oNOM, “fe noes} POL ,COH PART YER ( ACCORDING 10 THE NEW PATTERN )Chapter-1- INTRODUCTION TO ECNOMICS Definition Of Economic By Different Economists: In the words of Adam Smith: "Economics is a science of wealth” Walter defined economics as: "Economics is that body of knowledge which related to wealth.” In the words of Mills: "Economics is the science of wealth in relation to mass*. In short, the classical school of thought emphasized purely wealth. So we can say that, “Economics studies the production, consumption, exchange and distribution of wealth.” Robbins Definition of Economics ~ Prof. Lionel Robbins gave his definition of economics in his book “Nature and signifi- cance of Economic Science” in the year 1932 .He defined economics as, “Economics is the science that studies human behavior as a relationship between ends and scarce means which have alternative uses.” Robbins definition is based on: 1. Multiplicity of wants. 2. Scarcity of means In other words, Robbins definition says that: 1, The ends are unlimited, 2. The means to achieve those ends are limited, and 3. The means are capable of alternative uses. la ae ee ol BT hens mak owChapter 1\- INTRODUCTION TO ECNOMICS ATTRIBUTES OF THE DEFINITION Followings are some of the attributes of Robbins definition: Multiplicity of Ends: As a matter of fact, never come to an end. They are always unlimited. As soon as one want is satisfied, another comes forward. Thus it is the unli- mitedness of a person wants that never stops him from working and keeps him engaged in the work of earning money for the satisfaction of his wants. 2.Scarcity of Means: It refers to the limited resources due to which economic prob- lems arise. But if the resources were unlimited, then consequently there would have no economic problems and all the wants would have been satisfied. But it should be noted that the means are scare with respect to their demand. 3.Selection / Urgency of Wants: It is obvious that some of the wants are more urgent for us as compared to others. Naturally, we go to satisfy our urgent needs/wants first and then the remaining ones. Lf all the wants are same there would be no urgency to fulfill then and hence no economic problem would arise. 4 Alternative Uses: According to the Robbins definition all the scars means are capable} of alternative uses i.e. they can be put to a number of uses e.g. water can be used for drinking as well as for cooking. The main problem arises that where the utilization should be made first. 5,Human Science: Robbins in his definition has broadened the scope of economics. According to him economics is the study of human behavior as a whole both with in and out side the society. It does not restrict the subject matter within specific limits. CRITICISM OF THE DEFINATON Robin's definition also faces criticism from many economists. Some of the criticizing point's areas follow: la ae ee ol BE hens tak ae om oom oo LbChapter 1 - INTRODUCTION TO ECNOMICS 1.Economics as a Positive Science: According to Robins, economics discovers only the facts that give rise to certain problems and does not give suggestions as to how to deal with human behavior that varies from man to man and from time to time. So it is not a physical science, which deals with matter and energy and remains unchanged at any place. Economics is therefore not a physical science. [t discovers causes / efforts and suggestions. 2.Human Touch Missing: In Robbins definition the human touch is entirely missing. It does not take in to account the systematic thinking, human sympathy, imagination and the variety of human life. 3.Abstract and Complex: Robbins has made economics more abstract and complex and hence difficult. This distracts from its utility for the common man. Utilities of econo- » mics lie in being a concrete and realistic study. 4.Macro Concept: Another criticism on Robbins definition is that it ignores the macro aspect. It has ignored the issues like employment, national income from its boundaries. 5.Does not Covers Economics of Growth: The economic growth theory or economic development theory has been overlooked in Robbins definition. Economics of growth explains how an economy grows and the factors, which bring about an increase in nati- onal income and productivity of the economy. Robbins takes the resources as given and discusses only their allocation. MICRO ECONOMICS The word “micro” means a millionth part. When we speak of micro-economics or the micro approach, what we mean is that it is some small or component of the whole eco- homy that we are analyzing. For example, behavior or that of an individual firm or what happened in any particular industry. In micro economics what we study is that price of aparticular product or of a particular factor of production and not the general price level in the country. (Cont...) la adsl ee 2 ol lene etal as om oo owChapter 1\- INTRODUCTION TO ECNOMICS Micro-economics theory studies the behavior of individual decision-making units such as consumer, resources owner and business firms. In micro economics we study following issues. LIndividual consumer's behavior 2.One product's price. 