Economics ALL

eef
IIT (ISM) Dhanbad
Economics
Course: B.Tech 1st Year (Common)

Subject: Engineering Economics & Finance (MSI101)
Instructor: Mohd. Irfan
Brought to you by: Drive Uploaders Note:-

Authors: Sumit Sinha Content page has Embedded Links
Sohith Bandari
1
Recommended Reading Material
• Principles of Macroeconomics - N. Gregory Mankiw
• Microeconomics (8th Edition) - Robert S. Pindyck and Daniel
L. Rubinfeld, Pearson
• Economics for Dummies- Peter Antonioni and Sean Masaki
Flynn, Wiley
Course Objective
To introduce basic concepts of economics with emphasis on
using tools to perform economic evaluation
2
contents
i. Acknowledgment …………………………………………………… 1
ii. Content ………………………………………………………..……….. 3
4. Introduction to Economics …………………………………….. 4
iv. Introduction to Economics Notes …………………………… 48
5. Economic Growth and Development ……………………… 61
v. Economic Growth and Development Notes ……………. 104
6. Inflation and Recession ………………………………………….. 128
vi. Inflation and Recession Notes ………………………………… 143
7. Taxation …………………………………………………………………. 153
vii. Taxation Notes ……………………………………………………….. 172
8. Consumer Behaviour Analysis ………………………………… 186
viii. Consumer Behaviour Analysis Notes ………………………. 204
9. Supply and Demand Analysis ………………………………….. 222
ix. Supply and Demand Analysis Notes ………………………… 264
10. Decision Making under Risk and Uncertainty ………….. 297
x. Decision Making under Risk and Uncertainty Notes … 327
11. The End …………………………………………………………………… 352
3
Engineering Economics and Finance
(Units 4 - 10)
Unit 4
Introduction to Economics
4
INTRODUCTION TO ECONOMICS
5
• You have Rs. 1000 with you. You want to
purchase shoes and a shirt. Shoes cost Rs. 700
and shirt costs Rs. 800.
• Assume: cannot borrow money or purchase on
credit, no cheaper alternatives available
Can you purchase both the items?
How would you choose which item to purchase?
6
What is Economics?
• Scarce resources in households and economies
• Economics is the science of scarcity
• Scarcity forces households and economies to

make choices
• Economics is the study of choices
7
Economics is a science which studies human
behavior as a relationship between ends and
scarce means which have alternative uses
- Lionel Robbins (1932)
8
• You have Rs. 1000 with you. You want to
purchase shoes and a shirt. Shoes cost Rs. 700
and shirt costs Rs. 800.
• Assume: cannot borrow money or purchase on
credit, no cheaper alternatives available
What are ends?
What are scarce means?
What are alternative uses?
Where does human behavior figure in?
9
• In 2020, you can either pursue full-time work
and earn Rs. X or you can continue with your
full-time B.Tech degree and complete your
college education.
What are ends? Scarce means? Alternative uses?
Which of the two would you choose?
If cost of B.Tech is increased from Y to Z, would
that affect your pervious answer?
10
• There is 200X litres of oil reserves available on earth.
Current demand of oil is 100X litres.
Are the reserves sufficient to meet current demand? Is there

scarcity?
• Oil reserves increase at rate of X% and oil demand

increases at rate of Y% every 10 years (Y > X)
Is oil a scarce resource now? Alternative use?

Are reserves still sufficient to meet demand?
Does the new information affect decision about current use
of oil reserves?
11
Prominent Areas of Study in Economics
• How people decide on:

– How much to work
– What to buy
– How much to save
– How to invest savings
• More nuanced study:

– impact of information on multiple periods on
decisions
12
MICROECONOMICS VS MACROECONOMICS
13
• Microeconomics: studies how one agent or a small
group of agents decide to allocate resources
• Macroeconomics: studies economy as a whole; looks

at aggregate outcomes of all decisions that
consumers, firms and government make in an
economy
14
Example:
• Topics studied under microeconomics:
o What to produce
o How much to produce
o What price to set
o How much to purchase
• Topics studied under macroeconomics:

o Rate of inflation
o Quantity of output
o Quantum of wages
o Rate of unemployment
15
• Example:
An improvement in technology enables each worker to
produce 20 pieces of product X instead of 15 products
Micro-economic analysis:
• What will be cost of technology to the firm?
• Would the change lead to productivity gains?
Macro-economic analysis:
• What would the innovation cost if large number of
firms adopt it?
• What impact would it have on demand of labour? And
wages paid to labour? On skilled vs unskilled labour?
16
• Example:
Study on consumers and their purchase decisions
• Microeconomics:
o Assumption about how much consumer wants to
spend or save
• Macroeconomics:
o Impact of unemployment rate
o Impact of changes in tax regime
17
• Micro-economics:
o Takes a bottom-up approach
o Used by individual agents in taking decisions
• Macro-economics
o Takes a top-down approach
o Used a analytical tool to craft economic and fiscal
policy
18
ECONOMIC SYSTEMS
19
- - - - - - - - Economic System
Production (Su1pp1ly)
IJJ/Jor
Manufacturinig
I.and Capital
Distribution
Consum1ption (Demand),
20
Key Questions for an Economy
a) What goods and services to produce
b) How should the goods and services be produced
c) For whom to produce goods and services
21
Definition: Economic System
• System of production and distribution of goods
and services in a society
22
Types of Economic Systems
• Market Economy
– Also: Free Enterprise Economy/Capitalist Economy
• Centrally Planned Economy

– Also: Controlled Economy/ communist economy- North
Korea
• Mixed Economy – mixture of market+ controlled
23
Classification by Involvement of Government
Free market
economy
• Mixed
Economy
Planned
Economy
■ Level of involvement of government in economic activities
24
Free Market Economy
• Production and consumption determined by individuals and
private firms
• Key characteristics:
a) Production of products that yield the highest profits (the what)
b) Production through least costly techniques of production (the how)
c) Consumption depending upon people’s desires and incomes (the
for whom)
• Role of government:
– Minimal
– Protects property rights to ensure free competition
25
‘Invisible Hand’
• Idea by Adam Smith, An Inquiry into Nature and Cause
of Wealth of Nations, 1776.
• Metaphor for unseen forces that move market economy
• Idea: Self-interested individuals operate through a system
of mutual interdependence, leading to widespread
benefits
• Primary justification for economic system of free market
capitalism
26
Market Failure and Role of Government
• Market failure: inefficient distribution of goods and
services
– individual incentives for rational behavior do not lead to rational
outcomes for the group
• Example of market failure: Public good
• Public goods
– Def: non-excludable and non-rivalrous goods
– Ex: national security, street lighting
– Problem: ‘free-rider problem’
• People enjoy benefits but shirk public responsibility to pay
– Result: may be under-produced, overused or degraded
27
Planned Economy
• Production and distribution of goods and services determined by
government
• Key characteristics:
a) Means of production (land and capital) owned by government
b) Most people employed by government
c) Production based on consumers’ need assessment made by
government planner (the what)
d) Production processes based on input-output analysis by govt.
planners (the how)
e) Distribution through state outlets at fixed prices (the for whom)
28
Comparing Market and Planned Economy
Market Economy Planned Economy
Ownership of means With private firms and With government
of production individuals
29
Decisions about - By businesses - By government planners
production - Based on demand analysis - Based on planners’ assumption
- Based on cost-benefit about consumer needs
analysis - Based on input-output analysis
30
Flexibility to set With businesses With state outlets
prices
31
prices
Role of government - To protect businesses and - To take economic decisions
consumers - To co-ordinate production and
- To issue money distribution of goods
32
prices
Role of government - To protect businesses and - To take economic decisions
consumers - To co-ordinate production and
- To issue money distribution of goods
Prominent examples USA. Japan Cuba, Former Soviet Union,

China
33
Comparing Market and Planned Economy (Contd..)

Advantages - Market responds quickly - More equal distribution of
to consumer needs wealth
- Freedom to take economic - Production of goods according
decisions to needs of people
- Greater efficiency due to - Possible to make long-term
competition among plans for economy
producers
34
Comparing Market and Planned Economy (Contd..)

Advantages - Market responds quickly - More equal distribution of
to consumer needs wealth
- Freedom to take economic - Production of goods according
decisions to needs of people
- Greater efficiency due to - Possible to make long-term
competition among plans for economy
producers
Disadvantages - Creates inequal incomes - Vast bureaucracies
- May lead to inefficient use - Poor motivation to work
of resources - Over-dependence on skills of
- May lead to social ills planners
- Poor standard of living of
people
35
Mixed Economy
• Most economic decisions made by markets
• Government plays important role in:

o Overseeing the functioning of the market
o Pass laws that regulate economic life
o Produce educational services, police services etc.
o Control pollution.
o Decide on allocation of goods and services to poor
• Degree of government’s involvement decided by

government
o Implications for taxes
36
MARGINAL ANALYSIS
37
• Used as a tool for optimal economic decisions
• Main Components:
o Marginal Benefit
o Marginal Cost
• Marginal analysis: Comparing marginal

benefits of a decision with its marginal costs
38
Individual Level Decisions
Whether to study six hours or seven hours for EEF?

Marginal Benefit of 7th hour: additional 10 marks in exams
Marginal Cost of 7th hour: One less hour for other courses
Whether to ride the big roller coaster again?

Marginal Benefit of second ride: more thrill!
Marginal Cost of second ride: Stand in 4 hour queue again
Whether to bake 21 instead of 20 loaves of bread?

Marginal Benefit of 21st loaf: 15 more rupees
Marginal Cost of 21st loaf: Raw material and labour
39
Golden rule:
Produce/Consume additional units till:
benefit from additional unit = cost of additional
unit
Optimal level:
Marginal Benefitx = Marginal Costx
40
• Example:
Revenues and Cost
Number of Units Revenues from Sale Cost of Production
1 15 10
2 35 20
3 50 30
4 60 40
5 65 50
6 60 60
7 55 70
8 50 80
41
• Example:
Revenues and Cost
Number of Units Revenues from Sale Cost of Production Net Benefits
1 15 10 5
2 35 20 15
3 50 30 20
4 60 40 20
5 65 50 15
6 60 60 0
7 55 70 -15
8 50 80 -50
42
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal
of Units from Sale Production Benefits Benefits
1 15 10 5 15
2 35 20 15 20
3 50 30 20 15
4 60 40 20 10
5 65 50 15 5
6 60 60 0 -5
7 55 70 -15 -5
8 50 80 -50 -5
43
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal Marginal
of Units from Sale Production Benefits Benefits Cost
1 15 10 5 15 10
2 35 20 15 20 10
3 50 30 20 15 10
4 60 40 20 10 10
5 65 50 15 5 10
6 60 60 0 -5 10
7 55 70 -15 -5 10
8 50 80 -50 -5 10
44
• Example:
Revenues and Cost
Number Revenues Cost of Net Marginal Marginal Marginal
of Units from Sale Production Benefits Benefits Cost Analysis
1 15 10 5 15 10 5
2 35 20 15 20 10 10
3 50 30 20 15 10 5
4 60 40 20 10 10 0
5 65 50 15 5 10 -5
6 60 60 0 -5 10 -15
7 55 70 -15 -5 10 -15
8 50 80 -50 -5 10 -15
45
Qs:
Twentyfirst Century Electronics has discovered a theft problem at
its warehouse and has decided to hire security guards. The firm
wants to hire the optimal number of security guards. The
following table shows how the number of security guards affects
the number of radios stolen per week
Number of Security Guards Number of radios stolen per week
0 50
1 30
2 20
3 14
4 8
5 6
If each security guard is paid $200 a week and the cost of a

stolen radio is $25, how many security guards should the firm
hire? And what is the most the firm would be willing to pay to
hire the second security guard? 46
Solution:
No. of SG Radios stolen Radios saved Marginal benefit Marginal Cost
0 50 0 0 0
1 30 20 20 x 25 = 500 200
2 20 10 10 x 25 = 250 200
3 14 6 6 x 25 = 150 200
4 8 6 6 x 25 = 150 200
5 6 2 2 x 25 = 50 200
MB – MC most optimal at 2 guards

Maximum wages paid to second guard: 250 (MB = MC at this point)
47
CHAPTER
Ten Principles of Economics

T he word economy comes from the Greek word oikonomos, which means
"one who manages a household." At first, this origin might seem peculiar.
But in fact, households and economies have much in common.
A household faces many decisions. It must decide which members of the house-
hold do which tasks and what each member gets in return: Who cooks dinner?
Who does the laundry? Who gets the extra dessert at dinner? Who gets to choose
what TV show to watch? In short, the household must allocate its scarce resources
among its various members, taking into account each member's abilities, efforts,
and desires.
Like a household, a society faces many decisions. A society must find some
way to decide what jobs will be done and who will do them. It needs some peo-
ple to grow food, other people to make clothing, and still others to design com-
puter software. Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must also allocate the output of goods and services
they produce. It must decide who will eat caviar and who will eat potatoes. It
must decide who will drive a Ferrari and who will take the bus.
The management of society's resources is important because resources are
scarce. Scarcity means that society has limited resources and therefore cannot scarcity
produce all the goods and services people wish to have. Just as each member of the limited nature of
a household cannot get everything he or she wants, each individual in a society society's resources
cannot attain the highest standard of living to which he or she might aspire.
48
3
4 PARTI INTRODUCTION
economics Economics is the study of how society manages its scarce resources. In most
the study of how society societies, resources are allocated not by an all-powerful dictator but through the
manages its scarce combined actions of millions of households and firms. Economists therefore study
resources how people make decisions: how much they work, what they buy, how much
they save, and how they invest their savings. Economists also study how people
interact with one another. For instance, they examine how the multitude of buyers
and sellers of a good together determine the price at which the good is sold and
the quantity that is sold. Finally, economists analyze forces and trends that affect
the economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central
ideas. In this chapter, we look at Ten Principles of Economics. Don't worry if you
don't understand them all at first or if you aren't completely convinced. We will
explore these ideas more fully in later chapters. The ten principles are introduced
here to give you an overview of what economics is all about. Consider this chapter
a "preview of coming attractions."
HOW PEOPLE MAKE DECISIONS

There is no mystery to what an economy is. Whether we are talking about the
economy of Los Angeles, the United States, or the whole world, an economy is just
a group of people dealing with one another as they go about their lives. Because
the behavior of an economy reflects the behavior of the individuals who make up
the economy, we begin our study of economics with four principles of individual
decision making.
PRINCIPLE 1: PEOPLE FACE Th.ADE-OFFS

You may have heard the old saying, "There ain't no such thing as a free lunch."
Grammar aside, there is much truth to this adage. To get one thing that we like,
we usually have to give up another thing that we like. Making decisions requires
trading off one goal against another.
Consider a student who must decide how to allocate her most valuable
resource-her time. She can spend all her time studying economics, spend all of
it studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour that she could have
spent napping, bike riding, watching TV, or working at her part-time job for some
extra spending money.
Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children's college education. When they choose to spend an
extra dollar on one of these goods, they have one less dollar to spend on some
other good.
When people are grouped into societies, they face different kinds of trade-offs.
The classic trade-off is between "guns and butter." The more a society spends
on national defense (guns) to protect its shores from foreign aggressors, the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Also important in modem society is the trade-off between a clean environment
and a high level of income. Laws that require firms to reduce pollution raise the
49
Microeconomics Vs. Macroeconomics
Economics is the study of the allocation of scarce resources.
The basic idea is simple: each of us has an almost inexhaustible list of desires, but
most of us have a finite amount of money (or, more generally, resources) with which to
satisfy these desires. The British economist Adam Smith, whose "Wealth of Nations"
was arguably the first treatise on economics (published in 1776), famously phrased this
discussion in terms of whether a country should produce guns or butter. Today the
choice is between more esoteric items-we would all like to buy a new top of the line
laptop and regularly eat steak or lobster for lunch, but household finances dictate one
or the other (and you had better get used to the crummy sandwich from the snack bar if
you go for the laptop). Economics studies the best way to allocate the resources that are
available across these competing needs. Not all these needs can be satisfied, but eco-
nomics should be able to help you (and society) meet as many of them as possible.
A key way in which economies allocate resources is through prices. Prices tell pro-
ducers what the demand for a particular product is-if prices are high, then producers
know the good is in demand, and they can increase production. If prices are low, pro-
ducers know that demand for the product is weak, and they should cut back production.
Thus the market ensures that society produces more of the goods that people want and
less of those that they do not. By studying prices consumers decide which goods to pur-
chase and which to avoid; by examining prices and chasing profits, producers determine
which goods to provide. This is why economics focuses so much on the determination of
50
1.3 The Difference between Macro and Microeconomics 5
Economics
Microeconomic issues Macroeconomic issues
How much will a consumer How much income will a

spend on food? country save?
How much leisure time will What is the appropriate exchange

consumers enjoy? rate between currencies?
How much output will a firm produce? What will happen if taxes are raised?
How much research and development What will the unemployment rate be?
will a company undertake?
FI GURE 1 . 3 Macroeconomic Issues and Microeconomic Issues. Macroeconomics focuses on aggregate

outcome; microeconomics looks at individual markets, firms or households.
market prices and whether how they are set helps allocate resources effectively. Prices
are not just dropped from heaven; they are determined jointly with other economic de-
cisions at the firm level.
But what is macroeconomics? Broadly speaking, economics has two components:
microeconomics and macroeconomics. Essentially microeconomics examines how indi-
vidual units, whether they be consumers or firms, decide how to allocate resources and
whether those decisions are desirable. Macroeconomics studies the economy as a
whole; it looks at the aggregate outcomes of all the decisions that consumers, firms, and
the government make in an economy. Microeconomics is about how consumers and
firms allocate resources. By contrast macroeconomics is about the aggregate vari-
ables-for example, the overall levels of output, consumption, employment, and
prices-and how they move over time and between countries.
In terms of prices, microeconomics focuses on, for instance, the price of a particu-
lar firm's product, whereas macroeconomics focuses on the exchange rate (the price of
one country's money in terms of that of another country) or the interest rate (the price
of spending today rather than tomorrow).
1.3 The Difference between Macro and Microeconomics

These distinctions show that a gray area exists between micro and macroeconomics
that relates to aggregation-at what point do the actions of a number of firms cease to
be a microeconomic issue and become a macroeconomic issue? To answer that ques-
tion, let's think of another way of outlining the differences between microeconomics
and macroeconomics. In microeconomics the focus is on a small group of agents, say a
group of consumers or two firms battling over a particular market. In this case econo-
mists pay a great deal of attention to the behavior of the agents the model is focusing
on. They make assumptions about what consumers want or how much they have to
51
6 CH APTER 1 What Is Macroeconomics?
spend, or about whether the two firms are competing over prices or market share, and
whether one firm is playing an aggressive strategy, and so on. The result is a detailed
analysis of what particular firms or consumers should do in a given situation.
However, this microeconomic analysis does not explain what is happening in the
wider economic environment. Think about consumers' choice of what goods to con-
sume. In addition to consumers' own income and the price of the goods they wish to
purchase, their decisions depend on an enormous amount of other information. How
high is unemployment? Is the government going to increase taxes? Is the exchange rate
about to collapse, requiring a sharp increase in interest rates? Or consider our two firms
competing over a market. If one firm is highly levered (i.e., has a lot of debt), it may not
be able to adopt an aggressive price stance if it fears that interest rates are about to rise
sharply because then the losses from a price war might bankrupt it. Similarly, if im-
ported materials are important for the firm's production process, then a depreciating
currency will lead to higher import costs, reducing profit margins even before the firm
engages in a price war. While none of these background influences-shifts in interest
rates or movements in the exchange rate-are under the control of the firm or con-
sumer, they still influence decisions.
KEY POINT
Macroeconomics analyzes the backdrop of economic conditions against which companies and households
make decisions.
Microeconomics tends to focus on variables that an individual or firm can influ-

ence-for example, how much labor to offer, what prices to set, and how much to pro-
duce; macroeconomics focuses on employment, prices, and output in the whole
economy. However, the whole economy represents the outcome of millions of individ-
ual decisions that millions of firms and consumers make. Therefore, while each particu-
lar firm does not significantly affect inflation or the growth of output in the whole
economy, the economic performance of an economy does reflect the overall decisions
firms make. For instance, the chairman of the U.S. Federal Reserve will be concerned
about rising inflation and consider the need to raise interest rates. No doubt many
highly leveraged firms would rather the Federal Reserve did not raise rates. But the in-
flation rate determines whether interest rates increase, and the inflation rate reflects the
number of firms that are increasing prices and the amount by which each firm is raising
prices. In other words, all the individual pricing decisions that millions of firms make
determines the macroeconomic environment. While microeconomics is mainly con-
cerned with studying in detail the decisions of a few agents, taking as given the basic
economic backdrop, macroeconomics is about studying how the decisions of all the
agents who make up the economy create this backdrop.
Consider, for instance, the issue of whether a firm should adopt the latest develop-
ments in information technology (IT), which promise to increase labor productivity by,
say, 20%. A microeconomic analysis of this topic would focus mainly on the costs the
firm faces in adopting this technology and the likely productivity and profit gains that it
would create. Macroeconomics would consider this IT innovation in the context of the
whole economy. In particular, it would examine how if many firms were adopting this
52
1.4 Why Should People Interested in Business Study Macroeconomics? 7
technology, then costs in the whole economy would fall, and the demand for skilled
labor would rise. Combined with the resulting increase in labor productivity, this would
lead to an increase in wages and the firm's wage bill. It might also shift demand away
from unskilled towards skilled workers, causing the composition of unemployment and
relative wages to change. This example reveals the differences between the two ap-
proaches. The microeconomic analysis is one where the firm alone is contemplating
adopting a new technology, and the emphasis is on the firm's pricing and employment
decisions, probably holding wages fixed. In other words, the analysis assumes that the
firm's decisions do not influence the background economic environment. In contrast,
the macroeconomic analysis examines the consequences when many firms implement
the new technology and investigates how this affects economy-wide output, wages, and
unemployment. Both forms of analysis have a role to play, and which is more appropri-
ate depends on the issue to be analyzed and the question that needs answering.
53
Economic Systems
The way a country's resources are owned and the way that country takes decisions as to what to
produce, how much to produce and how to distribute what has been produced determine the type
of economic system that particular country practises.
1. MARKET ECONOMY (also called FREE ENTERPRISE ECONOMIES or CAPITALIST ECONOMY)
2. CENTRALLY - PLANNED or CONTROLLED ECONOMY
3. MIXED ECONOMY
1. MARKET ECONOMY in comparison to 2. PLANNED ECONOMY

e.g. USA, Japan e.g. Cuba, China, former Soviet Union
Private firms or individuals own means of State (government) owns all means of
production. They make choices about: production. Individuals are not permitted to
o What to produce own any property. Government+ government
o How to produce planners makes choices about What, How and
o For whom to produce For whom to produce.
What to produce is answered by consumers What to produce is answered by
according their demand for goods & services government planners, they make assumptions
How to produce is answered by the business- about consumers' needs and the mix of
men. They will choose the production method, goods and services
which reduces their costs to reach the higher How to produce is answered by the gov.
profit. planners according the input-output analysis.
For whom to produce - firms produce goods For whom to produce - for consumers
& services which consumers are willing and through state outlets. Prices can't change
able to buy. without state instructions. (Restrictions)
Role of government Role of government

1. To pass laws to protect businessmen & 1. Government make the most economic
consumers decisions with those on top of the hierarchy
2. To issue money giving economic commands to those further
3. To provide certain services - police down the ladder.
4. To prevent firms from dominating 2. Government plans, organizes and coordinates
The market and to restrict the power the whole production process in most
Of trade unions industries.
5. Repair and maintain state properties 3. Government is the employer of most workers
and tells them how to do their jobs.
Advantages:
Goods and services go where they are most in Advantages:
demand and free market responds quickly to There is more equal distribution of wealth
people's wants+ wide variety of G&S and income
No need for and overriding authority to Production is for need rather than profit.
determine allocation of goods&services Long-term plans can be made taking into
Producers and consumers are free to make account a range of future needs such as
changes to suit their aims population changes and the environment.
Competition and the opportunity to make large
profits, greater efficiency, innovation Disadvantages:
Vast bureaucracies employing - supervisors,
Disadvantages: coordinators ...
It mis-allocates resources(to those with more$) People are poorly motivated
It creates inequality of incomes Planners often get things wrong - shortages
It is not competent in providing certain of surpluses of some goods
services Poor standard of living
It leads to inefficiency (market imperfection)
It can encourage the consumption of harmful
goods - drugs
54
There are no pure free market economies or pure command economies. Because of:
Command economies are impossible to regulate all markets
Free market economies can't provide public goods (defence) and can't provide merit goods in
sufficient quantity.
3. MIXED ECONOMY
All Western European countries
The balance between state provision (government planning) and free market provision is more or less
equal. The government decides the "degree" of mixing. They will decide how much business activity
there will be in the private sector and the public sector.
• In the countries, where the government plays important - major economic role the social
provision will tend to be greater, taxed higher and distribution of wealth and income more
equal. (Sweden)
• Whereas in countries where the private sector plays the most important economic role, social
provision is lower with fewer free goods and services, also taxes will be lower and the
distribution of wealth and income less equal.(GB)
Some resources are allocated by the government and the rest by the market system.
Most decisions are taken in the market place but the government plays an important role in modifying
the functioning market.
Role of government
Sets laws and rules that regulate economic life - intervention to control or regulate markets
- Provide certain services e.g. education, police, defense healthcare
- Regulate business - to ensure that there is fair competition in the private sector
- Restricts the consuming harmful goods by making them illegal or placing high taxes on them
- Planning gives the government the power to give G&S, or money to the poorer people
PUBLIC SECTOR - is responsible for the supply of public goods & services and merit goods. These
goods are provided free when used and are paid by taxes e.g. roads, healthcare, street lighting
The central or local government makes decisions regarding resource allocation in the public sector.
In public sector, the state owns a significant proportion of production factors.
PRIVATE SECTOR - firms in response to the demand or consumers needs and wants make
production decisions
In the private sector individuals are allowed to own the factor of production.
Businesses are set up in this system by individuals to supply a wide variety of goods and services.
Competition exists between these firms.
THE ROLE OF GOVERNMENT IN A MARKET (MIXED) ECONOMY
There are various opinions of various economic thoughts about the role of government interventions.
Governments are generally argued to have four main macroeconomic goals:
to maintain full employment
to ensure price stability
to achieve high level of economic growth
to keep exports and imports in ballance
55
The Fundamentals of Managerial Economics 19
INSIDE BUSINESS 1-3
Joining the Jet Set
Recently, a major airline offered a one-year member- that money is paid today. If you pay annually, you pay
ship in its Air Club for $125. Alternatively, one could $125 today, $125 one year from today, and $125 two
purchase a three-year membership for $300. Many years from today. Given an interest rate of 5 percent,
managers and executives join air clubs because they the present value of these payments is
offer a quiet place to work or relax while on the road;
thus, productivity is enhanced. $125 $125
Let's assume you wish to join the club for three PV = $125 + 1.05 + (1.05)2
years. Should you pay the up-front $300 fee for a
three-year membership or pay $125 per year for three or
years for total payments of $375? For simplicity, let's PV= 125 + 119.05 + 113.38
suppose the airline will not change the annual fee of
$125 over the next three years.
= $357.43
On the surface it appears that you save $75 by Thus, in present value terms, you save $57.43 if you
paying for three years in advance. But this approach pay for three years in advance. If you wish to join for
ignores the time value of money. Is paying for all three years and expect annual fees to either remain
three years in advance profitable when you take the constant or rise over the next three years, it is better to
time value of money into account? pay in advance. Given the current interest rate, the air-
The present value of the cost of membership if line is offering a good deal, but the present value of
you pay for three years in advance is $300, since all of the savings is $57.43, not $75.00.
While the notion of the present value of a firm is very general, the simplified
formula presented above is based on the assumption that the growth rate of the
firm's profits is constant. In reality, however, the investment and marketing strate-
gies of the firm will affect its growth rate. Moreover, the strategies used by com-
petitors generally will affect the growth rate of the firm. In such instances, there is
no substitute for using the general present value formula and W1derstanding the
concepts developed in later chapters in this book.
Use Marginal Analysis

Marginal analysis is one of the most important managerial tools-a tool we will use
repeatedly throughout this text in alternative contexts. Simply put, marginal analysis
states that optimal managerial decisions involve comparing the marginal (or incre-
mental) benefits of a decision with the marginal (or incremental) costs. For example,
the optimal amount of studying for this course is determined by comparing (1) the
improvement in your grade that will result from an additional hour of studying and
(2) the additional costs of studying an additional hour. So long as the benefits of
studying an additional hour exceed the costs of studying an additional hour, it is
profitable to continue to study. However, once an additional hour of studying adds
more to costs than it does to benefits, you should stop studying.
56
20 Managerial Economics and Business Strategy
More generally, let B( Q) denote the total benefits derived from Q units of some
variable that is within the manager's control. This is a very general idea: B( Q) may
be the revenue a firm generates from producing Q units of output; it may be the
benefits associated with distributing Q units of food to the needy; or, in the context
of our previous example, it may represent the benefits derived by studying Q hours
for an exam. Let C( Q) represent the total costs of the corresponding level of Q.
Depending on the nature of the decision problem, C( Q) may be the total cost to a
finn of producing Q units of output, the total cost to a food bank of providing Q
units of food to the needy, or the total cost to you of studying Q hours for an exam.
Discrete Decisions
We first consider the situation where the managerial control variable is discrete. In
this instance, the manager faces a situation like that summarized in columns 1
through 3 in Table 1-1. Notice that the manager cannot use fractional units of Q-,
only integer values are possible. This reflects the discrete nature of the problem. In
the context of a production decision, Q may be the number of gallons of soft drink
produced. The manager must decide how many gallons of soft drink to produce (0,
1, 2, and so on), but cannot choose to produce fractional units (for example, one
pint). Column 2 of Table 1-1 provides hypothetical data for total benefits; column
3 gives hypothetical data for total costs.
Suppose the objective of the manager is to maximize the net benefits
N(Q) = B(Q) - C(Q),
which represent the premium of total benefits over total costs of using Q units of
the managerial control variable, Q. The net benefits-N(QJ-for our hypothetical
•- - - .. - . . . . . .. - - .
(1) (2) (3) (4) (5) (6) (7)
Control Total Total Net Marginal Marginal Marginal
Variable Benefits Costs Benefits Benefit Cost Net Benefit
Q B(Q) C{Q) N(Q) MB(Q) MC{Q) MNB(Q)
Ll(4)
or
Given Given Given (2)-(3) Ll(2) Ll(3) (5)-(6)
0 0 0 0
1 90 10 80 90 10 80
2 170 30 140 80 20 60
3 240 60 180 70 30 40
4 300 100 200 60 40 20
5 350 150 200 50 50 0
6 390 210 180 40 60 -20
7 420 280 140 30 70 -40
8 440 360 80 20 80 -60
9 450 450 0 10 90 -80
10 450 550 -100 0 100 -100
57
example are given in column 4 of Table 1-1. Notice that the net benefits in column
4 are maximized when net benefits equal 200, which occurs when 5 units of Qare
chosen by the manager. 5
To illustrate the importance of marginal analysis in maximizing net benefits,
marginal benefit it is useful to define a few terms. Marginal benefit refers to the additional bene-
The change in fits that arise by using an additional unit of the managerial control variable. For
total benefits example, the marginal benefit of the first unit of Q is 90, since the first unit of Q
arising from a
change in the increases total benefits from 0 to 90. The marginal benefit of the second unit of
managerial control Q is 80, since increasing Q from 1 to 2 increases total benefits from 90 to 170.
variable Q. The marginal benefit of each unit of Q-MB(Q)-is presented in column 5 of
Table 1-1.
marginal cost Marginal cost, on the other hand, is the additional cost incurred by using an
The change in total additional unit of the managerial control variable. Marginal costs-MC( Q)-are
costs arising from given in column 6 of Table 1-1. For example, the marginal cost of the first unit of
a change in the
managerial control Q is 10, since the first unit of Q increases total costs from 0 to 10. Similarly, the
variable Q. marginal cost of the second unit of Qis 20, since increasing Qfrom 1 to 2 increases
total costs by 20 (costs rise from 10 to 30).
Finally, the marginal net benefits of Q-MNB( Q)-are the change in net bene-
fits that arise from a one-unit change in Q. For example, by increasing Q from 0 to
1, net benefits rise from 0 to 80 in column 4 of Table 1-1, and thus the marginal net
benefit of the first unit of Qis 80. By increasing Qfrom 1 to 2, net benefits increase
from 80 to 140, so the marginal net benefit due to the second unit of Q is 60.
Column 7 of Table 1-1 presents marginal net benefits for our hypothetical example.
Notice that marginal net benefits may also be obtained as the difference between
marginal benefits and marginal costs:
MNB( Q) = MB( Q) - MC( Q)
Inspection of Table 1-1 reveals a remarkable pattern in the columns. Notice

that by using 5 units of Q, the manager ensures that net benefits are maximized. At
the net-benefit-maximizing level of Q (5 units), the marginal net benefits of Qare
zero. Furthermore, at the net-benefit-maximizing level of Q (5 units), marginal ben-
efits equal marginal costs (both are equal to 50 in this example). There is an impor-
tant reason why MB= MC at the level of Q that maximizes net benefits: So long as
marginal benefits exceed marginal costs, an increase in Q adds more to total bene-
fits than it does to total costs. In this instance, it is profitable for the manager to
increase the use of the managerial control variable. Expressed differently, when
marginal benefits exceed marginal costs, the net benefits of increasing the use of Q
are positive; by using more Q, net benefits increase. For example, consider the use
5Actually, net benefits are equal to 200 for either 4 or 5 units of Q. This is due to the discrete nature
of the data in the table, which restricts Q to be selected in one-unit increments. In the next section, we
show that when Q can be selected in arbitrarily small increments (for example, when the firm can
produce fractional gallons of soft drink), net benefits are maximized at a single level of Q. At this level
of Q, marginal net benefits are equal to zero, which corresponds to 5 units of Qin Table 1-1.
58
of 1 unit of Qin Table 1-1. By increasing Qto 2 units, total benefits increase by 80
and total costs increase by only 20. Increasing the use of Q from 1 to 2 units is prof-
itable, because it adds more to total benefits than it does to total costs.
I
Principle Marginal Principle
To maximize net benefits, the manager should increase the managerial control variable to
the point where marginal benefits equal marginal costs. This level of the managerial con-
trol variable corresponds to the level at which marginal net benefits are zero; nothing more
can be gained by further changes in that variable.
Notice in Table 1-1 that while 5 units of Qmaximizes net benefits, it does not
maximize total benefits. In fact, total benefits are maximized at 10 units of Q,
where marginal benefits are zero. The reason the net-benefit-maximizing level of Q
is less than the level of Q that maximizes total benefits is that there are costs asso-
ciated with achieving more total benefits. The goal of maximizing net benefits
takes costs into account, while the goal of maximizing total benefits does not. In the
context of a finn, maximizing total benefits is equivalent to maximizing revenues
without regard for costs. In the context of studying for an exam, maximizing total
benefits requires studying until you maximize your grade, regardless of how much
it costs you to study.
Continuous Decisions
The basic principles for making decisions when the control variable is discrete
also apply to the case of a continuous control variable. The basic relationships in
Table 1-1 are depicted graphically in Figure 1-2. The top panel of the figure
presents the total benefits and total costs of using different levels of Q under the
assumption that Q is infinitely divisible (instead of allowing the firm to produce
soft drinks only in one-gallon containers as in Table 1-1, it can now produce
fractional units). The middle panel presents the net benefits, B(Q) - C(Q), and
represents the vertical difference between Band C in the top panel. Notice that
net benefits are maximized at the point where the difference between B( Q) and
C( Q) is the greatest in the top panel. Furthennore, the slope of B( Q) is 6.BI fl Q,
or marginal benefit, and the slope of C(Q) is 6.C/6.Q, or marginal cost. The
slopes of the total benefits curve and the total cost curve are equal when net ben-
efits are maximized. This is just another way of saying that when net benefits are
maximized, MB = MC.
I
Principle Marginal Value Curves Are the Slopes of Total Value Curves
When the control variable is infinitely divisible, the slope of a total value curve at a given
point is the marginal value at that point. In particular, the slope of the total benefit curve at
a given Q is the marginal benefit of that level of Q. The slope of the total cost curve at a
given Qis the marginal cost of that level of Q. The slope of the net benefit curve at a given
Q is the marginal net benefit of that level of Q.
59
FIGURE 1-2 Determining the Optimal Level of a Control Variable: The Continuous Case
Maximum total
Total I benefits ~ I I
benefits I
and Slope;MB 1
costs
OL...:::=-----,lf------+-1+-I----+ Q
I I I
Net I I I
benefits I I I
I Maximum I I
: net benefits I I
I I Slope; MNB
- -::::;::o-r-=::-------
L------+----------+Q
I I N(Q) = B(Q) - C(Q)
I I
Marginal I I
benefits, costs, I I
and net benefits I I
I I
I I
I I
I I
I I
MB(Q) Q
A Calculus Since the slope of a function is the derivative of that function, the preceding principle
Alternative means that the derivative of a given function is the marginal value of that function. For
example,
MB= dB(Q)
dQ
MC= dC(Q)
dQ
dN(Q)
MNB=dQ
The bottom panel of Figure 1-2 depicts the marginal benefits, marginal costs,
and marginal net benefits. At the level of Q where the marginal benefit curve inter-
sects the marginal cost curve, marginal net benefits are zero. That level of Q maxi-
mizes net benefits.
60
Unit 5
Economic Growth and Development
61
Visible Indicators of Economic Change
....... Households able to afford better material comforts
Better infrastructure is available for all
Incomes derived from industry than agriculture
62
Definition: Economic Growth
• An increase in the amount of goods and services produced per head of
the population over a period of time
• Measurable indicator: Gross Domestic Product (GDP)
63
Gross Domestic Product (GDP)
• Def: Market value of all final goods and services produced within a
country in a given period of time
• Market price used to add up different and servies
• All goods and services included, other than a) products sold illegally and b)
unpaid g&s produced and consumed at home
• ‘Intermediate goods’ is not added
• Both tangible goods and intangible services are included
• Transactions regarding items produced in past not included, ex: resale
• Items included if produced domestically
• Measure of production within a specific interval of time
64
MEASURES OF GDP
65
GDP: Simple Economic Setup
Assumptions:
a) No savings/Investment b) No export or import c) No expenditure by government d) Production of only
consumption products
_~- Consumpt·o,n penditure

• Product market: Computers, food, courier services etc.
>..:···► IProdu t Market H•,.~
= :
• Factor market: Land, Labour, Entrepreneurship etc.
• Consumption exp: $ spend on goods and services

,.
:;
~
·<- 5
-- Facto.r Market ◄ _n 7 • Income Payments: Wages, rents, profits etc.
---+ I ome Payments _...,._...
Circular Flow of Income

66
Alternative Approaches for Measuring GDP
Flow-of-Product Approach Earnings or Income Approach
GDP is value of final goods and services bought GDP is total earnings of households or cost of
by consumers producing the final goods
GDP = (Number of Computers * Price) + GDP = (Number of Labourers * Wages) + (Acres

(Number of Cakes * Price) + ….. of Land * Rent per acre) + …..
Example: In a barbershop economy, only labour is required for cutting hair. One barber does 10 haircuts in a
day, and charges Rs. 50 for each haircut
GDP (Flow-of-Product Approach): Haircuts x Price of one haircut = 10 x 50 = Rs. 500
GDP (Earnings Approach): Wages and Profits of barber = Rs. 500
In a simple economic setup, GDP measured through both approaches will be exactly the same
67
Adding Other Components of GDP
• Consumption
• Investment
• Addition to nation’s capital stocks
• Buildings, equipment, software and industries
• Government purchases
• Output purchased by central, state and local governments
• Excludes ‘transfer payments’
• Net exports
• Difference between exports and imports
68
GDP: Expenditure Method
GDP = C + I+ G + NX
Where:
C: Consumption: spending by HH on goods and services
I: Gross Investment: purchase of ‘capital goods’ and inventories
G: Government purchases: spending on G&S by local, state or national government,
excluding transfer payments
NX: Net Exports: exports minus imports
69
GDP: Income Method
GDP = W + R + I + P + IT+ DD + Tc + D + Up - Tp
Where:
W: Wages (Payment made to labour)
R: Rent (Payment made for land)
I: Interest (Payment made for investments)
P: Profits (Payment for entrepreneurial risk taking)
IT: Indirect taxes (Taxes levied on goods and services)
DD: Dividends (Payment made to shareholders by companies out of profits)
Tc: Corporate taxes (Levy on profit of a firm)
D: Depreciation (Monetary value of asset that decreases overtime due to use)
Up: Undistributed corporate profits (Corporate profits not paid as taxes or dividends)
Tp: Transfer payments (Income received not in exchange for goods and services, like subsidy)
70
Nominal Vs Real GDP
• Nominal GDP: (Units of A) x (Price of A)
• Problem: Includes growth in both prices and volume
71
Nominal Vs Real GDP: Example
Impact of nominal GDP:
• Assume that in 1990, price of a shirt was Rs. 100 and production was 100 shirts. In 2000,
production is still 100 shirts but price of shirt has risen to Rs. 200. Compute change in
GDP and production.
• Change in GDP: (Rs. 200 x 100) - (Rs. 100 x 100) = 10000
• Change in real product: 100 – 100 = 0
• Real GDP:
• Calculated to nullify the effect of price rise or fall on goods
• Computed by taking prices of ‘base year’ in GDP computation of other years
72
Prices and Quantities
Price of Quantity of Price of Quantity of
Year Hot Dogs Hot Dogs Hambu rgers Hamburgers
2016 $1 100 $2 50
201 7 $2 150 $3 100
2018 $3 200 $4 150
Calcu lating Nominal GDP
2016 ($1 per hot dog x 100 hot dogs) + ($2 per hamburger x 50 hamburgers) = $200
2018 ($3 per hot dog x 200 hot dogs) + ($4 per hamburger x 150 hamburgers) = $1 ,200
Calculating Real GDP (base year 2016)
201 7 ($1 per hot dog x 150 hot dogs) + ($2 per hamburger x 100 hamburgers) = $350
73
Nominal Vs Real GDP (Contd..)
• Real GDP preferred to Nominal GDP
• Use of base year for calculating real GDP

• A ‘normal’ year to be taken for base year
• Base year should be revised every 4-5 years
74
Other Measures of National Income
• Gross National Product (GNP): GDP + incomes of citizens from
abroad – incomes of foreigners from own country
• Net National Product (NNP): GNP - depreciation
75
GDP and Well Being
• Excludes factors like environmental damage
• Excludes measures like leisure, state of health etc.
76
Other Indicators of Development
• Human Development Index (HDI)
• Measure of socio-economic development
• Combined measure of education, health, and adjusted real income per capita
77
Comparing Nations: GNI and HDI
Nation Life Mean years of GNI per capita GNI per capita HDI Rank
Expectancy schooling ($) rank
Qatar 78.3 9.8 1,16,818 1 36
78
Qatar 78.3 9.8 1,16,818 1 36
Norway 82.3 17.9 68,012 9 1
79
Qatar 78.3 9.8 1,16,818 1 36
Norway 82.3 17.9 68,012 9 1
United States 79.5 13.4 54,941 10 13
80
Qatar 78.3 9.8 1,16,818 1 36
Norway 82.3 17.9 68,012 9 1
United States 79.5 13.4 54,941 10 13
India 68.8 6.4 6,353 102 129
81
Qatar 78.3 9.8 1,16,818 1 36
Norway 82.3 17.9 68,012 9 1
United States 79.5 13.4 54,941 10 13
India 68.8 6.4 6,353 102 129
Tajikistan 71.2 10.4 3,317 130 127
Kyrgyzstan 71.1 10.9 3,255 132 121
82
WHEELS OF ECONOMIC GROWTH
83
Factors of Growth
1) Human resources 3) Capital
• Labor supply • Factories
• Education • Machinery
• Skills
• Roads
• Discipline
• Intellectual property
• Motivation
2) Natural resources 4) Tech Change and Innovation

• Land • Science
• Minerals • Engineering
• Fuels • Management
• Environmental quality • Entrepreneurship
84
DEVELOPED VS DEVELOPING COUNTRY
85
Classification in Terms of National Income
• Low income: GNI per capita of $1005 or less
• Middle income: GNI per capita > $1005 but =< $ 12235
• Lower middle income economies
• Upper middle income economies
• High income economies: GNI per capita > 12235
• Developed countries = High income economies

• Developing countries = Low + Middle income economies
86
The world by lncom•
dnSINCI acco,d.,.g to Wond a.ni. e,sbmatas ol 2016 GNI per apll& (a#T.,. US doLn, Adu method) •
- Low-,comedeuD\MS1.00Sl ..... .-• .
- to-,moddo,_,,.cs1.006-SJ,95!1
- UpP"' m,ddlo ,_..1Sl,956-Sl2.23Sl
- M,gh---thanSl2.2lS1 ,_.
Nodot.
=~w:..~=~~~bua/
Noll. ThoWartdO..dua'-saconorNeSaslawmc:DtM.k,w.,-n'Uddle.,naxne.
......,...,, •. ~.....,dlonding ......,.

