital

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movements. For this government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.

Under this system, each country keep value of its currency fixed in terms of some external standard. This
external standard can be gold, silver, other precious metal, another country’s currency or even some
internationally agreed unit of account.

Merits

 Stability in exchange rate: It provides stability to the foreign exchange market. There is no
uncertainty, with respect to exchange rate, which promotes the foreign trade.
 Promotes international investment: It creates condition for smooth flow of foreign capital
between nations. Both, lender and borrower will not be prepared to lend or borrow in order to
make long term investments, if they are not sure about the investments.
 Promotes International Trade: it creates confidence among the people that the existing rate will
continue in future which results in free flow of foreign trade between the nations.
 Prevent speculative activities: As exchange rate is fixed by the government, it eliminates the
possibility of speculative transactions in foreign exchange.

Demerits

 Huge foreign exchange required: Government has to maintain large reserves of foreign
currencies to maintain the exchange rate fixed by it. It restricts the movement of capital in
different parts of the world and hampers the international growth.
 Difficulty in fixing the exchange rate: It is very difficult to determine the level at which the
exchange rate should be fixed. There may be undervaluation or overvaluation of currency.
 Exchange rates are not fixed: Pegged or fixed exchange rates are not permanently fixed. Often
fluctuations in the international commodity prices and problems in the BOP compel countries to
bring changes in the exchange rates.

2. Flexible exchange rate system

Flexible exchange rate system refers to a system in which exchange rate is determined by forces of
demand and supply of different currencies in the foreign exchange market. The value of currency is
allowed to fluctuate freely according to changes in the demand and supply of foreign exchange. There is

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no official intervention in the foreign exchange market. It is also known as floating exchange rate
system.

The exchange rate is determined by the market i.e. through interactions of thousands of banks, firms
and other institutions seeking to buy and sell currency for purposes of making transactions in foreign
exchange.

Merits

 Maintains equilibrium level: It is self-adjusting and automatically removes the disequilibrium in

the balance of payments (BOP). It eliminates the problem of overvaluation or undervaluation of
currencies.
 No need for huge foreign exchange reserves: There is no need for the government to hold large
foreign exchange reserves. It enhances the movement of capital across different parts of the
world and promotes international growth.
 Optimum utilization of resources: It provides the opportunity for optimum utilization of
resources and raises the level of efficiency in the economy.

Demerits

 Instability in the exchange rate: The external value of domestic currency keeps on changing as
per the demand and supply of foreign exchange. It creates uncertainty about the amount of
receipts and payments in foreign exchange transactions.
 Speculative activities: Speculators manipulate the market and make the exchange rates too low
or high. This makes the foreign exchange market unstable and discourages the foreign trade
and foreign investments.
 Creates inflationary situations: It generates inflationary trends in the economy, when there is
increase in the prices of imports due to depreciation of the currency.

3. Managed floating exchange rate system

It refers to a system in which foreign exchange rate is determined by market forces and central bank
influences the exchange rate through intervention in the foreign exchange market.

It is a hybrid of a fixed exchange rate and a flexible exchange rate system. In this system, central bank
intervenes in the foreign exchange market to restrict the fluctuations in the exchange rate within the
certain limits. For this, central bank maintains reserves of foreign exchange to ensure that the exchange
rate stays within the targeted value.

Basis Fixed exchange rate Flexible exchange rate

Determination of It is officially fixed in terms of gold or It is determined by the forces of
exchange rate any other currency by government demand and supply of foreign
exchange.

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Government There is complete government control There is no government intervention
control as only government has the power to and it fluctuates freely according to
change it. market conditions.
Stability in The exchange rate generally remains The exchange rate keeps on changing.
exchange rate stable and only a small variation is
possible.

Demand for foreign exchange rate

The demand for foreign exchange rate comes from those people who need it to make payment in
foreign currency.

 Import of goods and services: foreign exchange is demanded to make the payment for imports
of goods and services.
 Tourism: Foreign exchange is needed to meet expenditure incurred in a foreign tour.
 Unilateral transfers sent abroad: Foreign exchange is required for making unilateral transfers
like sending gifts to other countries.
 Purchase of assets in foreign countries: It is demanded to make payment for purchase of assets
like land, shares, bonds etc. in the foreign countries.
 Speculation: Demand for foreign exchange arises when people want to make gains from
appreciation of currency.

Demand curve for foreign exchange slopes downwards due to inverse relationship between demand for
foreign exchange and foreign exchange rate.