3.One individual consumer's demand and his income. 4.Study of individual firm's location, cost, revenue, and profit. 5.Remuneration of individual factors of productions. MACRO ECONOMICS Macro-economics is concerned with aggregate and averages of the entire economy. Such as national income, aggregate output, total employment, total consumption, saving * and investment, aggregate demand, aggregate supply, general level of prices, etc. In other words, in micro-economics, we study how these aggregates and averages of the economy as a whole are determined and what causes fluctuations in them. Macro-economics deals also with how an economy grows. In other words, it analyses the chief determinants of economics development and various stages and processes of economics growth. This part of economics theory has been largely developed in the las: two-three decades. NEEDS FOR INTEGRATING FOR BOTH MICRO AND MACRO ECONOMICS Or BLENDING MICRO AND MACRO ECONIMICS It may be emphasized that neither of the two approaches outlined above can alone adequately help us in analyzing the working of the economic system. What is true of “the parts may not be true of the whole and what is true of the whole may not apply to the parts. It is very essential therefore to integrate the two approaches. Now to apply the mact‘o-approach to such individuals industries would obviously be wrong; and it would be equally wrong to apply the micro-analysis of these industries of the economic system as a whole, (Cont...) la ae ee ol BE Chen tak ay a ae oo LbChapter 1.- INTRODUCTION TO ECNOMICS What is needed is a proper integration of the macro and micro approaches to such problems. Which have no microelements involved and few micro problems that are with| out micro aspects Q- What are central problems of the economy? How are they solved ina free market economy? Ans-Free Market Economy: Ina free market economy decision-making is decentralized, whereas in controlled economy decision making is centralized. Free market economy is also known as price mechanism. In this economy individual owns the factor of production and decide indivi- dually how to use them. The price system, which is one characteristics of Market eco- “ nomy, is only possible way to organize society. Price Mechanism or price system or free market economy, is an economic system in which relative prices constantly change to reflect changes in supply and demand of different commodities. Problems Of Free Market Economy: 1.What and how much should be produced? 2.How should it be produced? 3.For whom the goods are produced? 4.Determination of money income? *What And How Much Should Be Produced? Ina free market economy or price system, the interaction of demand and supply for each good determined as to what and how much to produce. Lf he highest price that consumers are willing to pay for a commodity is less than the lowest cost at which a good can be produced, then output will be negligible or zero.Chapter 1 - INTRODUCTION TO ECNOMICS *How Should It Be Produced? A firm can use various combinations of labor and capital to produce the same amount of output. In price system, the least cost combination technique is chosen because it max- imizes profit. Firms using this technique will be able to offer for sale their products at a lower price and will make profit. The lower price will induce consumers to shift their demand from the high priced goods to the low priced goods. The inefficient firms will be forced to go out of business and in this way many firms will close their inefficient busi- ness and will induce consumers to shift their demand from the high priced products to the low priced products. *For Whom The Goods Are Produced? | Ina free market system, the choices about what is to be produced are made by the individual firms, but this choice is determined by money incomes in the society. Those people who will have higher income, they would command different commodities than those who have less income. *Determination Of Money Income? When a person is selling his human resources i.e. labor services then his income is based his wages, which he can get in the labor market. If a person owns land and capital then rent of land and interest of his capital will determines his ability