87
Other Classifications of Economies
• First and Third World
• Political classification at time of Cold War
• Newly Industrializing Countries

• Higher economic growth than other developing countries
• Example: India, China, South Africa, Brazil
• Least developed countries

• Low income, low human capital, high economic vulnerability economies
• 49 countries, 34 in Africa
• Emerging markets
• Some characteristics of developed markets
• India and China largest emerging markets
88
Common Features in Developing Countries
1) Lower levels of living and productivity
2) Lower levels of human capital
3) Higher levels of inequality and absolute poverty
4) Higher population growth rates
5) Greater social fractionalization
6) Larger rural populations but rapid rural-to-urban migration
7) Lower levels of industrialization
89
90
Lower Levels of Living and Productivity
• Vicious circle of poverty
• Low income leads to poor investment in:

• Education
• Health
• Plant and equipment
• Infrastructure
91
92
Lower Levels of Human Capital
FIGURE 2.5 Under-5 Mortality Rates, 1990 and 2005
160. - - - - - - - - - - - - - - - - - ,
• Developing countries lag in avg

i.O f---l 1 - - - - - - - - - - - - - ,
§ IZO
: 5 100
!.]
~]
,0
60
nutrition, health and education
~- 40
zo
J,o.,-Jncomc All de,,dupmg
• Under-5 mortality:
• 17 times of high income countries
countriet c:ounuiN
TA8U 2.8 Prlmnry School Enrollment llnd Pupil-Teacher Ratl1», 2010

Mt Primal')' School Primary l'upllol~chtr
• Pupil-Teacher Ratio:
Region or Group Enrollment ('bl Robo • One-third of high income countries
lntom, Group
~Odelle
so
87
45
2JI
• Complementary progress of health
pperMldd:e
High
94
9S
Z2
IS
and education
93
94
Higher Levels of Inequality and Absolute Poverty
INCOME INEQUALITY LEVEL:
THE GLOBAL STORY
Net Gini Index.: in Gini points.; 2013; c1verage across the region
• Poorest 20% receive 1.5% of world income
• High income inequality in developing
countries
Mlddle East and North Afrka • Extremes in relative incomes of rich and poor
UCs Asla
• Observed in resource-rich countries
Latin America .ind the <:arlbbean
• High extreme poverty in developing nations
• Lack income for food, clothing, shelter etc.
SulJ.S.-iharan Afrka
Chin.>
25 30 40 So 55
A$ EAN~5. lndones.la. M ala)'sla. the Phll lpplnes. Singapore. and Thailand:
LIC: Low ~lncom e Countries; NIEs: Newly Industrialized Ecoooml es:
DECO: Organisation for Economic Co--operatlon and DeYelopment
Source: IMF
95
96
Higher Population Growth Rates
nGURE 2.7 NumberofPeoplel.m.nginPovertybyRegion, 1981-2005
0 SU~llDACriC&
• Most population growth in
2.000
■ SouthAsta
developing world
.,,=-
• >5/6 people in developing countries
I.IOO
i 1,000
:q 1,400
;;;
.ij}
• Higher birth rates in developing
I.ZOO
3: I 000
11
countries
IOO
.:,
C 600
.g
400
"9C.
of
200
0 • Dependency burden: More children
to support
1981 1914 1987 1990 1993 1996 1999 2002 2005
97
98
Greater Social Fractionalization
• Social divisions more pronounced in low-income countries:
• Ethnic‘
• Linguistic
• Caste
• Religion
• Could result in internal strife, political instability and violent conflict
• Progress in culturally homogenous societies
• South Korea, Taiwan, Singapore, Hong Kong
• Exceptions
• Malaysia, Mauritius, United States
99
100
Larger Rural Populations
TABLE 2.10 The Urban Population in Oevdoped Countries

- - -
and Omloping Regioru
- - - • Rural people suffer from:
Pop, ti 1mJl,o,, 21'.mJ Vrbcln!hort
• Missing markets
ltg1
\\'011d 6,810 50
Moie developed mles
eu d~eloped OOW1tries
1,l.ll
5,5 8
5
44 • Limited information
1, hmnAfria
• Social stratification
436 3S
' cmAfria 205 so
tm Air.uica illld the C.arilttm 5 n
WcsletnAlla
Sooth IUA!Alil
231
1,726
64
JI • Massive migration puts pressure on
urban resources
Sovlhe~1tAli1 59 4J
..
101
102
Lower Levels of Industrialization
TA8l'E 2.11 Shatt of the Population Employed in the Industrial Sector in Selemd Colllltries, ~ ('b)
Aqricultu.n lnJUitr)' Mrvaca
~bore- ~hllff .Sh(llrit
oJ GOP of GDP of c.DP
• Small share of agriculture in

Mc,ln rnnalu (200&) Mala f~1•ru1ln (2008) Mole Female (2008)
Afiico
fgypt
Ethiopia
zg
12
43
6
13
44
26
27
6
17
38
13
46
61
SI
77
49
42 employment and output in
Machguca:
MaunUw
82
10
83
8
2.1
4
s
36
l
26
17
Z9
13
54
16
66
57
67 developed countries
SoulhAlrta II 7 3 35 14 34 54 80 63
'-11•
Bonglad"'h
~:don<£,
42
41
68
41
19
14
IS
21
13
IS
29
48
43
38
19
44
52
37 • Higher dependence on primary
Milla}'111
Pul!!ID
IS
36
10
72
10
20
32
23
2.3
13
48
27
SI
41
67
JS
42
53 exports in developing nations
Phllipplncs « 24 IS 18 II 32 39 65 53
South Kom 7 8 3 33 16 37 60 74 60
11,a,J.nd 43 40 12 22 19 44 JS 41 44
1/i.ri:."l!m S6 60 2Z 21 14 Z3 26 33
Latin Ammca
Colombu 27 6 9 22 16 36 SI 71 55
Cost• Rica 18 s 7 28 13 29 54 12 64
Mmco 19 4 4 31 18 37 so 77 59
Nlcarqu.l 42 8 19 zo 18 30 38 73 SI
O...lop<d Cow1tri01
Uwted Kingdom 2 32 9 Z4 66 90 76
UwtcdSutes 2 30 9 22 68 90 77
103
502 CHAPTER 25 • ECONOMIC GROWTH
Because economic growth is so important for What are the long-term patterns of economic
living standards, it is a central objective of policy. growth in high-income countries? Table 25-1 shows
Countries that run swiftly in the economic-growth the history of economic growth since 1870 for high-
race, such as Britain in the nineteenth century and income countries including the major countries of
the United States in the twentieth century, serve as North America and Western Europe, Japan, and
role models for other countries seeking the path to Australia. We see the steady growth of output over
affluence. At the other extreme, countries in eco- this period. Even more important for living standards
nomic decline often experience political and social is the growth in output per hour worked, which moves
turmoil. The revolutions in Eastern Europe and the closely with the increase in living standards. Over the
Soviet Union in 1989-1991 were sparked when those entire period, output per hour worked grew by an
nations' residents compared their economic stagna- average annual rate of 2.3 percent. If we compound
tion under socialism with the rapid growth experi- this rate over the 136 years, output per person at the
enced by their Western, market-oriented neighbors. end was 22 times higher than at the beginning (make
Economic growth is the single most important factor sure you can reproduce this number).
in the success of nations in the long run. What were the major forces behind this growth?
What can nations do to speed up their economic
growth rate? And what are the prospects for the
A. THEORIES OF twenty-first century? These are the issues that must
be confronted by economic-growth analysis.
ECONOMIC GROWTH
Economic growth involves the growth of poten-
Let's begin with a careful definition of exactly what tial output over the long run. The growth in output
we mean by economic growth: Economic growth rep- per capita is an important objective of government
resents the expansion of a country's potential GDP because it is associated with rising average real
or national output. Put differently, economic growth incomes and rising living standards.
occurs when a nation's production-possibility fron-
tier (PPF) shifts outward.
THE FOURWHEELS OF GROWTH
A closely related concept is the growth rate of out-
put per person. This determines the rate at which the What is the recipe for economic growth? To begin
country's living standards are rising. Countries are with, many roads lead to Rome. There are many suc-
primarily concerned with the growth in per capita cessful strategies on the road to self-sustained eco-
output because this leads to rising average incomes. nomic growth. Britain, for example, became the
Average Annual Growth Rate (percent per year)

GDP per Total hours
Period GDP hour worked worked Labor force
1870-1913 2.5 1.6 0.9 1.2

1913-1950 1.9 1.8 0.1 0.8
1950-1973 4.8 4.5 0.3 1.0
1973-2006 2.6 2.2 0.4 1.0
Total period 2.8 2.3 0.5 1.0
TABLE 25-1. Patterns of Growth in Advanced Countries

Over the last century-plus, major high-income countries like the United States, Germany,
France, and Japan have grown rapidly. Output has grown faster than inputs of labor,
reflecting increases in capital and technological advance.
Source: Angus Maddison, Phases o/CapitalislDevelaprnenl (Oxford University Press, Oxford, 1982), updated by authors.
The data cover 16 major countries starting in 1870, while more recent data cover 31 advanced economies.
104
THE FOUR WHEELS OF GROWTH 503
world economic leader in the 1800s by pioneering Human Resources

the Industrial Revolution, inventing steam engines Labor inputs consist of quantities of workers and of
and railroads, and emphasizing free trade. Japan, by the skills of the workforce. Many economists believe
contrast, came to the economic-growth race later. It that the quality oflabor inputs-the skills, knowledge,
made its mark by first imitating foreign technologies and discipline of the labor force-is the single most
and protecting domestic industries from imports and important element in economic growth. A country
then developing tremendous expertise in manufac- might buy fast computers, modern telecommunica-
turing and electronics. tions devices, sophisticated electricity-generating
Even though their individual paths may differ, equipment, and hypersonic fighter aircraft. However,
all rapidly growing countries share certain common these capital goods can be effectively used and main-
traits. The same fundamental process of economic tained only by skilled and trained workers. Improve-
growth and development that helped shape Britain ments in literacy, health, and discipline, and most
and Japan is at work today in developing countries recently the ability to use computers, add greatly to
like China and India. Indeed, economists who have the productivity of labor.
studied growth have found that the engine of eco-
nomic progress must ride on the same four wheels,
no matter how rich or poor the country. These four
Natural Resources
The second classic factor of production is natural
wheels, or factors of growth, are:
resources. The important resources here are arable
• Human resources (labor supply, education, skills, land, oil, gas, forests, water, and mineral deposits.
discipline, motivation) Some high-income countries like Canada and Norway
• Natural resources (land, minerals, fuels, environ- have grown primarily on the basis of their ample
mental quality) resource base, with large output in oil, gas, agricul-
• Capital (factories, machinery, roads, intellectual ture, fisheries, and forestry. Similarly, the United
property) States, with its fertile farmlands, is the world's largest
• Technological change and innovation (science, producer and exporter of grains.
engineering, management, entrepreneurship) But the possession of natural resources is not
necessary for economic success in the modern world.
Often, economists write the relationship in terms
New York City prospers primarily on its high-density
of an aggregate production function (or APF), which
service industries. Many countries, such as Japan,
relates total national output to inputs and technol-
had virtually no natural resources but thrived by
ogy. Algebraically, the APF is
concentrating on sectors that depend more on labor
Q = AF(K, L, R) and capital than on indigenous resources. Indeed,
tiny Hong Kong, with but a tiny fraction of the land
where Q = output, K = productive services of capi-
and natural resources of Nigeria, actually has a larger
tal, L = labor inputs, R = natural-resource inputs, A
GDP than does that giant country.
represents the level of technology in the economy,
and F is the production function. As the inputs of
capital, labor, or resources rise, we would expect Capital
that output would increase, although output will Capital includes tangible capital goods like roads,
probably show diminishing returns to additional power plants, and equipment like trucks and comput-
inputs of production factors. We can think of the ers, as well as intangible items such as patents, trade-
role of technology as augmenting the productivity marks, and computer software. The most dramatic
of inputs. Productivity denotes the ratio of output stories in economic history often involve the accu-
to a weighted average of inputs. As technology (A) mulation of capital. In the nineteenth century, the
improves through new inventions or the adoption transcontinental railroads of North America brought
of technologies from abroad, this advance allows a commerce to the American heartland, which had
country to produce more output with the same level been living in isolation. In the twentieth century,
of inputs. waves of investment in automobiles, roads, and power
Let's now see how each of the four factors con- plants increased productivity and provided the infra-
tributes to growth. structure which created entire new industries. Many
105
504 CHAPTER 25 • ECONOMIC GROWTH
believe that computers and information technology advances led to a vast improvement in the production
will do for the twenty-first century what railroads possibilities of Europe, North America, and Japan.
and highways did in earlier times. We are today witnessing an explosion of new
Accumulating capital, as we have seen, requires technologies, particularly in computation, commu-
a sacrifice of current consumption over many years. nication (such as the Internet), and the life sciences.
Countries that grow rapidly tend to invest heavily But this is not the first time that American society has
in new capital goods; in the most rapidly growing been shaken by fundamental inventions. Electricity,
countries, 10 to 20 percent of output may go into radio, the automobile, and television also diffused
net capital formation. The United States shows a rapidly through the American economy in an earlier
stark contrast with high-saving countries. The U.S. age. Figure 25-1 shows the diffusion of major inven-
net national saving rate, after averaging around tions of the twentieth century. This S-shaped pattern
7 percent during the first four decades after World is typical of the diffusion of new technologies.
War II, began to decline and actually fell to near- Technological change denotes changes in the
zero in 2008. The low saving rate was the result of processes of production or introduction of new
low personal saving and large government fiscal products or services. Process inventions that have
deficits. The low saving was seen primarily in the greatly increased productivity were the steam engine,
large external (trade) deficit. Economists worry the generation of electricity, antibiotics, the internal-
that the low saving rate will retard investment and combustion engine, the wide-body jet, the micropro-
economic growth in the decades to come and that cessor, and the fax machine. Fundamental product
the large foreign indebtedness may require major inventions include the telephone, the radio, the air-
adverse changes in exchange rates and real wages. plane, the phonograph, the television, the computer,
When we think of capital, we must not concen- and the DVR.
trate only on computers and factories. Many invest- The most dramatic developments of the modern
ments that are necessary for the efficient functioning era are occurring in information technology. Here,
of the private sector will be undertaken only by gov- tiny notebook computers can outperform the fastest
ernments. These investments are called social over- computer of the 1960s, while fiber-opticlines can carry
head capital and consist of the large-scale projects 200,000 simultaneous conversations that required
that precede trade and commerce. Roads, irrigation 200,000 paired copper-wire lines in an earlier period.
and water projects, and public-health measures are These inventions provide the most spectacular exam-
important examples. All these involve large invest- ples of technological change. Nonetheless, techno-
ments that tend to be "indivisible," or lumpy, and logical advance is in fact a continuous process of small
sometimes have increasing returns to scale. These and large improvements, as witnessed by the fact that
projects generally involve external economies, or the United States issues over 100,000 new patents
spillovers that private firms cannot capture, so the annually and that millions of other small refinements
government must step in to ensure that these social are routine activities in a modern economy.
overhead or infrastructure investments are effectively Economists have long pondered how to encour-
undertaken. Some investments, such as transporta- age technological progress because of its importance
tion and communication systems, involve "network" in raising living standards. Technological progress is
externalities in which productivity depends upon the a complex and multifaceted process, and no single
fraction of the population which uses or has access to formula for success has been found.
the network. Here are some historical examples: Toyota suc-
ceeded in instilling a workplace ethic of making
Technological Change and Innovation continuous quality improvements from the bottom
In addition to the three classic factors discussed up; this propelled Toyota to the top of the automo-
above, technological advance has been a vital fourth bile industry. Quite a different pattern arose in Sili-
ingredient in the rapid growth of living standards. con Valley's computer business. Here, technological
Historically, growth has definitely not been a process change was fostered by an entrepreneurial spirit of
of simple replication, adding rows of steel mills or free inquiry, light government regulation, free inter-
power plants next to each other. Rather, a never- national trade in intellectual property products,
ending stream of inventions and technological and the lure of lucrative stock options. Economists
106
THE FOUR WHEELS OF GROWTH 505
100
Automobiles
80
(/)
"O
0
..c: 60
Ql
(/)
::J
0 Electric power
..c:
0
~ 40
~
Ql
a.
Home computers
20
~,,,'
,, Internet
connections
0 '------=-=-----'------'-----'-------'---~.<e......l- - - - L - - - - - ' - - - - - - ' -- """"'=----'-..c;...-----'--------'
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
FIGURE 25-1. Diffusion of Major Technologies
Today's information technologies such as cellular telephones, computers, and the Internet are
spreading rapidly through American society. Similar diffusion patterns were seen with other
fundamental inventions in the past.
Source: Economic Report of the President, 2000, updated by authors.
Factor in economic growth Examples
Human resources Size oflabor force

Quality of workers ( education, skills, discipline)
Natural resources Oil and gas
Soils and climate
Capital stock Homes and factories
Machinery
Intellectual property
Social overhead capital
Technology and entrepreneurship Quality of scientific and engineering knowledge
Managerial know-how
Rewards for innovation
TABLE 25-2. The Four Wheels of Progress

Economic growth inevitably rides on the four wheels of labor, natural resources, capital, and
technology. But the wheels may differ greatly among countries, and some countries combine
them more effectively than others.
recognize that some approaches seem to kill the profit motivation, an inefficient pricing mechanism,
spirit of innovation. Many sectors of the Soviet Union and widespread corruption.
under central planning saw technological stagnation Table 25-2 summarizes the four wheels of eco-
because of the heavy hand of state regulation, lack of nomic growth.
107
CHAPTER
Measuring Economic Activity

20
¾'hen you can measure what you are speaking about,
and express it in numbers, you know something about it;
when you cannot measure it, when you cannot express it
in numbers, your knowledge is of a meager and unsatisfactory
kind; it may be the begi,nning of knowledge, but you
have scarcely, in your thoughts, advanced to the
stage of science.
Lord Kelvin
The single most important concept in macro- GROSS DOMESTIC PRODUCT:

economics is the gross domestic product (GDP), THE YARDSTICK OF AN
which measures the total value of goods and ser-
ECONOMY'S PERFORMANCE
vices produced in a country during a year. GDP
is part of the national income and product accounts What is the gross domestic product? GDP is the name
( or national accounts), which are a body of statistics we give to the total market value of the final goods
that enables policymakers to determine whether and services produced within a nation during a
the economy is contracting or expanding and given year. It is the figure you get when you apply
whether a severe recession or inflation threatens. the measuring rod of money to the diverse goods
When economists want to determine the level of and services-from apples to zithers-that a country
economic development of a country, they look at produces with its land, labor, and capital resources.
its GDP per capita. GDP equals the total production of consumption
While the GDP and the rest of the national and investment goods, government purchases, and
accounts may seem to be arcane concepts, they are net exports to other lands.
truly among the great inventions of modern times.
Much as a satellite in space can survey the weather The gross domestic product (GDP) is the most
across an entire continent, so can the GDP give an comprehensive measure of a nation's total output
overall picture of the state of the economy. In this of goods and services. It is the sum of the dollar val-
chapter, we explain how economists measure GDP ues of consumption ( C), gross investment (I), gov-
and other major macroeconomic indicators. ernment purchases of goods and services ( G), and
386
108
GROSS DOMESTIC PRODUCT: THE YARDSTICK OF AN ECONOMY'S PERFORMANCE 387
net exports (X) produced within a nation during a trade, and no investment. For the moment, our little
given year. economy produces only consumption goods, which are
items that are purchased by households to satisfy
In symbols:
their wants. (Important note: Our first example is
GDP = C + I+ G + X oversimplified to show the basic ideas. In the realistic
examples that follow, we will add investment, govern-
GDP is used for many purposes, but the most
ment, and the foreign sector.)
important one is to measure the overall performance
of an economy. If you were to ask an economic his-
Flow-of-Product Approach. Each year the public
torian what happened during the Great Depression,
consumes a wide variety of final goods and services:
the best short answer would be:
goods such as apples, computer software, and blue
Between 1929 and 1933, GDP fell from $104 billion jeans; services such as health care and haircuts. We
to $56 billion. This sharp decline in the dollar value include only final goods-goods ultimately bought
of goods and services produced by the American and used by consumers. Households spend their
economy caused high unemployment, hardship, incomes for these consumer goods, as is shown in
a steep stock market decline, bankruptcies, bank
the upper loop of Figure 20-1. Add together all the
failures, riots, and political turmoil.
consumption dollars spent on these final goods,
Similarly, if you were to ask a macroeconomist about and you will arrive at this simplified economy's
the second half of the twentieth century, she might total GDP.
reply: Thus, in our simple economy, you can easily
calculate national income or product as the sum of
The second half of the twentieth century was a unique
the annual flow of final goods and services: (price
economic period. During those years, the affluent
regions of the North-consisting of Japan, the United of blue jeans X number of blue jeans) plus (price
States, and Western Europe-experienced the most of apples X number of apples) and so forth for
rapid growth of output per capita in recorded his- all other final goods. The gross domestic product
tory. From the end of World War II until 2000, for is defined as the total money value of the flow of
example, real GDP per capita in the United States final products produced by the nation.
expanded by almost 250 percent. National accountants use market prices as
We now discuss the elements of the national weights in valuing different commodities because
income and product accounts. We start by showing market prices reflect the relative economic value
different ways of measuring GDP and distinguishing of diverse goods and services. That is, the relative
real from nominal GDP. We then analyze the major prices of different goods reflect how much consum-
components of GDP. We conclude with a discussion ers value their last (or marginal) units of consump-
of the measurement of the general price level and tion of these goods.
the rate of inflation.
Earnings or Income Approach. The second and equiv-
alent way to calculate GDP is the income accounts
Two Measures of National Product: (also called the earnings or cost approach). Look at
Goods Flow and Earnings Flow the lower loop in Figure 20-1. Through it flow all the
How do economists actually measure GDP? One of costs of doing business; these costs include the wages
the major surprises is that we can measure GDP in paid to labor, the rents paid to land, the profits paid
two entirely independent ways. As Figure 20-1 shows, to capital, and so forth. But these business costs are
GDP can be measured either as a flow of products or also the earnings that households receive from firms.
as a sum of earnings. By measuring the annual flow of these earnings or
To demonstrate the different ways of measur- incomes, statisticians will again arrive at the GDP.
ing GDP, we begin by considering an oversimplified Hence, a second way to calculate GDP is as the
world in which there is no government, no foreign total of factor earnings (wages, interest, rents, and
109
388 CHAPTER 20 • MEASURING ECONOMIC ACTIVITY
Circular Flow of Macroeconomic Activity
$
Consumption purchases
(a)
Final goods and services
(bread, computers, haircuts, etc.)
Purchasers
Producers
(households,
(businesses)
governments, ... )
(b)
Productive services
(labor, land, etc.)
Wages, rents, profits, etc.

$
FIGURE 20-1. Gross Domestic Product Can Be Measured Either as (a) a Flow of Final
Products or, Equivalently, as ( b) a Flow of Earnings or Incomes
In the upper loop, purchasers buy final goods and services. The total dollar flow of their
spending each year is one measure of gross domestic product. The lower loop measures the
annual flow of costs of output: the earnings that businesses pay out in wages, rent, interest,
dividends, and profits.
The two measures of GDP must always be identical. Note that this figure is the macro-
economic counterpart of Fig. 2-1, which presented the circular flow of supply and demand.
profits) that are the costs of producing society's final other than labor. If they sell 10 haircuts at $8 each,
products. GDP is $80. But the barbers' earnings (in wages and
profits) are also exactly $80. Hence, the GDP here
Equivalence of the Two Approaches. Now we have is identical whether measured as a flow of products
calculated GDP by the upper-loop flow-of-product ($80 worth of haircuts) or as a flow of costs and
approach and by the lower-loop earnings-flow incomes ($80 worth of wages and profits).
approach. Which is the better approach? The sur- In fact, the two approaches are identical because we
prise is that they are exactly the same. have included "profits" in the lower loop along with
We can see why the product and earnings other incomes. What exactly is profit? Profit is what
approaches are identical by examining a simple bar- remains from the sale of a product after you have paid
bershop economy. Say the barbers have no expenses the other factor costs-wages, interest, and rents. It
110
DETAILS OF THE NATIONAL ACCOUNTS 391
of farmers, millers, bakers, and grocers. The final cal- Real vs. Nominal GDP: ~~Deflating,,
culation shows the desired equality between ( 1) final GDP by a Price Index
sales of bread and (2) total earnings, calculated as We define GDP as the dollar value of goods and ser-
the sum of all values added in all the different stages vices. In measuring the dollar value, we use the mea-
of bread production. suring rod of market prices for the different goods and
Value-added approach: To avoid double counting,
services. But prices change over time, as inflation gen-
we take care to include only final goods in GDP and erally sends prices upward year after year. Who would
to exclude the intermediate goods that are used up want to measure things with a rubber yardstick-one
in making the final goods. By measuring the value that stretches in your hands from day to day-rather
added at each stage, taking care to subtract expendi- than a rigid and invariant yardstick?
tures on the intermediate goods bought from other The problem of changing prices is one of the
firms, the lower-loop earnings approach properly problems economists have to solve when they use
avoids all double counting and records wages, inter- money as their measuring rod. Clearly, we want a
est, rents, and profits exactly one time. measure of the nation's output and income that uses
an invariant yardstick. Economists can replace the
elastic yardstick with a reliable one by removing the
DETAILS OF THE NATIONAL price-increase component so as to create a real or
quantity index of national output.
ACCOUNTS
Here is the basic idea: We can measure the GDP for
Now that we have an overview of the national a particular year using the actual market prices of that
income and product accounts, we will proceed, year; this gives us the nominal GDP, or GDP at current
in the rest of this chapter, on a whirlwind tour of prices. But we are usually more interested in deter-
the various sectors. Before we start on the journey, mining what has happened to the real GDP, which
look at Table 20-3 to get an idea of where we are is an index of the volume or quantity of goods and
going. This table shows a summary set of accounts services produced. Real GDP is calculated by tracking
for both the product and the income sides. If you the volume or quantity of production after removing
understand the structure of the table and the the influence of changing prices or inflation. Hence,
definitions of the terms in it, you will be well on nominal GDP is calculated using changing prices,
your way to understanding GDP and its family of while real GDP represents the change in the volume
components. of total output after price changes are removed.
Product Approach Earnings Approach

Components of gross domestic product: Earnings or income approach to gross domestic product:
Consumption ( C) Compensation oflabor (wages, salaries, and supplements)
+ Gross private domestic investment (I) + Corporate profits
+ Government purchases ( G) + Other property income (rent, interest, proprietors' income)
+ Net exports (X) + Depreciation
+ Net production taxes
Equals: Gross domestic product Equals: Gross domestic product
TABLE 20-3. Overview of the National Income and Product Accounts

This table presents the major components of the two sides of the national accounts. The
left side shows the components of the product approach (or upper loop); the symbols
C, I, G, and X are often used to represent these four items of GDP. The right side shows
the components of the earnings or income approach (or lower loop). Each approach will
ultimately add up to exactly the same GDP.
111
CHAPTER 2 Comparative Economic Development 55
TABLE 2.4 2013 New Human Development Index and its Components for Selected Countries
Expected GNI Per
Life Mean Yrs Years Capita
NHDI Expectancy Schooling Schooling GNI Per NewHDI Rank Minus
Country Rank at Birth (of Adults) (of children) Capita value HDI Rank
United States 3 78.7 13.3 16.8 43,480 0.937 6
Canada 11 81.1 12.3 15.1 35,369 0.911 5
South Korea 12 80.7 11.6 17.2 28,231 0.909 15
United Kingdom 26 80.3 9.4 16.4 32,538 0.875 5
Chile 40 79.3 9.7 14.7 14,987 0.819 13
United Arab Emirates 41 76.7 8.9 12 42,716 0.818 -31
Russian Federation 55 69.1 11.7 14.3 14,461 0.788 0
Cuba 59 79.3 10.2 16.2 5,539 0.78 44
Mexico 61 77.1 8.5 13.7 12,947 0.775 4
Costa Rica 62 79.4 8.4 13.7 10,863 0.773 12
Brazil 85 73.8 7.2 14.2 10,152 0.73 -8
Turkey 90 74.2 6.5 12.9 13,710 0.722 -32
Sri Lanka 92 75.1 9.3 12.7 5,170 0.715 18
China 101 73.7 7.5 11.7 7,945 0.699 -11
Gabon 106 63.1 7.5 13 12,521 0.683 -40
Egypt 112 73.5 6.4 12.1 5,401 0.662 -6
Botswana 119 53 8.9 11.8 13,102 0.634 -55
South Africa 121 53.4 6.7 10.6 9,594 0.629 -42
Guatemala 133 71.4 4.1 10.7 4,235 0.581 -14
Ghana 135 64.6 7 11.4 1,684 0.558 22
Equatorial Guinea 136 51.4 5.4 7.9 21,715 0.554 -97
India 136 65.8 4.4 10.7 3,285 0.554 -3
Kenya 145 57.7 7 11.1 1,541 0.519 15
Bangladesh 146 69.2 4.8 8.1 1,785 0.515 9
Pakistan 146 65.7 4.9 7.3 2,566 0.515 -9
Madagascar 151 66.9 5.2 10.4 828 0.483 28
Papua New Guinea 156 63.1 3.9 5.8 2,386 0.466 -15
Cote d'Ivoire 168 56 4.2 6.5 1,593 0.432 -9
Burkina Faso 183 55.9 1.3 6.9 1,202 0.343 -18
Chad 184 49.9 1.5 7.4 1,258 0.34 -20
Niger 186 55.1 1.4 4.9 701 0.304 -4
Source: 2013 Human Development Report 2013, Table 1, pages 144-147 (New York: United Nations Development Programme, 2013)
conjunction with other economic measures of development, greatly increase

our understanding of which countries are experiencing development and
which are not. And by modifying a country's overall NHDI to reflect income
distribution, gender, regional, and ethnic differentials, as presented in recent
Human Development Reports, we are now able to identify not only whether a
country is developing but also whether various significant groups within that
country are participating in that development. 9
2.4 Characteristics of the Developing World:

Diversity within Commonality
As noted earlier, there are important historical and economic commonalities
among developing countries that have led to their economic development
112
56 PART ONE Principles and Concepts
BOX 2.2 What Is New in the New Human Development Index
In November 2010, the UNDP introduced its New

Human Development Index (NHDI), which has eight
there have also been many development
upside surprises, such as rapid improvements
notable changes, each with strengths but also a few in educational attainment in some coun-
potential drawbacks. tries; there is a risk that low expectations will
prove discouraging. Note that life expectancy,
1. Gross national income (GNI) per capita
which remains the indicator for health, is also
replaces gross domestic product (GDP) per
a projection based on prevailing conditions.
capita. This should be an unambiguous
4. The two previous components of the edu-
improvement: GNI reflects what citizens can
cation index, literacy and enrollment, have
do with income they receive, whereas that is
been correspondingly dropped. In contrast
not true of value added in goods and services
to expected attainment, literacy is clearly an
produced in a country that go to someone
achievement, and even enrollment is at least
outside it, and income earned abroad still
a modest achievement. However, literacy has
benefits some of the nation's citizens. As trade
always been badly and too infrequently mea-
and remittance flows have been expanding
sured and is inevitably defined more modestly
rapidly, and as aid has been better targeted
in a less developed country. And enrollment
to very low-income countries, this distinction
is no guarantee that a grade will be completed
has become increasingly important.
or for that matter that anything is learned or
2. The education index has been completely
that students (or teachers) even attend.
revamped. Two new components have been
5. The upper goalposts (maximum values) in
added: the average actual educational attain-
each dimension have been increased to the
ment of the whole population and the
observed maximum rather than given a pre-
expected attainment of today's children. Each
defined cutoff. In some ways, this returns
of these changes to the index has implica-
the index to its original design, which was
tions. Use of actual attainment-average years
criticized for inadequately recognizing small
of schooling-as an indicator is unambigu-
gains by countries starting at very low levels.
ously an improvement. Estimates are regularly
6. The lower goalpost for income has been
updated, and the statistic is easily compared
reduced. This is based on updated estimates
quantitatively across countries. And even
for the historic low for recorded income for
though it is at best a very rough guide to what is
any country. 10
actually learned-on average, a year of school-
7. Another minor difference is that rather than
ing in Mali provides students with much less
using the common logarithm (log) to reflect
than a year of schooling in Norway-this is
diminishing marginal benefit of income, the
the best measure we have at present because
NHDI now uses the natural log (ln), as used
more detailed data on quality that are credible
in the fifth equation in Box 2.1. This reflects
and comparable are simply not available.
a more usual construction of indexes.
3. Expected educational attainment, the other
8. Possibly the most consequential change is
new component, is somewhat more ambigu-
that the NHDI is computed with a geometric
ous: It is not an achievement but a UN fore-
mean rather than a simple arithmetic mean,
cast. History shows that much can go wrong
as examined previously.
to derail development plans. Nevertheless,
113
problems being studied within a common analytical framework in develop-

ment economics. These widely shared problems are examined here in detail
on an issue-by-issue basis. At the same time, however, it is important to
bear in mind that there is a great deal of diversity throughout the develop-
ing world, even within these areas of broad commonality. The wide range of
income, health, education, and HDI indicators already reviewed is sometimes
called a "ladder of development." 11 Different development problems call for
different specific policy responses and general development strategies. This
section examines the 10 major areas of "diversity within commonality" in the
developing world.
Lower Levels of Living and Productivity

As we noted at the outset of the chapter, there is a vast gulf in productivity
between advanced economies such as the United States and developing nations,
including India and the DRC, but also a wide range among these and other
developing countries. And as we have seen, all countries with averages below
what is defined as high income are considered developing in most taxonomies
(and some in the high-income range as defined by the World Bank are still
considered developing). The lower average levels but wide ranges of income
in developing areas are seen in Table 2.3. Even when adjusted for purchasing
power parity and despite extraordinary recent growth in China and India, the
low- and middle-income developing nations, with more than five-sixths (84%)
of the world's people, received only about 46% of the world's income in 2011,
as seen in Figure 2.3a. Though resulting from a number of deeper causes, the
wide disparity in income largely corresponds to the large gaps in output per
worker between developing and developed countries as seen in Figure 2.3b. 12
At very low income levels, in fact, a vicious circle may set in, whereby low
income leads to low investment in education and health as well as plant and
equipment and infrastructure, which in tum leads to low productivity and
economic stagnation. This is known as a poverty trap or what Nobel laureate
Gunnar Myrdal called "circular and cumulative causation." 13 However, it is
important to stress that there are ways to escape from low income, as you will
see throughout this book. Further, the low-income countries are themselves a
very diverse group with greatly differing development challenges. 14
Some star performers among now high-income economies such as South
Korea and Taiwan were once among the poorest in the world. Some middle-
income countries are also relatively stagnant, but others are growing rapidly-
China most spectacularly, as reviewed in the case study at the end of Chapter 4.
Indeed, income growth rates have varied greatly in different developing
regions and countries, with rapid growth in East Asia, slow or even no growth
in sub-Saharan Africa, and intermediate levels of growth in other regions.
Problems of igniting and then sustaining economic growth are examined in
depth in Chapters 3 and 4.
One common misperception is that low incomes result from a country's
being too small to be self-sufficient or too large to overcome economic inertia.
However, there is no necessary correlation between country size in population
or area and economic development (in part because each has different advantages
and disadvantages that can offset each other). 15
114
FIGURE 2.3 (a) Shares of Global Income, 2008. (b) Developing regions lag far behind the developed
world in productivity measured as output per worker.
(a) {b)
Output per worker, 1991, 2001, and 2011
- , - - East Asia and Pacific {Thousands of constant 2005 PPP-adjusted international dollars)
-
18%
Sub-Saharan Africa
J,,---- Europe and

11111
-
Central Asia
High-Income 7% Oceania
countries
54% -1---- Latin America
and Caribbean
8%
lllllliJ
Southern Asia
Middle East and
North Africa
3%
-
South-Eastern Asia
Sub-Saharan
Africa
2% Ill
Caucasus and Central Asia
Ii
Eastern Asia
111111!1
II
Northern Africa
f:j
Latin America and the Caribbean
YCI
Western Asia
,,
Developed regions
48
57
Developing regions
6
8
0 10 20 30 40 50 60 70
1991 ■ ■ 2001 ■ ■ 2011•

• Figures for 2011 are preliminary estimates.
Source: Figure 2.3a, Data from World Bank, World Development Indicators 2013 (Washington, D. C.: World Bank, 2013), p.24.
Figure 2.3b, United Nations, Millenium Development Goals Report 2012, p.9.
115
TABLE 2.5 The 12 Most and Least Populated Countries and Their Per Capita Income, 2008
Population GNI Per Population GNI Per Capita
Most Populous (millions) Capita (U.S. $) Least Populous0 (thousands) (U.S. $)
1. China 1,325 2,940 1. Palau 20 8,630
2. India 1,140 1,040 2. St. Kitts and Nevis 49 10,870
3. United States 304 47,930 3. Marshall Islands 60 3,270
4. Indonesia 227 1,880 4. Dominica 73 4,750
5. Brazil 192 7,300 5. Antigua and Barbuda 87 13,200
6. Pakistan 166 950 6. Seychelles 87 10,220
7. Bangladesh 160 520 7. Kiribati 97 2,040
8. Nigeria 151 1,170 8. Tonga 104 2,690
9. Russian Federation 142 9,660 9. Grenada 104 5,880
10. Japan 128 38,130 10. St. Vincent and the 109 5,050
Grenadines
11. Mexico 106 9,990 11. Micronesia 110 2,460
12. Philippines 90 1,890 12. Sao Tome and Principe 160 1,030
•criteria for inclusion in the least-populous rankings: United Nations member as of mid-2010, with 2008 comparable population and GNI per capita data in
tab. 1.6 in the source.
Source: The World Bank, World Development Indicators, 2010 (Washington, D.C.: World Bank, 2010), tabs 1.1 and 1.6.
The 12 most populous countries include representatives of all four cate-

gories: low-, lower-middle-, upper-middle-, and high-income countries (see
Table 2.5). The 12 least populous on the list include primarily lower-middle- and
upper-middle-income countries, although the 12th least populous country,
Sao Tome and Principe, has a per capita income of just $1,030. And four very
small but high-income European countries that are UN members (Andorra,
Monaco, Liechtenstein, and San Marino) would appear on the list if compa-
rable World Bank income data were available.
Lower Levels of Human Capital

Human capital-health, education, and skills-is vital to economic growth
and human development. We have already noted the great disparities in
human capital around the world while discussing the Human Development
Index. Compared with developed countries, much of the developing world
has lagged in its average levels of nutrition, health (as measured, for example,
by life expectancy or undernourishment), and education (measured by liter-
acy), as seen in Table 2.3. The under-5 mortality is 17 times higher in low-
income countries than in high-income countries, although great progress has
been made since 1990, as shown graphically in Figure 2.4.
Table 2.6 shows primary school enrollment rates (percentage of students
of primary age enrolled in school) and the primary school pupil-to-teacher
ratio for the four country income groups and for six major developing regions.
Enrollments have strongly improved in recent years, but student attendance
and completion, along with attainment of basic skills such as functional lit-
eracy, remain problems. Indeed, teacher truancy remains a serious problem in
South Asia and sub-Saharan Africa. 16
Moreover, there are strong synergies (complementarities) between prog-
ress in health and education (examined in greater depth in Chapter 8). For
116
FIGURE 2.4 Under-5 Mortality Rates, 1990 and 2012

200
D1990
- - ~
■ 2012
-
0 -- 11 ■ n-
Low Lower middle Upper middle High
income income income income
Source: Data drawn from World Bank, World Development Indicators, accessed 22 Sept. 2013
Reprinted with permission.
example, under-5 mortality rates improve as mothers' education levels rise, as

seen in the country examples in Figure 2.5.
The well-performing developing countries are much closer to the devel-
oped world in health and education standards than they are to the lowest-
income countries. 17 Although health conditions in East Asia are relatively
good, sub-Saharan Africa continues to be plagued by problems of malnourish-
ment, malaria, tuberculosis, AIDS, and parasitic infections. Despite progress,
South Asia continues to have high levels of illiteracy, low schooling attainment,
and undernourishment. Still, in fields such as primary school completion, low-
income countries are also making great progress; for example, enrollments in
India are up from 68% in the early 1990s to a reported 94% by 2008.
Higher Levels of Inequality and Absolute Poverty

Globally, the poorest 20% of people receive just 1.5% of world income. The
lowest 20% now roughly corresponds to the approximately 1.2 billion people
TABLE 2.6
Region or Group
Income Group
Primary School Enrollment and Pupil-Teacher Ratios, 2010
Net Primary School
Enrollment(%)
Primary Pupil-
Teacher Ratio
•
Low 80 45
Lower Middle 87 23 3
Upper Middle 94 22
High 95 15
Region
East Asia and Pacific 93 3 19
Latin America and the Caribbean 94 25
Middle East and North Africa 91 24
South Asia 86 40 3
Sub-Saharan Africa 73 49
Europe and Central Asia 92 16
•Data for 2009.
Source: Data from World Bank, World Development Indicators, 2010 (Washington, D.C.: World Bank, 2010), tabs 2.11 and 2.12.
117
FIGURE 2.5 Correlation between Under-5 Mortality and Mother's Education

Mother's Education
D No education
200 D Some primary
D Complete primary/some secondary
0
0
150 ■ Complete secondary/some higher
0
,-< ,s
~-~
O.,.c
<Jl Q)
~~
Q)
100
Q
50
0
Tanzania Bolivia Bangladesh Philippines Egypt
(2004-05) (2003) (2004) (2003) (2005)
Source: International Bank for Reconstruction and Development/World Bank, World Development Indicators, 2007 (Washington,
D.C.: World Bank, 2007), p. 119. Reprinted with permission.
living in extreme poverty on less than $1.25 per day at purchasing power parity. 18
Bringing the incomes of those living on less than $1.25 per day up to this
minimal poverti line would require less than 2% of the incomes of the world's
wealthiest 10%. 9 Thus, the scale of global inequality is also immense.
But the enormous gap in per capita incomes between rich and poor nations is
not the only manifestation of the huge global economic disparities. To appreciate
the breadth and depth of deprivation in developing countries, it is also necessary
to look at the gap between rich and poor within individual developing countries.
Very high levels of inequality-extremes in the relative incomes of higher- and
lower-income citizens-are found in many middle-income countries, partly
because Latin American countries historically tend to be both middle-income and
highly unequal. Several African countries, including Sierra Leone, Lesotho, and South
Africa, also have among the highest levels of inequality in the world. 20 Inequality is
particularly high in many resource-rich developing countries, notably in the Mid-
dle East and sub-Saharan Africa. Indeed, in many of these cases, inequality is sub-
stantially higher than in most developed countries (where inequality has in many
cases been rising). But inequality varies greatly among developing countries, with
generally much lower inequality in Asia. Consequently, we cannot confine our
attention to averages; we must look within nations at how income is distributed to
ask who benefits from economic development and why.
Corresponding to their low average income levels, a large majority of the
extreme poor live in the low-income developing countries of sub-Saharan Africa
and South Asia. Extreme poverty is due in part to low human capital but also to
social and political exclusion and other deprivations. Great progress has already
been made in reducing the fraction of the developing world's population living
on less than $1.25 per day and raising the incomes of those still below that level,
but much remains to be done, as we examine in detail in Chapter 5.
118
Absolute poverty The Development economists use the concept of absolute poverty to represent
situation of being unable or a specific minimum level of income needed to satisfy the basic physical needs
only barely able to meet the
subsistence essentials of food, of food, clothing, and shelter in order to ensure continued survival. A problem,
clothing, shelter, and basic however, arises when one recognizes that these minimum subsistence levels
health care. will vary from country to country and region to region, reflecting different
physiological as well as social and economic requirements. Economists have
therefore tended to make conservative estimates of world poverty in order to
avoid unintended exaggeration of the problem.
The incidence of extreme poverty varies widely around the developing
world. The World Bank estimates that the share of the population living on
less than $1.25 per day is 9.1 % in East Asia and the Pacific, 8.6% in Latin America
and the Caribbean, 1.5% in the Middle East and North Africa, 31.7% in South
Asia, and 41.1 % in sub-Saharan Africa. 21 The share of the world population
living below this level had fallen encouragingly to an estimated 21 % by 2010,
though there are concerns that the pace of poverty reduction may have slowed
recently. 22 But as Figure 2.6 shows, the number living on less than $1.25 per
day fell from about 1.9 billion in 1981 to about 1.2 billion by 2008, despite a
59% increase in the developing world's population.
Extreme poverty represents great human misery, and so redressing it is
a top priority of international development. Development economists have
also increasingly focused on ways in which poverty and inequality can lead
to slower growth. That is, not only do poverty and inequality result from
distorted growth, but they can also cause it. This relationship, along with
FIGURE 2.6 Number of People Living in Poverty by Region, 1981-2008

Number of poor by region, 1981-2008
~
§ 2,000
i11.
11.
11.
~ 1,500
0
N
.5
i South Asia
~
'° 1,000
......
...
<R
llJ
'tl
§
.w 500
;.::::
1984 1987 1990 1993 1996 1999 2002 2005 2008
Source: World Bank, "World Bank sees progress against extreme poverty, but flags
vulnerability," April 2012, http:/ /web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/
EXTRESEARCH/EXTPROGRAMS/EXTPOVRES/EXTPOVCALNET/0,,contentMDK:
22716987~pagePK:64168435~theSitePK:5280443~isCURL:Y,00.html.
119
measurements of inequality and poverty and strategies to address these problems,

is examined in depth in Chapter 5; because of their central importance in
development, poverty reduction strategies are examined throughout the text.
Higher Population Growth Rates

Global population has skyrocketed since the beginning of the industrial era,
from just under 1 billion in 1800 to 1.65 billion in 1900 and to over 6 billion by
2000. World population topped 7 billion by 2012. Rapid population growth
began in Europe and other now developed countries. But in recent decades,
most population growth has been centered in the developing world. Com-
pared with the developed countries, which often have birth rates near or even
below replacement (zero population growth) levels, the low-income develop-
ing countries have very high birth rates. More than five-sixths of all the people
in the world now live in developing countries; and some 97% of net popula-
tion growth (births minus deaths) in 2012 took place in developing regions.
But population dynamics varies widely among developing countries. Popula-
tions of some developing countries, particularly in Africa, continue to grow rap-
idly. From 1990 to 2008, population in the low-income countries grew at 2.2% per
year, compared to 1.3% in the middle-income countries (the high-income coun-
tries grew at 0.7% per year, reflecting both births and immigration).23
Middle-income developing countries show greater variance, with some
having achieved lower birth rates closer to those prevailing in rich countries.
The birth rate is about three times as high in the low-income countries as in
the high-income countries. In sub-Saharan Africa, the annual birth rate is 39
per 1,000-four times the rate in high-income countries. Intermediate but still
relatively high birth rates are found in South Asia (24), the Middle East and
North Africa (24), and Latin America and the Caribbean (19). East Asia and
the Pacific have a moderate birth rate of 14 per 1,000, partly the result of birth
control policies in China. The very wide range of crude birth rates around Crude birth rate The number
the world is illustrated in Table 2.7. As of 2010, the average rate of population of children born alive each
year per 1,000 population.
growth was about 1.4% in the developing countries.
A major implication of high birth rates is that the active labor force has
to support proportionally almost twice as many children as it does in richer
countries. By contrast, the proportion of people over the age of 65 is much
TABLE 2.7 Crude Birth Rates Around the World, 2012

45+ Chad, Dem. Rep. of Congo, Mali, Niger, Uganda, Zambia
40-44 Afghanistan, Angola, Benin, Burkina Faso, Liberia, Malawi, Mozambique, Nigeria, Somalia, South Sudan, Tanzania
35-39 Central African Republic, Cote d'Ivoire, Eritrea, Iraq, Jordan, Kenya, Madagascar, Senegal, Sierra Leone, Yemen
30-34 Ethiopia, Ghana, Papua New Guinea, Sudan, Timor-Leste, Vanatu, Zimbabwe
25-29 Algeria, Bolivia, Cambodia, Egypt, Guatemala, Haiti, Honduras, Kyrgyzstan, Pakistan, Philippines, Samoa, Tonga
20-24 Dominican Republic, El Salvador, India, Libya, Mexico, Peru, Saudi Arabia, South Africa, Venezuela
15-19 Argentina, Brazil, Colombia, Costa Rica, Indonesia, Jamaica, Sri Lanka, Turkey, Vietnam
10-14 Australia, Canada, China, France, Russia, United Kingdom, United States
<10 Austria, Croatia, Germany, Hungary, Italy, Japan, South Korea, Serbia, Portugal, Taiwan
Source: Population Reference Bureau, Population Data Sheet, 2012,
120
greater in the developed nations. Both older people and children are often
Dependency burden The referred to as an economic dependency burden in the sense that they must be
proportion of the total popu- supported financially by the country's labor force (usually defined as citizens
lation aged Oto 15 and 65+,
which is considered economi- between the ages of 15 and 64). In low-income countries, there are 66 children
cally unproductive and there- under 15 for each 100 working-age (15-65) adults, while in middle-income
fore not counted in the labor countries, there are 41 and in high-income countries just 26. In contrast, low-
force. income countries have just 6 people over 65 per 100 working-age adults, com-
pared with 10 in middle-income countries and 23 in high-income countries.
Thus, the total dependency ratio is 72 per 100 in low-income countries and
49 per 100 in high-income countries. 24 But in rich countries, older citizens are
supported by their lifetime savings and by public and private pensions. In
contrast, in developing countries, public support for children is very limited.
So dependency has a further magnified impact in developing countries.
We may conclude, therefore, that not only are developing countries char-
acterized by higher rates of population growth, but they must also contend
with greater dependency burdens than rich nations, though with a wide gulf
between low- and middle-income developing countries. The circumstances and
conditions under which population growth becomes a deterrent to economic
development is a critical issue and is examined in Chapter 6.
Greater Social Fractionalization