Fig 11.1

Supply for foreign exchange rate

The supply of foreign exchange comes from those people who receive it due to the following reasons

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 Export of goods and services: Supply of foreign exchange comes through exports of goods and
services.
 Foreign investments: The amount which foreigners invest in the home country, increases the
supply of foreign exchange.
 Remittances from abroad: Supply of foreign exchange increases in the form of gifts and other
remittances from abroad.
 Speculations: Supply of foreign exchange comes from those who want to speculate on the value
of foreign exchange.

Supply curve of foreign exchange slope upwards due to positive relationship between supply for foreign
exchange and foreign exchange rate.

Fig 11.2

Determination of foreign exchange rate

Flexible exchange rate is determined by the interaction of the forces of demand and supply. The
equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to
supply of foreign exchange.

Fig 11.3

As seen in the diagram, demand and supply of foreign exchange are measured on the X-axis and rate of
foreign exchange rate on the Y-axis. DD is the downward sloping demand curve and SS is the upward

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sloping supply curve of foreign exchange. Both the curves intersect each other at point E. the
equilibrium exchange rate is determined at OR and equilibrium quantity is OQ.

Flexible exchange rate is also known as free rate of exchange as it is freely determined by market forces
of demand and supply of foreign exchange.

If the exchange rate rises to OR2, then demand for foreign exchange will fall to OQ 2 and supply will rise to
OQ1. It will be a situation of excess supply. As a result, exchange rate will fall till it again reaches the
equilibrium level of OR.

If the exchange rate falls to OR1, then demand for foreign exchange will rise to OQ 1 and supply will fall to
OQ2. It will be a situation of excess demand. As a result, exchange rate will rise till it again reaches the
equilibrium level of OR.

Foreign exchange Market

Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and
sellers include individuals, firms, foreign exchange brokers, commercial banks and the central bank.

Functions

 It transfers purchasing power between the countries involved in the transaction. This function is
performed through credit instruments like foreign exchange, bank drafts and telephonic
transfers.
 It provides credit for foreign trade. Bills of exchange, with maturity period of three months are
generally used for international payments.
 When exporters and importers enter in to an agreement to sell and buy goods on some future
date at the current prices and exchange rate, it is called hedging. The purpose is to avoid losses
that might be caused due to exchange rate variations in the future.

Types

a. Spot market

Spot market refers to the market in which the receipts and payments are made immediately. Generally a
time of two days is allowed to settle the transactions. The rate of exchange that prevails in this type of
market is called spot rate.

b. Forward market

Forward market refers to the market in which sale and purchase of foreign currency is settled on a
specified future date at a rate agreed upon today. The exchange rate prevailing in this type of market is
called forward exchange rate.

CHAPTER – 12

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BALANCE OF PAYMENTS
Meaning

Balance of payment is an accounting statement that provides a systematic record of all the economic
transactions, between residents of a country and the rest of the world, in a given period of time.

 BOP accounting uses the double entry system for recording the transactions with the rest of the
world.
 All inflows or sources of foreign exchange rate are recorded on the credit side.
 All outflows or uses of foreign exchange are recorded on the debit side.
 In the accounting sense, BOP is always balanced like trial balance as it is prepared on double
entry system.
 However, in economic sense, BOP may not be equal. It can either be surplus or deficit.

Balance of trade

Balance of trade refers to the difference between the amount of exports and imports of visible items or
goods.

Balance of trade = Export of goods – import of goods

Exports are entered as positive items in the BOP while imports are entered as negative items in the BOP.
It is just a part of BOP account and plays a crucial role in the overall situation of BOP of a country. It is
also known as balance of visible trade or trade balance.

Basis Balance of trade Balance of payments

Meaning Balance of trade refers to difference It is an accounting treatment that
between amount of exports and import provides a systematic record of all
of visible items. economic transactions, between
residents of a country and rest of the
world in a given period of time.
Components BOT includes only visible items. BOP includes visible items, invisible
items, unilateral transfers and capital
transaction.
Capital It does not record any transaction of It records all transactions of capital
transactions capital nature. nature.
Scope It is a narrower concept It is a wider concept.
Settlement Unfavorable BOT can be met out of Unfavorable BOP cannot be met out of
favorable BOP favorable BOT.