to buy consumer products. If his income from interest and rent is less then his demand for goods, then he will have less consumer goods.Chapter 2)\- THEORY OF DEMAND DEMAND: Demand is the power to purchase a product coupled with willingness to pur- chase it. Ifa consumer holds only one of them, demand doest not exist. Explanation: If a poor man wants to purchase a car then it is not demand because he has wishes to purchase but not power. Similarly a rich man could purchase cycle; it is also not a demand, because he has power but not wish. LAW OF DEMAND The law of demand states that; “If other things remain constant, when the price of good increases, its demand decreases and when the price of good decreases its dem- and increases.” In short, there is an inverse or negative relationship between price and the quantity demanded." B Table Showing Law of Demand: Price Per Kg (Wheat) Quantity Demanded 0 Increase Ine Demand s * Decrease 2 + it ® cine se Price Per Kg ° 70 20 50 40 50 Quantity Demanded Of Wheat la ae ee ol BT hens mak ow om onlChapter 2'- THEORY OF DEMAND Explanation: From the above schedule and graph, it is clear that, there is an inverse relationship between price and quantity demanded because whenever prices of wheat are increased, demand of wheat is going to decrease. As we have seen in above graph when price was “1" the demand of wheat was “4- kg" and when price reached at "4" than its demand was "10kg", so demand is going to be decreased when price increases. ASSUMPTION OR LIMITATION OF THE LAW OF DEMAND LIncome Remains Constant:The income of the consumer must remain constant for the law of demand to hold. If there is a change in his income the result may not be in acc- ordance with the Law of demand. e 2.Taste, Habits And Fashion Should Not Change: It is also assumed that taste of the consumer remains unchanged if there is a change in consumer taste along with changes in price the law of demand may not hold. 3.Price Substitute Goods Should Remain Constant: To hold the law of the demand, it is assumed that, the prices of substitute and complements should remains constant. 4.Mo Change In Future Expectation: The consumer's products expectations regarding the future behavior of the market should not change. If the expectations change, the law of demand may not hold. 5,Weather Should Remain Constant: During winter season, utility of woolen clothes goes up; even though they might be very expensive its mean that weather should rem- gins constant to fulfilling the law of demand, 6.Population Growth: If number of consumers is greater, demand for goods and services| will increase and is number of consumer is less in number, demand will decrease, So to hold the law of demand population should remain constant. la ae ee ol BE hens tak ae om oom oo LbChapter 2.- THEORY OF DEMAND EXTENSION AND CONTRACTION OF DEMAND (Change Th Quantity Bemanded) Extension and contraction of demand occurs to change. in the price of the respective. commodities. "Extension" means that there is an increase in the quantity of the good purchased due to a fall in its price. "Contraction" means that there is decrease in demand of the good due to the rise in its price. Price Of Good Quantity Demanded 3 Rs 10Rs 10Rs 5Rs Extension a0 Price w Rcon fraction 7 Quantity Demanded Kg i ay ae tn A ah ht tt ol |Chapter 2\- THEORY OF DEMAND RISE AND FALL IN DEMAND (Change In Demand) When change in demand occurred by other factors than price will be called as rise and fall in demand. Those factors may be change in income, fashion, population, etc. Follo- wing changes are. explained as under: ‘Rise In Demand: When price of any commodity not change, but unity of demand chan- ge, means increases, that will be called as “Rise in demand". Schedule Showing “Rise in Demand”: Price Quantity Demanded Rs. 10 Pa Kg 100Kg Rs. 10 Pa Kg 200Kg Rs. 10 Pa Kg 300Kg Rs. 10 Pa Kg 400 Kg Rs. 10 Pa Kg 300Ke Quantity Demanded Ke la ae ee ol BT hens mak owChapter 2\- THEORY OF DEMAND ‘Fall In Demand: When price of any commodity remain unchanged, but quantity of demand decreases, so this change. in demand is known as fall in demand. Schedule Showing “Fall in Demand”: Price Quantity Demanded Rs. 10Pa Kg 400 Kg Rs. 10Pa Kg 300 Kg Rs. 10 Pa kg 200 Kg Rs. 10 Per kg 100 Kg Rs. 10 Per Kg 30Kg Quantity Demanded KeChapter 2.