Low-income countries often have ethnic, linguistic, and other forms of social
Fractionalization Significant divisions, sometimes known as fractionalization. This is sometimes asso-
ethnic, linguistic, and other ciated with civil strife and even violent conflict, which can lead developing
social divisions within a
country.
societies to divert considerable energies to working for political accommoda-
tions if not national consolidation. It is one of a variety of governance chal-
lenges many developing nations face. There is some evidence that many of the
factors associated with poor economic growth performance in sub-Saharan
Africa, such as low schooling, political instability, underdeveloped financial
systems, and insufficient infrastructure, can be statistically explained by high
ethnic fragmentation. 25
The greater the ethnic, linguistic, and religious diversity of a country, the
more likely it is that there will be internal strife and political instability. Some
of the most successful development experiences-South Korea, Taiwan, Sin-
gapore, and Hong Kong-have occurred in culturally homogeneous societies.
But today, more than 40% of the world's nations have more than five sig-
nificant ethnic populations. In most cases, one or more of these groups face
serious problems of discrimination, social exclusion, or other systematic dis-
advantages. Over half of the world's developing countries have experienced
some form of interethnic conflict. Ethnic and religious conflicts leading to
widespread death and destruction have taken place in countries as diverse
as Afghanistan, Rwanda, Mozambique, Guatemala, Mexico, Sri Lanka, Iraq,
India, Kyrgyzstan, Azerbaijan, Somalia, Ethiopia, Liberia, Sierra Leone,
Angola, Myanmar, Sudan, the former Yugoslavia, Indonesia, and the DRC.
Conflict can derail what had otherwise been relatively positive develop-
ment progress, as in Cote d'Ivoire since 2002 (see Chapter 14 and the case
study for Chapter 5). There is, however, a heartening trend since the late
1990s toward more successful resolution of conflicts and fewer new conflicts.
121
If development is about improving human lives and providing a widening

range of choice to all peoples, racial, ethnic, caste, or religious discrimination
is pernicious. For example, throughout Latin America, indigenous popula-
tions have significantly lagged behind other groups on almost every measure
of economic and social progress. Whether in Bolivia, Brazil, Peru, Mexico,
Guatemala, or Venezuela, indigenous groups have benefited little from overall
economic growth. Being indigenous makes it much more likely that an indi-
vidual will be less educated, in poorer health, and in a lower socioeconomic
stratum than other citizens. 26 This is particularly true for indigenous women.
Moreover, descendants of African slaves brought forcefully to the western
hemisphere continue to suffer discrimination in countries such as Brazil.
Ethnic and religious diversity need not necessarily lead to inequality, tur-
moil, or instability, and unqualified statements about their impact cannot
be made. There have been numerous instances of successful economic and
social integration of minority or indigenous ethnic populations in countries as
diverse as Malaysia and Mauritius. And in the United States, diversity is often
cited as a source of creativity and innovation. The broader point is that the
ethnic and religious composition of a developing nation and whether or not
that diversity leads to conflict or cooperation can be important determinants
of the success or failure of development efforts. 27
Larger Rural Populations but Rapid Rural-to-Urban Migration

One of the hallmarks of economic development is a shift from agriculture to
manufacturing and services. In developing countries, a much higher share of
the population lives in rural areas, and correspondingly fewer in urban areas,
as seen in Table 2.8. Although modernizing in many regions, rural areas are
poorer and tend to suffer from missing markets, limited information, and social
stratification. A massive population shift is also under way as hundreds of mil-
lions of people are moving from rural to urban areas, fueling rapid urbaniza-
tion, with its own attendant problems. The world as a whole has just crossed
the 50% threshold: For the first time in history, more people live in cities than
TABLE 2.8 The Urban Population in Developed Countries and Developing Regions
Region Population (millions, 2009) Urban Share (%)
World 6,810 50
More developed countries 1,232 75
Less developed countries 5,578 44
Sub-Saharan Africa 836 35
Northern Africa 205 50
Latin America and the 580 77
Caribbean
Western Asia 231 64
South-central Asia 1,726 31
Southeast Asia 597 43
East Asia 1,564 51
Eastern Europe 295 69
Source: Population Reference Bureau, 2009 World Data Sheet.
122
in rural areas. But sub-Saharan Africa and most of Asia remain predominantly
rural. Migration and agriculture issues are examined in Chapters 7 and 9.
Lower Levels of Industrialization and Manufactured Exports

One of the most widely used terminologies for the original Group of Seven
(G7) countries 28 and other advanced economies such as smaller European
countries and Australia is the "industrial countries." Industrialization is
associated with high productivity and incomes and has been a hallmark of
modernization and national economic power. It is no accident that most devel-
oping-country governments have made industrialization a high national pri-
ority, with a number of prominent success stories in Asia.
Table 2.9 shows the relationship between employment and share of GDP in
agriculture, industry, and services in selected developing and developed coun-
tries, in the 2004 to 2008 period. Generally, developing countries have a far
higher share of employment in agriculture than developed countries. More-
over, in developed countries, agriculture represents a very small share of both
employment and output-about 1% to 2% in Canada, the United States and
United Kingdom-although productivity is not below the average for these
economies as a whole. This is in sharp contrast to a majority of developing
nations, which have relatively low productivity in agriculture in comparison
TABLE 2.9 Share of the Population Employed in the Agricultural, Industrial, and Service Sectors in Selected
Countries, 2004-2008 (%)
Agriculture Industry Services
Share of Share of Share of
Males Females GDP (2008) Males Females GDP (2008) Males Females GDP (2008)
Africa
Egypt 28 43 13 26 6 38 46 51 49
Ethiopia 12 6 44 27 17 13 61 77 42
Madagascar 82 83 25 5 2 17 13 16 57
Mauritius 10 8 4 36 26 29 54 66 67
South Africa 11 7 3 35 14 34 54 80 63
Asia
Bangladesh 42 68 19 15 13 29 43 19 52
Indonesia 41 41 14 21 15 48 38 44 37
Malaysia 18 10 10 32 23 48 51 67 42
Pakistan 36 72 20 23 13 27 41 15 53
Philippines 44 24 15 18 11 32 39 65 53
South Korea 7 8 3 33 16 37 60 74 60
Thailand 43 40 12 22 19 44 35 41 44
Vietnam 56 60 22 21 14 40 23 26 38
Latin America
Colombia 27 6 9 22 16 36 51 78 55
Costa Rica 18 5 7 28 13 29 54 82 64
Mexico 19 4 4 31 18 37 50 77 59
Nicaragua 42 8 19 20 18 30 38 73 51
Developed Countries
United Kingdom 2 1 1 32 9 24 66 90 76
United States 2 1 1 30 9 22 68 90 77
Note: Ethiopia agricultural employment reflects limited coverage.
Source: World Bank, World Development Indicators, 2010 (Washington, D.C.: World Bank, 2010), tabs. 2.3 and 4.2.
123
to other sectors of their own economies-particularly industry. Madagascar is

a dramatic example: while about 82% of both men and women worked in agri-
culture, it represented only a quarter of total output. In Indonesia, 41 % of both
men and women worked in agriculture, but it represented just 14% of output.
The proportion of women who work in the agricultural sector varies greatly
across the developing world. Generally, in Latin America a significantly higher
proportion of men work in agriculture than women; but in numerous countries
in Africa and Asia, a larger proportion of women work in agriculture.
Table 2.10 reveals the structural transformation of employment that has
been occurring in developing countries. Where available, the table shows
employment shares in both 1990-1992 and 2008-2011 periods. There have
been substantial declines over this two-decade period in the share in employ-
ment in agriculture in most developing countries for which comparable data
is available. For example, in Indonesia the proportion of men who work in
agriculture fell from 54% to 37%; and the proportion of women who work
in agriculture fell from 57% to 35%. Partial exceptions include Pakistan and
Honduras, for which the share of women's agricultural employment rose by
approximately as much as that of men fell.
At the same time, the share of employment in industry in many devel-
oped countries is smaller now than in some developing countries, particularly
among women, as developed countries continue their secular trend to switch
to from industry to service sector employment. However, many developed-
country industrial jobs require high skills and pay high wages.
Relatively few countries managed a substantial gain of the fraction in
manufacturing in this period; Indonesia, Turkey, and Mexico showed modest
gains, particularly for men. (Other evidence indicates that a large fraction of
global manufacturing jobs were gained in one country-China-during this
period; but comparable data for China were unavailable for comparison.)
The share of industrial employment in Africa remains low for both men and
women in most countries.
Along with lower industrialization, developing nations tended to have a
higher dependence on primary exports. Most developing countries have diver-
sified away from agricultural and mineral exports to some degree. The middle-
income countries are rapidly catching up with the developed world in the share
of manufactured goods in their exports, even if these goods are typically less
advanced in their skill and technology content. However, the low-income coun-
tries, particularly those in Africa, remain highly dependent on a relatively small
number of agricultural and mineral exports. Africa will need to continue its
efforts to diversify its exports. We examine this topic in Chapter 12.
Adverse Geography
Many analysts argue that geography must play some role in problems of agri-
culture, public health, and comparative development more generally. Land-
locked economies, common in Africa, often have lower incomes than coastal
economies. 29 As can be observed on the map on the inside cover, develop-
ing countries are primarily tropical or subtropical, and this has meant that
they suffer more from tropical pests and parasites, endemic diseases such as
malaria, water resource constraints, and extremes of heat. A great concern
124
TABLE 2.10 Share of the Population Employed in the Agricultural, Industrial, and Service Sectors in Selected Countries, 1990-92 and 200S-2011 (%)
L=-
Agriculture Industry Services
Males Females Males Females Males Females
% of Male % of Female % of Male % of Female %of Male % of Female
Employment Employment Employment Employment Employment Employment
1990-92 2008-11 1990-92 2008-11 1990-92 2008-11 1990-92 2008-11 1990-92 2008-11 1990--92 2008--11 Region
Cameroon 49 58 13 12 38 30 Africa
Egypt, Arab Rep. 35 28 52 46 25 27 10 6 41 44 37 49 Africa
Liberia so 48 14 5 37 47 Africa
Mauritius 15 9 13 7 36 32 48 21 48 59 39 73 Africa
Namibia 45 23 52 8 21 24 8 9 34 53 40 83 Africa
Indonesia 54 37 57 35 15 24 13 15 31 40 31 so Asia
Malaysia 23 16 20 9 31 31 32 21 46 53 48 71 Asia
Pakistan 45 37 69 75 20 22 15 12 35 41 16 13 Asia
Philippines 53 41 32 23 17 18 14 10 29 41 55 68 Asia
Thailand 60 41 62 37 18 23 13 18 22 37 25 45 Asia
Turkey 33 18 72 39 26 31 11 15 41 51 17 45 Asia
Chile 24 14 6 5 32 31 15 10 45 55 79 85 Latin America
Costa Rica 32 20 5 4 27 25 25 11 41 55 69 84 Latin America
Dominican 26 19 3 2 23 21 21 7 52 47 76 60 Latin America
Republic
Honduras 53 so 6 12 18 19 25 21 29 31 69 67 Latin America
Mexico 34 19 11 4 25 30 19 18 41 51 70 78 Latin America
Canada 6 3 2 1 31 32 11 10 64 65 87 89 Developed
Japan 6 4 7 4 40 33 27 15 54 62 65 80 Developed
United Kingdom 3 2 1 1 41 29 16 8 55 69 82 91 Developed
United States 4 2 1 1 34 25 14 7 62 72 85 92 Developed
Note: Country selection reflects that only a limited number of countries are covered or have data over time. Data represent most recent in timeframe if average for the period is not available.
Source: World Bank, World Development Indicators, 2013 (Washington, D.C.: World Bank, 2013), tab. 2.3.
125
going forward is that global warming is projected to have its greatest negative
impact on Africa and South Asia (see Chapter 10). 30
The extreme case of favorable physical resource endowment is the oil- Resource endowment A
rich Persian Gulf states. At the other extreme are countries like Chad, Yemen, nation's supply of usable
factors of production, including
Haiti, and Bangladesh, where endowments of raw materials and minerals and mineral deposits, raw materials,
even fertile land are relatively minimal. However, as the case of the DRC shows and labor.
vividly, high mineral wealth is no guarantee of development success. Conflict over
the profits from these industries has often led to a focus on the distribution of wealth
rather than its creation and to social strife, undemocratic governance, high inequal-
ity, and even armed conflict, in what is called the "curse of natural resources."
Clearly, geography is not destiny; high-income Singapore lies almost directly
on the equator, and parts of southern India have exhibited enormous economic
dynamism in recent years. Prior to colonization, some tropical and subtropical
regions had higher incomes per capita than Europe. However, the presence of
common and often adverse geographic features in comparison to temperate
zone countries means it is beneficial to study tropical and subtropical develop-
ing countries together for some purposes. Redoubled efforts are now under way
to extend the benefits of the green revolution and tropical disease control to sub-
Saharan Africa. In section 2.7 of this chapter, we add further perspectives on the
possible indirect roles of geography in comparative development.
Underdeveloped Markets
Imperfect markets and incomplete information are far more prevalent in
developing countries, with the result that domestic markets, notably but not
only financial markets, have worked less efficiently, as examined in Chapters
4, 11, and 15. In many developing countries, legal and institutional founda-
tions for markets are extremely weak.
Some aspects of market underdevelopment are that they often lack (1) a
legal system that enforces contracts and validates property rights; (2) a sta-
ble and trustworthy currency; (3) an infrastructure of roads and utilities that Infrastructure Facilities that
results in low transport and communication costs so as to facilitate interre- enable economic activity and
markets, such as transporta-
gional trade; (4) a well-developed and efficiently regulated system of banking tion, communication and
and insurance, with broad access and with formal credit markets that select distribution networks, utili-
projects and allocate loanable funds on the basis of relative economic profit- ties, water, sewer, and energy
ability and enforce rules of repayment; (5) substantial market information for supply systems.
consumers and producers about prices, quantities, and qualities of products
and resources as well as the creditworthiness of potential borrowers; and
(6) social norms that facilitate successful long-term business relationships.
These six factors, along with the existence of economies of scale in major sec-
tors of the economy, thin markets for many products due to limited demand
and few sellers, widespread externalities (costs or benefits that accrue to com-
panies or individuals not doing the producing or consuming) in production
and consumption, and poorly regulated common property resources (e.g.,
fisheries, grazing lands, water holes) mean that markets are often highly
imperfect. Moreover, information is limited and costly to obtain, thereby
often causing goods, finances, and resources to be misallocated. And we have
come to understand that small externalities can interact in ways that add up
to very large distortions in an economy and present the real possibility of an
126
Imperfect market A market underdevelopment trap (see Chapter 4). The extent to which these imperfect
in which the theoretical markets and incomplete information systems justify a more active role for gov-
assumptions of perfect com-
petition are violated by the ernment (which is also subject to similar problems of incomplete and imperfect
existence of, for example, a information) is an issue that we will be dealing with in later chapters. But their
small number of buyers and existence remains a common characteristic of many developing nations and an
sellers, barriers to entry, and important contributing factor to their state of underdevelopment. 31
incomplete information.
Incomplete information The
absence of information that Lingering Colonial Impacts and Unequal
producers and consumers International Relations
need to make efficient deci-
sions resulting in underper- Colonial Legacy Most developing countries were once colonies of Europe or
forming markets.
otherwise dominated by European or other foreign powers, and institutions
created during the colonial period often had pernicious effects on development
that in many cases have persisted to the present day. Despite important varia-
tions that proved consequential, colonial era institutions often favored extrac-
tors of wealth rather than creators of wealth, harming development then and
now. Both domestically and internationally, developing countries have more
often lacked institutions and formal organizations of the type that have bene-
Property rights The fited the developed world: Domestically, on average, property rights have been
acknowledged right to use less secure, constraints on elites have been weak, and a smaller segment of soci-
and benefit from a tangible
(e.g., land) or intangible (e.g.,
ety has been able to gain access to and take advantage of economic opportuni-
intellectual) entity that may ties.32 Problems with governance and public administration (see Chapter 11), as
include owning, using, deriv- well as poorly performing markets, often stem from poor institutions.
ing income from, selling, and Decolonization was one of the most important historical and geopolitical
disposing.
events of the post-World War II era. More than 80 former European colonies
have joined the United Nations. But several decades after independence, the
effects of the colonial era linger for many developing nations, particularly the
least developed ones.
Colonial history matters not only or even primarily because of stolen
resources but also because the colonial powers determined whether the legal
and other institutions in their colonies would encourage investments by (and in)
the broad population or would instead facilitate exploitation of human and other
resources for the benefit of the colonizing elite and create or reinforce extreme
inequality. Development-facilitating or development-inhibiting institutions tend
to have a very long life span. For example, when the conquered colonial lands
were wealthier, there was more to steal. In these cases, colonial powers favored
extractive (or "kleptocratic") institutions at the expense of ones that encouraged
productive effort. When settlers came in large numbers to live permanently,
incomes ultimately were relatively high, but the indigenous populations were
largely annihilated by disease or conflict, and descendants of those who sur-
vived were exploited and blocked from advancement. A growing body of evi-
dence demonstrates that practices such as forced labor had pernicious effects on
human development even centuries after they were discontinued (see Box 2.3).
In a related point of great importance, European colonization often created
or reinforced differing degrees of inequality, often correlated with ethnicity,
which have also proved remarkably stable over the centuries. In some respects,
postcolonial elites in many developing countries largely took over the exploit-
ative role formerly played by the colonial powers. High inequality sometimes
emerged as a result of slavery in regions where comparative advantage in crops
127
Unit 6
Inflation
128
Definition
• Inflation
• A sustained increase in average price level of all goods and services produced
in an economy
• Deflation
• A sustained decrease in average price level of all goods and services produced
in an economy
129
Measure of Inflation: Consumer Price Index
CPI is designed to measure the changes over time in general level of

retail prices of selected goods and services that households purchase for
the purpose of consumption. Such changes affect the real purchasing
power of consumers’ income and their welfare. The CPI measures price
changes by comparing, through time, the cost of a fixed basket of
commodities.
130
Calculating CPI
1) Fix the basket
• Basket of goods and services bought be typical consumer
• Weight given to goods and services depending upon importance of the same to consumers
2) Find the prices
• Prices of each of the goods and services in basket at each point in time
3) Compute the basket’s cost
• Current year’s prices x Quantity of goods in basket
4) Choose a base year and compute the index
CPI = (Price of basket of G&S in current year / Price of basket of G&S in base year) x 100
5) Compute inflation rate
Inflation rate in year 2 = 𝑥 100
131
Example
Step 1 : Survecy Consumen to Determine a Fi ed Basket of Goods
Ba et = 4 hot dogs, 2 hamburgers
Step 2 : Find the Price of Each Good in Each Year
Y Price of Hat Dop Price of Hamburgl!rs
2016 1 $2
2017 2 3
2018 3 4
Step 3 : C()mpute the Cost of the Basl<et of Goods in Each Yea~
2016 4 hot dogs) ... ($ 2 per mburger 2 hambu.rgQrsJ = per basket
2017 4 hot dogs) + ( ~ hamburgoe,- 2 hamb~rs) = $ 14 per bas crt
2018 4 hot dogs) + C per ham urget" 2 ham trgers) = per bas crt
Step 4: Choose One YeM as a Base Ye.- (2016) and Compute, the CPI n Each Year
2016 ( $8/ 8 ) X 0 0 = 100
2017 ( 14/ 8 ) X 100 = 175
2018 ( 20/ 8 ) X 00 = 250
Step 5: Use the CPI to Compute the Inflation Rate from PT-ious YeaY
2017 ( 75 - 100)/100 100 = 75%
2018 (250 - 175)/175 X 100 = 43%
132
CPI Basket in India
Item Weight (Rural) Weight (Urban)
• Goods and services from 6 major groups
Food and beverages
considered for CPI
• Cereals and products
• Total 299 commodities
• Meat and fish
54.18 36.29
• Egg
• Weights given according to economic
• Milk and products
importance of each commodity
• …….
• Proportion of total spending on that
Pan, Tobacco and Intoxicants 3.26 1.36 item
Clothing and Footwear 7.36 5.57 • Prices collected from markets:

• 1181 village markets covering all
Housing - 21.67 districts
• 1114 urban markets distributed over
Fuel and light 7.94 5.58 310 towns
Miscellaneous
• Health
• Education 27.26 29.53
• Recreation and amusement 133
• …….
Problems in Measuring Cost of Living
• Substitution bias
• Fixed basket ignores possibility of consumer substitution
• May overstate increase in cost of living
• Introduction of new goods

• Greater variety due to new goods may reduce cost of maintaining level of economic well-
being
• Basket may not be revised quickly enough to introduce new goods
• Unmeasured quality change

• Change in quality of goods may change value of money
• Difficult to incorporate as quality is hard to measure
134
GDP Deflator vs CPI
• GDP deflator: ratio of nominal GDP to real GDP
• Reflects current level of prices relative to prices in base year
• Key differences b/w GDP deflator and CPI:

• GDP deflator reflects prices of G&S produced domestically while CPI reflects
prices of G&S bought by consumers
• CPI compares prices of fixed basket of goods, GDP deflator compares prices
of currently produced goods
135
Impact of Price Fluctuations
136
"So what's it going to be?
The same size as last year
or the sam,e price as last
year?"
Decline in value of money

Same amount of money will get lesser goods and services
137
On Purchasing Power of Money
In 2019, you have 1 crore rupees. Following are prices of some products in economy: house: 10 lakh, laptop: 1 lakh,
table: 10000, school bag: 1000, haircut: 100. How many of these products can you purchase in the current time period?
Now imagine a hyperinflation where prices double every month. How many products will you be able to purchase then?
Time period 0 1 2 3 4 5 6
Rate of inflation 0 100 200 400 800 1600 3200
Houses 10 0.1 0.0 0.0 0.0 0.0 0.0
Laptop 100 1.0 0.5 0.2 0.1 0.1 0.0
Table 1000 9.9 5.0 2.5 1.2 0.6 0.3
School bag 10000 99.0 49.8 24.9 12.5 6.2 3.1
Haircut 100000 990.1 497.5 249.4 124.8 62.5 31.2
138
On Recipients and Payers of Fixed Interest Rates
In 2019 you have Rs. 10,000; you want to use that to buy shirts which cost Rs. 100 and banks are offering
you interest rate of 5%. How many shirts can you purchase in current time period? How many can you
purchase after one year if all the money is put in savings bank account?
Ans: 100; 105
Now assume an inflation of 2%, 5%, 7% and 10%. How many shirts can you buy after one year now?
2% 5% 7% 10%
Number of shirts after one year 103 100 98 95
• Inflation can have significant impact on real interest rate (nominal interest rate – inflation rate)
• Reduction in real interest rate may:

• Erode values of savings
• Adversely impact on pensioners
• Make servicing debt easier
139
Adverse Impact of Falling Prices
• Falling prices encourage consumers to delay making purchases. May lead to:
• Less economic activity
• Less income generated by producers
• Lower economic growth
• Ideal case for inflation: low, stable, predictable
140
Causes of Inflation
• Demand Pull Inflation:
• Rate of increase in money supply higher than rate of increase in supply of goods and services
• “Too much money chasing too few goods”
• Cost Push Inflation:

• Sharp increase in cost of production
o Example: natural disasters, high oil prices
• Higher costs passed on to consumers as higher prices
141
Dealing with Inflation
• Contractionary policies
• Used when economy is overheated
• May involve raising interest rates, fixing exchange rate or setting prices
• Influencing inflation expectations

• Done through policy announcements
• Leads to built-in inflation components in contracts
• Success depends on credibility of central banks
142
BACK
TO THETOEDITOR
BASICS
LETTERS
What
Is Inflation?
Ceyda Oner
I
T may be one of the most familiar words in econom- consumers—requires an index with broader coverage, such
ics. Inflation has plunged countries into long peri- as the gross domestic product (GDP) deflator.
ods of instability. Central bankers often aspire to be The CPI basket is mostly kept constant over time for
known as “inflation hawks.” Politicians have won consistency, but is tweaked occasionally to reflect chang-
elections with promises to combat inflation, only to lose ing consumption patterns—for example, to include new
power after failing to do so. Inflation was even declared hi-tech goods and to replace items no longer widely pur-
Public Enemy No. 1 in the United States—by President chased. Because it shows how, on average, prices change
Gerald Ford in 1974. What, then, is inflation, and why is over time for everything produced in an economy, the
it so important? contents of the GDP deflator vary each year and are more
Inflation is the rate of increase in prices over a given current than the mostly fixed CPI basket. On the other
period of time. Inflation is typically a broad measure, such hand, the deflator includes non-consumer items (such as
as the overall increase in prices or the increase in the cost military spending) and is therefore not a good measure of
of living in a country. But it can also be more narrowly the cost of living.
calculated—for certain goods, such as food, or for services,
such as a haircut, for example. Whatever the context, infla- The good and the bad
tion represents how much more expensive the relevant set To the extent that households’ nominal income, which they
of goods and/or services has become over a certain period, receive in current money, does not increase as much as
most commonly a year. prices, they are worse off, because they can afford to pur-
chase less. In other words, their purchasing power or real—
Measuring inflation inflation-adjusted—income falls. Real income is a proxy
Consumers’ cost of living depends on the prices of many for the standard of living. When real incomes are rising, so
goods and services and the share of each in the house- is the standard of living, and vice versa.
hold budget. To measure the average consumer’s cost of In reality, prices change at different paces. Some, such as
living, government agencies conduct household surveys the prices of traded commodities, change every day; others,
to identify a basket of commonly purchased items and such as wages established by contracts, take longer to adjust
track over time the cost of purchasing this basket. (Hous- (or are “sticky,” in economic parlance). In an inflationary
ing expenses, including rent and mortgages, constitute the environment, unevenly rising prices inevitably reduce the
largest component of the consumer basket in the United purchasing power of some consumers, and this erosion of
States.) The cost of this basket at a given time expressed real income is the single biggest cost of inflation.
relative to a base year is the consumer price index (CPI), Inflation can also distort purchasing power over time for
and the percentage change in the CPI over a certain pe- recipients and payers of fixed interest rates. Take pension-
riod is consumer price inflation, the most widely used ers who receive a fixed 5 percent yearly increase to their
measure of inflation. (For example, if the base year CPI pension. If inflation is higher than 5 percent, a pensioner’s
is 100 and the current CPI is 110, inflation is 10 percent purchasing power falls. On the other hand, a borrower who
over the period.) pays a fixed-rate mortgage of 5 percent would benefit from
Core consumer inflation focuses on the underlying and 5 percent inflation, because the real interest rate (the nomi-
persistent trends in inflation by excluding prices set by nal rate minus the inflation rate) would be zero; servicing
the government and the more volatile prices of products, this debt would be even easier if inflation were higher, as
such as food and energy, most affected by seasonal fac- long as the borrower’s income keeps up with inflation. The
tors or temporary supply conditions. Core inflation is lender’s real income, of course, suffers. To the extent that
also watched closely by policymakers. Calculation of an inflation is not factored into nominal interest rates, some
overall inflation rate—for a country, say, and not just for gain and some lose purchasing power.
44 Finance & Development March

December
2010
2009
143
Indeed, many countries have grappled with high as high oil prices, can reduce overall supply and lead to “cost-
inflation—and in some cases hyperinflation, 1,000 percent or push” inflation, in which the impetus for price increases
more a year. In 2008, Zimbabwe experienced one of the worst comes from a disruption to supply. The food and fuel infla-
cases of hyperinflation ever, with estimated annual inflation tion of 2008 was such a case for the global economy—sharply
at one point of 500 billion percent. Such high levels of infla- rising food and fuel prices were transmitted from country to
tion have been disastrous, and countries have had to take dif- country by trade. Conversely, demand shocks, such as a stock
ficult and painful policy measures to bring inflation back to market rally, or expansionary policies, such as when a central
reasonable levels, sometimes by giving up their national cur- bank lowers interest rates or a government raises spending,
rency, as Zimbabwe has. can temporarily boost overall demand and economic growth.
Although high inflation hurts an economy, deflation, or If, however, this increase in demand exceeds an economy’s
falling prices, is not desirable either. When prices are falling, production capacity, the resulting strain on resources is
consumers delay making purchases if they can, anticipat- reflected in “demand-pull” inflation. Policymakers must
ing lower prices in the future. For the economy this means find the right balance between boosting demand and growth
less economic activity, less income generated by producers, when needed without overstimulating the economy and
and lower economic growth. Japan is one country with a causing inflation.
long period of nearly no economic growth, largely because Expectations also play a key role in determining inflation.
of deflation. Preventing deflation during the global finan- If people or firms anticipate higher prices, they build these
cial crisis that began in 2007 is one of the reasons the U.S. expectations into wage negotiations and contractual price
Federal Reserve and other central banks around the world adjustments (such as automatic rent increases). This behav-
have kept interest rates low for a prolonged period and have ior partly determines the next period’s inflation; once the
instituted other monetary policies to ensure financial sys- contracts are exercised and wages or prices rise as agreed,
tems have plenty of liquidity. Today global inflation is at one expectations have become self-fulfilling. And to the extent
of its lowest levels since the early 1960s, partly because of the that people base their expectations on the recent past, infla-
financial crisis. tion will follow similar patterns over time, resulting in infla-
tion inertia.
Policymakers must find the right
How policymakers deal with inflation
balance between boosting demand The right set of anti-inflation policies, those aimed at reducing
inflation, depends on the causes of inflation. If the economy
and growth when needed without has overheated, central banks—if they are committed to en-
suring price stability—can implement contractionary policies
overstimulating the economy and that rein in aggregate demand, usually by raising interest rates.
causing inflation. Some central bankers have chosen, with varying degrees of
success, to impose monetary discipline by fixing the exchange
Most economists now believe that low, stable, and—most rate—tying its currency to another currency and, therefore,
important—predictable inflation is good for an economy. If its monetary policy to that of the country to which it is linked.
inflation is low and predictable, it is easier to capture it in However, when inflation is driven by global rather than do-
price-adjustment contracts and interest rates, reducing its mestic developments, such policies may not help. In 2008,
distortionary impact. Moreover, knowing that prices will be when inflation rose across the globe on the back of high food
slightly higher in the future gives consumers an incentive and fuel prices, many countries allowed the high global prices
to make purchases sooner, which boosts economic activity. to pass through to the domestic economy. In some cases the
Many central bankers have made their primary policy objec- government may directly set prices (as some did in 2008 to
tive maintaining low and stable inflation, a policy called prevent high food and fuel prices from passing through).
inflation targeting (see “Inflation Targeting Turns 20,” in this Such administrative price-setting measures usually result in
issue). the government’s accrual of large subsidy bills to compensate
producers for lost income.
What creates inflation? Central bankers are increasingly relying on their ability
Long-lasting episodes of high inflation are often the result of to influence inflation expectations as an inflation-reduction
lax monetary policy. If the money supply grows too big rela- tool. Policymakers announce their intention to keep eco-
tive to the size of an economy, the unit value of the currency nomic activity low temporarily to bring down inflation, hop-
diminishes; in other words, its purchasing power falls and ing to influence expectations and contracts’ built-in inflation
prices rise. This relationship between the money supply and component. The more credibility central banks have, the
the size of the economy is called the quantity theory of money, greater the influence of their pronouncements on inflation
and is one of the oldest hypotheses in economics. expectations. N
Pressures on the supply or demand side of the economy
can also be inflationary. Supply shocks that disrupt produc- Ceyda Oner is an Economist in the IMF’s Asia and Pacific
tion, such as natural disasters, or raise production costs, such Department.
Finance & Development March 2010 45
144
CHAPTER
Measuring the Cost of Living
24
I
n 1931, as the U.S. economy was suffering through the Great Depression, the
New York Yankees paid famed baseball player Babe Ruth a salary of $80,000.
At the time, this pay was extraordinary, even among the stars of baseball.
According to one story, a reporter asked Ruth whether he thought it was right
that he made more than President Herbert Hoover, who had a salary of $75,000.
Ruth replied, “I had a better year.”
In 2015, the average salary earned by major league baseball players was about
$4 million, and Los Angeles Dodgers pitcher Clayton Kershaw was paid $31
million. At first, this fact might lead you to think that baseball has become
vastly more lucrative over the past eight decades. But as everyone
knows, the prices of goods and services have also risen.
495
Copyrigh
ht 2018
18
8 Cenga
engage
ge Learn
Learn
arn
ar
rrn
n
ning
ing.
iing
in
ng All Rig
gh
hts
ts R
ts Rese
Res
Re
es
ese
e se
served
rved
rv
rve
ve
v e
ed
d. Ma
May no
not b
be
e co
cop
c op
opiie
ied
ied,
ed,
ed
ed
d,, sc
sca
s ca
can
ann
nned
nne
nn
ne
n
ned
ed
e d, or
or d
du
dup
up
upllica
liic
lic
ica
ica
catte
ted,
ted
e
ed
ed,
d, iin
d, n who
wh
w
whol
hol
h
hool
ole
le or
or iin
n par
part
pa
p arrt
art
a rt. WCN
CN 02
2--2
2-2
2-20
-200-20
-20
200
20 0-2
0-20
-2
-20
20
2 03
145
496 PART VIII THE DATA OF MACROECONOMICS
In 1931, a nickel would buy an ice-cream cone and a quarter would buy a ticket
at the local movie theater. Because prices were so much lower in Babe Ruth’s day
than they are today, it is not clear whether Ruth enjoyed a higher or lower stan-
dard of living than today’s players.
In the preceding chapter, we looked at how economists use gross domestic
product (GDP) to measure the quantity of goods and services that the economy is
producing. This chapter examines how economists measure the overall cost of liv-
ing. To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to
find some way of turning dollar figures into meaningful measures of purchasing
power. That is exactly the job of a statistic called the consumer price index, or sim-
ply the CPI. After seeing how the CPI is constructed, we discuss how we can use
such a price index to compare dollar figures from different points in time.
The CPI is used to monitor changes in the cost of living over time. When the
CPI rises, the typical family has to spend more money to maintain the same stan-
dard of living. Economists use the term inflation to describe a situation in which
the economy’s overall price level is rising. The inflation rate is the percentage
change in the price level from the previous period. The preceding chapter showed
how economists can measure inflation using the GDP deflator. The inflation rate
you are likely to hear on the nightly news, however, is calculated from the CPI,
which better reflects the goods and services bought by consumers.
As we will see in the coming chapters, inflation is a closely watched aspect of
macroeconomic performance and is a key variable guiding macroeconomic pol-
icy. This chapter provides the background for that analysis by showing how econ-
omists measure the inflation rate using the CPI and how this statistic can be used
to compare dollar figures from different times.
24-1 The Consumer Price Index

consumer price index (CPI) The consumer price index (CPI) is a measure of the overall cost of the goods and
a measure of the overall services bought by a typical consumer. Every month, the Bureau of Labor Statistics
cost of the goods and (BLS), which is part of the Department of Labor, computes and reports the CPI. In
services bought by a this section, we discuss how the CPI is calculated and what problems arise in its
typical consumer measurement. We also consider how this index compares to the GDP deflator, another
measure of the overall level of prices, which we examined in the preceding chapter.
24-1a How the CPI Is Calculated

When the BLS calculates the CPI and the inflation rate, it uses data on the prices of
thousands of goods and services. To see exactly how these statistics are constructed,
let’s consider a simple economy in which consumers buy only two goods: hot dogs
and hamburgers. Table 1 shows the five steps that the BLS follows.
1. Fix the basket. Determine which prices are most important to the typical
consumer. If the typical consumer buys more hot dogs than hamburgers,
then the price of hot dogs is more important than the price of hamburgers
and, therefore, should be given greater weight in measuring the cost of
living. The BLS sets these weights by surveying consumers to find the basket
of goods and services bought by the typical consumer. In the example in the
table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.
2. Find the prices. Find the prices of each of the goods and services in the basket at
each point in time. The table shows the prices of hot dogs and hamburgers for
three different years.
Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
146
CHAPTER 24 MEASURING THE COST OF LIVING 497
Step 1: Survey Consumers to Determine a Fixed Basket of Goods TABLE 1

Basket 5 4 hot dogs, 2 hamburgers Calculating the
Consumer Price
Step 2: Find the Price of Each Good in Each Year
Index and the
Year Price of Hot Dogs Price of Hamburgers Inflation Rate:
2016 $1 $2 An Example
This table shows
2017 2 3
2018 3 4 how to calculate
the CPI and the
Step 3: Compute the Cost of the Basket of Goods in Each Year inflation rate for
a hypothetical
2016 ($1 per hot dog 3 4 hot dogs) 1 ($2 per hamburger 3 2 hamburgers) 5 $8 per basket
economy in which
consumers buy
only hot dogs and
Step 4: Choose One Year as a Base Year (2016) and Compute the CPI in Each Year hamburgers.
2016 ($8/$8) 3 100 5 100

2017 ($14/$8) 3 100 5 175
2018 ($20/$8) 3 100 5 250
Step 5: Use the CPI to Compute the Inflation Rate from Previous Year
2017 (175 − 100)/100 3 100 5 75%
2018 (250 – 175)/175 3 100 5 43%
3. Compute the basket’s cost. Use the data on prices to calculate the cost of
the basket of goods and services at different times. The table shows this
calculation for each of the three years. Notice that only the prices in this
calculation change. By keeping the basket of goods the same (4 hot dogs and
2 hamburgers), we are isolating the effects of price changes from the effects of
any quantity changes that might be occurring at the same time.
4. Choose a base year and compute the index. Designate one year as the base year, the
benchmark against which other years are to be compared. (The choice of base
year is arbitrary. The index is used to measure percentage changes in the cost
of living, and these changes are the same regardless of the choice of base year.)
Once the base year is chosen, the index is calculated as follows:
Price of basket of goods and services in current year
Consumer price index 5 3 100.
Price of basket in base year
That is, the price of the basket of goods and services in each year is divided by
the price of the basket in the base year, and this ratio is then multiplied by 100.
The resulting number is the CPI.
In the example in Table 1, 2016 is the base year. In this year, the basket of
hot dogs and hamburgers costs $8. Therefore, to calculate the CPI, the price of
the basket in each year is divided by $8 and multiplied by 100. The CPI is 100
in 2016. (The index is always 100 in the base year.) The CPI is 175 in 2017. This
means that the price of the basket in 2017 is 175 percent of its price in the base
year. Put differently, a basket of goods that costs $100 in the base year costs
147
$175 in 2017. Similarly, the CPI is 250 in 2018, indicating that the price level in
2018 is 250 percent of the price level in the base year.
inflation rate 5. Compute the inflation rate. Use the CPI to calculate the inflation rate, which is
the percentage change in the percentage change in the price index from the preceding period. That is,
the price index from the the inflation rate between two consecutive years is computed as follows:
preceding period CPI in year 2 2 CPI in year 1
Inflation rate in year 2 5 3 100.
CPI in year 1
As shown at the bottom of Table 1, the inflation rate in our example is 75 per-
cent in 2017 and 43 percent in 2018.
Although this example simplifies the real world by including only two goods, it
shows how the BLS computes the CPI and the inflation rate. The BLS collects and
processes data on the prices of thousands of goods and services every month and,
by following the five foregoing steps, determines how quickly the cost of living for
the typical consumer is rising. When the BLS makes its monthly announcement of
the CPI, you can usually hear the number on the evening television news or see it
in the next day’s newspaper.
In addition to the CPI for the overall economy, the BLS calculates several
other price indexes. It reports the index for some narrow categories of goods and
services, such as food, clothing, and energy. It also calculates the CPI for all goods
- FYI
What’s in the CPI’s Basket?
W hen constructing the consumer price index, the Bureau of Labor

Statistics tries to include all the goods and services that the typi-
cal consumer buys. Moreover, it tries to weight these goods and services
according to how much consumers buy of each item.
FIGURE 1
Figure 1 shows the breakdown of consumer spending into the major The Typical Basket of
categories of goods and services. By far the largest category is housing, Goods and Services
which makes up 42 percent of the typical consumer’s budget. This category This figure shows how the typical consumer divides spending
includes the cost of shelter (33 percent), fuel and utilities (5 percent), and among various categories of goods and services. The Bureau of
household furnishings and operation (4 percent). The next largest category, Labor Statistics calls each percentage the “relative importance”
at 16 percent, is transportation, which includes spending on cars, gaso- of the category.
line, buses, subways, and so on. The next category, at 15 percent, is food Source: Bureau of Labor Statistics.
and beverages; this includes food at home (8 percent), food away from
16%
home (6 percent), and alcoholic beverages (1 percent). Next are medical
Transportation
care at 8 percent, education and communication at 7 percent, and recre-
ation at 6 percent. Apparel, which includes clothing, footwear, and jewelry, 42%
15%
makes up 3 percent of the typical consumer’s budget. Housing
Food and
Also included in the figure, at 3 percent of spending, is a category beverages
for other goods and services. This is a catchall for consumer purchases
(such as cigarettes, haircuts, and funeral expenses) that do not naturally
Medical care 8%
fit into the other categories. ■
7%
6% 3% 3%
Education and
communication
Other goods
Recreation Apparel and services
148
and services excluding food and energy, a statistic called the core CPI. Because core CPI
food and energy prices show substantial short-run volatility, the core CPI better a measure of the overall
reflects ongoing inflation trends. Finally, the BLS also calculates the producer cost of consumer goods
price index (PPI), which measures the cost of a basket of goods and services and services excluding
bought by firms rather than consumers. Because firms eventually pass on their food and energy
costs to consumers in the form of higher consumer prices, changes in the PPI are
producer price index
often thought to be useful in predicting changes in the CPI.
a measure of the cost of
a basket of goods and
24-1b Problems in Measuring the Cost of Living
services bought by firms
The goal of the consumer price index is to measure changes in the cost of living.
In other words, the CPI tries to gauge how much incomes must rise to maintain a
constant standard of living. The CPI, however, is not a perfect measure of the cost of
living. Three problems with the index are widely acknowledged but difficult to solve.
The first problem is called substitution bias. When prices change from one year
to the next, they do not all change proportionately: Some prices rise more than
others. Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by relatively large amounts and by buying more
of the goods whose prices have risen less or perhaps even have fallen. That is,
consumers substitute toward goods that have become relatively less expensive.
If a price index is computed assuming a fixed basket of goods, it ignores the
possibility of consumer substitution and, therefore, overstates the increase in the
cost of living from one year to the next.
Let’s consider a simple example. Imagine that in the base year, apples are
cheaper than pears, so consumers buy more apples than pears. When the BLS
constructs the basket of goods, it will include more apples than pears. Suppose
that next year pears are cheaper than apples. Consumers will naturally respond to
the price changes by buying more pears and fewer apples. Yet when computing
the CPI, the BLS uses a fixed basket, which in essence assumes that consumers
continue buying the now expensive apples in the same quantities as before. For
this reason, the index will measure a much larger increase in the cost of living
than consumers actually experience.
The second problem with the CPI is the introduction of new goods. When a new
good is introduced, consumers have more variety from which to choose, and this
in turn reduces the cost of maintaining the same level of economic well-being. To
see why, consider a hypothetical situation: Suppose you could choose between a
$100 gift certificate at a large store that offered a wide array of goods and a $100
gift certificate at a small store with the same prices but a more limited selection.
Which would you prefer? Most people would pick the store with greater variety.
In essence, the increased set of possible choices makes each dollar more valuable.
The same is true with the evolution of the economy over time: As new goods are
introduced, consumers have more choices, and each dollar is worth more. But
because the CPI is based on a fixed basket of goods and services, it does not reflect
the increase in the value of the dollar that arises from the introduction of new
goods.
Again, let’s consider an example. When the iPod was introduced in 2001,
consumers found it more convenient to listen to their favorite music. Devices
to play music were available previously, but they were not nearly as portable
and versatile. The iPod was a new option that increased consumers’ set of
opportunities. For any given number of dollars, the introduction of the iPod made
people better off; conversely, achieving the same level of economic well-being
required a smaller number of dollars. A perfect cost-of-living index would have
reflected the introduction of the iPod with a decrease in the cost of living. The CPI,
149
however, did not decrease in response to the introduction of the iPod. Eventually,
the BLS revised the basket of goods to include the iPod, and subsequently, the
index reflected changes in iPod prices. But the reduction in the cost of living
associated with the initial introduction of the iPod never showed up in the index.
The third problem with the CPI is unmeasured quality change. If the quality of a
good deteriorates from one year to the next while its price remains the same, the
value of a dollar falls, because you are getting a lesser good for the same amount
of money. Similarly, if the quality rises from one year to the next, the value of
a dollar rises. The BLS does its best to account for quality change. When the
quality of a good in the basket changes—for example, when a car model has more
horsepower or gets better gas mileage from one year to the next—the Bureau
adjusts the price of the good to account for the quality change. It is, in essence,
IN THE NEWS
Monitoring Inflation in the Internet Age
The web is providing alternative ways wine, takeaway meals, bedroom furniture,
to collect data on the overall level of surgical procedures, pet dogs, college tuition,
prices. cigarettes, haircuts, funerals. When all of the
prices are marked down, the workers submit
Do We Need Google to Measure forms that are collated, checked, and input into
Inflation? massive spreadsheets. Then the government But just because the government expends
boils all those numbers down to one. It weights so much energy determining the rate of inflation
By Annie Lowrey
certain prices, taking into account that does not mean it is tallying it in the smartest or
A t some 23,000 retailers and businesses

in 90 U.S. cities, hundreds of government
workers find and mark down prices on very pre-
consumers spend more on rent than cereal, for
instance. It considers product improvements
and changes in spending habits. Then it comes
most accurate way. The reigning methodology
is, well, clunky. It costs Washington around
$234 million a year to get all those people to
cise products. And I’m not kidding when I say up with a master number showing how much go and bear witness to a $1.57 price increase
“very precise.” a customer’s spending needed to increase in a packet of tube socks and then to massage
Say the relevant worker is finding the to buy the same goods, month-on-month. those individual data points down to one number.
price for a motel room. She might write a That number is the Consumer Price Index, the Moreover, there is a weekslong lag between
report like this: Occupancy—two adults; government’s main gauge of inflation. the checkers tallying up the numbers and the
Type of accommodation—deluxe room; Room Each month, the Bureau of Labor Statistics government announcing the changes: The
classification/location—ocean view, room 306; goes through all that hassle because knowing inflation measure comes out only 12 times a year,
Time of stay—weekend; Length of stay—one the rate of inflation is such an important measure though prices change, sometimes dramatically,
night; Bathroom facilities—one full bathroom; of economic health—and it’s important to all the time. Plus, the methodology is archaic,
Kitchen facilities—none; Television—one, the government’s own budget. High inflation? given that we live in the Internet age. Prices
includes free movie channel; Telephone—one Savers panic, watching the spending power of are easily available online and a lot of shopping
telephone, free local calls; Air-conditioned— their accounts erode. Deflation? Everyone saves, happens on the Web rather than in stores.
yes; Meals included—breakfast; Parking—free awaiting cheaper prices in a few months. And But there might be a better way. In the
self parking; Transportation—Transportation wildly changing inflation makes it difficult for last few months, economists have come up
to airport, no charge; Recreation facilities—an businesses and consumers to make economic with new methods for calculating inflation
indoor and an outdoor pool, a private beach, decisions. Moreover, the government needs at Internet speed—nimbler, cheaper, faster,
three tennis courts, and an exercise room. to know the rate of inflation to index certain and perhaps even more accurate than
This mind-numbingly tedious process payments, like Social Security benefits or interest Washington’s. The first comes from the
goes on for a dizzying panoply of items: payments on TIPS bonds. Massachusetts Institute of Technology. In
150
trying to compute the price of a basket of goods of constant quality. Despite these
efforts, changes in quality remain a problem because quality is hard to measure.
There is still much debate among economists about how severe these
measurement problems are and what should be done about them. Several studies
written during the 1990s concluded that the CPI overstated inflation by about 1
percentage point per year. In response to this criticism, the BLS adopted several
technical changes to improve the CPI, and many economists believe that the bias
is now only about half as large as it once was. The issue is important because
many government programs use the CPI to adjust for changes in the overall
level of prices. Recipients of Social Security, for instance, get annual increases in
benefits that are tied to the CPI. Some economists have suggested modifying these
programs to correct for the measurement problems by, for instance, reducing the
magnitude of the automatic benefit increases.
2007, economists Roberto Rigobon and the company’s chief economist, Hal Varian. deflation—the worrisome incidence of prices
Alberto Cavallo started tracking prices online As reported by the Financial Times, earlier actually falling—where the CPI did not.
and inputting them into a massive database. this year, Varian decided to use Google’s The new indices lead to the big question of
Then, last month, they unveiled the Billion vast database of Web prices to construct the whether the government needs to update its
Prices Project, an inflation measure based on “Google Price Index,” a constantly updated methods to account for changes in the economy—
5 million items sold by 300 online retailers in measure of price changes and inflation. (The taking new pricing trends into consideration,
70 countries. (For the United States, the BPP idea came to him when he was searching for rejiggering its formula, updating more frequently.
collects about 500,000 prices.) a pepper grinder online.) Google has not yet The answer might be yes. (Economists have
The BPP’s inflation measure is markedly decided whether it will publish the price index, reformed the CPI before.) But the CPI and its
different from the government’s. The economists and has not released its methodology. But Stone Age method of calculation boasts one huge
just average all the prices culled online, Varian said that his preliminary index tracked benefit: It’s a stable, tested measure, consistent
meaning the basket of goods is whatever you CPI closely, though it did show periods of over time, since its methodology doesn’t change
can buy on the Web. (Some things, like books, much. Moreover, and somewhat remarkably, the
are most often bought online. Some items, like Google and Billion Prices Project indices actually
cats, are not.) Plus, the researchers do not seem to confirm the accuracy of the old-fashioned
weight certain items’ prices, even if they tend CPI, tracking it closely rather than showing it to
to make up a bigger proportion of household be off-base.
spending. Ultimately, there is a good argument for
Still, thus far, the BPP has tracked the CPI more inflation measures, not just better or
closely. And the online-based measure has newer ones. The government already calculates
additional advantages. It comes out daily, giving a number of rates of inflation to give a fuller
a better sense of inflation’s direction. It also lets picture of price changes, the value of money, and
researchers examine minute, day-to-day price the economy. Most notably, the BLS publishes a
changes. For instance, this month Rigobon and “core inflation” number, a measure of inflation
Cavallo noted that Black Friday discounts “had a outside volatile food and energy prices. There are
smaller effect on average prices in 2010 than in dozens of other measures, as well. The new Web-
GOGO IMAGES CORPORATION / ALAMY
2009,” contrary to reports of deeper discounting based yardsticks provide even more alternatives
this year. And it has already produced some and opportunities to examine the accuracy of the
academic insights. For instance, Cavallo found CPI—and to make new findings. That means,
that retailers change prices less often, but more, for now, those detective-like government rubes
percentage-wise, than economists previously painstakingly checking prices on clipboards get
thought. to stay in work. ■
A second inflation measure comes from
Web behemoth Google and is a pet project of “I wonder how much this costs online.” Source: Slate, December 20, 2010.
151
24-1c The GDP Deflator versus the Consumer Price Index