Components of Balance of payments

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All transactions in the balance of payments can be grouped under two broad categories:

A. Current account

Current account refers to an account which records all the transactions relating to export and import of
goods and services and unilateral transfers during a given period of time. The main components of
current account are as follows:

i. Export and import of goods

A major part of transactions in foreign trade is in the form of export and import of goods i.e. visible
items. It is also known as balance of trade. Payment for import of goods is written on the negative side
and receipt from exports is shown on the positive side.

ii. Export and import of services

It includes a large variety of non-factor services sold and purchased by the residents of a country, to and
from the rest of the world. Services are generally of three kinds: (a) shipping, (b) banking and (c)
insurance. Payments for these services are recorded on the negative side and receipt on the positive
side.

iii. Unilateral transfers

Unilateral transfers include gifts, donations, personal remittances and other one way transactions. These
refer to those receipts and payments, which take place without any service in return. Receipt of these
transfer are recorder on the credit side and payments on the debit side.

iv. Income receipts and payments to and from abroad

It includes investment income in the form of interest, rent and profits.

B. Capital account

Capital account of BOP records all those transactions, between the residents of a country and the rest of
the world, which cause a change in the assets or liabilities of the residents of the country or its
government. It is related to claims and liabilities of financial nature.

The main components of capital nature are as follows:

i. Borrowings and lending’s to and from abroad

All transactions relating to borrowings from abroad by private sector, government etc. receipts of such
loans and repayment of loans by foreigners are recorded on the positive side. All transactions of lending
to abroad by private sector and government lending abroad is recorded as negative or debit item.

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ii. Investment to and from abroad

Investment by rest of the world in shares of Indian companies, real estate in India etc. Such investments
from abroad are recorded on the positive side and investment by Indian residents in shares of foreign
companies, real estate abroad etc. Such investments to abroad are recorded on the negative side of
BOP.

iii. Change in foreign exchange reserves

The foreign exchange reserves are the financial assets of the government held in the central bank.
Change in reserves serves as the financial item in India’s BOP. So, any withdrawal from the reserves is
recorded on the negative side of BOP.

Basis Current account Capital account

Influence on Current account transactions bring a Capital transactions bring about a change
the economy change in the current level of a in the capital stock of the country.
country’s income.
Concept It is a flow concept as it includes all It is a stock concept as it includes all items
items of flow nature. expressing changes in stock.
Components Current account includes visible trade, Capital account includes borrowings,
invisible trade, unilateral transfers and lending, investments to and from abroad
income receipts and payments. and changes in foreign exchange reserves.

Autonomous items and accommodating items

Autonomous items

Autonomous items refer to those international economic transactions, which take place due to some
economic motive such as profit maximization. These items are also known as above the line items.
Autonomous transactions are independent of the state of BOP account.

Accommodating Items

Accommodating items refer to the transactions that are undertaken to cover deficit or surplus in
autonomous transactions i.e. such transactions are determined by net consequences of autonomous
transactions. These items are also known as below the line items in BOP.

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Basis Autonomous items Accommodating items
Meaning Autonomous items refer to those Accommodating items refer to the
international economic transactions, transactions that are undertaken to cover
which take place due to some deficit or surplus in autonomous transactions.
economic motive such as profit
maximization.
Effect on BOP Autonomous transactions are Accommodating transactions are undertaken
account independent of the state of BOP to maintain the balance in BOP account.
account.
Current/capital Autonomous transactions take place Accommodating transactions take place only
account on both current and capital accounts. on capital account.
Alternate name These items are also known as above These items are also known s below the line
the line items. items.

Causes of deficit in BOP

1. Economic factors

i. Development activities

Developing countries depend on developed nations for supply of machines, technology and other
equipment. This leads to increased level of imports, thereby, resulting in a deficit in the BOP account.

ii. High rate of inflation

When there is inflation in the domestic economy, foreign goods become relatively cheaper as compared
to domestic goods. It increases imports which causes a deficit in BOP, due to increase in imports.

iii. Cyclical fluctuations

When the domestic economy is going through a phase of boom, then domestic production may be
unable to satisfy the domestic demand. It leads to deficit in BOP, due to increase in imports.

iv. Change in Demand

Fall in demand for country’s goods in foreign markets leads to fall in exports and it adversely affects the
balance of payments.

2. Political factors

i. Political instability

Political instability may lead to large capital outflows and reduce the inflows of foreign funds, thus
creating disequilibrium in the BOP.

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ii. Political disturbances

Frequent changes in the government, inadequate support to the government in parliament also
discourages inflows of capital. This leads to a deficit due to higher outflows than inflows.

3. Social factors

i. Demonstration effect

When the people of underdeveloped countries come in contact with those of advanced countries, they
start adopting the foreign pattern of consumption. Due to this reason, their imports increase and it leads
to an adverse balance of payments for underdeveloped country.

ii. Changes in tastes, preferences, fashion and trends

An unfavorable change for the domestic goods leads to a deficit in the BOP.

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