- THEORY OF DEMAND “Fall In Demand: When price of any commodity remain unchanged, but quantity of demand decreases, so this change in demand is known as fall in demand. Schedule Showing “Fall in Demand": Price Quantity Demanded Re 10 Par Kg 400 Kg Rs. 10 Par Kg 300 Kg Rs. 10 PaKg 200Kg Rs. 10 Pa Kg 100Kg Rs. 10 PaKg 50Kg Price 200 300 Quantity Demanded Kg ee ae el TT lee te imalChapter 2 - THEORY OF DEMAND ELASTICITY OF DEMAND The law of demand state that as the price of a certain good goes up, its quantity demanded decreases with other factors remaining the same. One short coming of this statement is that it does not explain that how much of an increase or decrease in quantity demanded occurs due to a change in price. The elasticity of demand occurs due to a change in price. The elasticity of demand explains the percentage change in quantity demanded in response to change in price. There are various kinds of elasticity of demand: 1 Price elasticity 2, Income elasticity 3. Cross elasticity 4, Substitution elasticity PRICE ELASTICITY OF DEMAND: “Tt is the degree of responsiveness in the quantity demand of product to a change in its price." Price elasticity of demand can be measured with the help of any of the following three methods: ‘Total Outlay method “Percentage method ‘Geometric method “TOTAL OUTLAY METHOD: “In this method, we compare the total outlay of the consumer before and after varia- tion in price.” Here Elasticity of demand is expressed in three ways: ayUnity b)Greater than unity ‘c)Less than unity la ae ee ol BE hens tak ae om oom oo LbChapter 2.- THEORY OF DEMAND a)Elasticity Equal To Unity: If the quantity demanded of a product changes due to a change in price and the total outlay of the consumer remains constant then the elast- icity of demand will be equal to unity. b)Elasticity More Than Unity: If the quantity demanded of a product rises due toa change in price and the total outlay of the consumer increases then the elasticity of demand will be more than unity. c)Elasticity Less Than Unity: If a fall in the price results in the quantity demanded for the product to increase and the total outlay of the consumer to fall, elasticity of demand would be less than unity. “PERCENTAGE METHOD: The previous method gives only a rough measure of ela- sticity of demand. But with the percentage method we are able to be more precise as to how much elastic the demand is: This method is applies in two cases: a)Point elasticity of demand b)Are elasticity of demand a)Point Elasticity Of Demand: When elasticity of demand is measured for a very small change in price. Percentage change in Qty Demand Ed = Percentage change in Price ie. AQ a Ed= x AP Q la ae ee ol BE hens tak ae om oom oo LbChapter 2\- THEORY OF DEMAND b)Are Elasticity OF Demand: When elasticity of demand is to be measured for a signi ficant change in price. Percentage change in Qty Demand Ed= Percentage change in Price Ql-Qo Pl+ Po Ed = * Ql + Qo PI-P “GEOMETRIC METHOD: This method enables us to measure elasticity of demand ~ at any point on the demand curve. In the above diagram we have purposely derived a demand curve at which the tangent (MN) indicates that elasticity o demand =1 at point A. If the point were to be lower then elasticity of demand will be < 1 and if the point were to be any where between MA, then elasticity will be > 1 M o O1 N = w! Demand i ay eae tn A ah Ch tt ol |Chapter 2.- THEORY OF DEMAND INCOME ELASTICTY OD DEMAND. If other things remain constant, elasticity of demand regarding income is the degree of change in the quantity demanded of a product in response to change in income. Formula: Percentage change in Qty Demand a — a, Percentage change in Price AQ y Ed = x AY Q Income elasticity of demand may effect in two ways. Normal Goods: In the case of normal goods, when income increases the quantity deman- ded also increases. Hence, it will result in positive elasticity of demand, “Inferior Goods: In the case of inferior goods, when income increases quantity demanded falls because people will now have the purchasing power to buy better goods. Hence, it will result in negative income elasticity of demand. CROSS ELASTICTY OF DEMAND. Cross elasticity of demand may be defined as: “The degree of responsiveness of demanded for a commodity to change in price of related goods.” These related goods can either be substitute of the said product or there may be complementary to the product concerned, la ae ee ol BE hens tak ae om oom oo LbChapter 3 THEORY OF SUPPLY SUPPLY:"Any commodity which is brought for sale in the market in a certain price, in a certain quantity and for a certain time period, is called SUPPLY“ LAW OF SUPPLY: The law of supply states that: “If other factors remaining constant, when the price of a commodity increases, its quantities supplied increases and when the price of a commodity decreases, its quanti- ty supplied also decreases.” So, there is a positive and direct relationship between price and supply. Qs = f (p). (Supply is the function of Price) Schedule Price (Rs.) Quantity Supplied TRs Ey SRs. 80 12 Rs 