In the preceding chapter, we examined another measure of the overall level of
prices in the economy—the GDP deflator. The GDP deflator is the ratio of nominal
GDP to real GDP. Because nominal GDP is current output valued at current prices
and real GDP is current output valued at base-year prices, the GDP deflator
reflects the current level of prices relative to the level of prices in the base year.
Economists and policymakers monitor both the GDP deflator and the CPI to
gauge how quickly prices are rising. Usually, these two statistics tell a similar
story. Yet two important differences can cause them to diverge.
The first difference is that the GDP deflator reflects the prices of all goods and
services produced domestically, whereas the CPI reflects the prices of all goods and
services bought by consumers. For example, suppose that the price of an airplane
produced by Boeing and sold to the Air Force rises. Even though the plane is
part of GDP, it is not part of the basket of goods and services bought by a typical
consumer. Thus, the price increase shows up in the GDP deflator but not in
the CPI.
As another example, suppose that Volvo raises the price of its cars. Because
Volvos are made in Sweden, the car is not part of U.S. GDP. But U.S. consumers
buy Volvos, so the car is part of the typical consumer’s basket of goods. Hence, a
price increase in an imported consumption good, such as a Volvo, shows up in the
TH! WAU. ITRm JOUl!NAL CPI but not in the GDP deflator.
\AUDi0- VIDEO) This first difference between the CPI and the GDP deflator is particularly
FROM THE WALL STREET JOURNAL—PERMISSION, CARTOON
important when the price of oil changes. The United States produces some oil,
but much of the oil we use is imported. As a result, oil and oil products such as
4',
c.. .
II., t- gasoline and heating oil make up a much larger share of consumer spending than
I of GDP. When the price of oil rises, the CPI rises by much more than does the GDP
,0
deflator.
The second and subtler difference between the GDP deflator and the CPI
concerns how various prices are weighted to yield a single number for the overall
FEATURES SYNDICATE
level of prices. The CPI compares the price of a fixed basket of goods and services
to the price of the basket in the base year. Only occasionally does the BLS change
the basket of goods. By contrast, the GDP deflator compares the price of currently
produced goods and services to the price of the same goods and services in the base
“The price may seem a year. Thus, the group of goods and services used to compute the GDP deflator
little high, but you have changes automatically over time. This difference is not important when all prices
to remember that’s in are changing proportionately. But if the prices of different goods and services are
today’s dollars.” changing by varying amounts, the way we weight the various prices matters for
the overall inflation rate.
Figure 2 shows the inflation rate as measured by both the GDP deflator and
the CPI for each year since 1965. You can see that sometimes the two measures
diverge. When they do diverge, it is possible to go behind these numbers and
explain the divergence with the two differences we have discussed. For example,
in 1979 and 1980, CPI inflation spiked up more than the GDP deflator largely
because oil prices more than doubled during these two years. Yet divergence
between these two measures is the exception rather than the rule. In the 1970s,
both the GDP deflator and the CPI show high rates of inflation. In the late 1980s,
1990s, and the first decade of the 2000s, both measures show low rates of inflation.
QuickQuiz Explain briefly what the CPI measures and how it is constructed.
Identify one reason why the CPI is an imperfect measure of the
cost of living.
152
Unit 7
Taxation
153
A tax is a compulsory financial charge or some other type of levy
imposed upon a taxpayer by a governmental organization in order to
fund various public expenditures
154
Objectives of Taxation
• Raising Government Revenue
• Optimum allocation of available resources
• Encouraging savings and investment
• Reduction of inequalities in income and wealth
• Managing recession and inflation
• Taxation as a regulatory mechanism
155
Taxonomy of Taxation
• Incidence‐ direct and indirect
• Activity‐ manufacturing, trade, agriculture and services
• Purpose‐ revenue yielding or sumptuary (restriction)
• Nature of base‐ Income, wealth, capital, transactions, inheritance,
movement, etc.
156
Direct blxes
Income Weallh and as$elS
Income tax Wealth tax Profession tax-
Cash 110\'/ Estate duly Payroll taxes
Gift tax
Property~
land revenue
Figure 9.1 Direct taxes
Vehicles
Value lax Ootrol
added
tax/goods Stamp
and Manufacturing duties and
services sale point registration
tax (excise) fees
Other sale Electricity

points duties
(sales lax)
157
Direct Taxes
Advantages Disadvantages
• Enforces vertical equity • Tax evasion

• Possibility of evasion, esp. in lax legal
• Progressive systems
• Beneficial in reducing income inequalities
• Social conflict
• Productive
• Revenue earned increases with increase in • Certain sections of society not taxed
nations’s wealth • Feeling of social injustice
• Economic:
• Annual tax hence lower administrative costs
158
Indirect Taxes
Advantages Disadvantages
• No perception of direct pinch • Inflationary

• Directly affects prices of commodities
• Wider tax base

• Most products and services subject to
• Leads to inflationary trend
indirect taxes
• Regressive in nature
• Promotes social welfare • Rich and poor pay same rate
• Higher taxes on consumption of harmful
products
159
Share of Direct and Indirect Taxes to Tax Revenue
Direc1:md Indlrec1Ta.xes as a Perceuta:,c or GrossTn.x RC\·cnuc (1996-9; to 2016-1;)
• Indirect taxes constituted 71% of gross tax

revenue in 199-96
"" • Between 2006-07 to 2016-17, direct tax

contributed more to gross revenue from taxes
. ,. • Currently, direct and indirect taxes contribute
almost equally to tax revenue
• Indirect tax considered regressive, hence

rising share of revenue from indirect tax
undesirable
Year
160
Principles of Taxation
• A) Benefit Principle
• Individuals taxed in proportion to benefit received from government
programme
• Example: toll charges paid on a toll road
• B) Ability-to-pay Principle
• Amount of tax relates to income and wealth of people
• Considered redistributive
• Example: income tax
161
Horizontal and Vertical Equity
• Horizontal equity
• ‘Equals’ must be taxed equally
• Benefit principle: all cars pay same amount of toll tax
• Ability-to-pay principle: everyone with same wealth/income pays same tax
• Vertical equity
• People in unequal circumstances should be treated unequally
• Taxes paid increase with amount of earned income
162
Proportional, Progressive and Regressive Taxes
• Proportional Tax
• All taxpayers pay same proportion of income as tax
• Progressive tax
• Higher-income taxpayer pays higher fraction of income as tax
• Regressive tax
• Higher-income taxpayer pays lower fraction of income as tax
163
Levels of Collecting Taxes: India (Pre GST)
Central Government State Government Local Bodies
• Income tax • VAT • Octroi

• Customs duty • Professional tax • Property tax
• Central excise duty • Taxes on mineral rights • Taxes on services like
• Corporation tax • Excise on alcohol, drainage, water supply
narcotics produced
within state
• Taxes on vehicles
• Tolls
• Stamp duty
• Taxes on profession,
trades etc.
164
Goods and Services Tax (GST)
• GST: Value added tax levied on manufacture, sale and consumption of
goods and services
• Comprehensive tax
• Subsumes all indirect taxes, brings unified taxation system across country
• Multi-stage tax
• Levied at each stage of supply chain
• Tax levied only on value added
• Destination based consumption tax

• Collected at point of consumption
165
Multi-Stage Tax
• Feature similar to VAT, tax levied at every stage of value added
• Example:
• Product: shirt
• Breakdown of costs: raw material bought at Rs. 100, shirt manufactured at cost of Rs. 40 and packaged
at cost of Rs. 30
• Assume: no profits added at any stage, tax rate of 10%
166
Multi-Stage Tax
• Example:
• Product: shirt
at cost of Rs. 30
Before VAT
Action Cost 10% Tax Total
Buys raw material 100 10 110
Manufactures @ 40 150 15 165
Adds value @ 30 195 19.5 214.5
Total 170 44.5 214.5
At each stage tax paid on ‘final’ cost 167

Multi-Stage Tax
• Example:
• Product: shirt
at cost of Rs. 30
Before VAT After VAT

Actual
Action Cost 10% Tax Total Cost 10% Tax Total
Liability
Buys raw material 100 10 110 100 10 10 110
Manufactures @ 40 150 15 165 140 14 4 154
Adds value @ 30 195 19.5 214.5 170 17 3 187
Total 170 44.5 214.5 170 17 187
At each stage tax paid on ‘final’ cost Input tax credit reduces actual tax liability 168
Difference between VAT and GST
• Under VAT:
• Intrastate trade of goods is taxed with VAT
• Interstate transaction of goods is subjected to a Central Sales Tax (CST) and
local taxes
• Seller to comply with rules of each state, cargo stops at every state border
• Under GST
• All interstate transactions subjected to IGST (Integrated GST)
• Revenue spilt between centre and states where delivery made
169
Benefits of Adopting GST
• Reduction of cascading effect
• Making Indian goods more competitive in international markets
• Higher revenue yield
• More transparency in tax system
• Ease of compliance
170
Implications of GST
• Ease in inter-state goods movement
• Price reduction
• Unification of taxes to reduce overall tax burden
• Less compliance costs
• Reduction in cost of collecting various taxes
• Redress location bias among manufacturers
• Investors to not discriminate between states on basis of tax advantage
• Uniform per capita taxation
• States’ tax revenue driven by population rather than businesses/industries
• Fight tax evasion
• Promotes use of bills and invoices
• Wider tax base
• Small enterprises voluntarily choose to be part of GST for availing input tax credits
171
108 Public Finance
~Aryan polity in the early Vedic period was sufficiently organized to make it possible for the kin
to collect regular taxes (usually called Bali) from the subjects. The revenue of the king consisted Q
contributions of the agricultural produce and of the stock of cattle paid by the villagers at certain
specific r·ates (probably 1/6). In the post-Vedic period, the Jatakas furnish us with valuable informa
tion about some aspects of taxation during the period. In the Jataka, the tax collectors are known a
Niggahaka.
During the Mauryan period, principles and rules of taxation were consciously formulated. Th
laxes were levied on almost all the things, from cooked rice to dried fish. 'the Arthashastra of Kautily,1;
Dharmasutras, and Smritis provide large data regarding taxation. By far the most systematic accoun
of the sources of state revenue are described in the Arthashastra. It mentions different forms of revenu
not according to their incidence but according to their source-land-based (Parthiva) or those based ort
others (Aparthiva). Among the Parthiva sources are the contribution of the king's land (Bali), land rev.:
enue.(Bhaga), cesses collected on the supply of water from state resources, tree tax of 1/6 of the fruits of
trees, and taxes collected from cattle farms. It also included the taxes on income from medicinal herbs
and royal herbs (cosmetics products used by kings and rich families), profits of state mines ~nd quar:-
rics, and sale proceeds of the forest produce. Probably, no source has been left untapped (Shamasastry,:.
1909). Centuries later, in the 11th century, the Islamic rulers imposedjizya (a poll tax on non-Muslims)
which was abolished by Akbar. Subsequently, much of the modern tax structure in India was modelled:
on the British tax system.
9.3 OBJECTIVES OF TAXATION v/

For a long time, the classical economists were of the view that the only objective of taxation was to
raise government revenue. However, with the changes in circumstances and ideologies, the aim of taxes
has also been changed. Apart from the objective of raising the public revenue, taxes are levied to affect
consumption, production, and distribution to ensure social welfare through the economic development
of a country. Thus, the broad objectives of taxation can be listed as follows:
Raising government revenue As is well-known, a government raises its revenues from taxes, non-taxes,
borrowings, and money creation. It is safer for the government to avoid borrowings by increasing tax
revenue. In modern times, the aim of public finance is not merely to raise sufficient financial resources
to meet administrative expense, maintain law and order, and protect the country from foreign aggres-
sion but also to ensure social welfare.
Optimum allocation of available resources The revenues collected are used for expenditure allocation
to different productive sectors as per the growth plans and other economic policies. Besides this, the
imposition of tax itself leads to channeling of resources from the taxed to the non-taxed sectors. As
such, taxation can be a powerful tool to encourage development activities in the less developed areas
and sectors of the country where normal investors are not willing to invest.
Encouraging savings and investment Taxation policy can be directed to raise the ratio of savings
to national income and promote investment and capital formation both in the private and public
sectors.
Reduction of inequalities in income and wealth By using an efficient progressive tax system, govern-
ment can reduce inequalities in income and wealth.
Managing recession and inflation Tax policy can also be used to deal with critical economic situations
such as depression and inflation. In times of depression, tax rate is set to increase the consumption and
reduce the savings thereby help increase the aggregate demand and vice versa.
Taxation as a regulatory mechanism Tax policy is also used as a mechanism to check inflation, con-
sumption of alcoholic liquor and luxury goods as well as safeguard the local poor industries from
uneven competition. Taxation is an effective weapon by which private consumption can be curbed and
resources transferred to the state and thereby ensuring sustainable deveJopment.
172
Principles of Taxation 109
9,4 TYPES OF TAXES ANO ISSUES THEREOF

Before we discuss the principles of taxation, we shall bdefly look at the taxonomy of taxes. Taxes can
be classified on the basis of the following:
l. Incidence-Direct and indirect
2. Activity-Manufacturing, trade, agriculture, services
3. Purpose-Revenue yielding or sumptuary
4. Nature of the base-Income, wealth, capital, transactions, inheritance, movement, etc.
I'
9.4.1 Direct and Indirect Taxes ✓

The most common classification is based on the incidence, that is, direct versus indirect taxes. In case of
direct taxes (See Fig. 9.1), the impact (where the tax is paid) and incidence (where the burden is felt)Jalls on
the same person, for example, income tax or profession tax. Whereas in case of indirect taxes, the impact
is on one person and the incidence could be on another. In general, taxes on commodities are thought to
be of indirect nature. However, this is not
always true. It depends on the degree of Dlrec1 axes
shifting of the tax burden. Similarly, the
burden of the income taxes can aJso be
shifted. This is discussed later. lnoo111e Wealth and assets Olherbai;;es
Direct taxes can be made more
equitable by ensuring appropriate pro- Income tax WeaIIM tax Profession tax
gressivity. However, it is difficult to
Ca,.sh flow Estate duly Payroll taxes
determine the right degree of progres-
sivity. Direct laxes are administratively Glft1ax
more economical as there is no inter-
mediary between the taxpayer and the Property~
tax coJlector. Secondly, the direct taxes Land revenue
are viewed as more certain in terms of
determination of the liability and more Figure 9.1 Direct truces
accurate yield. Thirdly, direct taxes also
lndlreot taxes
create more civic consciousness among
taxpayers. However, direct taxes are
inconvenient as the taxpayer feels the Transactions Movement
pinch and evasion is relativeJy easy. of goods
Indirect taxes (See Fig. 9.2) can also be
Value Imports Ootrol
designed to be progressive by making suit- added
Sales
(customs)
able classification of goods. For example, tax/goods Stamp tnlry laX
higher tax rates can be imposed on luxury and Manufacturing duties apd
goods and essential commodities can be services si3-la pCi>lnl registr~tion
subject to low or negligible ta,"'<: rates. tax (_e)(clse) fees
Indirect taxes are convenient and dif- Other le Eleclriclty
ficult to evade as the tax is combined point duties
with price. They can also be made more (.sates tax
equitable if luxuries are taxed at higher Figure 9.2 Indirect taxes
rates. Further, indirect taxes can be used
to discourage the use of drugs and other sumptuary purposes. However, indirect taxes are uncertain in
incidence and mostly regressive. They involve additional bookkeeping costs for the traders.
9.4.2 Progressive, Proportional, and Regressive Taxes

·\/
Tax systems and individual taxes can be classified according to the share of income that an individual
taxpayer would pay in taxes as his/her income changes. A tax with a rising percentage on the taxpayer's
173
J/J/ic Finance
come as income rises is a 'progressive' tax. A tax levied at the same percentage on a taxpayer's incmn
irrespective of the level of income is called a 'proportional' tax. A tax with a falling percentage I
taxpayer's income as income rises is a 'regressive' tax. It should be noted that the degree of progressiv
ity refers to the ratio or percentage, not the amount, of income paid as tax. As an example, consid ,:
two taxpayers, A and B with incomes tl0,000 and fl,00,000. A proportional tax rate would mean that
the tax rate at 20 per cent for both A and B would result in the tax liabilities of '{2,000 and ~O OtlO
respectively. Under progressive taxation, the rate of tax differs between A and B, say, 20 per cent for A
and 30 per cent for B. The tax liabilities accordingly would be ~2,000 and ~30,000 respectively. The pro-
gressive taxation is based on the well-known marginal utility theory, that the marginal utility of money
decreases exponentially as a person earns more and more money. It means, the loss of utility shou1J
be the same for both A and B. However, if B is also taxed at 20 per cent, then the loss of utility for H
is muqh less than the loss of utility for A. In other words, the tax burden is less on the rich relative to
the poor. Thus, whether a tax is progressive, proportional, or regressive, it has normative implications.
A rate of income tax that is proportional to income does not adequately equalize the tax incidence.
Howeve1; there remains the question of degree of progressivity. For instance, two people might favour
a progressive income tax but disagree on how progressive the tax should be.
In the case of commodity taxes, it is more difficult to maintain tax progressivity. Most commodity
taxes are proportional in nature. Nevertheless, governments try to make commodity taxation progressive
by taxing the luxuries at a higher rate than necessities. However, besides making the tax system complex,
it is not clear to what extent the rate differentiation follows the progressivity principle. More so, because
if the sales tax is viewed purely as a tax on consumption, people tend to consume a smaller percentage
of their incomes as incomes rise, so a sales tax would be tend to be regressive with respect to income.
It should be noted that the issue of progressivity becomes even more complicated when one considers
income over longer periods of time. Consumption tends to be more stable over time than their income, and
income relative to consumption tends to vary systematically over a person's lifetime. A person's consumption
might exceed income when the person is young, as he/she may borrow against future earnings. College stu-
dents often provide a good example, as they may seek student loans or find other ways to consume in excess
of their incomes. Even after getting a job out of college, the person may buy a house against a big mort-
gage and borrow to buy a car, still consuming more than income. In midlife, people tend to save for future
expenses and retirement and pay back loans from earlier consumption, so income exceeds consumption. At
retirement, consumption again exceeds income as retirees draw down their savings. This smooth change in
income might be intenupted by periods of unemployment or other temporary fluctuations in income. One
would not expect a person who is temporarily unemployed to experience a decline in consumption as large as
the decline in income. When one considers the lifetime variation in incomes, it is apparent that the same per~
son will sometimes have much higher income than at other times, but consumption will not change as much.
Thus, when assessing theregressivity or progressivity of taxes on equity grounds, one probably should,
consider the person's lifetime income rather than at a particular point in time. For example, college stu-
dents with part-time jobs tend to be low-income individuals because they are spending more time in class
rather than working, but it is difficult to argue that because college students have low incomes, there
should be special programmes devised to raise their incomes. Although college students tend to have
low incomes while they are in school, their lifetime incomes are well above average. An important issue
here is the difference in the burden of taxation when it is calculated in relation to (a) current income and
(b) lifetime income. For a more detailed information, see Fullerton and Rogers (1993) and Prest (1962).
9.4.3 Sumptuary Taxes

There are certain taxes _that are designed and.lf!vi~d to discourage the consumption of the ta~ed goods •;
rather than for generatmg revenue. These are cMled 'sumptuary' taxes. Musgrave refers to this type of 2
good as a 'demerit' good, which should be taxed to · courage consumption. Merit good, in contrast, is
a good that should be subsidized to encourage its const p tion (Musgrave R. A., 1959; Summer, 1981).
Tobacco and alcohol taxes are good examples of cases ~-rlin,-in governments have tried to control or
discourage their consumption. Sumptuary taxes are also kno as Pigouvian' taxes r sin' taxes.
174
blic Finance
/ The aforementioned developmcnl8 showed lhut inclusion of services under VAT might not pose mu t
problem. Rather, inclusion of :-icrviccs would reduce the problem of separating service charges from tb
total cost. For example, when VAT is levied on food in a restaurant, the cost includes the service charge to
However, it is very difficult lo segregate the cost of food and service. Such services are popularly known · .
composite services. If the VAT includes service, the problem of composite service would not arise.
18.4 GOODS AND SERVICES TAX (GST) \ /

The shortcomings of the VAT impJcmcnted at the central and state g vemmeni I vcl · has led to for her
efforts to revamp the system arid convert it into a comprehensive VAT, which would encomp mofe
indirect taxes and include service taxes. It can thereby be referred as the oods and service ax (GST). It
such a system, both lhe i;ascadi11g effects of CENVAT and service tax would b removed with a continu-
ous chain of set-off from the original producer's point and service provider's point up to the retailer's level.·-:
At the slate level, more work was involved such as (1) granting additional power of levy of taxation:.
of services to the states; (2) introducing the system of comprehensive set-off relief, including set-off for :
cascading burden of CENVAT and service taxes; (3) subsuming of several taxes in the GST; and (4)
removal of burden of CST. The first step for the GST to be introduced at the state level was that the:
states should be given the required power of levy of taxation of all services, which hitherto rested only
with the Centre and therefore, a constitutional amendment was needed. Moreover, with the introduc-
tion of GST, the burden of central sales tax (CST) was also to be removed.
18.4.1 Run-up to GST Launc~

The Empowered Committee had set up in 2008 a Joint Working Group for designing a model and road
map for GST considering the views of the states. The Working Group comprising senior officials of the
states and central goveJl!t\m nt was asked to give recommendations on (1) commodities and services that
should be kept in the exen led list, (2) rules and principles of taxing the transactions of services includ-
ing the transactions in in e:rs te services, and (3) finalization of the model suggested for interstate trans-
action/movement of goods in uding stock transfers. The Working Group held several meetings for
this purpose during 2009 and Cc'l e out with the 'First Discussion Paper on Goods and Services Tax in
India' (Government of India Emp ered Committee of State Finance Ministers, 2009). The modalities
for amending the Constitution of In ·a were extensively deliberated in various meetings of the Empow-
ered Committee. The central g vemm~ t introduced the 115th Amendment Bill, 2011 in the Lok Sabha
to facilitate introduction of GST on 22 h 2011. The Bill basically sought to the following:
1. Amend the Constitution to provide for e introduction of a goods and services tax (GST).
2. Allow both Parliament and state legislatu to frame laws with respect to GST.
3 Grant Parliament the exclusive power to lev rST on imports and interstate trade.
4. Create a GST Council consisting of state F' 1 Ministers, the Union Finance Minister, and
Union Minister of State for Revenue to make rec mendalions with respect to GST.
. Provide f r u Di ·ptlle tU mcnl Auth rity sett le isp tes between states or between states and
the Union with regard to GST.
6. Exempt certain commodities from GST, including pet,r, um products and alcoholic liquor for
human consumption.
However, with the dissolution of the Lok Sabha (Lower House o e Parliament) in 2014 the Bill
lapsed. Later, on formation of the new government, the GST Bill was •,/ d as Constitution (122nd
Amendment) Bill, 2014 and placed in the Parliament. The major revisio r m the 155th Amendment
Bill are as follows:
1. Only the Centre may levy an integrated GST (IGST) on the interstate suppl of goods and services,
and imports.
2. Alcohol for human consumption has been exempted from the purview of GST. GST will apply to
five petroleum products at a later date.
175
Value Aaaea f uuuu.::. arn.1 ub, u,uuuJ ........~,- •• •
. The GST Council will recommend rates of tax, period of levy of additional tax, principles of
supply, special ~ions to certain states, etc.
4. The Bill empowers the re to impose an additional tax of up to 1 per cent, on the interstate supply
of goods for two years or m . This tax will accrue to states from where the supply originates.
5. Parliament may, by law, provide c ensation to states for any loss of revenue from the introduction
of GST, up to a five year period.
With these revisions, finally, the GST Bill was p ' ed a1 d India's biggest tax reform has become a
reality. A comprehensive Goods and Services Tax ( 'S "hus replaced the complex multiple indirect tax
1
structure with effect from 1 July 2017.

,./
18.4.2 Main Features of GST in India ..,/
he Indian G I a tination-ba ed tax on consumption f goods and services Jevied at all tages
right from manufacture up to final consumpti n wrlh credit taxes p id at previou stages a ailabl as
set-o.ff. ln ther w rd ) only value adtl'ti ns ate~ 11 s ge will be taxed and burden of tax will be b rne
by the final co umer. 1l would be a dual G 'T wilh the centre and state si.mu.Jtan ou ly levying 1 on
a ommon tax bas . Further an in egrated T JG 'T) wfll be levied and administered by nlr n
very int lat upply of good and service . '1 h · ain featUI s f the G dopled are as t Uow ;
GST replaces all major indirect taxes \_.,,.,,,,/

The GST is levied n the transaction va\u tha i , th pric a tu.ally paid r paya 1 for supply of
goods and services . IL replace all major imli e t Laxes Jevled b the entTal and tate ovenun nt. .
While identifying th 1 $Sib! entral a d state truce o be ubsumed under GST h following prin-
ciples were considered:
1. Taxes or levies should be primarily in the nature of indirect taxes, either on the supply of goods or
rvice ·.
2. Taxes or levies to e sub urned houlc.l part of the transaction chain, which commences with
imp rt/mat1ufacture/ ·oducti n of go d · r r vision of services at one end and the consumption
of go ds and services at the ther.
3. After merging um.I r th ST i ·hould re , u_J in free flow of tax credit in intra and interstate levels.
The taxes, lev1 s and fee that ar not pecillcally related to supply of goods and services should
not be subsumed under GST.
In particular, the following taxes will be subsumed:
Central taxes
1. enlraJ e ·c.is duty
2. Duties f ex is M <l1doal nd toile preparati n )
dditional duties of exci ( d of p cfa.l in portance, textiles, and textile products)
4 . dditfooai duties of cu t ms (commonly known a countervailing duty)
5. Spe ial ad itional duty ot' ·u om (S D)
6. Service tax
7. Central surcharges and cesses on supply of goods and services
State taxes
1. State VAT
2. Central sales tax
3. Luxury tax
4. Entry tax (all forms)
5. Entertainment and amusement tax (except when levied by the local bodies)
6. Taxes on aqvertisements ·
7. Purchase tax
176
, Finance
axes on lotteries, bettinp,, a11d ~umhling

9. State surcharges and cc,'l.~l:l.'I rclitliug to supply of goods and services, stamp duties, motor vehicle
tax, electricity duties an, 1101 y\ll included.
Coverage of goods \
The GST would apply lo 11II goods other than alcoholic liquor for human consumption and five
petroleum producls, 1111111dy, petroleum crude, motor spirit (petrol), high speed diesel, natural gas, and '
aviation turbine l'ucl. I 'url hur, i.:lectricity is also kept out of the coverage of GST. However, the exclu.._;
1
sion of these goods iN only temporary and the GST Council will decide the date from which they shalf
be included in (lS'I'. Till then, the existing taxation system (VAT and central excise) will continue im
respect or these commo<litics, As for the services, GST would apply to all services barring a few to be
specfficd. 'fobai.x:o und tobacco products will be subject to central excise duty in addition to GST, The
!isl or excmpli.:d goods and services would be common for the centre and the states.
Us8 of HSN systsm for commodity classification

IJefore the adoption of GST, states in India had their own classification of goods for sales tax purposes.
For the purpose of GST it is decided to follow a uniform classification of goods across the states and
also foJlow the international convention of using the Harmonized System of Nomenclature (HSN) clas-
sification3. Already the HSN code is used for customs and central excise purposes since 1986. The HSN
classification code normally consists of six digits. To make the classification more precise, two more
digits are added resulting in an eight-digit classification. All goods are classified under 91 chapters and
specific code is assigned to each item. The first four digits represent chapter and heading, the next two
digits represent sub-heading, and the last 2 digits represent sub-sub-heading indicating the tariff item.
While taxpayers whose turnover is above ~1.5 crore but below t5 crore shall use 2-digit code,
taxpayers whose turnover is t5 crore and above shall use 4-digit code. Taxpayers whose turnover is
below tl.5 crore are not required to mention HSN code in their invoices. Services will be classified as
per the Services Accounting Code (SAC) as used hitherto for the service tax. For classifying the goods
, for GST, dealers are expected to apply the General Interpretative Rules (GIR)4.
GST-a destination-based consumption tax ,,/

The GST in India, as also in many countries, is designed as a destination-based consumption tax, in the
sense it is levied and collected at the stage where the good or service is finally consumed rather than the
point of origin (production or import). The tax revenue accrues in the jurisdiction where they are ultimately
consumed (also referred as 'place of supply'). For example, if a manufacturer in Gujarat produces the
goods and sells to a dealer in Maharashtra, the tax may be levied and collected by the Gujarat government,
but the revenue is passed on to the final consumer in Maharashtra by means of input tax credit system.
There are several implications of this. The destination-based tax may not be very encouraging for
the states which produce these goods because the revenue will not accrue to them. This might lead to
Lhe producing states restricting the movement of goods across their state border. Such a move might
adversely affect the economy. This was the reason that states like Gujarat have opposed the conversion
of sales tax to GST as it might lead to a drop in its revenues. It is only when the central government
has promised to compensate such states for a period of five years that these states have agreed to the
change to GST. It is also true that the increased exports of Gujarat might increase its income which may
increase the consumption and thereby the revenue of the state might improve.
No doubt, initially, the destination-based GST would seem to be beneficial to the states that con-
sume more goods/services than they produce. The more they consume, the more revenue they get from
3 The HSN coding system developed by the World Customs Organization (WCO) is used by over 200 countries for the purpose of
customs tariffs Over 98 per cent of the merchandise in international trade is classified under the HSN code,
4 The General Interpretative Rules (GIR) are for the Interpretation of the Harmonized System, It is a set of 6 rules for ensuring uniform
legal interpretation of the HSN for the proper classification of goods.
177
Va/UeAaaea (l:WOOt; c;tf/U vt::IVlvo;;:,1 IClAUUVH III UI UU,1 ......
interstate trade. However, in the long-run, such benefits that come through increased consumption may
not be good for overall economy of the state.
Treatment of intrastate transactions

India being a federal co1.mlry, b th th centt and the stat have be n us igne the p wer to levy and
collect taxes. After c n iderable deli b ra Lion consensus h as merged in ravour f t.he dual form of the
GST as the most a p~ priat fo r Indian federation. Under his fort G Ti levied within a state both
by the Shlle guvem.w nt and th central goverrunent. Th O 'T lcvi d by the states and the centre are
called tate G S ST and entral GST (CGST), res ·lively. Both would be levied on the same
value excluding any ior ta.x,. Hithe1to when VAT was levi d by a state, the VAT base included the
CENVAT levied by the central government.
For example, if acommodi.tYis ·old wiU1in a statefo · fl0 and if the G an GS ai; levi dat
6 per cent and 10 per cent respectively then the c m inJ d · ax liability ~ ul '16 and the ba vaJll!
of the commodity i • the sam or b I SG T Rml , ~1~ Under the 1:arlier ◄ NY, T aml stat Va
y t m fir t tbe f!NVAT would have e n levi d that wo tld bave added 10 L the pri e and th n the
slate ~ al er ccnl wou1 bi e b en levi d n the CENVAT inclusive price of U 10 making the state
VAT liability l be ~6.6 resulli gin a combined t · to be ~16.6 due to the cascading effect.
Tbc. upplier will e allowed credit · par~tcly against th re ecLivc G T and SG T. Howev ~ th
credit o f CG T p, id ill nol be allow d fo sc ►off agains · T pay bl an vi ver a. For exampl
suppo e the rate of 'T is 10 per cent and tha l f G T is 6 per ent. When a JeaJer of ·te l in y
Uttar Pradesh su lie te 1 bars and rods to a builder 1 cuted within Ute same state for a ~ 10 · the
dealer w uld charge COST of ~10 and SGST of ,6 u Lh basic price. He would be required d po il
the CGST component into a ce 1lral. govermne l a coun t and he SG ortion int Lhe ace wit f Lhe
Uttar Pradesh government. However while paying ST. Lh builder when Hin his product (build-
ing) to the next purchaser, would be allowed to u ly lbe credit f G . T pnid on hi pi.tr as and
for SGST the credit of SGST alone. In other words, n ilh r G T '.edit c be used fo r p a nl 1
SGST nor can SGST credit be used for payment o f GST. h sam is Lh c e with G on ervi ·
Treatment of interstate transactions

In case of transacti across the states or union territories, the two GSTs are combined into one and
called the Integrated (IGST). To understand the IGST mechanism, consider the following steps:
Step I: Dealer of the sellin state collects IGST from the purchaser on interstate transaction at the
combined rate of S and CGST
Step 2: While depositing the I , the seller takes back the input credit of SGST and CGST paid by
him on purchase of such g ds rs rvic s within the state.
Step 3: The selling state transfers th amounl of input credit of SGST taken by the selling dealer
against the IGST to the Centre. ,his will ensure that the selling state will not get any revenue
out of this transaction.
Step 4: The interstate buyer shall take credit o lGST against his 1iabi1ity of IGST. For this purpose, the
tota] amount of IGST wi11 be bifurcat · two parts SGST and CGST.
Step 5: With regards to the mechanism of transt "ing the SGST to the consumer state, the central
agency will transfer the amount of input ere · • of IGST used by selling dealer of consumer
state whi]e paying his liability of SGST.
There are two options for administering the I • T:
The first option is when the goods are sold from ne s at . an Lbe th e ·porling 'tate oll · · i c
IGST from the selling dealer located within hat state. Wh n the p t.r basing d al r ll · th
the next dealer, he naturally claims the tax refund. Fi r this, l1 x:p rtin . rn.Le hou ld lnwsfer Ute er di l
lirectly t the fo111 ,rting state to the extent the cred it is aJJowe l lh deaJ r r the imp r · slate.
These ond option 1 instead of the exporting state transferring directly to the importing state, the
~ ortin s ate Ltan for it to some agency which in turn can transfer the amount to the importing state
178
/c,=inance
/ods and Services Tax Co,mc/1

A GST Council has bcl:ll ct 1w11 it Ult!d comprising the Union Finance Minister (who will be the Chairman
of the Coundl), the M111islur of State (Revenue), and the State Finance/Taxation Ministers to make
recommendations lo th I Jnion und the states on
1. the taxes, ec8scs. 1111<1 . 11 harges levied by the Centre, the states, and the local bodies which may be
subsumed 1111tkr ClS'I';
2. the goods ;11ul :iervicc:-i II may be subjected to or exempted from the GST;
3. the d11tc on which the L" shall be levied on petroleum crude, high speed diesel, motor sprit (com-
monly lrnown 11s petrol), m ttral gas, and aviation turbine fuel;
4. model <,ST law,">, principles f levy, apportionment of IGST, and the principles that govern the
pla~c or supply;
5 lhc threshold fjmJt of turnove b Iow which the goods and services may be exempted from GST;
6 llw rates including floor rates w th bands of GST;
7, any special rate or rates for a s ecified period to raise additional resources during any natural
calamity or disaster;
8. special provision with respect to Lb North-East states, Jammu and Kashmir, Himachal Pradesh,
and Uttarakhand; and
9. any other matter relating to the GST, s the Council may decide.
The main function of the GST Council is ~ su re harmonization and smooth functioning of the GST
implementation and help developing a ha l'm uized national market for goods and services. It will also
establish a dispute resolution mechanism. Th ou sti tution 101 Act, 2016 provides that every decision
of the GST Council shall be taken by a majo }\y of not less than three-fourths of the weighted votes
of the members present and voting. The vote of\he central government shall have a weightage of one-
third of the votes cast and the votes of all the tat governments taken together shall have a weightage
of two-thirds of the total votes cast in that meeting. One-half of the total number of members of the
GST Council shall constitute the quorum at its meetings.
Input tax credit

Taxpayer is allowed to take credit of taxes paid on inputs (input tax credit), as self-assessed, in his/her
return. Taxpayer can take credit of taxes paid on all goods and services, other than the items in the nega-
tive list, and utilize the input tax credit amount for payment of output tax. Credit of taxes paid on inputs
can be taken where the inputs are used for business purposes or making taxable supplies. Full input tax
credit shall be allowed on capital goods on its receipt as against the current practice of central govern-
ment and many state governments of staggering the credit in more than one installment. Unutilized input
tax credit can be carried forward. The facility of distribution of input tax credit for services amongst
group companies has been provided for through the mechanism of Input Service Distributor (ISD).
Refund
Time limit for claiming online refund has been increased from one year to two years. Refund shall be
granted within 60 days from the date of receipt of complete application. Interest is payable if refund is
not sanctioned within the stipulated period of 60 days. If the refund claim is less than ~2 lakh, there is
no need for the claimant to furnish any documentary evidence to prove that he/she has not passed on
the incidence of tax to any other person. Only a self-certification to this effect would suffice. Further,
refund of input tax credit shall be allowed in case of exports or where the credit accumulation is on
account of inverted duty structure (i.e., where the tax rate on output is higher than that on inputs).
Use of information technology

A strong information technology network is essential for implementation of GST. A special-purpose
vehicle called the Goods and Service Tax Network (GSTN) has been set up to cater to the needs of
179
Value Added (Goods and Services) Taxation in India 243
GST. The GSTN shall provide a shared information technology (IT) infrastructure and services to
central and state governments, taxpayers, and other stakeholders for implementation of GST. The func-
tions of the GSTN would include: (1) facilitating registration; (2) forwarding the returns to central and
state authorities; (3) computation and settlement of IGST; (4) matching of tax payment details with
banking network; (5) providing various MIS reports to the central and the state governments based on
the taxpayer return information; (6) providing analysis of taxpayers' profile; and (7) running the match-
ing engine for matching, reversal, and reclaim of input t~x credit. The GSTN will also make available
standard software for small traders to keep their accounts in so that it can be uploaded as their monthly
returns on GSTN website. This will make compliance easier for small traders.
The GST implementation was initially met with resistance from some of the states. The main cause
of resistance was the perceived or expected erosion of the tax powers of states. The first discussion
paper on GST reviewed the experience of VAT system in states and summarized: 'The Empowered
Committee has been monitoring closely the process of implementation of State-level VAT, and devia-
tions from the agreed VAT rates has been contained to less than 3 per cent of the total list of commodi-
ties. Responses of industry and also of trade have been indeed encouraging. The rate of growth of tax
revenue has nearly doubled from the average annual rate of growth in the pre-VAT five-year period after
the introduction of VAT.' (Empowered Committee of State Finance Ministers, November 2009, p. 8).
It should be noted that at the time of introducing VAT earljer, many states were worried about
losing revenues. However, they were promised to reimburse losses arising due to the change to VAT. The
issues are more complicated with GST as states lose their power to tax. As a compensatory measure the
Centre has proposed to create a ~50,000 crore fund to help states with shortfalls in tax revenues after
implementing GST.
Minimized interaction between taxpayer and tax collector

The physical interaction such as visiting the tax office for filing of periodical returns, etc. between the
taxpayer and the tax authorities would be minimal under GST. Certain important provisions in this
regard are illustrated as follows:
1. Registration will be granted online and shall be deemed to have been granted if no deficiency is
communicated to the applicant within three working days by the tax administration.
2. Tax is paid based on self-assessment. The return filed by the taxpayer would be treated as self-assessed.
3. Payment of tax shall be made electronically through Internet banking, credit card, real time gross settle-
ment (RTGS), or national electronic funds transfer (NEFT). Smaller taxpayers shall be allowed to pay
tax over the bank counter. All challans for payment of tax shall be generated online on the GSTN.
4. The taxpayer shall furnish the details of outward supplies electronically without any physical
interface with the tax authorities. Inward supply details would be auto-drafted from the supply
details filed by the corresponding suppliers.
5. Taxpayers shall file, electronically, monthly returns of outward and inward supplies, input tax
credit availed, tax payable, tax paid, and other prescribed particulars. Composition taxpayers shall
file, electronica11y, quarterly returns. Omission/incorrect particulars can be self-rectified before the
last date of filing of return for the month of September of the following year or the actual date of
filing of annual return, whichever is earHer.
6. For mismatched invoices, reversal and reclaim of input tax credit shall be done electronically on the
GSTN portal without any taxpayer contact. This electronic system would also prevent, inter alia,
input tax credit being taken on the basis of fake invoices or twice on the same invoice.
7. Taxpayers shall be allowed to keep and maintain accounts and other records in electronic Corm.
18.4.3 Benefits of Adopting GST ·./

The following are the benefits of adopting GST.
Reduction of cascading effect By combining a large number of centr_al and state taxes into a single tax
and allowing set-off of taxes paid in the previous stages of transactions, GST would remove the effects
180
,,c Finance
& cascacling a d h Ip building u common natioQal market. For the consumers, the biggest gain woul I
-Y~be in term o a duction in lhc overall tax burden on goods, which is currently estimated at 25-30 per
cen.
Making Indian goods more competitive in international markets GST will make goods and services
duced in India more competitive in the national as well as international market. Further, all imported
goods will be subjct:tcd Lu IGST, which is sum of SGST an<l CGST thus making the import taxatio1\
equivalent Lo do11wsliG tax.
Under lire <,ST regime, exports will be zero-rated which will encourage Indian exports th-q.~:
improving tlw balance of payments position. Exporters will be given immediate refund of 90 per cen
of their dai1m arising on account of exports, within seven days. There may also be revenue gain for
the Centre and lhc states due to widening of the tax base, increase in trade volumes, and improved bu
compliance.
Higher l'Cvenne yield GST is expected to bring buoyancy to the government revenue ~y widening the.
tax base and improving the taxpayer compliance and likely to improve the Ease of Doing Business
.Index of the country.
More transparency in the tax system GST will bring more transparency to indirect tax laws, which
will help the tax payers to take credit, the government to verify the correctness of taxes paid, and the :.
consumer to know the exact amount of taxes paid.
Ease of compliance The taxpayers would not be required to maintain elaborate records and comply ;
with countless tax laws and rules of the central government and the state governments such as central
excise, service tax, VAT, central sales tax, octroi, entry tax, luxury tax, and entertainment tax. They need
to maintain records in respect of Central Goods and Services Tax Act and State Goods and Services
Tax Act for all intrastate supplies (which are almost identical laws) and with Integrated Goods and
Services Tax for all interstate supplies. GST is largely technology driven and so can reduce the human
interface to a great extent and this would lead to speedy decisions.
i 18.4.4 Possible Impact of GST on Indian Economr,,./.

A study undertaken by the National Council of Applied Economic Research (NCAER) attempted a
cost-benefit analysis of GST regime in India (NCAER, 2009). The observations of the report are as
follows:
Medium-term gains Introduction of OST is expected to cause India's GD:P to grow by 0.9 per cent
to 1.7 per cent. The dollar value increment is estimated to be between $9.5 billion and $8.6 billion
respectively.
Long-term gains The present value of total additional gain in GDP due to the introduction of OST,
would be between $325 billion and $63 7 billion. This is nearly 30-60 per cent of the size of Indian
economy currently.
Export gains OST will lower the taxation of inputs leading to lower prices of Indian goods and
services. This wilt make the Tndian goods and services more competjtive in the international market and
boost Indian exports. The uniformity in tax rates and procedures across the country will also reduce
the compliance costs. The gains due to this simplicity are expected to vary between 3.2 per cent and 6.3
per cent with corresponding absolute value range between $5.4 billion and $10.7 billion, respectively.
Import-s are expected to gain somewhere between 2.4 and 4. 7 per cent with corresponding absolute val-
ues $6.9 billion and $13.6 billion, respectively.
Others OST would lead to efficient allocation of factors of production resulting is lower prices. It
is expected that the rea1 returns to the factors of production would go up. The NCAER results show
gains in real returns to land ranging between 0.42 and 0.82 per cent, whereas wage rate gains would vary
between 0.68 and 1.33 per cent. The rea] returns to capital would gain between 0.37 and 0. 74 per cent.
181
Value Added (Goods and Services) Taxation in India 245
Kelkar adds that GST could help add productive employment of four to five million. Barring impact
on economy, GST could help the consumers as well. The lower taxation will lead to lower prices of
goods and services. NCAER sums up the findings as implementation of a comprehensive GST in India
is expected to lead to efficient allocation of factors of production thus leading to gains in GDP and
exports. This would translate into enhanced economic welfare and returns to the factors of production,
namely land, labour, and capital.
However, NCAER adds that as with any other modeJling exercise, the results are subject to certain
limitations. However, going by the international experiences there could be two additional problems,
which are discussed next.
Inflation Most of the international case studies show rising inflation during the initial months of OST
impleme_ntation. In Australia's case, the in price rise was noticed after the GST was introduced. The
inflation situation stabilizes as implementation gains pace and is understood by consumers and produc-
ers. In India's case, inflation risk could be more.
Tax revenue shortfall Reserve Bank in India in the State Finances Report (2010-11) said the revenue
implications of GST are likely to vary across states. It is too early to estimate, with any precision, the
impact of OST on state finances. Other issues are enhancing the administrative capacity of states and
building IT (information technology) infrastructure to capture the full benefits of GST. The report
points that VAT led to improvement in tax revenue for most states. However, just like VAT there could
be some shortfalls in revenues in some states over a short term. As mentioned earlier, the central
government has already proposed to create a {50,000 crore fund to help the states which suffer from
the shortfall. However, a higher shortfall could lead to both centre and states to borrow more from the
markets. This will be critically watched as it has further ramifications on fiscal deficits, interest rates,
and inflation.
18.5 GST IMPACT ON INFORMAL SECTOR

The introduction of OST is expected to shrink the informal sector. In fact, an important objective of
introducing OST is to bring the informal sector into the main stream economy. In India, the informal
sector accounts for nearly half of the economy and account for nearly 80 per cent of the total job cre-
ation. Many of the firms in the informal sector make profits due to tax avoidance and tax evasion. With
the introduction of GST, tax evasion becomes difficult due to the wide coverage and cross-checking of
the transactions and therefore the profitability of the unorganized firms may go down.
However, given the present form of the GST, most unorganized firms can continue to operate outside
the OST framework. This is so as business firms whose turnover is less than '{2 million are exempt, and
firms with turnover up to '{7 .5 million are given the option of a flat-rate tax payment. Thus, the negative
impact of GST on the informal sector may be smaller than many expect.
18.6 A CRITICAL ANALYSIS OF GST

The OST in India in its present form is not yet perfect and at best it can be regarded as symbolic
transformation from the existing tax regime. This is so particularly, since it does noi subsume all taxes
and also it leaves out major revenue earning items such as liquor, ATF, diesel, petrol, and electricity,
which shall result in cascading of corresponding taxes. In addition, taxes applicable at municipal level
have also been kept out of GST purview. It is still far from perfect as many or the globally accepled
processes, policies, and systems pertaining to GST are yet to be brought into the system. Yet, GST is a
welcome change from the existing maze of tax structures.
An important departure from the international practices in adopting the VAT is the introduction or
input credit matching concept. It should be noted that the input tax credit can be availed by lhc buyer
if and only if the seller has deposited the tax amount received from the buyer.
Another departure is that Indian OST requires separate registrn.tions of the same legal L:nliiy. The
international practice is to group certain transactions among closely related entities and make them
zero-rated.
182
Cascading.jpg (JPEG Image, 768 × 2947 pixels) https://assets1.cleartax-cdn.com/s/img/20170725151139/Cascading.jpg
clearTax
CASCADING EFFECT
UNDER CURRENT INDIRECT TAX REGIME
Quick gu ide to und@rstand how GST puts a c;hecl< on cascading efft?Ct oHax
HERE'S AN EXAMPLE
Let's suppose that there is an automobHe manufacturer in Sanand, Gujarat, who is manufac-
turing a very sped Re part of ar, induction motor. This rn turn is sold to a dealer in Manesar, Har-
yana, who is cls.sernbling induct.ion motors. These assembled motors are further sold to ,moth-
er dealer in Gurgaon, Haryana. This dealer sells the fnduttfon mottir to an automobile service
station in Delhi, who assembles the car and sell it to the final consumer.
AUTOMOBILE DEALIN,GS
(:A) {B) jc ) (D )
tnln-,t..t
GUJARAT MANESAR GURGAON DELHI CONSUMER
► I,.,
..,
Q
3
E
0
Dealer ot Specilit; Pa~ A"-s.emblyel Seller o! the motot:- J\utom,;,'bile F;r>al :,
□f lnducti<>n m □t.;ir. lmju,;~lon majors. to Servi ce St~tiom., SeNii;:e St~ti<m. ConsuJTI••
j
Before we go deeper into our case study, one th il'lg that needs to be understood is that
on aU the Inter-state transactJons. Central Sa,les Ta)l is app licable. Similarly all
intra-state sale of goods attract Vah.-e Added TaiK(VAT} while Exc:ise Duty is
applicable on manufacturing activities.
t t
When Manufacturer ,cA" sells his goods from G,ujaratto Haryana, he fs liab(e to collect
both f'xcise Duty and Central Sales Tax at the rate of 12.5% and 2% respective ly being an
inter-state sale. Further, Dealer •1Bj 1 wi ll not getar,y credit oHhis Excise Duty and est
Dealer "B" in tum seUs it to Dea let "C" in Gurgaon and charges VAT on s1.Jch sale_ De\iller
"C" sells ft to Dea[er "D" in Delh" and collects CST, and finally Dealer "D" se lls these
goods to the end consumer in Delhi, collecting VAT.
to a oo
183
1 of 3 11-03-2020, 11:07
lntr-a-stat~ - - - -
Ma nufactur,a,r ·°'A''
serl~ hl s goods : tmmMaM~ar (furn Guri:a<>n
1 w Gu a11n tt, Dell\i
I
... J...
Collect Collri!ct Co!l@ct
Ex:tisie Duty %
VAT % CST 0%
+CST %
,rom G11j f'!t

"'
10 ~~ryan Not lia ble to
C.ST or Excise duty VAT
CONSUMER · - -- • - -
UNDER CURRENT TAX REGIME
PARTICULARS Dealer A Dealer B DealerC Dealer D TOTAL
SE LUNG PRICE sooo 7000 9000 13000
EXCISE DUTY@ 12.5% 625 NA NA NA
CST@2.% 112.S NA 180 NA
VAT@S,. 5% NA 385 NA 715
s,ELLJNG PRICE 5737 5 7385 9180 13715

INCLUDING TAX
CREDLT AVAIII.ABlE 0 0 385 0
TOTAL TAX PAID 737.5 385 0 715 1837.5
UNDER GST REGIME
PARTICULARS Deal,er A Dealer B Dealer c Dealer D TOTAL
SE LLING PRICE sooo 7000 9000 1300,0
GST@ i:6% 12% 600 840 1080 1560
SELUNG PRtCE 5600 7840 10080 14560

INCLUDING TAX
CREDIT AVAILABLrE 0 600 840 1080

184
2 of 3 11-03-2020, 11:07
TOTAL TAX PAID 600 240 240 480 1560
Now if you notice in above example, there is a cascad f11geffect of ax rfght after the manufac-
turf ng wherein CST .is levied on an amount inclusive of Excise Duty. Further all subsequent
levies indudces some amount of t<lx. Thus effective rate of ta:x under current regime turns out to
be 14.U %) while under GST it will be 12% an Hlustratlve figure.
EX<;i Se Duty
MANUFACTURING
PRODUCT
CST
Casc::ading effoc:t of tax right after the :manufac:turing

where'in CST is l,evied on an amount inclusive of Excise Duty.
185
3 of 3 11-03-2020, 11:07
Unit‐ 8
Consumer Behavior Analysis
186
Utility
• Want satisfying power of a good or service
• Cardinal versus Ordinal Approach
• Total Utility and Marginal Utility
• Law of Diminishing Marginal Utility
187
80
70 ♦
...
~
-... ♦
♦ ♦
60 ♦
50 .-..
-~
.+--'
=> 40
(0 ♦
+-'
~ 30
20 .
10
0 I I I I I I I I I I
0 1 2 3 4 5 6 7 8 9 10 11
Sli ces
188
25
20
..-
♦
15 ♦
,i?:
·p
=> 10
♦
ctl
c::
·-
C)
~ 5
♦
♦
ro
♦
~
"""
0 I I I I I I I T I I
-5 •
-10
0 2 3 4 5 6 7 8 9 10 11
Sli ces
189
Consumer Behavior
• Consumer Opportunities
– The possible goods and services consumer can
afford to consume.
• Consumer Preferences
– The goods and services consumers actually
consume.
• Given the choice between 2 bundles of goods
a consumer either
– Prefers bundle A to bundle B: A  B.
– Prefers bundle B to bundle A: A  B.
– Is indifferent between the two: A  B.
190
Indifference Curve Analysis
Indifference Curve Good Y
– A curve that defines the III.
combinations of 2 or more goods
II.
that give a consumer the same
level of satisfaction. I.
Marginal Rate of
Substitution
– The rate at which a consumer is
willing to substitute one good for
another and maintain the same
satisfaction level.
Good X
191
Consumer Preference Ordering
Properties
• Completeness
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity
192
Complete Preferences
• Completeness Property
Good Y
– Consumer is capable of
expressing preferences (or III.
indifference) between all possible
bundles. (“I don’t know” is II.
NOT an option!) I.
• If the only bundles available A
B
to a consumer are A, B, and
C, then the consumer
– is indifferent between A
and C (they are on the C
same indifference curve).
– will prefer B to A.
– will prefer B to C.
Good X
193
More Is Better!
• More Is Better Property
– Bundles that have at least Good Y
as much of every good and
more of some good are III.
preferred to other bundles.
• Bundle B is preferred to A II.
since B contains at least as I.
much of good Y and strictly
more of good X.
• Bundle B is also preferred to 100
A B
C since B contains at least as
much of good X and strictly
more of good Y. I
I
I
• More generally, all bundles 33.33

I
I C
on ICIII are preferred to --~------
bundles on ICII or ICI. And all 'I
bundles on ICII are preferred
to ICI. 1 3
Good X
194
Diminishing Marginal Rate of
Substitution
• Marginal Rate of Substitution
– The amount of good Y the consumer is willing to give up
Good Y
to maintain the same satisfaction level decreases as
more of good X is acquired.
– The rate at which a consumer is willing to substitute one
good for another and maintain the same satisfaction
III.
level.
• To go from consumption
bundle A to B the consumer II.
must give up 50 units of Y to
get one additional unit of X. I.
• To go from consumption 100 A
bundle B to C the consumer
must give up 16.67 units of Y I
I
to get one additional unit of

I
I
I
B
X. 50
___ .LI __ _
I
• To go from consumption C
I I
33.33
I
- - - ,I ___ TI __ _
D
bundle C to D the consumer 25
____I ____ I - - - I - - -
1 I I
must give up only 8.33 units I

I
I
I
I
I
of Y to get one additional unit

I I I
I I I
I I
of X.
1 2 3 4 Good X
195
Consistent Bundle Orderings
• Transitivity Property Good Y
– For the three bundles A, B, and C,
the transitivity property implies III.
that if C  B and B  A, then C  II.
A.
I.
– Transitive preferences along with
A
the more‐is‐better property imply 100
C
that 75
B
• indifference curves will not 50
intersect.
• the consumer will not get
caught in a perpetual cycle of
indecision.
1 2 5 7 Good X
196
The Budget Constraint
• Opportunity Set Y The Opportunity Set
– The set of consumption

Budget Line
bundles that are affordable.
M/PY Y = M/PY – (PX/PY)X
• PxX + PyY  M.
• Budget Line
– The bundles of goods that exhaust a
consumers income.
• PxX + PyY = M.
• Market Rate of Substitution M/PX
X
– The slope of the budget line
• ‐Px / Py
197
Changes in the Budget Line
Y
M1/PY
• Changes in Income
– Increases lead to a parallel,
M0/PY
outward shift in the budget
line (M1 > M0).
– Decreases lead to a parallel, M2/PY
downward shift (M2 < M0).
• Changes in Price X
– A decreases in the price of M2/PX M0/PX M1/PX
Y
good X rotates the budget New Budget Line for
line counter‐clockwise (PX0 > a price decrease.
M0/PY
PX1).
– An increases rotates the
budget line clockwise (not
shown).
M0/PX0 M0/PX1
X
198
Consumer Equilibrium
• The equilibrium Y
consumption bundle Consumer
is the affordable M/PY
Equilibrium
bundle that yields the
highest level of
satisfaction.
– Consumer equilibrium
occurs at a point where
MRS = PX / PY. III.
– Equivalently, the slope of II.
the indifference curve
equals the budget line. I.
M/PX
X
199
y
---[- ---_,
--- _____,.J_
I
I
I
X
0 M x1 M
pl
Pl X
200
Numerical Example
M-0--K \) ; -X.,y-\- -X.., ;- 2-.'t" t- ?_

S · t. G · ~S- -;=.- l O ')L ~ ~ 'i
201
MV")L ::: olLJ ::=- ~ .+ \ --CC)
~')0
\)'r ~ --®
fV\
-~
o\ \.)
'i
-
.- ry__. ~ ')_
7- 'T '2
~y'T~::=.- 10%+ 2-0

5~.:= \O')LtlS-
~~ "2----"i-,. 2:>
202
\) .
60'')
0 ,;- :::- l o ~ + s- (3.-'}L + ?:.j
a) ~ }D'X ~) D'X + \ ~-
2-0 rt- ::::- S- 0
4
r : :.
r")L ;::..
2-Y LI ,,. 3, :::= ) l

( ")(~ i J "' ( ~_;, )1j
203
198 Part Ill: Microeconomics: The Science of Consumer and Firm Behaviour _ __
We start the chapter by discussing utility, which is how economists measure

human happiness. Economists assume that people act in ways that maxi-
mise their happiness, but our actions are constrained, especially by limited
budgets. We explain how people navigate these constraints to get the most
happiness possible given the limits involved. Finally, we show how these
decisions underlie and explain the slope and position of demand curves.
KnouJin9 the Name of the Game:

Constrained Optimisation
Later in this chapter we discuss how people choose what to buy when they
buy. But first we focus on why they must choose.
People need to make choices because their means for satisfying their wants
are limited. You never have enough money or time to do everything you
desire. Consequently, you need to choose wisely to get the most happiness
out of the limited resources that you do have.
Economists and engineers refer to problems of this sort as constrained opti-

misation problems, because people are trying to optimise their happiness
given the fact that they're constrained by their limited resources. The rest of
this chapter shows you how economists model the way that people go about
solving their everyday constrained optimisation problem: working out how
people decide to best spend their limited incomes on available goods and
services - choosing not only which things to buy, but also how much of each.
Findin9 a Common Denominator

to Measure Happiness: UtilitlJ.
In order for people to choose between the exceedingly different goods and
services available in the economy, they must have a way of comparing them
all. Comparing costs is pretty easy; you just compare prices. But how do
you compare the benefits of various goods and services? How do you assess
whether spending £20 on Swiss chocolate bars or on a cotton shirt is better?
In what ways are chocolate and shirts even comparable?
Obviously, people do manage to make the comparison and rank the two
options. Economists imagine that people do this by assigning a common mea-
sure of happiness to each possible thing they can buy and use. Economists
call this common measure of happiness utility, and they imagine that if they
204
Chapter 9: Getting to Know Homo Economicus, the Utility-Maximising Consumer 199
were able to get inside your brain and measure utility, they'd do so using
a unit that they very uncreatively call a util. However, making such strong
claims about how people measure happiness is not necessary.
Some people very naturally object to assigning specific numbers of utils to

different things - for example, 25 utils to the pleasure associated with eating
a brownie, or 75 utils to the pleasure associated with watching a sunset.
(Although the philosopher Jeremy Bentham did come up with a scheme for
doing just that.) Making such specific assignments is called cardinal utility
(like cardinal numbers: 1, 2, 3 ...). The objections to cardinal utility centre
on doubts about whether people even make such assessments - after all,
how many utils do you think you receive from a sunny day or a baby's smile?
A much less objectionable thing to do is to think in terms of ordinal utility, a

system in which you simply rank things. For example, instead of saying that
the sunset has a utility of 75, which makes it preferred to the brownie with a
utility of 25, you can simply say that sunsets are preferred to brownies. This
system has a much more intuitive feeling for most people and eliminates the
need to try to measure things using the imaginary unit called the util.
Even better, it's been proven mathematically that you can describe the same
human choice behaviour using ordinal utility that you can using cardinal util-
ity, which means that economists don't have to use cardinal utility.
But we're going to anyway!
Why? Because using the cardinal utility system is a much easier way to
explain the crucial concept of diminishing marginal utility. You can also
explain diminishing marginal utility using the ordinal system, but the maths
is a bit scary, and we usually leave this method for real geeks. So although it
may seem a bit unrealistic, the cardinal utility system really is the best way
to convey this incredibly important idea.
Gettin9 Less from More: Diminishin9

Mar9inal UtilitlJ.
People get bored even with things they like and get tired of repetition and
sameness. Economists have to take account of this tendency when studying
how people choose to spend their money.
If you love your pizza, and you haven't had any pizza in a long time, you get a
great big rush of utility from eating a slice. The melted cheese, the basil and
garlic in the sauce, and the familiar warmth in your mouth all make you very,
very happy. But eating that first slice dampens the thrill of pizza, and so if you
eat a second slice, it may taste good, but not as good as the first. And if you
205
have a third slice, that's not as good as the second. And by the time you get to
your third 13-inch stuffed-crust slice of pizza, you're likely to start to get sick
and experience pain rather than pleasure.
This phenomenon isn't limited to pizza; it applies to nearly everything.

Unless you're addicted to something, you get tired of it the more you have it,
and each additional unit brings you less happiness than the previous unit.
To make this phenomenon clearer, look at Figure 9-1, which shows the cumu-
lative total utility of a pizza lover who eats more and more slices of pizza. For
example, total utility after eating one slice of pizza is 20 utils, after eating two
slices, 36 utils and after three slices, the total utility is 50 utils.
80
70 ♦ ♦
♦ ♦
60 ♦
~ 50
·.;:::;
:::,
cc 40
Figure 9-1:
The total
-
~ 30
♦
utility of a 20
pizza con-
noisseur 10
who eats
more and 0
0 2 3 4 5 6 7 8 9 10 11
more slices
of pizza. Slices
When you look at these numbers, you notice that the extra utility each addi-
I
tional slice brings is decreasing:
Y' First slice: Total utility increases by 20 utils, from 0 to 20 utils.

Y' Second slice: The increase is only 16 utils; total utility increases from 20
utils to 36 utils.
Y' Third slice: Total utility increases only 14 utils, from 36 to 50.
Economists refer to this phenomenon as diminishing marginal utility because

the extra utility, or marginal utility, that each successive slice brings decreases
relative to the marginal utility brought by the previous slice. (Remember that
we're interested in only the extra utility from each extra slice, the marginal
206
Chapter 9: Getting to Know Homo Economicus, the Utility-Maximising Consumer 201
utility.) Diminishing marginal utility is simply a reflection of the fact that
people get fed up or bored with things. Or, in the case of food and drink, their
appetite decreases with each unit they consume.
Look at what happens in Figure 9-1 after slice number eight. Total utility actu-
ally goes down, because slice number nine can make even the most rabid
pizza lover feel a little sick. Add on slice number ten, and total utility falls
again.
This decrease in total utility implies that marginal utility must be negative for
slices nine and ten. Look at Table 9-1, which gives both the total and marginal
utilities for each slice. As you can see, the data matches Figure 9-1 and shows
that although total utility increases for slices one through seven, it stalls at
slice number eight and falls for slices nine and ten.
Table 9-1 Total and Marginal Utility of Eating Ten Slices of Pizza
Slice Total Utility Marginal Utility
20 20
2 36 16
3 50 14
4 58 8
5 64 6
6 68 4
7 70 2
8 70 0
9 68 -2
10 64 -4
The right column shows the diminishing marginal utility that comes with
eating more and more slices of pizza, because the marginal utility that comes
with each additional slice is always less than that of the previous slice.
Specifically, although marginal utility is 20 utils for the first slice, it falls to 0
utils for slice eight and then actually becomes negative for slices nine and ten
because eating them makes just about anyone ill.
In Figure 9-2, we plot out the marginal utility for each slice of pizza. You can
see quite clearly from the downward slope of the points that marginal utility
diminishes as one eats more and more slices of pizza.
207
You have to be careful not to confuse diminishing marginal utility with

negative marginal utility. As you see in Table 9-1 and Figure 9-2, diminishing
marginal utility for all slices of pizza starts with the second, because each
successive slice has a smaller marginal utility than the previous one. But the
marginal utilities are still positive for all slices up to slice seven, and they
become negative only for slices nine and ten.
25
20
♦
15 ♦
~
·.;::;
:::> 10 ♦
·='°
~ 5
♦
♦
"'
:i1: ♦
0
♦
Figure 9-2: •
The mar-
-5
ginal utility
-10
derived from 0 2 3 4 5 6 7 8 9 10 11
each slice
of pizza. Slices
That fact implies that you enjoy eating every slice up to and including the
seventh slice because doing so brings you an increase in utility (happiness).
So don't think that just because marginal utility is diminishing for a particu-
lar slice, you don't want to eat it. Marginal utility can be diminishing but still
positive. The only slices you want to avoid outright are the ninth and tenth.
Choosin9 amon9 Manv Options When

Facin9 a Limited 8ud9et
The phenomenon of diminishing marginal utility makes studying human
choices very interesting because whether you prefer chocolate ice cream or
vanilla ice cream can't be determined in the abstract. Instead, your prefer-
ence depends on what you've already eaten.
208
Consumer Behavior
118
INTRODUCTION
This chapter develops tools that help a manager understand the behavior of individ-
uals, such as consumers and workers, and the impact of alternative incentives on
their decisions. This is not as simple as you might think. Human beings use com-
plicated thought processes to make decisions, and the human brain is capable of
processing vast quantities of information. At this very moment your heart is pump-
ing blood throughout your body, your lungs are providing oxygen and expelling
carbon dioxide, and your eyes are scanning this page while your brain processes the
information on it. The human brain can do what even supercomputers and sophisti-
cated "artificial intelligence" technology are incapable of doing.
Despite the complexities of human thought processes, managers need a model that
explains how individuals behave in the marketplace and in the work environment. Of
course, attempts to model individual behavior cannot capture the full range of real-
world behavior. Life would be simpler for managers of finns if the behavior of indi-
viduals were not so complicated. On the other hand, the rewards for being a manager
of a firm would be much lower. If you achieve an understanding of individual behav-
ior, you will gain a marketable skill that will help you succeed in the business world.
Our model of behavior will necessarily be an abstraction of the way individu-
als really make decisions. We must begin with a simple model that focuses on
essentials instead of dwelling on behavioral features that would do little to enhance
our understanding. Keep these thoughts in mind as we begin our study of an eco-
nomic model of consumer behavior.
CONSUMER BEHAVIOR
Now that you recognize that any theory about individual behavior must be an
abstraction of reality, we may begin to develop a model to help us understand how
consumers will respond to the alternative choices that confront them. A consumer is
an individual who purchases goods and services from firms for the purpose of con-
sumption. As a manager of a firm, you are interested not only in who consumes the
good but in who purchases it. A six-month-old baby consumes goods but is not
responsible for purchase decisions. If you are employed by a manufacturer of baby
food, it is the parent's behavior you must understand, not the baby's.
In characterizing consumer behavior, there are two important but distinct fac-
tors to consider: consumer opportunities and consumer preferences. Consumer
opportunities represent the possible goods and services consumers can afford to
consume. Consumer preferences determine which of these goods will be con-
sumed. The distinction is very important: While I can afford (and thus have the
opportunity to consume) one pound of beef liver each week, my preferences are
such that I would be unlikely to choose to consume beef liver at all. Keeping this
distinction in mind, let us begin by modeling consumer preferences.
In today's global economy literally millions of goods are offered for sale. However,
to focus on the essential aspects of individual behavior and to keep things manageable,
209
The Theory of Individual Behavior 119
we will assume that only two goods exist in the economy. This assumption is made
purely to simplify our analysis: All of the conclusions that we draw from this two-good
setting remain valid when there are many goods. We will let X represent the quantity of
one good and Y the quantity of the other good. By using this notation to represent the
two goods, we have a veiy general model in the sense that X and Ycan be any two goods
rather than restricted to, say, beef and pork.
Assume a consumer is able to order his or her preferences for alternative bun-
dles or combinations of goods from best to worst. We will let >- denote this order-
ing and write A >- B whenever the consumer prefers bundle A to bundle B. If the
consumer views the two bundles as equally satisfying, we will say she or he is
indifferent between bundles A and Band use A - Bas shorthand notation. If A >- B,
then, if given a choice between bundle A and bundle B, the consumer will choose
bundle A. If A - B, the consumer, given a choice between bundle A and bundle B,
will not care which bundle he or she gets. The preference ordering is assumed to
satisfy four basic properties: completeness, more is better, diminishing marginal
rate of substitution, and transitivity. Let us examine these properties and their
implications in more detail.
Property 4-1: Completeness. For any two bundles-say, A and B---either A >- B,
B> A, orA-B.
By assuming that preferences are complete, we assume the consumer is capable
of expressing a preference for, or indifference among, all bundles. If preferences
were not complete, there might be cases where a consumer would claim not to
know whether he or she preferred bundle A to B, preferred B to A, or was indiffer-
ent between the two bundles. If the consumer cannot express her or his own prefer-
ence for or indifference among goods, the manager can hardly predict that
individual's consumption patterns with reasonable accuracy.
Property 4-2: More Is Better. If bundle A has at least as much of eveiy good as
bundle Band more of some good, bundle A is preferred to bundle B.
If more is better, the consumer views the products under consideration as
"goods" instead of "bads." Graphically, this implies that as we move in the northeast
direction in Figure 4-1, we move to bundles that the consumer views as being better
than bundles to the southwest. For example, in Figure 4-1 bundle A is preferred to
bundle D because it has the same amount of good X and more of good Y. Bundle C is
also preferred to bundle D, because it has more of both goods. Similarly, bundle Bis
preferred to bundle D.
While the assumption that more is better provides important information about
indifference curve consumer preferences, it does not help us determine a consumer's preference for all
Acmvethat possible bundles. For example, note in Figure 4-1 that the "more is better" property
defines the does not reveal whether bundle Bis preferred to bundle A or bundle A is preferred
combinations of to bundle B. To be able to make such comparisons, we will need to make some
two goods that give
a consumer the additional assumptions.
same level of An indifference curve defines the combinations of goods X and Y that give the
satisfaction. consumer the same level of satisfaction; that is, the consumer is indifferent between
210
FIGURE 4-1 The Indifference Curve
6
I
I
5 I
I
I
4 ---•---
I
I I
I I C
3 ---1--------
I
I
I I
I I
2 I I
I
I
I I
1 ---+D I
I
I
I
X
0 1 2 3 4 5 6
any combination of goods along an indifference curve. A typical indifference curve

is depicted in Figure 4-1. By definition, all combinations of X and Ylocated on the
indifference curve provide the consumer with the same level of satisfaction. For
example, if you asked the consumer, "Which would you prefer-bundle A, bundle B,
or bundle C?" the consumer would reply, "I don't care," because bundles A, B, and
Call lie on the same indifference curve. In other words, the consumer is indifferent
among the three bundles.
The shape of the indifference curve depends on the consumer's preferences.
Different consumers generally will have indifference curves of different shapes.
One important way to summarize information about a consumer's preferences is in
marginal rate of terms of the marginal rate of substitution. The marginal rate of substitution (MRS)
substitution is the absolute value of the slope of an indifference curve. The marginal rate of sub-
(MRS) stitution between two goods is the rate at which a consumer is willing to substitute
The rate at which a
consumer is one good for the other and still maintain the same level of satisfaction.
willing to The concept of the marginal rate of substitution is actually quite simple. In
substitute one good Figure 4-1, the consumer is indifferent between bundles A and B. In moving from
for another good A to B, the consumer gains 1 unit of good X To remain on the same indifference
and still maintain curve, she or he gives up 2 units of good Y. Thus, in moving from point A to point
the same level of
satisfaction. B, the marginal rate of substitution between goods X and Yis 2.
The careful reader will note that the marginal rate of substitution associated with
moving from A to B in Figure 4-1 differs from the rate at which the consumer is will-
ing to substitute between the two goods in moving from B to C. In particular, in mov-
ing from B to C, the consumer gains 1 unit of good X But now he or she is willing to
give up only 1 unit of good Y to get the additional unit of X The reason is that this
indifference curve satisfies the property of diminishing marginal rate ofsubstitution.
211
Property 4-3: Diminishing Marginal Rate of Substitution. As a consumer

obtains more of good X, the amount of good Y he or she is willing to give up to
obtain another unit of good X decreases.
This assumption implies that indifference curves are convex from the origin;
that is, they look like the indifference curve in Figure 4-1. To see how the locations
of various indifference curves can be used to illustrate different levels of consumer
satisfaction, we must make an additional assumption: that preferences are transitive.
Property 4-4: Transitivity. For any three bundles, A, B, and C, if A> Band B > C,
then A > C. Similarly, if A - Band B - C, then A - C.
The assumption of transitive preferences, together with the more-is-better
assumption, implies that indifference curves do not intersect one another. It also
eliminates the possibility that the consumer is caught in a perpetual cycle in which
she or he never makes a choice.
To see this, suppose Billy's preferences are such that he prefers jelly beans to
licorice, licorice to chocolate, and chocolate to jelly beans. He asks the clerk to fill
a bag with jelly beans, because he prefers jelly beans to licorice. When the clerk
hands him a bagful of jelly beans, Billy tells her he likes chocolate even more than
jelly beans. When the clerk hands him a bagful of chocolate, he tells her he likes
licorice even more than chocolate. When the clerk hands him a bagful of licorice,
Billy tells her he likes jelly beans even more than licorice. The clerk puts back the
licorice and hands Billy a bagful of jelly beans. Now Billy is right back where he
started! He is unable to choose the "best" kind of candy because his preferences for
kinds of candy are not transitive.
The implications of these four properties are conveniently summarized in
Figure 4-2, which depicts three indifference curves. Every bundle on indifference
curve III is preferred to those on curve II, and every bundle on indifference curve II
is preferred to those on curve I. The three indifference curves are convex and do not
cross. Curves farther from the origin imply higher levels of satisfaction than curves
closer to the origin.
FIGURE 4-2 A Family of Indifference Curves
III
~--------- X
0
212
INSIDE BUSINESS 4-1
Indifference Curves and Risk Preferences
Have you ever wondered why some individuals choose between a higher reward (return) and the level of
to undertake risky prospects, such as skydiving and safety of the investment.
investing in risky financial assets, while others choose The relatively steep indifference curves drawn in
safer activities? Indifference curve analysis provides an panel (a) describe an investor who has a high mar-
answer to this question. ginal rate of substitution between return and safety;
The accompanying figures plot three potential she or he must receive a large return to be induced to
investment options (represented by points A, B, and give up a small amount of safety. The relatively flat
C), each with different expected returns and risks. indifference curves drawn in panel (b) indicate an
Option A is the safest investment, but it offers the investor with a low marginal rate of substitution
lowest return (2.94 percent); option B is of medium between return and safety. This individual is willing
safety, with a moderate return (4.49 percent); and to give up a lot of safety to get a slightly higher return.
fund C is the least safe, but it carries the highest An investor with indifference curves such as those in
potential return (6.00 percent). panel (a) finds investment option A most attractive,
Investors view safety and the level of the return because it is associated with the highest indifference
on an investment as "goods"; investments with higher curve. In contrast, an investor with indifference
returns and higher levels of safety are preferred to curves such as those in panel (b) achieves the highest
investments with lower returns and lower levels of indifference curve with investment option C. Both
safety. Investors are willing to substitute between the types of investors are rational, but one investor is
level of return and the level of safety. Given the three willing to give up some additional financial return for
options, from an investor's viewpoint, there is a tradeoff more safety.
Return Return
;~
6.00 6.00
I
I
I
I
4.49 - - - - ..J_ - - 4.49
I I
2.94 ----------- -
I
I
I
2.94
I
I
I
I
I
I I I
I I I
I I I
I I I
I I I
~---+----+----+- Safety '----+---+----+-. Safety

0 Low Medium High 0 Low Medium High
(a): Safety Chooser (b): Risk Chooser
CONSTRAINTS
In making decisions, individuals face constraints. There are legal constraints, time
constraints, physical constraints, and, of course, budget constraints. To maintain
our focus on the essentials of managerial economics without delving into issues
213
beyond the scope of this course, we will examine the role prices and income play in
constraining consumer behavior.
The Budget Constraint

Simply stated, the budget constraint restricts consumer behavior by forcing the
consumer to select a bundle of goods that is affordable. If a consumer has only $30
in his or her pocket when reaching the checkout line in the supermarket, the total
value of the goods the consumer presents to the cashier cannot exceed $30.
To demonstrate how the presence of a budget constraint restricts the con-
sumer's choice, we need some additional shorthand notation. Let M represent the
consumer's income, which can be any amount. By using M instead of a particular
value of income, we gain generality in that the theory is valid for a consumer with
any income level. We will let F.c and Py represent the prices of goods X and Y,
budget set respectively. Given this notation, the opportunity set (also called the budget sei)
The bundles of may be expressed mathematically as
goods a consumer
can afford. P.:X+ PyY:s M
In words, the budget set defines the combinations of goods X and Y that are afford-
able for the consumer: The consumer's expenditures on good X, plus her or his
expenditures on good Y, do not exceed the consumer's income. Note that if the con-
sumer spends his or her entire income on the two goods, this equation holds with
budget line equality. This relation is called the budget line:
The bundles of
goods that exhaust P.:X+ PyY= M
a consumer's
income. In other words, the budget line defines all the combinations of goods X and Ythat
exactly exhaust the consumer's income.
It is useful to manipulate the equation for the budget line to obtain an alterna-
tive expression for the budget constraint in slope-intercept form. If we multiply
both sides of the budget line by 1/Py we get
Px M
-X+ Y=-
Py Py
Solving for Y yields
M Px
Y=---X
Py Py
Note that Y is a linear function of X with a vertical intercept of Ml Py and a slope of
-P.cfPy
The consumer's budget constraint is graphed in Figure 4-3. The shaded area
represents the consumer's budget set, or opportunity set. In particular, any combi-
nation of goods X and Y within the shaded area, such as point G, represents an
affordable combination of X and Y. Any point above the shaded area, such as point
H, represents a bundle of goods that is unaffordable.
214
FIGURE 4-3 The Budget Set

y
The upper boundary of the budget set in Figure 4-3 is the budget line. If a con-
sumer spent her or his entire income on good X the expenditures on good X would
exactly equal the consumer's income:
P;¥=M
By manipulating this equation, we see that the maximum affordable quantity of
good X consumed is
M
X=-
Px
This is why the horizontal intercept of the budget line is
M
Px
Similarly, if the consumer spent his or her entire income on good Y, expenditures on
Ywould exactly equal income:
J}Y=M
market rate of
substitution Consequently, the maximum quantity of good Ythat is affordable is
The rate at which M
one good may be Y=-
traded for another 1}
in the market;
slope of the The slope of the budget line is given by - PxlPy and represents the market rate of
budget line. substitution between goods X and Y. To obtain a better understanding of the market
215
FIGURE 4-4 The Budget Line
4 I
I
I
I
3 ---------~---------
Budget line
X
0 2 4
rate of substitution between goods X and Y, consider Figure 4-4, which presents a
budget line for a consumer who has S10 in income and faces a price of S1 for good
X and a price of S2 for good Y. If we substitute these values of .Px, Py, and Minto the
formula for the budget line, we observe that the vertical intercept of the budget line
(the maximum amount of good Y that is affordable) is Ml Py = 10/2 = 5. The hori-
zontal intercept is Ml Px = 10/1 = 10 and represents the maximum amount of good X
that can be purchased. The slope of the budget line is - PxlPy = - (112).
The reason the slope of the budget line represents the market rate of substitution
between the two goods is as follows. Suppose a consumer purchased bundle A in
Figure 4-4, which represents the situation where the consumer purchases 3 units of
good Yand 4 units of good X If the consumer purchased bundle B instead of bundle A,
she would gain one additional unit of good Y. But to afford this, she must give up 2
units (4 - 2 = 2) of good X For every unit of good Ythe consumer purchases, she
must give up 2 units of good X in order to be able to afford the additional unit of
good Y. Thus the market rate of substitution is dl1dX = (4 - 3)/(2 - 4) = -1/2,
which is the slope of the budget line.
Changes in Income
The consumer's opportunity set depends on market prices and the consumer's
income. As these parameters change, so will the consumer's opportunities. Let us
now examine the effects on the opportunity set of changes in income by assuming
prices remain constant.
Suppose the consumer's initial income in Figure 4-5 is M-1. What happens if
M1 increases to M1 while prices remain unchanged? Recall that the slope of the
budget line is given by - Pxl Py. Under the assumption that prices remain
216
FIGURE 4-5 Changes in Income Shrink or Expand Opportunities
y
M1
Jl,f,< AJl< M1
~
AJl Increase
~
Jl,f,
~ in income
X
0 Jl,f, AJl M1
~ ~ ~
unchanged, the increase in income will not affect the slope of the budget line.
However, the vertical and horizontal intercepts of the budget line both increase
as the consumer's income increases, because more of each good can be pur-
chased at the higher income. Thus, when income increases from Ml to M1, the
budget line shifts to the right in a parallel fashion. This reflects an increase in
the consumer's opportunity set, because more goods are affordable after the
increase in income than before. Similarly, if income decreases to M from Ml,
the budget line shifts toward the origin and the slope of the budget line remains
unchanged.
Changes in Prices
Now suppose the consumer's income remains fixed at M, but the price of good X
decreases to Pl< P]. Furthermore, suppose the price of good Y remains
FIGURE 4-6 A Decrease in the Price of Good X

y
217
unchanged. Since the slope of the budget line is given by - Pxl Py, the reduction in
the price of good X changes the slope, making it flatter than before. Since the
maximum amount of good Y that can be purchased is Ml?,, a reduction in the
price of good X does not change the Y intercept of the budget line. But the maxi-
mum amount of good X that can be purchased at the lower price (the X intercept
of the budget line) is MlPl, which is greater than MlPj. Thus, the ultimate effect
of a reduction in the price of good Xis to rotate the budget line counterclockwise,
as in Figure 4-6. Similarly, an increase in the price of good Xleads to a clockwise
rotation of the budget line, as the next demonstration problem indicates.
Demonstration Problem 4-1

A consumer has initial income of $100 and faces prices of P,. = $1 and Py= $5. Graph the
budget line, and show how it changes when the price of good Xincreases to Pl= $5.
Answer:
Initially, if the consumer spends his entire income on good X, he can purchase Ml P,. = 100/1
= 100 units of X This is the horizontal intercept of the initial budget line in Figure 4-7. If the
consumer spends his entire income on good Y, he can purchase Ml Py = 100/5 = 20 units of
Y. This is the vertical intercept of the initial budget line. The slope of the initial budget line
is -P,./Py= -115.
When the price of good X increases to 5, the maximum amount of X the consumer can
purchase is reduced to Ml P,. = 100/5 = 20 units of X This is the horizontal intercept of the
new budget line in Figure 4-7. If the consumer spends his entire income on good Y, he can
purchase Ml Py = 100/5 = 20 units of Y. Thus, the vertical intercept of the budget line
remains unchanged; the slope changes to - Pl/ Py= - 5/5 = -1.
FIGURE 4-7 An Increase in the Price of Good X

y
New budget
20
X
0 20 100
218
CONSUMER EQUILIBRIUM
The objective of the consumer is to choose the consumption bundle that maximizes
his or her utility, or satisfaction. If there was no scarcity, the more-is-better property
would imply that the consumer would want to consume bundles that contained
infinite amounts of goods. However, one implication of scarcity is that the con-
sumer must select a bundle that lies inside the budget set, that is, an affordable
bundle. Let us combine our theory of consumer preferences with our analysis of
constraints to see how the consumer goes about selecting the best affordable
bundle.
Consider a bundle such as A in Figure 4-8. This combination of goods X and Y
lies on the budget line, so the cost of bundle A completely exhausts the consumer's
income. Given the income and prices corresponding to the budget line, can the
consumer do better-that is, can the consumer achieve a higher indifference
curve? Clearly, if the consumer consumed bundle B instead of bundle A, she or he
would be better off since the indifference curve through B lies above the one
through A. Moreover, bundle B lies on the budget line and thus is affordable. In
short, it is inefficient for the consumer to consume bundle A because bundle B
both is affordable and yields a higher level of well-being.
Is bundle B optimal? The answer is no. Bundle B exhausts the consumer's
budget, but there is another affordable bundle that is even better: bundle C. Note
that there are bundles, such as D, that the consumer prefers more than bundle C,
consumer but those bundles are not affordable. Thus, we say bundle C represents the con-
equilibrium sumer's equilibrium choice. The term equilibrium refers to the fact that the con-
The equilibrium sumer has no incentive to change to a different affordable bundle once this point
consumption
bundle is the is reached.
affordable bundle An important property of consumer equilibrium is that at the equilibrium con-
that yields the sumption bundle, the slope of the indifference curve is equal to the slope of the
greatest satis- budget line. Recalling that the absolute value of the slope of the indifference curve
faction to the
consumer.
FIGURE 4-8 Consumer Equilibrium

y
219
is called the marginal rate of substitution and the slope of the budget line is given
by - P,J Py we see that at a point of consumer equilibrium,
MRS=~
Py
If this condition did not hold, the personal rate at which the consumer is willing to
substitute between goods X and Y would differ from the market rate at which he or
she is able to substitute between the goods. For example, at point A in Figure 4-8,
the slope of the indifference curve is steeper than the slope of the budget line. This
means the consumer is willing to give up more of good Yto get an additional unit of
good X than she or he actually has to give up, based on market prices. Conse-
quently, it is in the consumer's interest to consume less of good Yand more of good
X This substitution continues until ultimately the consumer is at a point such as C
in Figure 4-8, where the MRS is equal to the ratio of prices.
COMPARATIVE STATICS
Price Changes and Consumer Behavior

A change in the price of a good will lead to a change in the equilibrium consump-
tion bundle. To see this, recall that a reduction in the price of good X leads to a
counterclockwise rotation of the budget line. Thus, if the consumer initially is at
equilibrium at point A in Figure 4-9, when the price of good X falls to P!, his or her
opportunity set expands. Given this new opportunity set, the consumer can achieve
FIGURE 4-9 Change in Consumer Equilibrium Due to a Decrease in the Price of Good X (Note
that good Y is a substitute for X .)
y
___( ____ _ A
fl
yl --- ----- ·-'
I
I
I
I
I
I
X
0 xi M x1 M
pl
P1 X
220
x. y + ~ -t 2.y t- 2-
~ ,S- ,;::.- l t) rx_ ~ ~ 'i
---CD
--®
7-- .,.- '2.
<; '-(-\- ,;--- .=- 1 0% + '2_0

§~.::- \0')(.tl~
ur ,: . 1-'"I- ;- 2, cSv
\) <06 (! " )
~ s- =- lo -x__ 'T s- (3-rx- +~_j
a) -:=.. I O'X. -t) D'X +- \ ~-
2-0 rt- :::=- S-o
'")(.._~4
r c:::. 2-Y LI ,. '.?, ,:;:;- 11
{ rx;~J ~ l ly~ )1j 221
The Market Forces of
Supply and Demand
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
222
1
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Markets and Competition
• Market
– A group of buyers and sellers of a
particular good or service
– Buyers
• Determine the demand for the product
– Sellers
• Determine the supply of the product
223
2
Markets and Competition
• Competitive market
– Market in which there are many buyers
and many sellers
– Each has a negligible impact on market
price
– Price and quantity are determined by all
buyers and sellers
• As they interact in the marketplace
224
3
Demand
• Quantity demanded
– Amount of a good that buyers are willing
and able to purchase
• Law of demand
– Other things equal, when the price of the
good rises
• Quantity demanded of a good falls
225
4
Demand
• Demand schedule - a table
– Relationship between the price of a good
and quantity demanded
• Demand curve - a graph
and quantity demanded
• Individual demand
– Demand of one individual
226
5
Figure 1
Catherine’s Demand Schedule and Demand Curve
Price of Ice-Cream Cones
1. A decrease
Price of Quantity of $3.00 in price . . .
Ice-Cream Cones 2.50
Cone Demanded
2. . . . increases quantity
$0.00 12 cones 2.00
of cones demanded.
0.50 10 1.50
1.00 8
1.50 6 1.00 Demand curve
2.00 4
2.50 2 0.50
3.00 0
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
The demand schedule is a table that shows the quantity demanded at each price. The demand
curve, which graphs the demand schedule, illustrates how the quantity demanded of the good
changes as its price varies. Because a lower price increases the quantity demanded, the
demand curve slopes downward.
227
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6
Demand
• Market demand curve
– Sum the individual demand curves
horizontally
– Total quantity demanded of a good varies
• As the price of the good varies
• Other things constant
228
7
Figure 2
Market Demand as the Sum of Individual Demands
Catherine’s demand + Nicholas’s demand = Market demand
Price of Price of Price of
Ice-Cream Ice-Cream Ice-Cream
Cones Cones Cones
$3.00 DCatherine $3.00 $3.00

DNicholas
2.50 2.50 2.50
2.00 2.00 2.00
1.50 1.50 1.50 DMarket

1.00 1.00 1.00
0.50 0.50 0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 0 1 2 3 4 5 6 7 0 2 4 6 8 10 12 14 16 18
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
229
Demand
• Shifts in the demand curve
– Increase in demand
• Any change that increases the quantity
demanded at every price
• Demand curve shifts right
– Decrease in demand
• Any change that decreases the quantity
demanded at every price
• Demand curve shifts left
230
9
Figure 3
Shifts in the Demand Curve
Price of
Ice-Cream Increase in
Cones Demand
Decrease in
Demand
Demand
Demand
Demand curve, D1
curve, D2
curve, D3
0
Any change that raises the quantity that buyers wish to purchase at any given price
shifts the demand curve to the right. Any change that lowers the quantity that buyers
wish to purchase at any given price shifts the demand curve to the left.
231
Demand
• Variables that can shift the demand curve
– Income
– Prices of related goods
– Tastes
– Expectations
– Number of buyers
232
11
Demand
• Income
– Normal good
• An increase in income leads to an increase in
demand
– Inferior good
• An increase in income leads to a decrease in
demand
233
12
Demand
• Prices of related goods
– Substitutes - two goods
• An increase in the price of one
• Leads to an increase in the demand for the
other
– Complements – two goods
• An increase in the price of one
• Leads to a decrease in the demand for the
other
234
13
Demand
• Tastes
– Change in tastes – changes the demand
• Expectations about the future
– Expect an increase in income
• Increase in current demand
– Expect higher prices
• Increase in current demand
• Number of buyers – increase
– Market demand - increases
235
14
Table 1
Variables That Influence Buyers
Variable A Change in This Variable . .. .