120 16 Rs. 160 Explanation: From the above table we know that as, we increased the price out supply| also increased that is when price was "4" it supply was “40" as we increased the price. resulted its supply was also increased when price reached at 16 then the quantity of supply touched at 160. The above graph represents the positive relation between price and supply because both are directly proportional. When the price of a particular com- modity increases, its quantity supply also increase and the curve will move from left to right upward. la ae ee ol BT hens mak owChapter 3 THEORY OF SUPPLY S$ = Supply Curve slop Directly Proportional Price (Rs) 40 80 120 160 Quantity Supplied ASSUMPTION OF THE LAW OF SUPPLY 1,Constant Cost Of Production: For the explanation of the law of supply, the cost of production is assumed to remain constant. If the cost of production sere to fall, the supply would increase even though there is not change in price and the Law of supply does not hold. 2.Constant Price Of Capital Goods: Capital goods are used to produce more goods. Examples of such goods are machinery, agricultural equipment etc. If the prices of capital goods falls, the cost of production would also fall, this will result in an increase in supply, 3.Constant Technology; For example in the agricultural sector, electrical machines have introduced to obtain more output this results in the reduced cost of production as less money is used to pay for labor, hence, price falls where as, with the use of modern equipment, supply increases and thus Las of supply does not hold. le ee ee ol BT hens ak owCHAPTER 4- CONSUMPTION AND CONSUMER BEHAVIOUR UTILTIY “Utility is defined as the satisfaction which is derived from the consumption of some goods or services.” VARIOUS CONCEPTS OF UTILITY ‘Tnitial Utility: Initial utility is the satisfaction which obtains from the consumption of the first unit of commodity. For example when a person consumed first unit of apple then he obtains utility is called initial utility. “Positive Utility: When the level of satisfaction increases unit of commodity that situ- ation of utility is called positive utility. - Zero Utility: When a consumer does not obtain utility from the consumption of com- modity is called zero utility. “Negative Utility: When the consumption of commodity gives harm instead of utility in consumer is called negative utility. *Marginal Utility: It is the amount of added utility obtained from one unit increases in consumption marginal utility means the quantity of satisfaction which is obtained from the consumption of additional unit of commodity. “Total Utility: It is utility which is obtained from the consumption of all units of com- modity. Where marginal utility is zero, total utility will be maximum. LAW OF DIMINISHING MARGINAL UTILITY This law describes a familiar and fundamental tendency of human behavior. "The additional benefit which a person derives from an increase of his stock of a thing diminishes with every increase in the stocks that he already has”. (Cont...) le ee ee ol BT lene mak ow om onlCHAPTER 4- CONSUMPTION AND CONSUMER BEHAVIOUR This law based upon two facts 1. Total wants of a man are unlimited but each single want can be satisfied. As a man gets more and more of a commodity the desire of his want for that good goes on fail- ing. A paint is reached when consumer no longer want any more units of that good. 2. Different goods are not perfect substitutes for each other in the satisfaction of various particular wants. As such marginal utility will decline as the consumer gets ad- ditional units of a specific good. Schedule Showing Law Of Diminishing Marginal Utility: Units Of Apples Total Utility Marginal Utility Consumed 1 10 10 2 18 8 3 24 6 4 28 4 5. 30 2 6 30 0 7 28 2 Explanation of the Law: Suppose a man is very thirsty. He goes to market and buy a glass of sweet water. The glass of water gives him immense pleasure or says first glass of water is great utility for him. If he takes second glass utility is than first one. And if he increases the glass of water will reach at the stage where he feel negative increase or say utility is decl- ined. Simply we say ina given span of time the more use of product the lesser will be the utility. la ae ee ol BE hens tak ae om oom oo LbCHAPTER 4- CONSUMPTION AND CONSUMER BEHAVIOUR Dramatically Representation: Marginal Utilicp Units Of Apples The above graph is negative, because there is an inverse relation between consumption and marginal utility. Assumption of the Law: Assumption of law of diminishing utility are: 1. Rational behavior of consumer 2. Constant marginal utility of money 3. Diminishing marginal utility 4. Utility is additive 5. Consumption to be continuous 6. Suitable quantity of a commodity 7. Characteristics of the consumer does not change 8. No change of fashion, customer, tastes 9. No change in the price of commodity le le ee ol ET lene mak owChapter 5- INDIFFERENCE CURVE INDIFFERENCE CURVE An indifference curve may be defined as: “A graphic representation of different combination of two goods which yield the same evel of satisfaction to the consumer.” Graphical Representation: Combination Commodity x Commodity y A i 7 B 2 4 C 3 2 D 4 1 7 A 6 Fal 3 8 B 4 o o 3 2 c 1 D oo A ae Hh A BT Sa emt em oon llChapter 5- INDIFFERENCE CURVE Tn above example all the four combinations provide same level of satisfaction to cons- umer therefore consumer becomes indifference as to which combination he should choose. This tendency when shown with the help of a graph is known as indifference curve. On one IC whatever may be the point level of satisfaction will be the same. PROPERTIES OF INDIFFERENCE CURVE We note the few properties of indifference curve. LDownward Sloping To The Right Or Negatively Slopped: An indifference curve slopes downwards from left to right. It is because when the consumer decides to have more units of one of the two goods, he will have to reduce the number of units of another good, if he is to remain on the same indifference curve. Looking at the diagram below: an GOOD Y a wo GOOD X la ae ee ol BE hens tak ae om oom oo LbChapter 5- INDIFFERENCE CURVE 2.Two Indifference Curve Never Intersect Each Other The second condition of indifference curve. is that no two such curves will ever cut each other. It can be explained by the diagram: ¥ Apples Q a Il Icz oO Mangoes x In the above diagram C lies on the both indifference curves, which is in turn means that C is equal to both A and B at a time, which represent different level of satisfa- ction. 3. Convex to the origin Convexity means we use more and more of good X and Y less and less of good Y. The. marginal rate of substitution of x for y goods falling. As we see that the marginal rate of substitution (MRS) of many for apples falls while the MRS of mangoes for apples remains constant and MRS of mangoes for apples incr- ease which is not happen in general. le ee ee ol BT lene mak owChapter 5- INDIFFERENCE CURVE Hence it is proved that Indifference Curve is convex to the origin. 0 1 2 2 -d ? GOOD X 4.Higher The Indifference Curve Higher The Level Of Satisfaction: Higher the indifference curve, higher the satisfaction, and lower the indifference curve, lower the satisfaction. g GOOD X a al be oh hee tems ae a oom onsChapter 5- INDIFFERENCE CURVE In the diagram on X-axis goods x and on Y-axis good y is taken. [C1, I€2, C3 is three different ICs. IC1 gives satisfaction, than IC2. In the same way the satisfaction inc- reases as we move on the higher ICs. Consumer's Equilibrium, by Indifference Curve Technique “Consumer's equilibrium refers to the position of deriving maximum satisfaction with his given money income and given prices of goods in the market”. Conditions OF Equilibrium Or Assumptions For Equilibrium Consumer is rational and tries to maximize his satisfaction. “Income of the consumer is fixed and given. » ‘Prices of X and Y are given in the market and consumer cannot change. them. “Units of X and ¥ are same in quantity and are not divisible. Now suppose, *Income of consumer is Rs. 20 “Price of commodity X is Rs. 2.and consumer can purchase max. 10 units of X. “Price of commodity X is Rs. land consumer can purchase max. 20 units of Y. *Consumer budget line is AB. *Consumer spends 10 Rs. On purchasing 5 units of X commodity. *Consumer spends 10 Rs. On purchasing 10 units of Y commodity. *Consumer's equilibrium will be on point Ewhere [C2 touches the budget line AB. ani ah SM htt moChapter 5- INDIFFERENCE CURVE Consumer's equilibrium can be explained by means of the following diagram. 4, S 15) 2 > o E 1d os C3 $ IC2 tl 5 198 1s 20 GOOD X Tn graph, IC-3 provides a higher satisfaction but it is above budget line AB and is be- yond the reach of a consumer. IC-1 is below the budget line AB and is the lowest one, which provides less satisfaction. AC-1 provides more satisfaction. This curve is also tangent on budget line at E, here the consumer will purchase both X and Y goods and will spend all his income and will obtain maximum possible satisfaction and will be in Equilbirum position, MARGIANL RATE OF SUBSTITUTION Marginal rate of Substitution (MRS) shows how much of one commodity is substituted for how much of another MRS is an important tool of indifference curve. As we see that when our consumer has 15 apples and no mangoes he will prepared to forgot 4 apples for 1 mango and yet remain