Price of the good itse!lf Represents a mov,ement along the demand curve
Income Shifts the dema nd curve
Prices of related goods Shifts the dema nd curve
Tastes Shifts the demand curve
Expectations Shifts the dema nd curve
Number of buyers Shifts the dema nd curve
This table lists the variables that affect how much consumers choose to buy of any
good. Notice the special role that the price of the good plays: A change in the good’s
price represents a movement along the demand curve, whereas a change in one of
the other variables shifts the demand curve.
236
Two ways to reduce the quantity of smoking demanded
1. Shift the demand curve for cigarettes

and other tobacco products
– Public service announcements
– Mandatory health warnings on cigarette
packages
– Prohibition of cigarette advertising on
television
• If successful
– Shift demand curve to the left
237
Two ways to reduce the quantity of smoking demanded
2. Try to raise the price of cigarettes

– Tax the manufacturer
• Higher price
– Movement along demand curve
• 10% ↑ in price → 4% ↓ in smoking
• Teenagers: 10% ↑ in price → 12% ↓ in
smoking
238
Figure 4
Shifts in the Demand Curve versus Movements along the Demand Curve
(a) A Shift in the Demand Curve (b) A Movement along the Demand Curve
Price of Cigarettes, per Pack Price of Cigarettes, per Pack
A policy to discourage An increase in the price
smoking shifts the of cigarettes results in a
demand curve to the left movement along the
demand curve
$4.00
C
$2.00
B A
2.00
l A
D1
D2 D1
0 10 20 0 12 20
Number of Cigarettes Smoked per Day Number of Cigarettes Smoked per Day
If warnings on cigarette packages convince smokers to smoke less, the demand curve for cigarettes shifts to the
left. In panel (a), the demand curve shifts from D1 to D2. At a price of $2.00 per pack, the quantity demanded
falls from 20 to 10 cigarettes per day, as reflected by the shift from point A to point B. By contrast, if a tax raises
the price of cigarettes, the demand curve does not shift. Instead, we observe a movement to a different point on
the demand curve. In panel (b), when the price rises from $2.00 to $4.00, the quantity demanded falls from 20 to
12 cigarettes per day, as reflected by the movement from point A to point C.
239
Supply
• Quantity supplied
– Amount of a good
– Sellers are willing and able to sell
• Law of supply
– Other things equal
– When the price of the good rises
• Quantity supplied of a good rises
240
19
Supply
• Supply schedule - a table
and the quantity supplied
• Supply curve - a graph
and the quantity supplied
• Individual supply
– Supply of one seller
241
20
Figure 5
Ben’s Supply Schedule and Supply Curve
Price of Ice-Cream Cones
Supply curve
Price of Quantity
$3.00
Ice-cream Of Cones 1. An increase
Cone Supplied 2.50 in price . . .
$0.00 0 cones
0.50 0 2.00
1.00 1 1.50 2. . . . increases
1.50 2 quantity of cones
2.00 3 1.00
supplied.
2.50 4
3.00 5 0.50
0 1 2 3 4 5 6 7 8 9 10 11 12
The supply schedule is a table that shows the quantity supplied at each price. This supply curve,
which graphs the supply schedule, illustrates how the quantity supplied of the good changes as
its price varies. Because a higher price increases the quantity supplied, the supply curve slopes
upward. 242
Supply
• Market supply curve
– Sum of individual supply curves
horizontally
– Total quantity supplied of a good varies
• As the price of the good varies
• All other factors that affect how much
suppliers want to sell are hold constant
243
22
Figure 6
Market Supply as the Sum of Individual Supplies
Ben’s supply + Jerry’s supply = Market supply
Price of Price of Price of

Ice-Cream Ice-Cream Ice-Cream
Cones Cones Cones
SBen
SMarket
$3.00 $3.00 SJerry $3.00
2.50 2.50 2.50
2.00 2.00 2.00
1.50 1.50 1.50
1.00 1.00 1.00
0.50 0.50 0.50

I I
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 0 2 4 6 8 1012141618
Quantity of Quantity of Quantity of
Ice-Cream Cones Ice-Cream Cones Ice-Cream Cones
244
Supply
• Shifts in supply
– Increase in supply
• Any change that increases the quantity
supplied at every price
• Supply curve shifts right
– Decrease in supply
• Any change that decreases the quantity
supplied at every price
• Supply curve shifts left
245
24
Exhibit 7
Shifts in the Supply Curve
Price of Supply Supply Supply
Ice-Cream curve, S3 curve, S1 curve, S2
Cones
Decrease
In supply
Increase in
Supply
0
Any change that raises the quantity that sellers wish to produce at any given price
shifts the supply curve to the right. Any change that lowers the quantity that sellers
wish to produce at any given price shifts the supply curve to the left.
246
Supply
• Variables that can shift the supply curve
– Input Prices
– Technology
– Expectations about future
– Number of sellers
247
26
Supply
• Input Prices (costs)
– Supply – negatively related to prices of
inputs
– Higher input prices – decrease in supply
• Technology
– Advance in technology – increase in
supply
248
27
Supply
• Expectations about future
– Affect current supply
– Expected higher prices
• Decrease in current supply
• Number of sellers – increase
– Market supply - increase
249
28
Table 2
Variables That Influence Sellers
Variable A Chang1e in This Variable ...

Price of the good itself Repres,ents a movement along the supply curve
Input pric,es Sh ifts the supply curve
Technology Sh ifts the supply curve
Expectations Sh ifts the supply curve
Number of selllers Sh ifts the supply curve
This table lists the variables that affect how much producers choose to sell of any
good. Notice the special role that the price of the good plays: A change in the good’s
price represents a movement along the supply curve, whereas a change in one of the
other variables shifts the supply curve.
250
Supply and Demand Together
• Equilibrium - a situation
– Supply and demand forces are in balance
– A situation in which market price has
reached the level where
• Quantity supplied = quantity demanded
– Supply and demand curves intersect
251
30
• Equilibrium price
– Balances quantity supplied and quantity
demanded
– Market-clearing price
• Equilibrium quantity
– Quantity supplied and quantity demanded
at the equilibrium price
252
31
Figure 8
The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cones Equilibrium Supply
$3.00
2.50
Equilibrium
Equilibrium
price ---- 2.00
quantity
1.50
1.00
Demand
0.50
0
1 2 3 4 5 6 7 8 9 10 11 12
The equilibrium is found where the supply and demand curves intersect. At the
equilibrium price, the quantity supplied equals the quantity demanded. Here the
equilibrium price is $2.00: At this price, 7 ice-cream cones are supplied, and 7 ice-
cream cones are demanded.
253
• Surplus
– Quantity supplied > quantity demanded
– Excess supply (surplus)
– Downward pressure on price
• Movements along the demand and supply
curves
• Increase in quantity demanded
• Decrease in quantity supplied
254
33
• Shortage
– Quantity demanded > quantity supplied
– Excess demand (shortage)
– Upward pressure on price
• Movements along the demand and supply
curves
• Decrease in quantity demanded
• Increase in quantity supplied
255
34
Figure 9
Markets Not in Equilibrium
Price of (a) Excess Supply Price of (b) Excess demand
Ice-Cream Ice-Cream
Cones Surplus Supply Cones Supply
$2.50
2.00 $2.00
1.50
Demand Demand
Shortage
Quantity Quantity Quantity Quantity
demanded supplied supplied demanded
0 4 7 10 0 4 7 10
Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones
In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium price, the
quantity supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers try to increase sales by
cutting the price of a cone, and this moves the price toward its equilibrium level. In panel (b), there is a
shortage. Because the market price of $1.50 is below the equilibrium price, the quantity demanded (10
cones) exceeds the quantity supplied (4 cones). With too many buyers chasing too few goods, suppliers
can take advantage of the shortage by raising the price. Hence, in both cases, the price adjustment moves
the market toward the equilibrium of supply and demand
256
• Law of supply and demand
– The price of any good adjusts
• To bring the quantity supplied and the
quantity demanded for that good into balance
– In most markets
• Surpluses and shortages are temporary
257
36
• Three steps to analyzing changes in
equilibrium
1. Decide whether the event shifts the
supply curve, the demand curve, or, in
some cases, both curves
2. Decide whether the curve shifts to the
right or to the left
3. Use the supply-and-demand diagram
• Compare the initial and the new equilibrium
• Effects on equilibrium price and quantity
258
37
• A change in market equilibrium due to a
shift in demand
– One summer - very hot weather
– Effect on the market for ice cream?
1. Hot weather – shifts the demand curve
(tastes )
2. Demand curve shifts to the right
3. Higher equilibrium price; higher
equilibrium quantity
259
38
Figure 10
How an increase in demand affects the equilibrium
Price of 1. Hot weather increases the
Ice-Cream demand for ice cream . . .
Cones Supply
2. …resulting in
a higher price . . .
New equilibrium
$2.50
Initial equilibrium
2.00
3. …and a higher
D1 D2
quantity sold.
0 7 10 Quantity of Ice-Cream Cones
An event that raises quantity demanded at any given price shifts the demand curve to the right.
The equilibrium price and the equilibrium quantity both rise. Here an abnormally hot summer
causes buyers to demand more ice cream. The demand curve shifts from D1 to D2, which causes
the equilibrium price to rise from $2.00 to $2.50 and the equilibrium quantity to rise from 7 to 10
cones. 260
• A change in market equilibrium due to a
shift in supply
– One summer - a hurricane destroys part of
the sugarcane crop: higher price of sugar
– Effect on the market for ice cream?
1. Change in price of sugar - supply curve
2. Supply curve - shifts to the left
3. Higher equilibrium price; lower
equilibrium quantity
261
40
Figure 11
How a Decrease in Supply Affects the Equilibrium
Price of 1. An increase in the price of sugar reduces
Ice-Cream the supply of ice cream . . .
Cones New equilibrium S2
2. …resulting in
a higher price . . .
S1
$2.50
2.00
Initial equilibrium
3. …and a smaller
quantity sold.
Demand
0 4 7 Quantity of Ice-Cream Cones
An event that reduces quantity supplied at any given price shifts the supply curve to the left.
The equilibrium price rises, and the equilibrium quantity falls. Here an increase in the price of
sugar (an input) causes sellers to supply less ice cream. The supply curve shifts from S1 to S2,
which causes the equilibrium price of ice cream to rise from $2.00 to $2.50 and the equilibrium
quantity to fall from 7 to 4 cones.
262
How Prices Allocate Resources
• Prices
– Signals that guide the allocation of
resources
– Mechanism for rationing scarce resources
– Determine who produces each good and
how much is produced
263
42
0
~
a.::
11,1
Ii:
ca:
::c
u Market Forces: Demand and Supply
Learning Objectives
HEADLI NE
After completing this chapter, you will be
able to:
Samsung and Hynix Semiconductor LOl Explain the laws of demand and supply,
to Cut Chip Production and identify factors that cause demand
and supply to shift.
Sam Robbins, owner and CEO of PC Solutions,
arrived at the office and glanced at the front page L02 Calculate consumer surplus and producer
of The Wall Street Journal waiting on his desk. surplus, and describe what they mean.
One of the articles contained statements from exec- L04 Explain price determination in a
utives of two of South Korea's largest semiconduc- competitive market, and show how
tor manufacturers-Samsung Electronic Company equilibrium changes in response to
and Hynix Semiconductor-indicating that they changes in determinants of demand
would suspend all their memory chip production and supply.
for one week. The article went on to say that L05 Explain and illustrate how excise taxes,
another large semiconductor manufacturer was ad valorem taxes, price floors, and
likely to follow suit. Collectively, these three chip price ceilings impact the functioning of
manufacturers produce about 30 percent of the a market.
world's basic semiconductor chips.
PC Solutions is a small but growing company that L06 Apply supply and demand analysis as a
qualitative forecasting tool to see the "big
assembles PCs and sells them in the highly competitive
picture" in competitive markets.
market for "clones." PC Solutions experienced 100
percent growth last year and is in the process of inter-
viewing recent graduates in an attempt to double its
workforce.
After reading the article, Sam picked up the phone
and called a few of his business contacts to verify for himself the information contained in the
Journal. Satisfied that the information was correct, he called the director of personnel, Jane
Remak.
What do you think Sam and Jane discussed?
35
264
INTRODUCTION
This chapter describes supply and demand which are the driving forces behind the
market economies that exist in the United States and around the globe. As sug-
gested in this chapter's opening headline, supply and demand analysis is a tool that
managers can use to visualize the "big picture." Many companies fail because their
managers get bogged down in the day-to-day decisions of the business without
having a clear picture of market trends and changes that are on the horizon.
To illustrate, imagine that you manage a small retail outlet that sells PCs. A magic
genie appears and says, "Over the next month, the market price of PCs will decline and
consumers will purchase fewer PCs." The genie revealed the big picture: PC prices
and sales will decline. If you wony about the details of your business without knowl-
edge of these future trends in prices and sales, you will be at a significant competitive
disadvantage. Absent a view of the big picture, you are likely to negotiate the wrong
prices with suppliers and customers, cany too much inventory, hire too many employ-
ees, and-if your business spends money on informative advertising-purchase ads in
which your prices are no longer competitive by the time they reach print.
Supply and demand analysis is a qualitative tool which, like the above genie,
empowers managers by enabling them to see the "big picture." It is a qualitative
forecasting tool you can use to predict trends in competitive markets, including changes
in the prices of your firm's products, related products (both substitutes and comple-
ments), and the prices of inputs (such as labor services) that are necessary for your
operations. As we will see in subsequent chapters, after you use supply and demand
analysis to see the big picture, additional tools are available to assist with details-
determining how much the price will change, how much sales and revenues will
change, and so on.
For those of you who have taken a principles-level course in economics, some
parts of this chapter will be a review. However, make sure you have complete mas-
tery of the tools of supply and demand. The rest of this book will assume you have
a thorough working knowledge of the material in this chapter.
DEMAND
Suppose a clothing manufacturer desires information about the impact of its pricing
decisions on the demand for its jeans in a small foreign market. To obtain this infor-
mation, it might engage in market research to determine how many pairs of jeans
consumers would purchase each year at alternative prices per unit. The numbers
from such a market survey would look something like those in Table 2-1. The mar-
ket research reveals that if jeans were priced at $10 per pair, 60,000 pairs of jeans
would be sold per year; at $30 per pair, 20,000 pairs of jeans would be sold annually.
When there is no ambiguity, it is sometimes convenient to say simply "price"
rather than "price per pair" or "price per unit." For instance, if one of your class-
mates says gasoline is priced at $3.99 in Indianapolis, you understand that she
means $3.99 per gallon. Looking at the rows in Table 2-1, notice that the only dif-
ference in the entries is the price of jeans and the quantity of jeans sold. Everything
265
Market Forces: Demand and Supply 37
TABLE 2-1 The Demand Schedule for Jeans in a Small Foreign Market
Price Quantity of Average Advertising Average Price

of Jeans Jeans Sold Consumer Income Expenditure of Shirts
$ 0 80,000 $25,000 $50,000 $20

5 70,000 25,000 50,000 20
10 60,000 25,000 50,000 20
15 50,000 25,000 50,000 20
20 40,000 25,000 50,000 20
25 30,000 25,000 50,000 20
30 20,000 25,000 50,000 20
35 10,000 25,000 50,000 20
40 0 25,000 50,000 20
else that might influence buyer decisions, such as consumer income, advertising, and
the prices of other goods such as shirts, is held constant. In effect, the market survey
does not ask consumers how much they would buy at alternative levels of income or
advertising; it simply seeks to determine how much would be purchased at alterna-
tive prices. The market research reveals that, holding all other things constant, the
quantity of jeans consumers are willing and able to purchase goes down as the price
rises. This fundamental economic principle is known as the Jaw ofdemand: Price and
quantity demanded are inversely related. That is, as the price of a good rises (falls)
and all other things remain constant, the quantity demanded of the good falls (rises).
market demand Figure 2-1 plots the data in Table 2-1. The straight line, called the market
curve demand curve, interpolates the quantities consumers would be willing and able to
A curve indicating
the total quantity of
a good all con-
FIGURE 2-1 The Demand Curve
sumers are willing
and able to Price (S)
purchase at each
possible price,
holding the prices
of related goods, 40
income,
advertising, and 35
other variables
constant. 30
25
20
15
5
Quantity
(thousands per year)
0 10 20 30 40 50 60 70 80
266
purchase at prices not explicitly dealt with in the market research. Notice that the
line is downward sloping, which reflects the law of demand, and that all other fac-
tors that influence demand are held constant at each point on the line.
Demand Shihers
Economists recognize that variables other than the price of a good influence
demand. For example, the number of pairs of jeans individuals are willing and
financially able to buy also depends on the price of shirts, consumer income, adver-
tising expenditures, and so on. Variables other than the price of a good that influ-
ence demand are known as demand shifters.
When we graph the demand curve for good x; we hold everything but the price
of X constant. A representative demand curve is given by JJl in Figure 2-2. The
movement along a demand curve, such as the movement from A to B, is called a
change in change in quantity demanded Whenever advertising, income, or the price of related
quantity goods changes, it leads to a change in demand; the position of the entire demand
demanded curve shifts. A rightward shift in the demand curve is called an increase in demand,
Changes in the
price of a good lead since more of the good is demanded at each price. A leftward shift in the demand
to a change in the curve is called a decrease in demand
quantity demanded Now that we understand the general distinction between a shift in a demand
of that good. This curve and a movement along a demand curve, it is useful to explain how five
corresponds to a demand shifters-consumer income, prices of related goods, advertising and con-
movement along a
given demand sumer tastes, population, and consumer expectations-affect demand.
CUIVe.
change in
demand
Changes in FIGURE 2-2 Changes in Demand
variables other than
the price of a good, Price
such as income or
the price of another
good, lead to a
change in demand.
This corresponds to
a shift of the entire
demand cUIVe.
Increase
in
demand
D'
' - - - - - - - - - - - - - - - - - - ' ~ Quantity
0
267
INSIDE BUSINESS 2-1
Asahi Breweries Ltd. and the Asian Recession
Recently, recession-plagued Japan saw many business While part of Asahi's growth and success is
failures. Even businesses that traditionally do well dur- attributable to the company's sales force and marketing
ing economic downturns, such as the beer brewing activities-both create greater consumer awareness-
industry, were hit hard. Analysts blame the downturn in this does not fully explain why Asahi has done espe-
the beer market on two factors: (1) Japanese incomes cially well during the recent Asian recession. One
(GDP) declined significantly as a result of the recession, possibility is that Asahi beer is an inferior good. This
and (2) Japan's government imposed a beer tax in an does not mean that Asahi beer is "skunky" or of low
effort to raise revenue. quality; indeed, its Super Dry is the beer of choice for
As a result of these events, top Japanese breweries many Japanese beer drinkers. The term inferior good
such as Kirin Brewery Company, Ltd., and Sapporo simply means that when Japanese incomes decline
Breweries Ltd. experienced a sharp decline in domes- due to a recession, the demand for Asahi beer
tic beer sales. Meanwhile, their competitor-Asahi increases.
Breweries-touted double-digit growth and increased
its market share. Asahi attributes its growth in sales to
its superior sales network and strong marketing Sources: Annual Reports for Asahi Breweries Ltd., Sapporo
campaign for its best-selling beer, Asahi Super Dry. Breweries Ltd., and Kirin Brewery Company, Ltd.
Income
Because income affects the ability of consumers to purchase a good, changes in
income affect how much consumers will buy at any price. In graphical terms, a
change in income shifts the entire demand curve. Whether an increase in income
shifts the demand curve to the right or to the left depends on the nature of consumer
consumption patterns. Accordingly, economists distinguish between two types of
goods: normal and inferior goods.
A good whose demand increases (shifts to the right) when consumer incomes
normal good rise is called a normal good Normal goods may include goods such as steak, airline
A good for which travel, and designer jeans: As income goes up, consumers typically buy more of
an increase these goods at any given price. Conversely, when consumers suffer a decline in
(decrease) in
income leads to an income, the demand for a normal good will decrease (shift to the left).
increase (decrease) Changes in income tend to have profound effects on the demand for durable
in the demand for goods, and these effects are typically amplified in developing countries and rural areas.
that good. In 2004, for instance, farmers in India enjoyed higher incomes thanks to the impact on
crops of beneficial monsoons. As a result, the demand in rural areas of India for tractors
inferior good and motorcycles surged, almost tripling the level of demand in the previous year. By
A good for which 2009, this surge in demand reversed due to significant reductions in consumer incomes
an increase stemming from a global economic recession. The demand for durables in developed
(decrease) in countries also declined dramatically, and automakers were especially hard hit.
income leads to a
decrease (increase) In some instances, an increase in income reduces the demand for a good. Econ-
in the demand for omists refer to such a good as an inferior good Bologna, bus travel, and "generic"
that good. jeans are possible examples of inferior goods. As income goes up, consumers
268
typically consume less of these goods at each price. It is important to point out that
by calling such goods inferior, we do not imply that they are of poor quality; we use
this term simply to define products that consumers purchase less of when their
incomes rise and purchase more of when their incomes fall.
Prices of Related Goods

Changes in the prices of related goods generally shift the demand curve for a good.
For example, if the price of a Coke increases, most consumers will begin to substi-
tute Pepsi, because the relative price of Coke is higher than before. As more and
more consumers substitute Pepsi for Coke, the quantity of Pepsi demanded at each
price will tend to increase. In effect, an increase in the price of Coke increases the
demand for Pepsi. This is illustrated by a shift in the demand for Pepsi to the right.
substitutes Goods that interact in this way are known as substitutes.
Goods for which Many pairs of goods readily come to mind when we think of substitutes: chicken
an increase and beef, cars and trucks, raincoats and umbrellas. Such pairs of goods are substitutes
(decrease) in the
price of one good for most consumers. However, substitutes need not serve the same function; for
leads to an increase example, automobiles and housing could be substitutes. Goods are substitutes when
(decrease) in the an increase in the price of one good increases the demand for the other good.
demand for the Not all goods are substitutes; in fact, an increase in the price of a good such as
other good. computer software may lead consumers to purchase fewer computers at each price.
complements Goods that interact in this manner are called complements. Beer and pretzels are
Goods for which another example of complementary goods. If the price of beer increased, most beer
an increase drinkers would decrease their consumption of pretzels. Notice that when good Xis
(decrease) in the a complement to good Y, a reduction in the price of Y actually increases (shifts to
price of one good
leads to a decrease the right) the demand for good X More of good Xis purchased at each price due to
(increase) in the the reduction in the price of the complement, good Y.
demand for the
other good. Advertising and Consumer Tastes
Another variable that is held constant when drawing a given demand curve is the
level of advertising. An increase in advertising shifts the demand curve to the right,
from D1 to ll, as in Figure 2-3. Notice that the impact of advertising on demand can
be interpreted in two ways. Under the initial demand curve, D1, consumers would
buy 50,000 units of high-style clothing per month when the price is $40. After the
advertising, the demand curve shifts toll, and consumers will now buy 60,000 units
of the good when the price is $40. Alternatively, when demand is D1, consumers will
pay a price of $40 when 50,000 units are available. Advertising shifts the demand
curve toll, so consumers will pay a higher price-$50-for 50,000 units.
Why does advertising shift demand to the right? Advertising often provides
consumers with information about the existence or quality of a product, which in
turn induces more consumers to buy the product. These types of advertising mes-
sages are known as informative advertising.
Advertising can also influence demand by altering the underlying tastes of con-
sumers. For example, advertising that promotes the latest fad in clothing may increase
the demand for a specific fashion item by making consumers perceive it as "the" thing
to buy. These types of advertising messages are known as persuasive advertising.
269
FIGURE 2-3 Advertising and the Demand for Clothing
Price of
high-style
clothing
$50
$40
Quantity of
~-------t----+-----► high-style
0 50,000 60,000 clothing
Population
The demand for a product is also influenced by changes in the size and composition
of the population. Generally, as the population rises, more and more individuals
wish to buy a given product, and this has the effect of shifting the demand curve to
the right. Over the twentieth century, the demand curve for food products shifted to
the right considerably with the increasing population.
It is important to note that changes in the composition of the population can
also affect the demand for a product. To the extent that middle-aged consumers
desire different types of products than retirees, an increase in the number of con-
sumers in the 30- to 40-year-old age bracket will increase the demand for products
like real estate. Similarly, as a greater proportion of the population ages, the
demand for medical services will tend to increase.
Consumer Expectations
Changes in consumer expectations also can change the position of the demand curve
for a product. For example, if consumers suddenly expect the price of automobiles to
be significantly higher next year, the demand for automobiles today will increase. In
effect, buying a car today is a substitute for buying a car next year. If consumers expect
future prices to be higher, they will substitute current purchases for future purchases.
This type of consumer behavior often is referred to as stockpiling and generally occurs
when products are durable in nature. The current demand for a perishable product such
as bananas generally is not affected by expectations of higher future prices.
270
Other Factors
In concluding our list of demand shifters, we simply note that any variable that
affects the willingness or ability of consumers to purchase a particular good is a
potential demand shifter. Health scares affect the demand for cigarettes. The birth
of a baby affects the demand for diapers.
The Demand Function

By now you should understand the factors that affect demand and how to use
graphs to illustrate those influences. The final step in our analysis of the demand
side of the market is to show that all the factors that influence demand may be sum-
demand function marized in what economists refer to as a demand function.
A function that The demand function for good X describes how much X will be purchased at
describes how alternative prices of X and related goods, alternative levels of income, and alterna-
much of a good
will be purchased tive values of other variables that affect demand. Formally, let Q1 represent the
at alternative quantity demanded of good x; P,, the price of good x; Py the price of a related good,
prices of that good M income, and H the value of any other variable that affects demand, such as the
and related goods, level of advertising, the size of the population, or consumer expectations. Then the
alternative income demand function for good X may be written as
levels, and
alternative values
of other variables Q1 = f(I{, Py, M. JI)
affecting demand.
Thus, the demand function explicitly recognizes that the quantity of a good
consumed depends on its price and on demand shifters. Different products will
have demand functions of different forms. One very simple but useful form is the
linear representation of the demand function: Demand is linear if Q1 is a linear
function of prices, income, and other variables that influence demand. The follow-
linear demand ing equation is an example of a linear demand function:
function
A representation of Q1 = ao + ax[{+ ayl'y + a MM+ aHH
the demand
function in which The af, are fixed numbers that the firm's research department or an economic con-
the demand for a sultant typically provides to the manager. (Chapter 3 provides an overview of the
given good is a
linear function of statistical techniques used to obtain these numbers.)
prices, income lev- By the law of demand, an increase in P,, leads to a decrease in the quantity
els, and other vari- demanded of good X This means that ax< 0. The sign of ay will be positive or neg-
ables influencing ative depending on whether goods X and Y are substitutes or complements. If ay is
demand. a positive number, an increase in the price of good Y will lead to an increase in the
consumption of good X; therefore, good Xis a substitute for good Y. If ayis a nega-
tive number, an increase in the price of good Y will lead to a decrease in the con-
sumption of good X; hence, good Xis a complement to good Y. The sign of aMalso
can be positive or negative depending on whether Xis a normal or an inferior good.
If aMis a positive number, an increase in income (M) will lead to an increase in the
consumption of good x; and good Xis a normal good. If a Mis a negative number,
an increase in income will lead to a decrease in the consumption of good x; and
good Xis an inferior good.
271

An economic consultant for X Corp. recently provided the firm's marketing manager with
this estimate of the demand function for the firm's product:
Q1 = 12,000 - 3P,, + 4Py- lM + 2Ax
where Q1 represents the amount consumed of good X, Px is the price of good X, Py is the price
of good Y, M is income, and Ax represents the amount of advertising spent on good X
Suppose good X sells for $200 per unit, good Y sells for S15 per unit, the company utilizes
2,000 units of advertising, and consumer income is $10,000. How much of good X do con-
sumers purchase? Are goods Xand Ysubstitutes or complements? Is good Xa normal or an
inferior good?
Answer:
To find out how much of good X consumers will purchase, we substitute the given values of
prices, income, and advertising into the linear demand equation to get
Q1 = 12,000 - 3(200) + 4(15) - 1(10,000) + 2(2,000)
Adding up the numbers, we find that the total consumption of Xis 5,460 units. Since
the coefficient of Pyin the demand equation is 4 > 0, we know that a $1 increase in the price
of good Ywill increase the consumption of good Xby 4 units. Thus, goods X and Y are sub-
stitutes. Since the coefficient of Min the demand equation is -1 < 0, we know that a $1
increase in income will decrease the consumption of good Xby 1 unit. Thus, good Xis an
inferior good.
The information summarized in a demand function can be used to graph a

demand curve. Since a demand curve is the relation between price and quantity, a
representative demand curve holds everything but price constant. This means one
may obtain the formula for a demand curve by inserting given values of the demand
shifters into the demand function, but leaving Px in the equation to allow for various
values. If we do this for the demand function in Demonstration Problem 2-1 (where
Py= $15, M = $10,000, and Ax= 2,000), we get
qj = 12,000 - 3Px + 4(15) - 1(10,000) + 2(2,000)
which simplifies to
qj = 6,060 - 3Px (2-1)
Because we usually graph this relation with the price of the good on the vertical
axis, it is useful to represent Equation 2-1 with price on the left-hand side and
everything else on the right-hand side. This relation is called an inverse demand
function. For this example, the inverse demand function is
1
Px = 2,020 - 3qJ
272
FIGURE 2-4 Graphing the Inverse Demand Function
Price
$2,020
0 6,060
It reveals how much consumers are willing and able to pay for each additional unit
of good X This demand curve is graphed in Figure 2-4.
Consumer Surplus
We now show how a manager can use the demand curve to ascertain the value a
consumer or group of consumers receives from a product. The concepts developed
in this section are particularly useful in marketing and other disciplines that empha-
size strategies such as value pricing and price discrimination.
By the law of demand, the amount a consumer is willing to pay for an additional
unit of a good falls as more of the good is consumed. For instance, imagine that the
demand curve in Figure 2-5(a) represents your demand for water immediately after
participating in a lOK run. Initially, you are willing to pay a very high price-in this
case, $5 per liter-for the first drop of water. As you consume more water, the amount
you are willing to pay for an additional drop declines from $5.00 to $4.99 and so on as
you move down the demand curve. Notice that after you have consumed an entire liter
of water, you are willing to pay only $4 per liter for another drop. Once you have
enjoyed 2 liters of water, you are willing to pay only $3 per liter for another drop.
To find your total value (or benefit) of 2 liters of water, we simply add up the
maximum amount you were willing to pay for each of these drops of water between
0 and 2 liters. This amount corresponds to the area underneath the demand curve in
Figure 2-5(a) up to the quantity of 2 liters. Since the area of this region is $8, the
total value you receive from 2 liters of water is $8.
Fortunately, you don't have to pay different prices for the different drops of water
you consume. Instead, you face a per-unit price of, say, $3 per liter and get to buy as
many drops (or even liters) as you want at that price. Given the demand curve in Figure
2-5(a), when the price is $3 you will choose to purchase 2 liters of water. In this case,
consumer surplus your total out-of-pocket expense for the 2 liters of water is $6. Since you value 2 liters
The value con-
sumers get from a of water at $8 and only have to pay $6 for it, you are getting $2 in value over and above
good but do not the amount you have to pay for water. This "extra" value is known as consumer
have to pay for. surplu~the value consumers get from a good but do not have to pay for. This concept
273
FIGURE 2-5 Consumer Surplus
Price per Price

liter
5
4 I
I
I
3 ---,---
' I
I I
pO
2 --~---~-- X
' I
I I I
--"1---t---,---
1 I I I
I I D - - - Quantity
'----+--+----+--+---+-
I I
.___ _ __.__ __,,_D____ Quantity
0 1 2 3 4 5 Oilers) o Qo
(a) (b)
is important to managers because it tells how much extra money consumers would be
willing to pay for a given amount of a purchased product.
More generally, consumer surplus is the area above the price paid for a good
but below the demand curve. For instance, the shaded triangle in Figure 2-5(b)
illustrates the consumer surplus of a consumer who buys C!x units at a price of PJ,.
To see why, recall that each point on the demand curve indicates the value to the
consumer of another unit of the good. The difference between each price on the
demand curve and the price Pl paid represents surplus (the value the consumer
receives but does not have to pay for). When we add up the "surpluses" received for
each unit between Oand C!x (this sum equals the shaded region), we obtain the con-
sumer surplus associated with purchasing C!x units at a price of Pl each.
Managers can use the notion of consumer surplus to determine the total amount
consumers would be willing to pay for a package of goods. While this will be dis-
cussed in detail in Chapter 11 where we examine pricing strategies, we illustrate the
basic idea in the following problem.

A typical consumer's demand for the Happy Beverage Company's product looks like that
in Figure 2-5 (a). If the firm charges a price of $2 per liter, how much revenue will the firm
earn and how much consumer surplus will the typical consumer enjoy? What is the most
a consumer would be willing to pay for a bottle containing exactly 3 liters of the firm's
beverage?
Answer:
At a price of $2 per liter, a typical consumer will purchase 3 liters of the beverage. Thus, the
firm's revenue is $6 and the consumer surplus is $4.50 (the area of the consumer surplus tri-
angle is one-half the base times the height, or .5(3)($5 - $2) = $4.50). The total value of 3
liters of the firm's beverage to a typical consumer is thus $6 + $4.50, or $10.50. This is also
274
the maximum amount a consumer would be willing to pay for a bottle containing exactly
3 liters of the firm's beverage. Expressed differently, if the firm sold the product in 3-liter
bottles rather than in smaller units, it could sell each bottle for $10.50 to earn higher rev-
enues and extract all consumer surplus.
SUPPLY
In the previous section we focused on demand, which represents half of the forces
that determine the price in a market. The other determinant is market supply. In a
competitive market there are many producers, each producing a similar product. The
market supply market supply curve summarizes the total quantity all producers are willing and able
curve to produce at alternative prices, holding other factors that affect supply constant.
A curve indicating While the market supply of a good generally depends on many things, when we
the total quantity
of a good that all graph a supply curve, we hold everything but the price of the good constant. The
producers in a movement along a supply curve, such as the one from A to B in Figure 2-6, is
competitive market called a change in quantity supplied The fact that the market supply curve slopes
would produce at upward reflects the inverse Jaw of supply: As the price of a good rises (falls) and
each price, holding other things remain constant, the quantity supplied of the good rises (falls). Producers
input prices, tech-
nology, and other are willing to produce more output when the price is high than when it is low.
variables affecting
supply constant. Supply Shihers
change in Variables that affect the position of the supply curve are called supply shifters, and they
quantity supplied include the prices of inputs, the level of technology, the number of fmns in the market,
Changes in the taxes, and producer expectations. Whenever one or more of these variables changes, the
price of a good position of the entire supply curve shifts. Such a shift is known as a change in supply.
lead to a change
in the quantity The shift from SJ to SI- in Figure 2-6 is called an increase in supplysince producers sell
supplied of that more output at each given price. The shift from SJ to 9 in Figure 2-6 represents a
good. This corre- decrease in supply since producers sell less of the product at each price.
sponds to a
movement along a
given supply FIGURE 2-6 Changes in Supply
curve.
Price
change in supply
Changes in vari-
ables other than the
price of a good,
such as input prices
or technological
advances, lead to a
change in supply.
This corresponds to
a shift of the entire
supply curve.
' - - - - - - - - - - - . Quantity
0
275
INSIDE BUSINESS 2-2
The Trade Act of 2002, NAFTA, and the Supply Curve
Over the past two decades, presidents from both investment in Mexican petrochemicals and financial
political parties have signed trade agreements service sectors.
and laws that include provisions designed to reduce The Trade Act of 2002 was enacted under George
the cost of producing goods at home and abroad. W. Bush and gives the President the ability to negoti-
These cost reductions translate into increases in ate additional international agreements (subject to an
the supply of goods and services available to U.S. up-or-down vote by Congress). Only time will tell
consumers. whether President Obama will continue the course set
The North American Free Trade Agreement by Presidents Clinton and Bush.
(NAFTA) between the United States, Canada, and
Sources: Economic Report ofthe President, Washington,
Mexico was signed into law by Bill Clinton and con- D.C.: U.S. Government Printing Office, February 2007, p. 60;
tained provisions to eliminate or phase out tariffs and Economic Report ofthe President, Washington, D.C.: U.S.
other barriers in industrial products (such as textiles Government Printing Office, February 2006, p. 153;
and apparel) and agricultural products. NAFTA also Economic Report ofthe President, Washington, D.C.: U.S.
included provisions designed to reduce barriers to Government Printing Office, February 1995, pp. 220-21.
Input Prices
The supply curve reveals how much producers are willing to produce at alternative
prices. As production costs change, the willingness of producers to produce output
at a given price changes. In particular, as the price of an input rises, producers are
willing to produce less output at each given price. This decrease in supply is
depicted as a leftward shift in the supply curve.
Technology or Government Regulations

Technological changes and changes in government regulations also can affect the
position of the supply curve. Changes that make it possible to produce a given out-
put at a lower cost, such as the ones highlighted in Inside Business 2-2, have the
effect of increasing supply. Conversely, natural disasters that destroy existing tech-
nology and government regulations, such as emissions standards that have an
adverse effect on businesses, shift the supply curve to the left.
Number of Firms
The number of firms in an industry affects the position of the supply curve. As addi-
tional firms enter an industry, more and more output is available at each given
price. This is reflected by a rightward shift in the supply curve. Similarly, as firms
leave an industry, fewer units are sold at each price, and the supply decreases (shifts
to the left).
Substitutes in Production
Many firms have technologies that are readily adaptable to several different products.
For example, automakers can convert a truck assembly plant into a car assembly
276
plant by altering its production facilities. When the price of cars rises, these firms
can convert some of their truck assembly lines to car assembly lines to increase the
quantity of cars supplied. This has the effect of shifting the truck supply curve to
the left.
Taxes
The position of the supply curve is also affected by taxes. An excise tax is a tax on
each unit of output sold, where the tax revenue is collected from the supplier. For
example, suppose the government levies a tax of S.20 per gallon on gasoline. Since
each supplier must now pay the government S.20 per gallon for each gallon of
gasoline sold, each must receive an additional S.20 per gallon to be willing to sup-
ply the same quantity of gasoline as before the tax. An excise tax shifts the supply
curve up by the amount of the tax, as in Figure 2-7. Note that at any given price,
producers are willing to sell less gasoline after the tax than before. Thus, an excise
tax has the effect of decreasing the supply of a good.
Another form of tax often used by a government agency is an ad valorem tax. Ad
valorem literally means "according to the value." An ad valorem tax is a percentage
tax; the sales tax is a well-known example. If the price of a good is S1 and a 10 percent
ad valorem tax is attached to that good, the price after the tax is S1.10. Because an ad
valorem tax is a percentage tax, it will be higher for high-priced items.
In Figure 2-8, SJ represents the supply curve for backpacks before the inception
of a 20 percent ad valorem tax. Notice that 1,100 backpacks are offered for sale when
the price of a backpack is S10 and 2,450 backpacks are offered when the price is S20.
FIGURE 2-7 A Per Unit (Excise) Tax
Price
of
gasoline
si
t {$1.20
$1
t =per unit tax
of20C
Quantity
~------------~- of
0 gasoline
per week
277
FIGURE 2-8 An Ad Valorem Tax
Price
of
backpacks
S1 = 1.20 X 5°
So
$24
$20
$12
$10
Quantity
~----+-----+-----~- of
0 1,100 2,450 backpacks
per week
Once the 20 percent tax is implemented, the price required to produce each unit goes
up by 20 percent at any output level. Therefore, price will go up by S2 at a quantity of
1,100 and by $4 at a quantity of 2,450. An ad valorem tax will rotate the supply curve
counterclockwise, and the new curve will shift farther away from the original curve
as the price increases. This explains why S1 is steeper than 5° in Figure 2-8.
Producer Expectations
Producer expectations about future prices also affect the position of the supply curve.
In effect, selling a unit of output today and selling a unit of output tomorrow are sub-
stitutes in production. If firms suddenly expect prices to be higher in the future and
the product is not perishable, producers can hold back output today and sell it later at
a higher price. This has the effect of shifting the current supply curve to the left.
supply function
The Supply Function
A function that You should now understand the difference between supply and quantity supplied
describes how
much of a good and recognize the factors that influence the position of the supply curve. The final
will be produced at step in our analysis of supply is to show that all the factors that influence the supply
alternative prices of a good can be summarized in a supply function.
of that good, The supply function of a good describes how much of the good will be pro-
alternative input duced at alternative prices of the good, alternative prices of inputs, and alternative
prices, and
alternative values values of other variables that affect supply. Formally, let ~ represent the quantity
of other variables supplied of a good, P,, the price of the good, W the price of an input (such as the
affecting supply. wage rate on labor), Pr the price of technologically related goods, and H the value
278
of some other variable that affects supply (such as the existing technology, the num-
ber of firms in the market, taxes, or producer expectations). Then the supply func-
tion for good X may be written as
Q5x = f(J{, pl' w, JI)
Thus, the supply function explicitly recognizes that the quantity produced in a
market depends not only on the price of the good but also on all the factors that are
potential supply shifters. While there are many different functional forms for dif-
ferent types of products, a particularly useful representation of a supply function is
linear supply the linear relationship. Supply is linear if Q5x is a linear function of the variables that
function influence supply. The following equation is representative of a linear supply func-
A representation tion:
of the supply
function in which Ql = f3o + f3xPx + f3rPr + f3wW + f3HH
the supply of a
given good is a The coefficients (the /3;5) represent given numbers that have been estimated by the
linear function of firm's research department or an economic consultant.
prices and other
variables affecting
supply.
Your research department estimates that the supply function for television sets is given by
~= 2,000 + 3-Px- 4Pr- Pw
where Px is the price of TV sets, Pr represents the price of a computer monitor, and Pw is the
price of an input used to make television sets. Suppose TVs are sold for $400 per unit, com-
puter monitors are sold for $100 per unit, and the price of an input is $2,000. How many tel-
evision sets are produced?
Answer:
To find out how many television sets are produced, we insert the given values of prices into
the supply function to get
~= 2,000 + 3(400) - 4(100) - 1(2,000)
Adding up the numbers, we find that the total quantity of television sets produced is 800.
The information summarized in a supply function can be used to graph a sup-

ply curve. Since a supply curve is the relationship between price and quantity, a
representative supply curve holds everything but price constant. This means one
may obtain the formula for a supply curve by inserting given values of the supply
shifters into the supply function, but leaving f>x in the equation to allow for various
values. If we do this for the supply function in Demonstration Problem 2-3 (where
Pr= SlO0 and Pw = 2,000), we get
Q5x = 2,000 + 3f>x- 4(100) - 1(2,000)
279
which simplifies to
~= 3Px- 400 (2-2)
Since we usually graph this relation with the price of the good on the vertical axis,
it is useful to represent Equation 2-2 with price on the left-hand side and everything
else on the right-hand side. This is known as an inverse supply function. For this
example, the inverse supply function is
400 1
e= 3 + 3~
which is the equation for the supply curve graphed in Figure 2-9. This curve
reveals how much producers must receive to be willing to produce each additional
unit of good X
Producer Surplus
Just as consumers want price to be as low as possible, producers want price to be as
high as possible. The supply curve reveals the amount producers will be willing to
produce at a given price. Alternatively, it indicates the price firms would have to
receive to be willing to produce an additional unit of a good. For example, the sup-
ply curve in Figure 2-9 indicates that a total of 800 units will be produced when
the price is $400. Alternatively, if 800 units are produced, producers will have to
receive $400 to be induced to produce another unit of the good.
producer surplus Producer surplus is the producer analogue to consumer surplus. It is the
The amount pro- amount of money producers receive in excess of the amount necessary to induce
ducers receive in them to produce the good. More specifically, note that producers are willing to
excess of the
amount necessary sell each unit of output below 800 units at a price less than $400. But if the price
to induce them to
produce the good.
FIGURE 2-9 Producer Surplus
Price
Producer i
Px = ~ + ~
/ surplus
7 ______________________
S
A ____ B
$400
$400
Tc
Quantity
0 100 200 300 400 500 600 700 800 900
280
is $400, producers receive an amount equal to $400 for each unit of output
below 800, even though they would be willing to sell those individual units for a
lower price.
Geometrically, producer surplus is the area above the supply curve but below
the market price of the good. Thus, the shaded area in Figure 2-9 represents the sur-
plus producers receive by selling 800 units at a price of S400-an amount above
what would be required to produce each unit of the good. The shaded area, ABC, is
the producer surplus when the price is S400. Mathematically, this area is one-half of
800 times S266.67, or S106,668.
Producer surplus can be a powerful tool for managers. For instance, suppose
the manager of a major fast-food restaurant currently purchases 10,000 pounds of
ground beef each week from a supplier at a price of S1.25 per pound. The producer
surplus the meat supplier earns by selling 10,000 pounds at S1.25 per pound tells
the restaurant manager the dollar amount that the supplier is receiving over and
above what it would be willing to accept for meat. In other words, the meat sup-
plier's producer surplus is the maximum amount the restaurant could save in meat
costs by bargaining with the supplier over a package deal for 10,000 pounds of
meat. Chapters 6 and 10 will provide details about how managers can negotiate
such a bargain.
MARKET EQUILIBRIUM
The equilibrium price in a competitive market is determined by the interactions of all

buyers and sellers in the market. The concepts of market supply and market demand
make this notion of interaction more precise: The price of a good in a competitive mar-
ket is determined by the interaction of market supply and market demand for the good.
Since we will focus on the market for a single good, it is convenient to drop
subscripts at this point and let P denote the price of this good and Q the quantity
of the good. Figure 2-10 depicts the market supply and demand curves for such
a good. To see how the competitive price is determined, let the price of the good
be JJL. This price corresponds to point B on the market demand curve; consumers
wish to purchase Q1 units of the good. Similarly, the price of pl corresponds to
point A on the market supply curve; producers are willing to produce only Ql
units at this price. Thus, when the price is JJL, there is a shortage of the good;
that is, there is not enough of the good to satisfy all consumers willing to pur-
chase it at that price.
In situations where a shortage exists, there is a natural tendency for the price to
rise. As the price rises from pl to pe in Figure 2-10, producers have an incentive
to expand output from Ql to q. Similarly, as the price rises, consumers are willing
to purchase less of the good. When the price rises to P, the quantity demanded is q.
At this price, just enough of the good is produced to satisfy all consumers willing
and able to purchase at that price; quantity demanded equals quantity supplied.
Suppose the price is at a higher level-say, pH_ This price corresponds to
point F on the market demand curve, indicating that consumers wish to purchase
281
FIGURE 2-10 Market Equilibrium
Price
Surplus s
_ _ _A..,_ _.,.
pl
F•I
I
I
I
I
pe ---------:-------
'II
I
I
I I
pl --------- -------- ~-------

:A L..___~~B•
I ~ I
Shortage :
I
I
D
I
Quantity
0 q
Ql units of the good. The price pH corresponds to point G on the market supply
curve; producers are willing to produce Q1 units at this price. Thus, when the
price is pH, there is a surplus of the good; firms are producing more than they can
sell at a price of pH_
Whenever a surplus exists, there is a natural tendency for the price to fall to
equate quantity supplied with quantity demanded. As the price falls from pH to
P, producers have an incentive to reduce quantity supplied to q. Similarly, as
the price falls, consumers are willing to purchase more of the good. When the
price falls to P, the quantity demanded is Q8; quantity demanded equals quantity
supplied.
Thus, the interaction of supply and demand ultimately determines a competi-
tive price, P, such that there is neither a shortage nor a surplus of the good. This
price is called the equilibrium price and the corresponding quantity, q, is called the
equilibrium quantity for the competitive market. Once this price and quantity are
realized, the market forces of supply and demand are balanced; there is no tendency
for prices either to rise or to fall.
IPrinciple Competitive Market Equilibrium

Equilibrium in a competitive market is determined by the intersection of the market demand
and supply curves. The equilibrium price is the price that equates quantity demanded with
quantity supplied. Mathematically, if Q1(P) and (l(P) represent the quantity demanded and
supplied when the price is P, the equilibrium price, P, is the price such that
qt(P) = (l(P)
The equilibrium quantity is simply Q1(P) or, equivalently, Q<(P).
----------'
282

According to an article in China Daily, China recently accelerated its plan to privatize tens
of thousands of state-owned firms. Imagine that you are an aide to a senator on the Foreign
Relations Committee of the U.S. Senate, and you have been asked to help the committee
determine the price and quantity that will prevail when competitive forces are allowed to
equilibrate the market. The best estimates of the market demand and supply for the good (in
U.S. dollar equivalent prices) are given by q1 = 10 - 2P and Q5 = 2 + 2P, respectively.
Determine the competitive equilibrium price and quantity.
Answer:
Competitive equilibrium is determined by the intersection of the market demand and supply
curves. Mathematically, this simply means that Q1 = (l. Equating demand and supply yields
10- 2P= 2 + 2P
or
8=4P
Solving this equation for P yields the equilibrium price, P = 2. To determine the equilib-
rium quantity, we simply plug this price into either the demand or the supply function (since,
in equilibrium, quantity supplied equals quantity demanded). For example, using the supply
function, we find that
q = 2 + 2(2) = 6
PRICE RESTRICTIONS AND MARKET EQUILIBRIUM
The previous section showed how prices and quantities are determined in a free mar-
ket. In some instances, government places limits on how much prices are allowed to
rise or fall, and these restrictions can affect the market equilibrium. In this section, we
examine the impact of price ceilings and price floors on market allocations.
Price Ceilings
One basic implication of the economic doctrine of scarcity is that there are not
enough goods to satisfy the desires of all consumers at a price of zero. As a conse-
quence, some method must be used to determine who gets to consume goods and
who does not. People who do not get to consume goods are essentially discrimi-
nated against. One way to determine who gets a good and who does not is to allo-
cate the goods based on hair color: If you have red hair, you get the good; if you
don't have red hair, you don't get the good.
The price system uses price to determine who gets a good and who does not.
The price system allocates goods to consumers who are willing and able to pay the
most for the goods. If the competitive equilibrium price of a pair of jeans is S40,
consumers willing and able to pay S40 will purchase the good; consumers unwill-
ing or unable to pay that much for a pair of jeans will not buy the good.
283
It is important to keep in mind that it is not the price system that is "unfair" if one
cannot afford to pay the market price for a good; rather, it is unfair that we live in a
world of scarcity. Any method of allocating goods will seem unfair to someone because
there are not enough resources to satisfy everyone's wants. For example, if jeans were
allocated to people on the basis of hair color instead of the price system, you would
think this allocation rule was unfair unless you were born with the "right" hair color.
Often individuals who are discriminated against by the price system attempt to
persuade the government to intervene in the market by requiring producers to sell
the good at a lower price. This is only natural, for if we were unable to own a house
because we had the wrong hair color, we most certainly would attempt to get the
government to pass a law allowing people with our hair color to own a house. But
then there would be too few houses to go around, and some other means would
have to be used to allocate houses to people.
Suppose that, for whatever reason, the government views the equilibrium price
of pe in Figure 2-11 as "too high" and passes a law prohibiting firms from charging
price ceiling prices above JX. Such a price is called a price ceiling.
Themaximwn Do not be confused by the fact that the price ceiling is below the initial equilib-
legal price that can rium price; the term ceiling refers to that price being the highest permissible price
be charged in a
market. in the market. It does not refer to a price set above the equilibrium price. In fact, if
a ceiling were imposed above the equilibrium price, it would be ineffective; the
equilibrium price would be below the maximum legal price.
Given the regulated price of JX, quantity demanded exceeds quantity supplied
by the distance from A to B in Figure 2-11; there is a shortage of (11 - (l units. The
reason for the shortage is twofold. First, producers are willing to produce less at the
lower price, so the available quantity is reduced from (l to (l. Second, consumers
wish to purchase more at the lower price; thus, quantity demanded increases from
(l to (11. The result is that there is not enough of the good to satisfy all consumers
willing and able to purchase it at the price ceiling.
How, then, are the goods to be allocated now that it is no longer legal to ration
them on the basis of price? In most instances, goods are rationed on the basis of
"first come, first served." As a consequence, price ceilings typically result in long
lines such as those created in the 1970s due to price ceilings on gasoline. Thus,
price ceilings discriminate against people who have a high opportunity cost of time
and do not like to wait in lines. If a consumer has to wait in line two hours to buy 10
gallons of gasoline and his or her time is worth $5 per hour, it costs the consumer
2 X $5 = S10 to wait in line. Since 10 gallons of gasoline are purchased, this amounts
to spending $1 per gallon waiting in line to purchase the good.
This basic idea can be depicted graphically. Under the price ceiling of JX, only q
units of the good are available. Since this quantity corresponds to point F on the
demand curve in Figure 2-11, we see that consumers are willing to pay pF for another
full economic unit of the good. By law, however, they cannot pay the firm more than JX. The differ-
price ence, pF - JX, reflects the price per unit consumers are willing to pay by waiting in
The dollar amount line. The full economic price paid by a consumer (P) is thus the amount paid to
paid to a firm under
a price ceiling, plus the firm (JX), plus the implicit amount paid by waiting in line (pF - JX). The latter
the nonpecuniary price is paid not in dollars but through opportunity cost and thus is termed the
price. nonpecuniary price.
284
FIGURE 2-11 A Price Ceiling
Price
pF
pe
Shortage
D
Quantity
0 Q' Q·
pF p: + (pF- P:)
Full Dollar Nonpecuniary
economic price price
price
As Figure 2-11 shows, pF is greater than the initial equilibrium price, P. When
opportunity costs are taken into account, the full economic price paid for a good is
actually higher after the ceiling is imposed.
Since price ceilings reduce the quantity available in the market, such regulations
reduce social welfare even if they do not result in long lines. The dollar value of the
lost social welfare is given by the shaded triangle in Figure 2-11. Intuitively, each
point on the demand curve represents the amount consumers would be willing to pay
for an additional unit, while each point on the supply curve indicates the amount pro-
ducers would have to receive to induce them to sell an additional unit. The vertical
difference between the demand and supply curves at each quantity therefore repre-
sents the change in social welfare (consumer value less relevant production costs)
associated with each incremental unit of output. Summing these vertical differences
for all units between q and q yields the shaded triangle in Figure 2-11 and thus rep-
resents the total dollar value of the lost social welfare due to a price ceiling. The tri-
angle in Figure 2-11 is sometimes called "deadweight loss."
Demonstration Problem 2-S

Based on your answer to the Senate Foreign Relations Committee (Demonstration Problem
2-4), one of the senators raises a concern that the free market price might be too high for the
typical Chinese citizen to pay. Accordingly, she asks you to explain what would happen if
the Chinese government privatized the market, but then set a price ceiling at the Chinese
285
equivalent of $1.50. How do you answer? Assume that the market demand and supply
curves (in U.S. dollar equivalent prices) are still given by
(11 = 10 - 2P and q = 2 + 2P
Answer:
Since the price ceiling is below the equilibrium price of $2, a shortage will result. More
specifically, when the price ceiling is $1.50, quantity demanded is
(11 = 10 - 2(1.50) =7
and quantity supplied is
q = 2 + 2(1.50) = 5
Thus, there is a shortage of 7 - 5 = 2 units.
To determine the full economic price, we simply determine the maximum price con-
sumers are willing to pay for the five units produced. To do this, we first set quantity equal
to 5 in the demand formula:
5 = 10- 2PF
or
2P'= 5
Next, we solve this equation for pF to obtain the full economic price, pF = $2.50.
Thus, consumers pay a full economic price of $2.50 per unit; $1.50 of this price is in money,
and S1 represents the nonpecuniary price of the good.
Based on the preceding analysis, one may wonder why the government would
ever impose price ceilings. One answer might be that politicians do not understand
the basics of supply and demand. This probably is not the answer, however.
The answer lies in who benefits from and who is harmed by ceilings. When
lines develop due to a shortage caused by a price ceiling, people with high opportu-
nity costs are hurt, while people with low opportunity costs may actually benefit.
For example, if you have nothing better to do than wait in line, you will benefit
from the lower dollar price; your nonpecuniary price is close to zero. On the other
hand, if you have a high opportunity cost of time because your time is valuable to
you, you are made worse off by the ceiling. If a particular politician's constituents
tend to have a lower than average opportunity cost, that politician naturally will
attempt to invoke a price ceiling.
Sometimes when shortages are created by a ceiling, goods are not allocated
on the basis of lines. Producers may discriminate against consumers on the basis
of other factors, including whether or not consumers are regular customers. Dur-
ing the gasoline shortage of the 1970s, many gas stations sold gas only to cus-
tomers who regularly used the stations. In California during the late 1990s, price
ceilings were imposed on the fees that banks charged nondepositors for using
their automatic teller machines (ATMs). The banks responded by refusing to let
nondepositors use their ATM machines. In other situations, such as ceilings on
286
INSIDE BUSINESS 2-3
Price Ceilings and Price Floors around the Globe
Federal, state, and local authorities around the world are they have an effect similar to that shown in Figure
often persuaded to enact laws that restrict the prices that 2-12. However, since governments do not hire work-
businesses can legally charge their customers. Many ers who are unable to find employment at the artifi-
states in the United States have usury laws-price ceil- cially high wage, the "surplus" of labor translates into
ings on interest rates-that restrict the rate that banks unemployment. Over a dozen Canadian provinces
and other lenders can legally charge their customers. also have enacted minimum wage laws. In addition,
Italy also has usury laws, and the penalties to lenders Ontario, British Columbia, and Quebec have estab-
breaking the law include fines up to 30 million lire and lished floor prices (called "minimum retail prices")
six years in jail. Thailand allowed gasoline prices to on beer to keep prices artificially high in an attempt
be determined by market forces during the 1990s, to discourage alcohol consumption and to protect
but its Commerce Ministry imposed a price ceiling in Canadian brewers from inexpensive U.S. brands.
an attempt to hold down the rapidly rising gasoline
Sources: "Oil Sales: Ceiling Set on Retail Margin," The
prices during the early 2000s. Nation, June 15, 2002; "An Oil Shock of Our Own
More than 20 states in the United States have Making," The Nation, May 20, 2004; "Italian Usury Laws:
enacted minimum wage legislation-that is, a price Mercy Strain'd" The Economist, November 23, 2000;
floor on the hourly rate a business can legally pay its "Democrats Look to Keep Minimum Wage on Table," The
employees. These restrictions are in addition to the Wall Street Joumal, June 20, 2006; "Beer Price War Punishes
minimum wage set by the federal government, and Mom-and-Pop Shops," The Gazette, November 4, 2005.
loan interest rates, banks may allocate money only to consumers who are rela-
tively well-to-do.
The key point is that in the presence of a shortage created by a ceiling, man-
agers must use some method other than price to allocate the goods. Depending on
which method is used, some consumers will benefit and others will be worse off.
Price Floors
In contrast to the case of a price ceiling, sometimes the equilibrium competitive
price may be considered too low for producers. In these instances, individuals may
lobby for the government to legislate a minimum legal price for a good. Such a
price floor price is called a price floor. Perhaps the best-known price floor is the minimum
The minimum wage, the lowest legal wage that can be paid to workers.
legal price that can If the equilibrium price is above the price floor, the price floor has no effect on the
be charged in a
market.
market. But if the price floor is set above the competitive equilibrium level, such as pr
in Figure 2-12, there is an effect. Specifically, when the price floor is set at Pf, quantity
supplied is Qs and quantity demanded is Qd. In this instance, more is produced than
consumers are willing to purchase at that price, and a surplus develops. In the context
of the labor market, there are more people looking for work than there are jobs to go
around at that wage, and unemployment results. In the context of a product market, the
surplus translates into unsold inventories. In a free market, price would fall to alleviate
287
FIGURE 2-12 A Price Floor
Price
s
pt+----------------- Floor
pe -------
----+-- Cost of
purchasing
excess supply
Quantity
0 Q5
the unemployment or excess inventories, but the price floor prevents this mechanism
from working. Buyers end up paying a higher price and purchasing fewer units.
What happens to the unsold inventories? Sometimes the government agrees to
purchase the surplus. This is the case with price floors on many agricultural prod-
ucts, such as cheese. Under a price floor, the quantity ofunsold products is given by
the distance from G to Fin Figure 2-12, or (l - (11. If the government purchases
this surplus at the price floor, the total cost to the government is P'((l - qt). Since
the area ofa rectangle is its base times its height, the cost to the government of buy-
ing the surplus is given by the shaded area FGQ'q1in Figure 2-12.

One of the members of the Senate Foreign Relations Committee has studied your analysis of
Chinese privatization (Demonstration Problems 2-4 and 2-5) but is worried that the free-
market price might be too low to enable producers to earn a fair rate of return on their
investment. He asks you to explain what would happen if the Chinese government priva-
tized the market, but agreed to purchase the good from suppliers at a floor price of $4. What
do you tell the senator? Assume that the market demand and supply curves (in U.S. dollar
equivalent prices) are still given by
Q1= 10- 2P and Q>= 2 + 2P
Answer:
Since the price floor is above the equilibrium price of $2, the floor results in a surplus. More
specifically, when the price is $4, quantity demanded is
Q1 = 10 - 2(4) = 2
288
and quantity supplied is

Q5 = 2 + 2(4) = 10
Thus, there is a surplus of 10 - 2 = 8 units. Consumers pay a higher price ($4), and
producers have unsold inventories of 8 units. However, the Chinese government must pur-
chase the amount consumers are unwilling to purchase at the price of $4. Thus, the cost to
the Chinese government of buying the surplus of 8 units is $4 x 8 = $32.
COMPARATIVE STATICS
You now understand how equilibrium is determined in a competitive market and

how government policies such as price ceilings and price floors affect the market.
Next, we show how managers can use supply and demand to analyze the impact of
changes in market conditions on the competitive equilibrium price and quantity.
The study of the movement from one equilibrium to another is known as
comparative static analysis. Throughout this analysis, we assume that no legal
restraints, such as price ceilings or floors, are in effect and that the price system is
free to work to allocate goods among consumers.
Changes in Demand
Suppose that The Wall Street Journal reports that consumer incomes are expected
to rise by about 2.5 percent over the next year, and the number of individuals over
25 years of age will reach an all-time high by the end of the year. We can use our
supply and demand apparatus to examine how these changes in market conditions
will affect car rental agencies like Avis, Hertz, and National. It seems reasonable to
presume that rental cars are normal goods: A rise in consumer incomes will most
likely increase the demand for rental cars. The increased number of consumers
aged 25 and older will also increase demand, since at many locations those who
rent cars must be at least 25 years old.
We illustrate the ultimate effect of this increase in the demand for rental cars in
Figure 2-13. The initial equilibrium in the market for rental cars is at point A,
where demand curve JJJ intersects the market supply curve S. The changes reported
in The Wall Street Journal suggest that the demand for rental cars will increase over
the next year, from JJJ to some curve like D1. The equilibrium moves to point B,
where car rental companies rent more cars and charge a higher price than before the
demand increase.
The reason for the rise in rental car prices is as follows. The growing number of
consumers aged 25 or older, coupled with the rise in consumer incomes, increases
the demand for rental cars. At the old price of $45 per day, there are only 100,000
cars available. This is less than the 108,000 cars that customers want to rent at that
price. Car rental companies thus find it in their interest to raise their prices and to
increase their quantity supplied of rental cars until ultimately enough cars are avail-
able at the new equilibrium price of $49 to exactly equal the quantity demanded at
this higher price.
289
FIGURE 2-13 Effect of a Change in Demand for Rental Cars
Price
$49
$45
D1
~ - - - - - - - + - - - - + - - - + - - - - - Quantity
0 100 104 108 (thousands
rented per day)

The manager of a fleet of cars currently rents them out at the market price of $49 per day,
with renters paying for their own gasoline and oil. In a front-page newspaper article, the
manager learns that economists expect gasoline prices to rise dramatically over the next
year, due to increased tensions in the Middle East. What should she expect to happen to the
price of the cars her company rents?
Answer:
Since gasoline and rental cars are complements, the increase in gasoline prices will decrease
the demand for rental cars. To see the impact on the market price and quantity of rental cars,
let D1 in Figure 2-13 represent the initial demand for rental cars, so that the initial equilib-
rium is at point B. An increase in the price of gasoline will shift the demand curve for rental
cars to the left (to JJl), resulting in a new equilibrium at point A. Thus, she should expect the
price of rental cars to fall.
Changes in Supply
We can also use our supply and demand framework to predict how changes in one or
more supply shifters will affect the equilibrium price and quantity of goods or serv-
ices. For instance, consider a bill before Congress that would require all employers,
small and large alike, to provide health care to their workers. How would this bill
affect the prices charged for goods at retailing outlets?
290
INSIDE BUSINESS 2-4
Globalization and the Supply of Soft Drinks
In today's global economy, the number of firms in Rasna's entry into U.S. and U.K. soft drink mar-
the market critically depends on the entry and exit kets would shift the supply curves in these markets
decisions of foreign firms. For example, Rasna to the right. Other things equal, this will negatively
Ltd.-a leader in the Indian concentrated soft drink impact the bottom lines of firms that currently sell in
market that sells nearly 3 billion glasses of product these markets: The increase in supply will reduce the
each year-recently announced plans to boost its equilibrium prices of soft drinks and the profits of
exports by 30 percent. The company currently exports existing soft drink makers.
products to nearly 40 countries and is now eyeing Source: "Rasna Plans Exports to US, UK, and Africa,"
the U.S. and U.K. markets. Financial Express, India, May 26, 2004.
This health care mandate would increase the cost to retailers and other firms of
hiring workers. Many retailers rely on semiskilled workers who earn relatively low
wages, and the cost of providing health insurance to these workers is large relative
to their annual wage earnings. While fmns might lower wages to some extent to offset
the mandated health insurance costs paid, the net effect would be to raise the total
cost to the firm of hiring workers. These higher labor costs, in turn, would decrease
the supply of retail goods. The final result of the legislation would be to increase the
prices charged by retailing outlets and to reduce the quantity of goods sold there.
We can see this more clearly in Figure 2-14. The market is initially in equilib-
rium at point A, where demand curve D intersects the market supply curve, SJ.
Higher input prices decrease supply from SJ to 9, and the new competitive equilibrium
FIGURE 2-14 Effect of a Change in Supply
Price
pl
pl
~------+----,f-----------,► Quantity
0 (j qi
291
INSIDE BUSINESS 2-5
Using a Spreadsheet to Calculate Equilibrium in the

Supply and Demand Model
The Web site for the seventh edition of Managerial Eco- examine the quantitative impact of price regula-
nomics and Business Strategy, www.mhhe.com/baye7e, tions, such as price ceilings and price floors, and the
contains a file named SupplyandDemandSolver.xls. resulting lost social welfare (or deadweight loss)
With a few clicks of a mouse, you can use this tool to associated with prices that are regulated at levels
determine equilibrium in the linear supply and demand above or below the equilibrium price.
model under different scenarios by accessing different It is important to stress that this tool is not a sub-
tabs in the file. You can also use this program to see how stitute for being able to perform these tasks without
equilibrium prices and quantities change through "real- the aid of the tool. But the tool will help you visualize
time" comparative static exercises. how different demand and supply parameters lead to
Additionally, this tool permits you to calculate different quantitative effects. Just as important, you
both producer and consumer surplus and investigate can create an never-ending number of practice prob-
how their magnitudes change when demand and lems and solve them by hand, and then use this tool to
supply parameters change. You can also use it to check your answers.
moves to point B. In this instance, the market price rises from pi to P, and the equi-
librium quantity decreases from (JJ to Q1-.
Simultaneous Shifts in Supply and Demand

Managers in both the private and public sectors sometimes encounter events that
lead to simultaneous shifts in both demand and supply. A tragic example occurred
at the end of the last century when an earthquake hit Kobe, Japan. The earthquake
did considerable damage to Japan's sake wine industry, and the nation's supply of
sake wine decreased as a result. Unfortunately, the stress caused by the earthquake
led many to increase their demand for sake and other alcoholic beverages. We can
use the tools of this chapter to examine how these simultaneous changes in supply
and demand affected the equilibrium price and quantity of sake.
In Figure 2-15, the market is initially in equilibrium at point A, where demand
curve JJJ intersects market supply curve 5°. Since the earthquake led to a simulta-
neous decrease in supply and increase in demand for sake, suppose supply
decreases from 5° to S1 and demand increases from JJJ to IY. In this instance, a new
competitive equilibrium occurs at point B; the price of sake increases from pi to P,
and the quantity consumed increases from (JJ to Q1-.
As the curves are drawn in Figure 2-15, the effect of the decrease in supply and
increase in demand was to increase both the price and the quantity. But what if
instead of shifting from 5° to S1, the supply curve shifted much farther to the left to
S2 so that it intersected the new demand curve at point C instead of B? In this
instance, price would still be higher than the initial equilibrium price, pi_ But the
resulting quantity would be lower than the initial equilibrium (point C implies a
lower quantity than point A). Thus, we have seen that when demand increases and
292
FIGURE 2-15 A Simultaneous Increase in Demand and Decrease in Supply Raises the
Equilibrium Price
Price
5l
~----+------<,__---+------- Quantity
TABLE 2-2 Equilibrium Price and Quantity: The Impact of Simultaneous Shifts in Demand and Supply
Nature of the Change Increase in Demand Decrease in Demand
Increase in Supply Price: Ambiguous Price: Decreases

Quantity: Increases Quantity: Ambiguous
Decrease in Supply Price: Increases Price: Ambiguous

Quantity: Ambiguous Quantity: Decreases
supply decreases, the market price rises, but the market quantity may rise or fall
depending on the relative magnitude of the shifts.
When using supply and demand analysis to predict the effects of simultaneous
changes in demand and supply, you must be careful that the predictions are not artifacts
of how far you have shifted the curves. As shown in Table 2-2, simultaneous changes
in demand and supply generally lead to ambiguities regarding whether the equilibrium
price or quantity will rise or fall. A valuable exercise is to draw various simultaneous
shifts in supply and demand to verify the results summarized in Table 2-2.

Suppose you are the manager of a chain of computer stores. For obvious reasons you have
been closely following developments in the computer industry, and you have just learned
that Congress has passed a two-pronged program designed to further enhance the U.S. com-
puter industry's position in the global economy. The legislation provides increased funding
for computer education in primary and secondary schools, as well as tax breaks for firms
that develop computer software. As a result of this legislation, what do you predict will hap-
pen to the equilibrium price and quantity of software?
293
Answer:
The equilibrium quantity certainly will increase, but the market price may rise, remain the same,
or fall, depending on the relative changes in demand and supply. To see this, note that the
increased funding for computer education at primary and secondary schools will lead to an
increase in the demand for computer software, since it is a normal good. The reduction in taxes
on software manufacturers will lead to an increase in the supply of software. You should draw a
figure to verify that if the rightward shift in supply is small compared to the rightward shift in
demand, both the equilibrium price and quantity will increase. If supply increases by the same
amount as demand, there will be no change in the price but the equilibrium quantity will rise.
Finally, if supply increases more than the increase in demand, the resulting equilibrium will entail
a lower price and a greater quantity. fu all cases, the equilibrium quantity increases. But the effect
on the market price depends on the relative magnitudes of the increases in demand and supply.
ANSWERING THE HEADLINE
FIGURE 2-16 Rising Chip Prices Decrease the Supply of PCs
Price
of PCs
~ - - - - - - - - - - - Q u a n t i t y of PCs
Now that we have developed a formal apparatus for understanding how markets
work, we will return to the story that opened this chapter.
Sam recognized that a cut in chip production will ultimately lead to higher chip
prices. Since chips are a key input in the production of PCs, an increase in the price
of chips would in turn lead to a decrease in the market supply of PCs, as indicated by
the change in supply from SJ to 9- in Figure 2-16. Notice that total quantity of PCs
sold in the market falls as the equilibrium moves from point A to point B. In light of
this anticipated decline in PC sales, Sam and Jane discussed the wisdom of going
ahead with their plan to double PC Solutions' workforce at this time.
SUMMARY
This chapter provided an overview of supply and demand and the interaction of
these forces. We covered applications of demand, supply, price ceilings, price
floors, and comparative statics. By reading this chapter and working through the
294
Suppose demand and supply functions for good X are:
𝑄𝑑 = 50 − 8𝑃
𝑄𝑆 = −17.5 + 10𝑃
a) What is equilibrium price and quantity?
b) What is market outcome if price is at $ 2.75? What do you expect to happen? Why?
c) What is market outcome if price is at $ 4.25? What do you expect to happen? Why?
d) What happens to equilibrium price and quantity if demand function becomes 𝑄𝑑 = 59 − 8𝑃
e) What happens to equilibrium price and quantity if supply function becomes 𝑄𝑆 = −40 +
10𝑃 (demand is 𝑄𝑑 = 59 − 8𝑃)?
Solution:
𝑄𝑑 = 50 − 8𝑃
𝑄𝑆 = −17.5 + 10𝑃
a)
At equilibrium: Qd = Qs
50 − 8𝑃 = − 17.5 + 10𝑃
18P = 67.5
P = $3.75
Substituting price in demand/supply function:
Qd = 50 – (8 x 3.75)
= 50 – 30
= 20
(P*, Q*) = ($3.75, 20)
b)
Quantity supplied at $2.75: -17.5 + (10 x 2.75) = - 17.5 + 27.5
Qs = 10
Quantity demanded at $2.75: 50 – (8 x 2.75) = 50 – 22
Qd = 28
Price of $2.75 is lower than equilibrium price and hence it would lead to shortage of the good in the
market. At this price, buyers will demand a higher quantity and suppliers will supply lower quantity
as compared to equilibrium
295
c)
Quantity supplied at $4.25: -17.5 + (10 x 4.25) = - 17.5 + 42.5
Qs = 25
Quantity demanded at $4.25: 50 – (8 x 4.25) = 50 – 34
Qd = 16
Price of $4.25 is higher than equilibrium price and hence it would lead to surplus supply of the good
in the market. At this price, buyers will demand a lower quantity and suppliers will supply a higher
quantity as compared to equilibrium
d)
59 − 8𝑃 = − 17.5 + 10𝑃
18P = 76.5
P = $4.25
Qd = 59 – (8 x 4.25)
= 50 – 34
= 16
(P*, Q*) = ($4.25, 16)
e)
50 − 8𝑃 = −40 + 10𝑃
18P = 90
P = $5
Qd = 50 – (8 x 5)
= 50 – 40
= 10
(P*, Q*) = ($5, 10)
296
Unit-10: Decisions Under Risk and
Uncertainty
297
Risk vs. Uncertainty
• Risk
• Must make a decision for which the
outcome is not known with certainty
• Can list all possible outcomes & assign
probabilities to the outcomes
• Uncertainty
• Cannot list all possible outcomes
• Cannot assign probabilities to the outcomes
298
15-2
Measuring Risk with
Probability Distributions
• Table or graph showing all possible
outcomes/payoffs for a decision & the
probability each outcome will occur
• To measure risk associated with a
decision
• Examine statistical characteristics of the
probability distribution of outcomes for the
decision
299
15-3
Probability Distribution for Sales
(Figure 15.1)
0.30
0.30
-~ 0.20
.:.a
0
...D
0
'--
0...
0.10
0 47,500 50,000 52,500 55,000 57,500

Sales
300
15-4
Expected Value
• Expected value (or mean) of a
probability distribution is:
n
E( X )  Expected value of X   pi X i
i 1
Where Xi is the ith outcome of a decision,

pi is the probability of the ith outcome, and
n is the total number of possible outcomes
301
15-5
Expected Value
• Does not give actual value of the
random outcome
• Indicates “average” value of the outcomes if
the risky decision were to be repeated a
large number of times
302
15-6
Variance
• Variance is a measure of absolute risk
• Measures dispersion of the outcomes about
the mean or expected outcome
n
Variance(X) =  X2   pi ( X i  E( X ))2
i 1
• The higher the variance, the greater the

risk associated with a probability
distribution
303
15-7
Identical Means but Different
Variances (Figure 15.2)
>-
:t:
.:0
0
...0
e
a..
f (profit)
304
15-8
Standard Deviation
• Standard deviation is the square root of
the variance
 X  Variance( X )
• The higher the standard deviation, the

greater the risk
305
15-9
Probability Distributions with
Different Variances (Figure 15.3)
50%
~ ~
30%
.:0 .:0
0 0
..D ..D
e
0...
e
0...
Profit Profit
30 40 50 60 70 30 40 50 60 70
Distribution A Distribution B
306
15-10
Coefficient of Variation
• When expected values of outcomes differ
substantially, managers should measure
riskiness of a decision relative to its
expected value using the coefficient of
variation
• A measure of relative risk
Standard deviation 
 
Expected value E( X )
307
15-11
Decisions Under Risk
• No single decision rule guarantees
profits will actually be maximized
• Decision rules do not eliminate risk
• Provide a method to systematically include
risk in the decision making process
308
15-12
Summary of Decision Rules
Under Conditions of Risk
Expected Choose decision with highest expected value
value rule
Mean- Given two risky decisions A & B:
variance • If A has higher expected outcome & lower
rules variance than B, choose decision A
• If A & B have identical variances (or standard
deviations), choose decision with higher
expected value
• If A & B have identical expected values, choose
decision with lower variance (standard deviation)
Coefficient of Choose decision with smallest coefficient of
variation rule variation
309
15-13
Probability Distributions for
Weekly Profit (Figure 15.4)
E(X) = 3,500 E(X) = 3,750
A = 1,025 B = 1,545
 = 0.29  = 0.41
0.40 Atlanta 0.40 Boston
0.30 0.30
0.30 0.30
0.25
- ~
"' "'_g 0.20
i 0.20
.,e
0.20
0.10 0.10
X X
0 1,000 2,000 3,000 4,000 5,000 6,000 0 1,000 2,000 3,000 4,000 5,000 6,000
Profit (dollars) Profit (dollars)
0.40 Cleveland
E(X) = 3,500
0.30 0.30 C = 2,062
 = 0.59
0.30
"'_g
0
0.20
cl:
0.10
X
0 1,000 2,000 3,000 4,000 5,000 6,000
Profit (dollars)
310
15-14
Which Rule is Best?
• For a repeated decision, with identical
probabilities each time
• Expected value rule is most reliable to
maximizing (expected) profit
• Average return of a given risky course of
action repeated many times approaches
the expected value of that action
311
15-15
Which Rule is Best?
• For a one-time decision under risk
• No repetitions to “average out” a bad
outcome
• No best rule to follow
• Rules should be used to help analyze &
guide decision making process
• As much art as science
312
15-16
Expected Utility Theory
• Actual decisions made depend on the
willingness to accept risk
• Expected utility theory allows for
different attitudes toward risk-taking in
decision making
• Managers are assumed to derive utility
from earning profits
313
15-17
Expected Utility Theory
• Managers make risky decisions in a way
that maximizes expected utility of the
profit outcomes
E U (  )  p1U ( 1 )  p2U ( 2 )  ...  pnU ( n )
• Utility function measures utility associated

with a particular level of profit
• Index to measure level of utility received for a
given amount of earned profit
314
15-18
Manager’s Attitude Toward Risk
• Determined by the manager’s marginal
utility of profit:
MU profit  U (  )I 
• Marginal utility (slope of utility curve)

determines attitude toward risk
315
15-19
• Risk averse
• If faced with two risky decisions with equal
expected profits, the less risky decision is
chosen
• Risk loving
• Expected profits are equal & the more risky
decision is chosen
• Risk neutral
• Indifferent between risky decisions that
have equal expected profit
316
15-20
• Can relate to marginal utility of profit
• Diminishing MUprofit
• Risk averse
• Increasing MUprofit
• Risk loving
• Constant MUprofit
• Risk neutral
317
15-21
(Figure 15.5)
U(n )
B
50
><
(I)
--0
·-C:>, 40 A/
c/
:'=
-+=
::)
Panel A - Risk averse:
diminishing MU profit
25
50 100 150
Profit (thousands)
318
15-22
(Figure 15.5)
U(n )
X
(l)
--0
C
·- B'
>,.
-:'= 45
Panel B - Risk neutral:
constant MU profit
+=
::J
30
~/
15
c/
/ 50 100 150
Profit (thousa nds)
319
15-23
(Figure 15.5)
U(n)
B''/
><
Q)
-0
C
·-
>-
-:!:: 40
+=
K/
Panel C - Risk loving: :::>
increasing MU profit
20
10 C" /
I/
50 100 150
Profit (thousands)
320
15-24
Finding a Certainty Equivalent for
a Risky Decision (Figure 15.6)
P=l
A -- Earn $5,000 weekly profit (Certa inty equivalent)
p Earn $6,000 weekly profit

B
~
(Risky decision)
1- p Earn $ l ,000 weekly profit
321
15-25
Manager’s Utility Function for Profit
(Figure 15.7)
U(n)
1.00 1.0
0 .95
0.85
X
"
7:)
C:
0.7
~
:5
0.5
0 1,000 2,000 3,000 4,000 5,000 6,000

Weekly profit (do llars)
322
15-26
Expected Utility of Profits
• According to expected utility theory,
decisions are made to maximize the
manager’s expected utility of profits
• Such decisions reflect risk-taking attitude
• Generally differ from those reached by
decision rules that do not consider risk
• For a risk-neutral manager, decisions are
identical under maximization of expected utility
or maximization of expected profit
323
15-27
Decisions Under Uncertainty
• With uncertainty, decision science
provides little guidance
• Four basic decision rules are provided to
aid managers in analysis of uncertain
situations
324
15-28
Summary of Decision Rules
Under Conditions of Uncertainty
Maximax rule Identify best outcome for each possible decision
& choose decision with maximum payoff.
Maximin rule Identify worst outcome for each decision &
choose decision with maximum worst payoff.
Minimax Determine worst potential regret associated with
regret rule each decision, where potential regret with any
decision & state of nature is the improvement in
payoff the manager could have received had the
decision been the best one when the state of
nature actually occurred. Manager chooses
decision with minimum worst potential regret.
Equal Assume each state of nature is equally likely to
probability occur & compute average payoff for each.
rule Choose decision with highest average payoff.
325
15-29
~\-e..v, ~ $ovv L ~ fl) f 'P\e_. 0 . ( C . ~ '1'n ~ ¥~~a
~
326
15-30
Chapter
Decisions Under Risk

and Uncertainty
After reading this chapter, you will be able to:
15.1 Explain the difference between decision making under risk and under uncertainty.
15.2 Compute the expected value, variance, standard deviation, and coefficient of
variation of a probability distribution.
15.3 Employ the expected value rule, mean-variance rules, and the coefficient of
variation rule to make decisions under risk.
15.4 Explain expected utility theory and apply it to decisions under risk.
15.5 Make decisions under uncertainty using the maximax rule, the maximin rule,
the minimax regret rule, and the equal probability rule.
A ll the analysis of managerial decision making up to this point in the text has
been developed under the assumption that the manager knows with certainty
the marginal benefits and marginal costs associated with a decision. While
managers do have considerable information about the outcome for many decisions,
they must frequently make decisions in situations in which the outcome of a deci-
sion cannot be known in advance. A manager may decide, for example, to invest in a
new production facility with the expectation that the new technology and equipment
will reduce production costs. Even after studying hundreds of technical reports, a
manager may still not know with certainty the cost savings of the new plant until the
plant is built and operating. In other words, the outcome of the decision to build the
new plant is random because the reduction in costs (the outcome) is not known with
certainty at the time of the decision. Another risky decision involves choosing the
profit-maximizing production level or the price to charge when the marginal benefit
and marginal cost can take on a range of values with differing probabilities.
In this chapter we will present some basic rules that managers, and for that mat-
ter all decision makers, can and do use to help make decisions under conditions
625
327
626 C H A PT E R 15 Decisions Under Risk and Uncertainty
of risk and uncertainty. In the first section, we explain the difference between
decision making under risk and decision making under uncertainty. The larger
portion of this chapter is devoted to analyzing decisions under risk, rather than
situations of uncertainty, because, as you will see, managers facing random ben-
efits and costs are more often confronted with situations involving risk than un-
certainty. As you will also see, the rules we present in this chapter for decision
making under risk and uncertainty provide only guidelines for making decisions
when outcomes are not certain, because no single rule for making such decisions
is, or can be, universally employed by all managers at all times. Nevertheless, the
rules presented give an overview of some of the helpful methods of analyzing risk
and uncertainty.
Before plunging into our presentation of decision making under uncertainty
and risk, we want to address a question that may be concerning you: Why do
we devote such a large portion of this text to managerial decision making un-
der certainty or complete information, knowing full well that a large proportion
of managerial decisions are made with incomplete information-that is, under
risk or uncertainty? There are two good reasons. First, the theory of optimization,
weighing marginal benefits and marginal costs, as explained in Chapter 3 and
applied throughout the text, provides the basic foundation for all decision mak-
ing regardless of the amount of information available to a decision maker about
the potential outcomes of various actions. To learn how to do something under
less-than-ideal conditions, one must first learn how to do it under ideal condi-
tions. Second, even though a decision maker does not have complete information
about the marginal benefits and marginal costs of all levels of an activity or choice
variable, the MB = MC rule from Chapter 3 is the most productive approach to
profit-maximization decisions under many, if not most, relevant circumstances.
15.1 DISTINCTIONS BETWEEN RISKAND UNCERTAINTY

When the outcome of a decision is not known with certainty, a manager faces a
decision-making problem under either conditions of risk or conditions of uncer-
risk tainty. A decision is made under risk when a manager can make a list of all pos-
A decision-making sible outcomes associated with a decision and assign a probability of occurrence
condition under which
to each one of the outcomes. The process of assigning probabilities to outcomes
a manager can list all
outcomes and assign
sometimes involves rather sophisticated analysis based on the manager's exten-
probabilities to each sive experience in similar situations or on other data. Probabilities assigned in this
outcome. way are objective probabilities. In other circumstances, in which the manager has
little experience with a particular decision situation and little or no relevant his-
torical data, the probabilities assigned to the outcomes are derived in a subjective
way and are called subjective probabilities. Subjective probabilities are based upon
hunches, "gut feelings," or personal experiences rather than on scientific data.
An example of a decision made under risk might be the following: A manager
decides to spend $1,000 on a magazine ad believing there are three possible out-
comes for the ad: a 20 percent chance the ad will have only a small effect on sales,
a 60 percent chance of a moderate effect, and a 20 percent chance of a very large
328
C H A PT E R 15 Decisions Under Risk and Uncertainty 627
effect. This decision is made under risk because the manager can list each poten-
tial outcome and determine the probability of each outcome occurring.
uncertainty In contrast to risk, uncertainty exists when a decision maker cannot list all pos-
A decision-making sible outcomes and/ or cannot assign probabilities to the various outcomes. When
condition under which
faced with uncertainty, a manager would know only the different decision options
a manager cannot list
all possible outcomes available and the different possible states of nature. The states of nature are the
and/or cannot assign future events or conditions that can influence the final outcome or payoff of a de-
probabilities to the cision but cannot be controlled or affected by the manager. Even though both risk
various outcomes. and uncertainty involve less-than-complete information, there is more informa-
tion under risk than under uncertainty.
An example of a decision made under uncertainty would be, for a manager of
a pharmaceutical company, the decision of whether to spend $3 million on the re-
search and development of a new medication for high blood pressure. The payoff
from the research and development spending will depend on whether the presi-
dent's new health plan imposes price regulations on new drugs. The two states of
nature facing the manager in this problem are (1) government does impose
price regulations or (2) government does not impose price regulations. While
the manager knows the payoff that will occur under either state of nature, the
manager has no idea of the probability that price regulations will be imposed on
drug companies. Under such conditions, a decision is made under uncertainty.
This important distinction between conditions of uncertainty and conditions
of risk will be followed throughout this chapter. The decision rules employed by
managers when outcomes are not certain differ under conditions of uncertainty
and conditions of risk.
15.2 MEASURING RISKWITH PROBABILITY DISTRIBUTIONS

Before we can discuss rules for decision making under risk, we must first discuss
how risk can be measured. The most direct method of measuring risk involves the
characteristics of a probability distribution of outcomes associated with a particu-
lar decision. This section will describe these characteristics.
Probability Distributions
probability A probability distribution is a table or graph showing all possible outcomes
distribution (payoffs) for a decision and the probability that each outcome will occur. The prob-
A table or graph showing
abilities can take values between 0 and 1, or, alternatively, they can be expressed
all possible outcomes
or payoffs of a decision as percentages between 0 and 100 percent.1 If all possible outcomes are assigned
and the probabilities that probabilities, the probabilities must sum to 1 (or 100 percent); that is, the prob-
each outcome will occur. ability that some other outcome will occur is 0 because there is no other possible
outcome.
'If the probability of an outcome is 1 (or 100 percent), the outcome is certain to occur and no risk
exists. If the probability of an outcome is O, then that particular outcome will not occur and need not
be considered in decision making.
329
To illustrate a probability distribution, we assume that the director of advertis-

ing at a large corporation believes the firm's current advertising campaign may
result in any one of five possible outcomes for corporate sales. The probability
distribution for this advertising campaign is as follows:
Outcome Probability
(sales) (percent)
47,500 units 10
50,000 units 20
52,500 units 30
55,000 units 25
57,500 units 15
Each outcome has a probability greater than 0 but less than 100 percent, and the
sum of all probabilities is 100 percent ( = 10 + 20 + 30 + 25 + 15). This probability
distribution is represented graphically in Figure 15.1.
From a probability distribution (either in tabular or in graphical form), the riski-
ness of a decision is reflected by the variability of outcomes indicated by the dif-
ferent probabilities of occurrence. For decision-making purposes, managers often
turn to mathematical properties of the probability distribution to facilitate a for-
mal analysis of risk. The nature of risk can be summarized by examining the cen-
tral tendency of the probability distribution, as measured by the expected value of
the distribution, and by examining the dispersion of the distribution, as measured
by the standard deviation and coefficient of variation. We discuss first the measure
of central tendency of a probability distribution.
FIGURE 15.1
The Probability
0.30
Distribution for Sales 0.30
Following an Advertising
Campaign
.€ 0.20
.1i
0
...0
e
a..
0.10
0 47,500 50,000 52,500 55,000 57,500

Sales
330
Expected Value of a Probability Distribution

expected value The expected value of a probability distribution of decision outcomes is the
The weighted average weighted average of the outcomes, with the probabilities of each outcome serving
of the outcomes, with
as the respective weights. The expected value of the various outcomes of a prob-
the probabilities of each
outcome serving as the
ability distribution is
respective weights. n
E(X) = Expected value of X = !,p;X;

i=l
where X; is the ith outcome of a decision, P; is the probability of the ith outcome,
and n is the total number of possible outcomes in the probability distribution.
Note that the computation of expected value requires the use of fractions or deci-
mal values for the probabilities Pv rather than percentages. The expected value of a
mean of the probability distribution is often referred to as the mean of the distribution.
distribution The expected value of sales for the advertising campaign associated with the
The expected value of
probability distribution shown in Figure 15.1 is
the distribution.
E(sales) = (0.10)(47,500) + (0.20)(50,000) + (0.30)(52,500)
+ (0.25)(55,000) + (0.15)(57,500)
= 4,750 + 10,000 + 15,750 + 13,750 + 8,625
= 52,875
While the amount of actual sales that occur as a result of the advertising cam-
paign is a random variable possibly taking values of 47,500, 50,000, 52,500,
55,000, or 57,500 units, the expected level of sales is 52,875 units. If only one
of the five levels of sales can occur, the level that actually occurs will not equal
the expected value of 52,875, but expected value does indicate what the average
value of the outcomes would be if the risky decision were to be repeated a large
number of times.
Dispersion of a Probability Distribution

As you may recall from your statistics classes, probability distributions are gener-
ally characterized not only by the expected value (mean) but also by the variance.
variance The variance of a probability distribution measures the dispersion of the distribu-
The dispersion of a tion about its mean. Figure 15.2 shows the probability distributions for the profit
distribution about its outcomes of two different decisions, A and B. Both decisions, as illustrated in
mean.
Figure 15.2, have identical expected profit levels but different variances. The larger
variance associated with making decision Bis reflected by a larger dispersion (a
wider spread of values around the mean). While distribution A is more compact
(less spread out), A has a smaller variance.
The variance of a probability distribution of the outcomes of a given decision
is frequently used to indicate the level or degree of risk associated with that deci-
sion. If the expected values of two distributions are the same, the distribution with
the higher variance is associated with the riskier decision. Thus in Figure 15.2,
decision B has more risk than decision A. Furthermore, variance is often used to
331
FIGURE 15.2
Two Probability
Distributions with
Identical Means but
Different Variances
£
.:c0
..0
e
a..
E {profit)
compare the riskiness of two decisions even though the expected values of the
distributions differ.
Mathematically, the variance of a probability distribution of outcomes Xv de-
noted by CT~ is the probability-weighted sum of the squared deviations about the
expected value of X
n
Variance (X) = CT; = !,pJX; - E(X)] 2
i- 1
As an example, consider the two distributions illustrated in Figure 15.3. As is
evident from the graphs and demonstrated in the following table, the two distri-
butions have the same mean, 50. Their variances differ, however. Decision A has
a smaller variance than decision B, and it is therefore less risky. The calculation of
the expected values and variance for each distribution are shown here:
Decision A Decision B
Profit Probability Probability
(X) (p) piXi [Xi- E(X))2pi (p) piXi [Xi - E(X))2pi
30 0.05 1.5 20 0.10 3 40

40 0.20 8 20 0.25 10 25
50 0.50 25 0 0.30 15 0
60 0.20 12 20 0.25 15 25
70 0.05 3.5 20 0.10 7 40
E(X) = 50 crJ = 80 E(X) = 50 crJ = 130
Since variance is a squared term, it is usually much larger than the mean. To
avoid this scaling problem, the standard deviation of the probability distribution
standard deviation is more commonly used to measure dispersion. The standard deviation of a prob-
The square root of the ability distribution, denoted by CTx, is the square root of the variance:
variance.
CTx = \!Variance (X)
332
C HAP TE R 15 Decisions Under Risk and Uncertainty 631
FIGURE 15.3
Probability Distributions with Different Variances
50%
€ € 30%
.:0 .:0
0 0
....0 ....0
e
a..
e
a..
Profit Profit
30 40 50 60 70 30 40 50 60 70
Distribution A Distribution B
The standard deviations of the distributions illustrated in Figure 15.3 and in the
preceding table are <TA = 8.94 and a 8 = 11.40. As in the case of the variance of a
probability distribution, the higher the standard deviation, the more risky the de-
cision.
Managers can compare the riskiness of various decisions by comparing their
standard deviations, as long as the expected values are of similar magnitudes.
For example, if decisions C and D both have standard deviations of 52.5, the two
decisions can be viewed as equally risky if their expected values are close to one
another. If, however, the expected values of the distributions differ substantially
in magnitude, it can be misleading to examine only the standard deviations. Sup-
pose decision C has a mean outcome of $400 and decision D has a mean outcome
of $5,000 but the standard deviations remain 52.5. The dispersion of outcomes for
decision D is much smaller relative to its mean value of $5,000 than is the dispersion
of outcomes for decision C relative to its mean value of $400.
coefficient of variation When the expected values of outcomes differ substantially, managers should
The standard deviation
divided by the expected
measure the riskiness of a decision relative to its expected value. One such
value of the probability measure of relative risk is the coefficient of variation for the decision's distri-
distribution. bution. The coefficient of variation, denoted by u, is the standard deviation
333
divided by the expected value of the probability distribution of decision out-

comes
Standard deviation o-
v = Expected value = E(X)
The coefficient of variation measures the level of risk relative to the mean of the
Now try Technical probability distribution. In the preceding example, the two coefficients of varia-
Problem 1. tion are vc = 52.5/400 = 0.131 and v 0 = 52.5/5,000 = 0.0105.
15.3 DECISIONS UNDER RISK

Now that we have shown how to measure the risk associated with making a par-
ticular managerial decision, we will discuss how these measures of risk can help
managers make decisions under conditions of risk. We now set forth three rules to
guide managers making risky decisions.
Maximization of Expected Value

Information about the likelihood of the various possible outcomes, while quite
helpful in making decisions, does not solve the manager's decision-making prob-
lem. How should a manager choose among various decisions when each decision
has a variety of possible outcomes? One rule or solution to this problem, called
expected value rule the expected value rule, is to choose the decision with the highest expected value.
Choosing the decision The expected value rule is easy to apply. Unfortunately, this rule uses informa-
with the highest
tion about only one characteristic of the distribution of outcomes, the mean. It
expected value.
fails to incorporate into the decision the riskiness (dispersion) associated with
the probability distribution of outcomes. Therefore, the expected value rule is not
particularly useful in situations where the level of risk differs very much across
decisions-unless the decision maker does not care about the level of risk associ-
ated with a decision and is concerned only with expected value. (Such a decision
maker is called risk neutral, a concept we will discuss later in this chapter.) Also,
the expected value rule is only useful to a manager when the decisions have dif-
ferent expected values. Of course, if decisions happen to have identical expected
values, the expected value rule offers no guidance for choosing between them,
and, considering only the mean, the manager would be indifferent to a choice
among them. The expected value rule cannot be applied when decisions have
identical expected values and should not be applied when decisions have different
levels of risk, except in the circumstance noted earlier: that is, when the decision
maker is risk neutral.
To illustrate the expected value rule (and other rules to be discussed later), con-
sider the owner and manager of Chicago Rotisserie Chicken, who wants to decide
where to open one new restaurant. Figure 15.4 shows the probability distributions
of possible weekly profits if the manager decides to locate the new restaurant in
either Atlanta (Panel A), Boston (Panel B), or Cleveland (Panel C) . The expected
values, standard deviations, and coefficients of variation for each distribution are
displayed in each panel.
334
CHAPTER 15 Decisions Under Risk and Uncertainty 633
FIGURE 15.4
0.40 Atlanta
Probability Distributions E(X) = 3,500
for Weekly Profit atThree aA = 1,025
Restaurant Locations 0.30 0.30 u = 0.29
0.30
£
J5
C
...c 0.20
e
a..
0.10
X
0 2,000 3,000 4,000 5,000
Profit (dollars)
0.40 Boston
E(X) = 3,750
aa = 1,545
u = 0.41
0.30
0.25
€
J5
C
...c 0.20
e
a..
0.10
X
0 1,000 2,000 3,000 4,000 5,000 6,000
Profit (dollars)
0.40 Cleveland
E(X) = 3,500
ac = 2,062
0.30 u = 0.59 0.30
0.30
£
J5
C
...c 0.20
e
a..
0.10
X
0 1,000 2,000 3,000 4,000 5,000 6,000
Profit (dollars)
335
On the basis of past experience, the manager calculates that weekly profit
in Atlanta will take one of four values: $3,000 or $4,000 per week each with a
30 percent chance of occurring, and $2,000 or $5,000 a week each with a 20 percent
chance of occurring. The expected weekly profit in Atlanta is $3,500. If the man-
ager decides to open a restaurant in Boston, the weekly profits may be any of six
indicated values ranging from $1,000 to $6,000 weekly with the indicated prob-
abilities and an expected value of $3,750. For Cleveland, the manager assigns a
probability of 30 percent to weekly profits of $1,000 and $6,000 and a probability
of 10 percent to each of the profits $2,000, $3,000, $4,000, and $5,000, with an ex-
pected value of $3,500 for the distribution. If the manager is not concerned with
risk (is risk neutral) and follows the expected value rule, the new restaurant will
be opened in Boston, with the highest expected profit of $3,750. Note that if the
manager had been choosing between only the Atlanta and Cleveland locations,
the expected value rule could not have been applied because each has an expected
value of $3,500. In such cases some other rule may be used.
Mean-Variance Analysis
Managers who choose among risky alternatives using the expected value rule are,
in effect, ignoring risk (dispersion) and focusing exclusively on the mean outcome.
An alternative method of making decisions under risk uses both the mean and the
variance of the probability distribution, which incorporates information about the
level of risk into the decisions. This method of decision making, commonly known
mean-variance as mean-variance analysis, employs both the mean and the variance (or standard
analysis deviation) to make decisions according to the rules listed below.
Method of decision
Given two risky decisions (designated A and B), the mean-variance rules for de-
making that employs
both the mean and cisions under risk are
the variance to make
1. If decision A has a higher expected outcome and a lower variance than deci-
decisions.
sion B, decision A should be made.
2. If both decisions A and B have identical variances (or standard deviations),
the decision with the higher expected value should be made.
3. If both decisions A and B have identical expected values, the decision with the
lower variance (standard deviation) should be made.
The mean-variance rules are based on the assumption that a decision maker pre-
fers a higher expected return to a lower, other things equal, and a lower risk to a
higher, other things equal. It therefore follows that the higher the expected outcome
and the lower the variance (risk), the more desirable a decision will be. Under rule 1,
a manager would always choose a particular decision if it has both a greater expected
value and a lower variance than other decisions being considered. With the same
level of risk, the second rule indicates managers should choose the decision with the
higher expected value. Under rule 3, if the decisions have identical expected values,
the manager chooses the less risky (lower standard deviation) decision.
Returning to the problem of Chicago Rotisserie Chicken, no location dominates
both of the other locations in terms of any of the three rules of mean-variance
336
analysis. Boston dominates Cleveland because it has both a higher expected value
and a lower risk (rule 1). Atlanta also dominates Cleveland in terms of rule 3
because both locations have the same expected value ($3,500), but Atlanta has a
lower standard deviation-less risk (<TA= 1,025 < 2,062 = <Tc).
If the manager compares the Atlanta and Boston locations, the mean-variance
rules cannot be applied. Boston has a higher weekly expected profit ($3,750 >
$3,500), but Atlanta is less risky (<TA= 1,025 < 1,545 = <T8 ). Therefore, when mak-
ing this choice, the manager must make a trade-off between risk and expected
return, so the choice would depend on the manager's valuation of higher expected
return versus lower risk. We will now set forth an additional decision rule that
uses information on both the expected value and dispersion and can be used to
make decisions involving trade-offs between expected return and risk.
Coefficient of Variation Analysis

As we noted in the discussion about measuring the riskiness of probability dis-
tributions, variance and standard deviation are measures of absolute risk. In con-
trast, the coefficient of variation [<T/E(X)] measures risk relative to the expected
value of the distribution. The coefficient of variation, therefore, allows managers
coefficient of to make decisions based on relative risk instead of absolute risk. The coefficient
variation rule of variation rule states: "When making decisions under risk, choose the decision
Decision-making rule
with the smallest coefficient of variation [<T/E(X)]." This rule takes into account
that the decision to be
chosen is the one with both the expected value and the standard deviation of the distribution. The lower
the smallest coefficient the standard deviation and the higher the expected value, the smaller the coeffi-
of variation . cient of variation. Thus a desired movement in either characteristic of a probability
distribution moves the coefficient of variation in the desired direction.
We return once more to the decision facing the manager of Chicago Rotisserie
Chicken. The coefficients of variation for each of the possible location decisions are
UAtlanta = l,025/3,500 = 0.29
U 8 0 510n = l,545/3,750 = 0.41
UOeveland = 2,062/3,500 = 0.59
The location with the smallest coefficient of variation is Atlanta, which has a coef-
ficient of 0.29. Notice that the choice between locating in either Atlanta or Boston,
which could not be made using mean-variance rules, is now resolved using the
coefficient of variation to make the decision. Atlanta wins over Boston with the
smaller coefficient of variation (0.29 < 0.41), while Cleveland comes in last.
Which Rule Is Best?

At this point, you may be wondering which one of the three rules for making deci-
sions under risk is the "correct one." After all, the manager of Chicago Rotisserie
Chicken either reached a different decision or reached no decision at all depending
on which rule was used. Using the expected value rule, Boston was the choice.
Using the coefficient of variation rule, Atlanta was chosen. According to mean-
variance analysis, Cleveland was out, but the decision between Atlanta and Boston
337
ILLUSTRATION 15.1
Lowering Risk by Diversification Portfolio risk
Although investors can't do much about the amount of

risk associated with any specific project or inveshnent,
they do have some control over the amount of risk as-
sociated with their entire portfolio of inveshnents. The
Wall Street Journal advised: "The best strategy, invest-
ment advisors say, is to diversify by spreading your ~"""s::-~i--- Total risk
money among a wide variety of stocks, bonds, real ---------------------
estate, cash, and other holdings."
/Market r i s k ~
The Wall Street Journal pointed out that you will
have to expect the value of your holdings to fluctuate
with changes in the economy or market conditions.
The returns should comfortably beat those from CDs, Number of
and the ups and downs should be a lot smaller than securities/assets
if you simply put all your money in the stock market. in the portfolio
One inveshnent adviser stated, "Diversified portfolios
of stocks and bonds had much less risk while provid-
ing nearly as much return as an all-stock portfolio dur- of risk: market risk and unique risk. Market risk is the
ing the past 15, 20, and 25 years." During the period risk faced due to economywide changes, such as eco-
since 1968, stocks soared in five years but were losing nomic fluctuations and fluctuations in the market rate
inveshnents in six years. Investors who put a third of of interest. Unique risk is the risk associated with the
their money in stocks, a third in Treasury bonds, and a particular security or inveshnent, such as fluctuations
third in "cash equivalent" inveshnents would have lost in the sales of a particular firm or region relative to the
money in only four years, with the largest annual loss entire economy.
being less than 5 percent. The annual compound return As different securities are added to a portfolio, the
over the 25 years in that inveshnent would have been unique risk associated with a specific security is diver-
9 percent, compared with 10.56 percent in an all-stock sified away. That is, as more securities are added, the
portfolio, 8.26 percent in all bonds, and 9.89 percent in entire portfolio is less subject to the unique risk asso-
60 percent stock and 40 percent bonds. But the more ciated with a given stock. As the number of securities
diversified inveshnent would have been less risky. or assets is increased, unique risk decreases and the
The theoretical arguments in the Wall Street Journal total risk of the portfolio (the standard deviation) ap-
article are based on portfolio theory. The core of port- proaches the market risk.
folio theory is deceptively simple: As more securities
are added to an investor's portfolio, the portfolio risk Source: Based on Tom Herman, "The First Rollovers of
(the standard deviation of portfolio returns) declines. A Spring Bring Advice on Diversification," The Wall Street
particular security or inveshnent is subject to two types Journal, April 8, 1993.
could not be resolved using mean-variance analysis. If the decision rules do not all
lead to the same conclusion, a manager must decide which rule to follow.
When a decision is to be made repeatedly, with identical probabilities each
time, the expected value rule provides managers with the most reliable rule for
maximizing (expected) profit. The average return of a given risky course of action
repeated many times will approach the expected value of that action. Therefore,
338
C H A P T E R 15 Decisions Under Risk and Uncertainty 637
the average return of the course of action with the highest expected value will
tend to be higher than the average return of any course of action with a lower
expected value, when carried out a large number of times. Situations involving
repeated decisions can arise, for example, when a manager must make the same
risky decision once a month or even once every week. Or a manager at corporate
headquarters may make a decision that directs activities of dozens, maybe even
hundreds, of corporate offices in the country or around the world. When the risky
decision is repeated many times, the manager at corporate headquarters believes
strongly that each of the alternative decision choices will probably result in an av-
erage profit level that is equal to the expected value of profit, even though any one
corporate office might experience either higher or lower returns. In practice, then,
the expected value rule is justifiable when a decision will be repeated many times
under identical circumstances.
When a manager makes a one-time decision under risk, there will not be any
follow-up repetitions of the decision to "average out" a bad outcome (or a good
outcome). Unfortunately, there is no best rule to follow when decisions are not
repetitive. The rules we present for risky decision making should be used by man-
agers to help analyze and guide the decision-making process. Ultimately, making
decisions under risk (or uncertainty) is as much an art as it is a science.
The "art" of decision making under risk or uncertainty is closely associated
with a decision maker's preferences with respect to risk taking. Managers can dif-
fer greatly in their willingness to take on risk in decision making. Some managers
are quite cautious, while others may actually seek out high-risk situations. In the
next section, we present a theory, not a rule, of decision making under risk that
formally accounts for a manager's attitude toward risk. This theory, usually re-
ferred to as expected utility theory, postulates that managers make risky decisions
with the objective of maximizing the expected utility of profit. The theory can, in
Now tryTechnical some situations, provide a more powerful tool for making risky decisions than the
Problems 2-3. rules presented in this section.
15.4 EXPECTED UTILITY: A THEORY OF DECISION MAKING UNDER RISK

As we just mentioned, managers differ in their willingness to undertake risky
decisions. Some managers avoid risk as much as possible, while other managers
actually prefer more risk to less risk in decision making. To allow for different
attitudes toward risk taking in decision making, modern decision theory treats
managers as deriving utility or satisfaction from the profits earned by their firms.
Just as consumers derived utility from the consumption of goods in Chapter 5,
expected utility in expected utility theory, managers are assumed to derive utility from earning
theory profits. Expected utility theory postulates that managers make risky decisions in
A theory of decision
making under risk that
a way that maximizes the expected utility of the profit outcomes. While expected
accounts for a manager's utility theory does provide a tool for decisions under risk, the primary purpose of
attitude toward risk. the theory, and the reason for presenting this theory here, is to explain why man-
agers make the decisions they do make when risk is involved. We want to stress
that expected utility theory is an economic model of how managers actually make
339
decisions under risk, rather than a rule dictating how managers should make deci-
sions under risk.
Suppose a manager is faced with a decision to undertake a risky project or,
more generally, must make a decision to take an action that may generate a range
of possible profit outcomes, 1r1, 1r2, ••• , ,rn' that the manager believes will occur
expected utility with probabilities p1, p2 , • •• , Pn, respectively. The expected utility of this risky
The sum of the decision is the sum of the probability-weighted utilities of each possible profit
probabilityweighted outcome
utilities of each possible
profit outcome.
E[U(,r)] = P1U(,rl) + P2U(,r2) + · · · + PnU(,rJ
where U(1r) is a utility function for profit that measures the utility associated with
a particular level of profit. Notice that expected utility of profit is different from
the concept of expected profit, which is the sum of the probability-weighted prof-
its. To understand expected utility theory, you must understand how the manag-
er's attitude toward risk is reflected in the manager's utility function for profit. We
now discuss the concept of a manager's utility of profit and show how to derive
a utility function for profit. Then we demonstrate how managers could employ
expected utility of profit to make decisions under risk.
A Manager's Utility Function for Profit

Since expected utility theory is based on the idea that managers enjoy utility or
satisfaction from earning profit, the nature of the relation between a manager's
utility and the level of profit earned plays a crucial role in explaining how manag-
ers make decisions under risk. As we now show, the manager's attitude toward
risk is determined by the manager's marginal utility of profit.
It would be extremely unusual for a manager not to experience a higher level
of total utility as profit increases. Thus the relation between an index of utility and
the level of profit earned by a firm is assumed to be an upward-sloping curve. The
amount by which total utility increases when the firm earns an additional dollar
marginal utility of profit is the marginal utility of profit
of profit
The amount by which MUprofit = dU(,r)/ d,r
total utility increases
w ith an additional where U(1r) is the manager's utility function for profit. The utility function for
dollar of profit earned profit gives an index value to measure the level of utility experienced when a
by a firm . given amount of profit is earned. Suppose, for example, the marginal utility of
profit is 8. This means a $1 increase in profit earned by the firm causes the utility
index of the manager to increase by eight units. Studies of attitudes toward risk
have found most business decision makers experience diminishing marginal utility
of profit. Even though additional dollars of profit increase the level of total satis-
faction, the additional utility from extra dollars of profit typically falls for most
managers.
The shape of the utility curve for profit plays a pivotal role in expected utility
theory because the shape of U(,r) determines the manager's attitude toward risk,
which determines which choices a manager makes. Attitudes toward risk may
340
risk averse be categorized as risk averse, risk neutral, or risk loving. People are said to be risk
Term describing a averse if, facing two risky decisions with equal expected profits, they choose the
decision maker who less risky decision. In contrast, someone choosing the more risky decision, when
makes the less risky of
the expected profits are identical, is said to be risk loving. The third type of at-
two decisions that have
the same expected value. titude toward risk arises for someone who is indifferent between risky situations
when the expected profits are identical. In this last case, a manager ignores risk in
risk loving
decision making and is said to be risk neutral.
Term describing a
decision maker who Figure 15.5 shows the shapes of the utility functions associated with the three
makes the riskier of two types of risk preferences. Panel A illustrates a utility function for a risk-averse
decisions that have the manager. The utility function for profit is upward-sloping, but its slope diminishes
same expected value. as profit rises, which corresponds to the case of diminishing marginal utility. When
risk neutral profit increases by $50,000 from point A to point B, the manager experiences an in-
Term describing a crease in utility of 10 units. When profit falls by $50,000 from point A to point C,
decision maker who utility falls by 15 units. A $50,000 loss of profit creates a larger reduction in utility
ignores risk in decision
than a $50,000 gain would add to utility. Consequently, risk-averse managers are
making and considers
only expected values of more sensitive to a dollar of lost profit than to a dollar of gained profit and will
decisions. place an emphasis in decision making on avoiding the risk of loss.
In Panel B, the marginal utility of profit is constant (AU/ A1r = 15/50 = 0.3), and
the loss of $50,000 reduces utility by the same amount that a gain of $50,000 in-
creases it. In this case, a manager places the same emphasis on avoiding losses as
on seeking gains. Managers are risk neutral when their utility functions for profit
are linear or, equivalently, when the marginal utility of profit is constant.
Panel C shows a utility function for a manager who makes risky decisions in
a risk-loving way. The extra utility from a $50,000 increase in profit (20 units) is
greater than the loss in utility suffered when profit falls by $50,000 (10 units). Con-
sequently, a risk-loving decision maker places a greater weight on the potential for
gain than on the potential for loss. We have now developed the following relation.
Relation A manager's attitude toward risky decisions can be related to his or her marginal utility of
profit. Someone who experiences diminishing (increasing) marginal utility for profit will be a risk-averse
Now try Technical (risk-loving) decision maker. Someone whose marginal utility of profit is constant is risk neutral.
Problems 4-5.
Deriving a Utility Function for Profit

As discussed earlier, when managers make decisions to maximize expected util-
ity under risk, it is the utility function for profit that determines which decision
a manager chooses. We now show the steps a manager can follow to derive his
or her own utility function for profit, U(1r). Recall that the utility function does
not directly measure utility but does provide a number, or index value, and that
it is the magnitude of this index that reflects the desirability of a particular profit
outcome.
The process of deriving a utility function for profit is conceptually straightfor-
ward. It does, however, involve a substantial amount of subjective evaluation. To
illustrate the procedure, we return to the decision problem facing the manager of
Chicago Rotisserie Chicken (CRC). Recall that CRC must decide where to locate
341
FIGURE 15.5
U('lT)
A Manager's Attitude
toward Risk 50
X
40
Ql
"'O
Panel A - Risk averse:
-=
diminishing MU profit €
5 25
50 100 150
Profit (thousands)
U('lT)
~ 45
"'O
Panel B - Risk neutral: ·=
constant MU profit
~
S 30
15
50 100 150
Profit (thousands)
U('lT)
Panel C - Risk loving:

increasing MU profit
20
10
50 100 150
Profit (thousands)
342
the next restaurant. The profit outcomes for the three locations range from $1,000 to
$6,000 per week. Before the expected utilities of each location can be calculated,
the manager must derive her utility function for profits covering the range $1,000
to $6,000.
The manager of CRC begins the process of deriving U(-rr) by assigning mini-
mum and maximum values that the index will be allowed to take. For the lower
bound on the index, suppose the manager assigns a utility index value of 0-
although any number, positive or negative, will do-to the lowest profit outcome
of $1,000. For the upper bound, suppose a utility index value of 1 is assigned-any
value greater than the value of the lower bound will do-to the highest profit out-
come of $6,000. Again, we emphasize, choosing 0 and 1 for the upper and lower
bounds is completely arbitrary, just as long as the upper bound is greater alge-
braically than the lower bound. For example, lower and upper bounds of -12
and 50 would also work just fine. Two points on the manager's utility function
for profit are
U($1,000) = 0 and U($6,000) = 1
Next, a value of the utility index for each of the remaining possible profit out-
comes between $1,000 and $6,000 must be determined. In this case, examining
profit in increments of $1,000 is convenient. To find the value of the utility index
for $5,000, the manager employs the following subjective analysis: The manager
begins by considering two decision choices, A and B, where decision A involves
receiving a profit of $5,000 with certainty and risky decision B involves receiving
either a $6,000 profit with probability p or a $1,000 profit with probability 1 - p.
Decisions A and B are illustrated in Figure 15.6. Now the probability p that will
make the manager indifferent between the two decisions A and B must be deter-
mined. This is a subjective determination, and any two managers likely will find
different values of p depending on their individual preferences for risk.
Suppose the manager of Chicago Rotisserie Chicken decides p = 0.95 makes
decisions A and B equally desirable. In effect, the manager is saying that the
expected utility of decision A equals the expected utility of decision B. If the
expected utilities of decisions A and Bare equal, E(UA) = E(U8 )
1 X U($5,000) = 0.95 X U($6,000) + 0.05 X U($1,000)
FIGURE 15.6
Finding a Certainty
~ Earn $5,000 weekly profit
&------ (Certainty equivalent)
Equivalent for a Risky
Decision
P Earn $6,000 weekly profit
~ (Risky decision)
1- p Earn $1,000 weekly profit
343
Only U($5,000) is unknown in this equation, so the manager can solve for the util-
ity index for $5,000 of profit
U($5,000) = (0.95 X 1) + (0.05 X 0) = 0.95
The utility index value of 0.95 is an indirect measure of the utility of $5,000 of
profit. This procedure establishes another point on the utility function for
certainty equivalent profit. The sum of $5,000 is called the certainty equivalent of risky decision B
The dollar amount that a because it is the dollar amount that the manager would be just willing to trade
manager would be just
for the opportunity to engage in risky decision B. In other words, the manager is
willing to trade for the
opportunity to engage in indifferent between having a profit of $5,000 for sure or making a risky decision
a risky decision. having a 95 percent chance of earning $6,000 and a 5 percent chance of earning
$1,000. The utility indexes for $4,000, $3,000, and $2,000 can be established in
exactly the same way.
This procedure for finding a utility function for profit is called the certainty
equivalent method. We now summarize the steps for finding a utility function for
profit, U(Tr), in a principle.
@] Principle To implement the certainty equivalent method of deriving a utility of profit function, the
following steps can be employed:
1. Set the utility index equal to 1 for the highest possible profit (7r Hl and Ofor the lowest possible
profit ('TT J
2. Define a risky decision to have probability p0 of profit outcome 'TTHand probability (1 - p0l of profit out-
come 'TTr For each possible profit outcome 'TT 0 ('TT H < '1T0 < 'TTJ, the manager determines subjectively
the probability p0 that gives that risky decision the same expected utility as receiving 'TT0 with certainty:
p0 V('TTHl = (1 - P0l V('TT1l = V('TT0l
The certain sum 'TT 0 is called the certainty equivalent of the risky decision. Let the subjective prob-
ability p0 serve as the utility index for measuring the level of satisfaction the manager enjoys when
earning a profit of 'TT 0•
Figure 15.7 illustrates the utility function for profit for the manager of Chicago
Rotisserie Chicken. The marginal utility of profit diminishes over the entire range
Now tryTechnical of possible profit outcomes ($1,000 to $6,000), and so this manager is a risk-averse
Problem 6. decision maker.
Maximization of Expected Utility

When managers choose among risky decisions in accordance with expected utility
theory, the decision with the greatest expected utility is chosen. Unlike maximi-
zation of expected profits, maximizing expected utility takes into consideration
the manager's preferences for risk. As you will see in this example, maximizing
expected utility can lead to a different decision than the one reached using the
maximization of expected profit rule.
Return once more to the location decision facing Chicago Rotisserie Chicken.
The manager calculates the expected utilities of the three risky location decisions
344
FIGURE 15.7
A Manager's Utility Function for Profit
U('TT)
1 1.0
0.95
0.85
0.7
~
-0
.!::
ts 0.5
0 1,000 2,000 3,000 4,000 5,000 6,000

Weekly profit (dollars)
using her own utility function for profit shown in Figure 15.7. The expected utili-
ties for the three cities are calculated as follows:
Atlanta E(UA) = 0U($1,000) + 0.2U($2,000) + 0.3U($3,000) + 0.3U($4,000)

+ 0.2U($5,000) + 0U($6,000)
= 0 + (0.2)(0.5) + (0.3)(0.7) + (0.3)(0.85) + (0.2)(0.95) + 0
= 0.755
Boston E(U8 ) = 0.1U($1,000) + 0.15U($2,000) + 0.15U($3,000)
+ 0.25U($4,000) + 0.2U($5,000) + 0.15U($6,000)
= (0.1)(0) + (0.15)(0.50) + (0.15)(0.7) + (0.25)(0.85)
+ (0.2)(0.95) + (0.15)(1)
= 0.733
Cleveland E(Uc) = 0.3U($1,000) + 0.1U($2,000) + 0.1U($3,000) + 0.1U($4,000)
+ 0.1U($5,000) + 0.3U($6,000)
= (0.3)(0) + (0.1)(0.5) + (0.1)(0.7) + (0.1)(0.85) + (0.1)(0.95)
+ (0.3)(1.0)
= 0.600
345
644 CHAPTER 15 Decisions Under Risk and Uncertainty
TABLE 15.1
Expected Utility of Profit: A Risk-Neutral Manager
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Probabilities Probability-weighted utility
Marginal
Profit Utility utility Atlanta Boston Cleveland
(,r) [U(,r)] [~U(,r)/ ~,r] (PA) (Pal (Pd P8 X U PcX U
$1 ,000 0 0 0.1 0.3 0 0 0
$2,000 0.2 0.0002 0.2 0.15 0.1 0.04 0.03 0.02
$3,000 0.4 0.0002 0.3 0.15 0.1 0.12 0.06 0.04
$4,000 0.6 0.0002 0.3 0.25 0.1 0.18 0.15 0.06
$5,000 0.8 0.0002 0.2 0.2 0.1 0.16 0.16 0.08
$6,000 1.0 0.0002 0 0.15 0.3 0 0.15 0.3
Expected utility = 0.50 0.55 0.50
To maximize the expected utility of profits, the manager of Chicago Rotisserie

Chicken chooses to open its new restaurant in Atlanta. Even though Boston has
the highest expected profit [E(ir) = $3,750], Boston also has the highest level of
risk (er= 1,545), and the risk-averse manager at CRC prefers to avoid the relatively
high risk of locating the new restaurant in Boston. In this case of a risk-averse
decision maker, the manager chooses the less risky Atlanta location over the more
risky Cleveland location even though both locations have identical expected profit
levels.
To show what a risk-neutral decision maker would do, we constructed a utility
function for profit that exhibits constant marginal utility of profit, which, as we
have explained, is the condition required for risk neutrality. This risk-neutral util-
ity function is presented in columns 1 and 2 of Table 15.1. Marginal utility of profit,
in column 3, is constant, as it must be for risk-neutral managers. From the table
you can see that the expected utilities of profit for Atlanta, Boston, and Cleveland
are 0.50, 0.55, and 0.50, respectively. For a risk-neutral decision maker, locating in
Boston is the decision that maximizes expected utility. Recall that Boston also is
the city with the maximum expected profit [E(ir) = $3,750]. This is not a coinci-
dence. As we explained earlier, a risk-neutral decision maker ignores risk when
making decisions and relies instead on expected profit to make decisions in risky
situations. Under conditions of risk neutrality, a manager makes the same decision
by maximizing either the expected value of profit, E(ir), or the expected utility of
profit, E[U(ir)].2
Finally, consider how a manager who is risk loving decides on a location for
CRC's new restaurant. In Table 15.2, columns 1 and 2 show a utility function for
2The appendix to this chapter demonstrates the equivalence for risk-neutral decision makers of
maximizing expected profit and maximizing expected utility of profit.
346
TABLE 15.2
Expected Utility of Profit: A Risk-Loving Manager
(1) (2) (3) (4) (5) (6) (7) (8) (9)

Probabilities Probabil ity-weighted utility
Marginal
Profit Utility utility Atlanta Boston Cleveland
('IT) [U('lT)] [AU('lT)/A'lT] (PA) (Pal (Pd PAX u Pax U PcX U
$1,000 0 0 0.1 0.3 0 0 0
$2,000 0.08 0.00008 0.2 0.15 0.1 0.016 0.012 0.008
$3,000 0.2 0.00012 0.3 0.15 0.1 0.06 0.03 0.02
$4,000 0.38 0.00018 0.3 0.25 0.1 0.114 0.095 0.038
$5,000 0.63 0.00025 0.2 0.2 0.1 0.126 0.126 0.036
$6,000 1.0 0.00037 0 0.15 0.3 0 0.15 0.3
Expected utility = 0.32 0.41 0.43
profit for which marginal utility of profit is increasing. Column 3 shows the mar-
ginal utility of profit, which, as it must for a risk-loving manager, increases as
profit increases. The expected utilities of profit outcomes for Atlanta, Boston, and
Cleveland are 0.32, 0.41, and 0.43, respectively. In the case of a risk-loving decision
maker, Cleveland is the decision that maximizes expected utility. If Atlanta and
Cleveland were the only two sites being considered, then the risk-loving manager
Now try Technical would choose Cleveland over Atlanta, a decision that is consistent with the defini-
Problems 7-8. tion of risk loving. We now summarize our discussion in the following principle.
@I Principle If a manager behaves according to expected utility theory, decisions are made to maximize
the manager's expected utility of profits. Decisions made by maximizing expected utility of profit reflect
the manager's risk-taking attitude and generally differ from decisions reached by decision rules that do not
consider risk. In the case of a risk-neutral manager, the decisions are identical under either maximization of
expected utility or maximization of expected profit.
15.5 DECISIONS UNDER UNCERTAINTY

Practically all economic theories about behavior in the absence of complete infor-
mation deal with risk rather than uncertainty. Furthermore, decision science has
little guidance to offer managers making decisions when they have no idea about
the likelihood of various states of nature occurring. This should not be too surpris-
ing, given the nebulous nature of uncertainty. We will, however, present four rather
maximax rule simple decision rules that can help managers make decisions under uncertainty.
Decision-making guide
that calls for identifying
the best outcome for The Maximax Criterion
each possible decision
and choosing the decision For managers who tend to have an optimistic outlook on life, the maximax rule pro-
with the maximum payoff vides a guide for making decisions when uncertainty prevails. Under the maximax
of all the best outcomes. rule, a manager identifies for each possible decision the best outcome that could
347
TABLE 15.3 States of nature

The Payoff Matrix for Decisions Recovery Stagnation Recession
Dura Plastic, Inc.
Expand plant capacity by 20% $5 million -$1 million -$3.0 million
Maintain same plant capacity 3 million 2 million 0.5 million
Reduce plant capacity by 20% 2 million 1 million 0.75 million
occur and then chooses the decision that would give the maximum payoff of all the
best outcomes. Under this rule a manager ignores all possible outcomes except the
best outcome from each decision.
To illustrate the application of this rule, suppose the management at Dura
Plastic is considering changing the size (capacity) of its manufacturing plant.
Management has narrowed the decision to three choices. The plant's capacity
will be (1) expanded by 20 percent, (2) maintained at the current capacity, or (3)
reduced by 20 percent. The outcome of this decision depends crucially on how
the economy performs during the upcoming year. Thus the performance of the
economy is the "state of nature" in this decision problem. Management envi-
sions three possible states of nature occurring: (1) The economy enters a period
of recovery, (2) economic stagnation sets in, or (3) the economy falls into a reces-
sion.
For each possible decision and state of nature, the managers determine the profit
payoff matrix outcome, or payoff, shown in the payoff matrix in Table 15.3. A payoff matrix is a
A table with rows table with rows corresponding to the various decisions and columns correspond-
corresponding to
ing to the various states of nature. Each cell in the payoff matrix in Table 15.3 gives
various decisions and
columns corresponding
the outcome (payoff) for each decision when a particular state of nature occurs.
to various states of For example, if management chooses to expand the manufacturing plant by
nature, with each cell 20 percent and the economy enters a period of recovery, Dura Plastic is projected to
giving the outcome or earn profits of $5 million. Alternatively, if Dura Plastic expands plant capacity but
payoff associated with
the economy falls into a recession, it is projected that the company will lose $3
that decision and state
of nature.
million. The managers do not know which state of nature will actually occur, or
the probabilities of occurrence, so the decision to alter plant capacity is made un-
der conditions of uncertainty. To apply the maximax rule to this decision, manage-
ment first identifies the best possible outcome for each of the three decisions. The
best payoffs are
$5 million for expanding plant size by 20 percent.
$3 million for maintaining plant size.
$2 million for reducing plant size by 20 percent.
Each best payoff occurs if the economy recovers. Under the maximax rule, man-
agement would decide to expand its plant.
While the maximax rule is simple to apply, it fails to consider ''bad" outcomes
in the decision-making process. The fact that two out of three states of nature re-
sult in losses when management decides to expand plant capacity, and neither of
348
C HAP TE R 15 Decisions Under Risk and Uncertainty 647
ILLUSTRATION 15.2
Floating Power Plants Lower Risks and The Wall Street Journal reported that Smith's idea of
Energize Developing Nations building power plants on barges spawned a niche in-
dustry that "could become a significant portion of the
Two crucial industries in developing countries are world's [electricity] generating capacity." Nations such
agriculture and manufacturing. A third-world nation as the Dominican Republic, Ghana, India, and Haiti
cannot emerge from poverty without achieving a sig- have signed agreements with producers of floating
nificant ability to feed itself and to manufacture both power plants that would not have been financed with-
durable goods for consumption and capital goods for out the risk reduction created by the mobility of a float-
production. Neither of these two crucial industries can ing platform. Indeed, the Wall Street Journal estimated
develop without energy. Domestically generated elec- that the floating nature of the power plant not only
tricity can provide a versatile source of energy capable makes financing possible but also probably "lower(s)
of meeting many of the most fundamental energy the financing costs by two or three percentage points"-
demands of a developing country. no small change on a half-a-billion-dollar loan.
A serious roadblock to construction of electric This Illustration highlights the importance of risk
power plants in developing countries has been the risk in decision making. If financial institutions were man-
of default on the financing required to purchase power aged by risk-loving managers, land-based power
plants. With prices beginning in the hundreds of mil- plants would likely be common in developing nations.
lions of dollars, investors are understandably reluctant Apparently, developing nations can expect to generate
to lend these enormous amounts when repossession most of their electricity on barges anchored in their
of the asset is, for all practical purposes, impossible. harbors-evidence that large financial lenders are
Donald Smith, president of Smith Cogeneration, found indeed risk averse.
a solution to the problem of default risk: Build floating
power plants on huge barges that can be relocated in Source: Adapted from William M. Bulkley, "Building Power
the event of a default. Plants That Can Float," The Wall Street Journal, May 22, 1996.
the other decisions would result in a loss, is overlooked when using the ma:ximax
criteria. Only managers with optimistic natures are likely to find the maximax rule
to be a useful decision-making tool.
The Maximin Criterion

For managers with a pessimistic outlook on business decisions, the maximin rule
maximin rule may be more suitable than the maximax rule. Under the maximin rule, the man-
Decision-making guide ager identifies the worst outcome for each decision and makes the decision associ-
that calls for identifying
ated with the maximum worst payoff. For Dura Plastic, the worst outcomes for
the worst outcome
for each decision and each decision from Table 15.3 are
choosing the decision
-$3 million for expanding plant size by 20 percent.
with the maximum worst
payoff. $0.5 million for maintaining plant size.
$0.75 million for reducing plant size by 20 percent.
Using the maximin criterion, Dura Plastic would choose to reduce plant capacity
by 20 percent. The maximin rule is also simple to follow, but it fails to consider any
of the "good" outcomes.
349
TABLE 15.4
States of nature
Potential Regret Matrix
for Dura Plastic, Inc. Decisions Recovery Stagnation Recession
Expand plant capacity by 20% $0 million $3 million $3.75 million
Maintain same plant capacity 2 million 0 million 0.25 million
Reduce plant capacity by 20% 3 million 1 million 0 million
The Minimax Regret Criterion

Managers concerned about their decisions not turning out to be the best once the
state of nature is known (i.e., after the uncertainty is resolved) may make their deci-
potential regret sions by minimizing the potential regret that may occur. The potential regret asso-
For a given decision ciated with a particular decision and state of nature is the improvement in payoff
and state of nature, the
the manager could have experienced had the decision been the best one when that
improvement in payoff
the manager could have
state of nature actually occurred. To illustrate, we calculate from Table 15.3 the
experienced had the potential regret associated with Dura Plastic's decision to maintain the same level
decision been the best of plant capacity if an economic recovery occurs. The best possible payoff when
one when that state of recovery occurs is $5 million, the payoff for expanding plant capacity. If a recovery
nature actually occurs.
does indeed happen and management chooses to maintain the same level of plant
capacity, the payoff is only $3 million, and the manager experiences a regret of $2
million ( = $5 - $3 million).
Table 15.4 shows the potential regret for each combination of decision and state
of nature. Note that every state of nature has a decision for which there is no po-
tential regret. This occurs when the correct decision is made for that particular
minimax regret rule state of nature. To apply the minimax regret rule, which requires that managers
Decision-making guide make a decision with the minimum worst potential regret, management identifies
that calls for determining
the maximum possible potential regret for each decision from the matrix:
the worst potential regret
associated with each $3.75 million for expanding plant size by 20 percent.
decision, then choosing
the decision with the
$2 million for maintaining plant size.
minimum worst potential $3 million for reducing plant size by 20 percent.
regret.
Management chooses the decision with the lowest worst potential regret: maintain
current plant capacity. For Dura Plastic, the minimax regret rule results in man-
agement's choosing to maintain the current plant capacity.
The Equal Probability Criterion

In situations of uncertainty, managers have no information about the probable state
of nature that will occur and sometimes simply assume that each state of nature is
equally likely to occur. In terms of the Dura Plastic decision, management assumes
each state of nature has a one-third probability of occurring. When managers as-
sume each state of nature has an equal likelihood of occurring, the decision can be
made by considering the average payoff for each equally possible state of nature.
350
equal probability rule This approach to decision making is often referred to as the equal probability rule.
Decision-making guide To illustrate, the manager of Dura Plastic calculates the average payoff for each
that calls for assuming
each state of nature is
decision as follows:
equally likely to occur, $0.33 million [ = (5 +(-1) + (-3))/3] for expanding plant size.
computing the average
payoff for each equally $1.83 million [ = (3 + 2 + 0.5)/3] for maintaining plant size.
likely possible state of $1.25 million [ = (2 + 1 + 0.75)/3] for reducing plant size.
nature, and choosing the
decision with the highest Under the equal probability rule, the manager's decision is to maintain the current
average payoff. plant capacity since this decision has the maximum average return.
The four decision rules discussed here do not exhaust the possibilities for man-
agers making decisions under uncertainty. We present these four rules primarily
to give you a feel for decision making under uncertainty and to show the impre-
cise or "unscientific" nature of these rules. Recall that management could choose
any of the courses of action depending upon which rule was chosen. These and
Now tryTechnical other rules are meant only to be guidelines to decision making and are not substi-
Problem 9. tutes for the experience and intuition of management.
15.6 SUMMARY
■ Decision making under conditions of risk or uncer- decision were to be repeated a large number of times.
tainty occur when a manager must make a decision The variance of a probability distribution measures the
for which the outcome is not known with certainty. dispersion of the outcomes about the mean or expected
Under conditions of risk, the manager can make a list outcome and is a measure of absolute risk. The higher
of all possible outcomes and assign probabilities to the (lower) the variance, the greater (lower) the risk as-
various outcomes. The process of assigning probabili- sociated with a probability distribution. The standard
ties to outcomes may involve either analysis of data deviation is the square root of the variance. A measure
on past outcomes or, if very little data exist, subjective of relative risk is appropriate when the expected values
probabilities may be used. Uncertainty exists when a of outcomes differ substantially. The coefficient of varia-
decision maker cannot list all possible outcomes and/or tion, which is the ratio of the standard deviation divided
cannot assign probabilities to the various outcomes. by the expected value, is one measure of relative risk
When faced with uncertainty, managers know only associated with a risky decision. (L02)
the different decision options available and the differ- ■ While decision rules do not eliminate the risk sur-
ent possible states of nature. The states of nature are rounding a decision, they do provide a method of sys-
the future events or conditions that can influence the tematically including the risk in the process of decision
final outcome or payoff of a decision but cannot be con- making. Three rules for making decisions under risk
trolled by the manager. (L01) are presented in this chapter: the expected value
■ To measure the risk associated with a decision, manag- rule, the mean-variance rules, and the coefficient of
ers can examine several statistical characteristics of the variation rule. Under the expected value rule, the man-
probability distribution of outcomes for the decision. ager should choose the decision with the highest ex-
The expected value or mean of a probability distribu- pected value. Under the mean-variance rules, choosing
tion is the weighted average of the outcomes, with the between two risky decisions A and B is governed by a
probabilities of each outcome serving as the respective set of three rules: (1) If decision A has a higher expected
weights. The expected value of a distribution does not outcome and a lower variance than decision B, deci-
give the actual value of the random outcome, but rather sion A should be made, (2) if both decisions have iden-
indicates the "average" value of the outcomes if the risky tical variances, the decision with the higher expected
351
thank you
the end
see endsem/quiz-4
drive folder
for more
:)
352

Economics ALL

Uploaded by

Copyright:

Available Formats

Economics ALL

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Economics ALL

Uploaded by

Copyright:

Available Formats

eef

IIT (ISM) Dhanbad

Course: B.Tech 1st Year (Common)

Brought to you by: Drive Uploaders Note:-

• Scarcity forces households and economies to

Are the reserves sufficient to meet current demand? Is there

• Oil reserves increase at rate of X% and oil demand

Is oil a scarce resource now? Alternative use?

• How people decide on:

• More nuanced study:

• Macroeconomics: studies economy as a whole; looks

• Topics studied under macroeconomics:

• Centrally Planned Economy

• Mixed Economy – mixture of market+ controlled

■ Level of involvement of government in economic activities

• Example of market failure: Public good

Prominent examples USA. Japan Cuba, Former Soviet Union,

Market Economy Planned Economy

Market Economy Planned Economy

• Government plays important role in:

• Degree of government’s involvement decided by

• Marginal analysis: Comparing marginal

Whether to study six hours or seven hours for EEF?

Whether to ride the big roller coaster again?

Whether to bake 21 instead of 20 loaves of bread?

Number of Units Revenues from Sale Cost of Production Net Benefits

If each security guard is paid $200 a week and the cost of a

MB – MC most optimal at 2 guards

Ten Principles of Economics

HOW PEOPLE MAKE DECISIONS

PRINCIPLE 1: PEOPLE FACE Th.ADE-OFFS

Economics is the study of the allocation of scarce resources.

Microeconomic issues Macroeconomic issues

How much will a consumer How much income will a

How much leisure time will What is the appropriate exchange

FI GURE 1 . 3 Macroeconomic Issues and Microeconomic Issues. Macroeconomics focuses on aggregate

1.3 The Difference between Macro and Microeconomics

Microeconomics tends to focus on variables that an individual or firm can influ-

1. MARKET ECONOMY in comparison to 2. PLANNED ECONOMY

Role of government Role of government

THE ROLE OF GOVERNMENT IN A MARKET (MIXED) ECONOMY

INSIDE BUSINESS 1-3

Joining the Jet Set

Use Marginal Analysis

MNB( Q) = MB( Q) - MC( Q)

Inspection of Table 1-1 reveals a remarkable pattern in the columns. Notice

....... Households able to afford better material comforts

Better infrastructure is available for all

Incomes derived from industry than agriculture

• Measurable indicator: Gross Domestic Product (GDP)

_~- Consumpt·o,n penditure

• Consumption exp: $ spend on goods and services

Circular Flow of Income

GDP = (Number of Computers * Price) + GDP = (Number of Labourers * Wages) + (Acres

• Problem: Includes growth in both prices and volume

• Use of base year for calculating real GDP

Norway 82.3 17.9 68,012 9 1

Norway 82.3 17.9 68,012 9 1

United States 79.5 13.4 54,941 10 13

Norway 82.3 17.9 68,012 9 1