at the same level of satisfaction. In his second combination he will be prepared to accept 4 apples for the loss may be defined as the amount of apples that is scarified for obtaining one mango or it may also| be defined as the amount for the loss of one mango so that he may remain at the same. level of satisfaction. la le ee ol I BE Chen te tak ae a aoe oo LbChapter 5- INDIFFERENCE CURVE In Hick's Word We may define Marginal rate of Substitution of X for ¥ as the quantity of ¥. Which would just compensate the consumer for the loss of the marginal unit of X. It's a common observation that as we come to have more and more of one good, we shall be prepared to foryo less and less of the other. It is simply says that MRS of good X for good Y will falls as we have more of x and less of Y which we see clearly in other combination and get ratios (3 : 1, 2:1,1: 1) LAW OF MARGINAL RATE OF SUBSTITUTION Marginal rate of substitution goes on decreasing therefore it is called *Law of dimin- ishing marginal rate of substitution.” If a person has more unit of good X then he goes ‘on losing interest in X and in latter transaction he will be prepared to give away less units of ¥ for the exchange of X. Hence MRS of X for Y diminishes as the consumer has more of X and less of Y. In the table given below in combination B, consumer is willing to give away 3 Ys for one &, but in transaction C for one more X, he is ready to exchange it with only two Y, whereas in the last transaction, he is ready to exchange for additional X, with only one Y, it means the rate of exchange is continuously diminishing and the only reason is reducing the stock of Y, the importance of Y is now increasing for him and he is not willing to give away or exchange it with same number of commodity X. Combinations xX bg MLR.S Of X for Y A i 7 B 2 4 13 ¢ 3 2 12 D 4 1 11 la ae ee ol BE hens tak ae om oom oo LbChapter 5- INDIFFERENCE CURVE B (1:3) GOOD Y (12) D (1:2) GOOD xX INCOME EFFECT "Income effect may be defined as a measure of the change in the consumer's equilibr- ium and in the quantity of goods purchased, solely due to.a change in his money income; price of goods remaining constant.” An increase in income of a consumer makes him to buy more of X and Y goods provide prices of both of them do not change. In the same way decrease in income causes him to buy less of X and Y. When income of a person increases, prices remaining the same, he purchases more units of X and Y, his satisfaction and welfare increases and vice versa. This situation is called Positive Income Effect. Income Effect for Normal Goods Tn case when both goods are normal, income effect is explained with help of diagram: Income Max. units of | Max. units of Budget Line Equilibrium x ¥ Point 10 10 10 AA 20 20 20 BB 3 5 CC le le ee ol ET lene mak ow on onlChapter 5- INDIFFERENCE CURVE Normal Goods ICC Fncome ConsumptionCurve ce Ave Goupx In the above diagram consumer has initial income level of Rs. 10 and he can purchase. maximum 10 units of X and 10 units ¥ with budget line of AA and equilibrium will be on E where IC2 touches budget line AA. If income is increasing from 10 to 20 equilibrium will move on point El where IC3 touches budget BB. While income decreases from 10 to 5, the consumer equilibrium will move downward on point E2 where [C1 touches bud- get lines CC. Income Effect for Inferior Goods: It is matter of common observation that when.a person's income is low, he is obliged to| use inferior goods for subsistence, but as his income raises gradually, he uses less and less of inferior goods, which are substitute for the superior ones, this the income is negative or unfavorable in case of inferior goods, as illustrated in figure below:Chapter 5- INDIFFERENCE CURVE a & INFERIOR GOOD be soca A 5 oe GOOD "X" SUPERIOR ~ The inferior good is ¥, so that the ICC is inclined towards OX on which units of X are _ measured, showing that income increases, less and less of good Y is being bought. PRICE EFFECT “Price effect may be defined as the measure of a change in the consumer's equilibrium and the resulting change in the price of that commodity only; price of the other comm- odity and money income of the consumer remaining constant.” Explanation: Suppose consumer income = Rs. 10 Price of y per unit = Rs. 1 Price of x per unit = Rs. 2,1,1 POC (Price = Consumption ‘CunveChapter 5- INDIFFERENCE CURVE In this condition consumer equilibrium will be on E where IC2 touches budget line AA. Now we assume that price reduced from Rs 2 to Rs 1 nownew. budget line will be AB consumer's equilibrium will be El where 1C3 touches budget line AB, and if price X increases from Rs. 2 to Rs. 4 the budget line will be AC and consumer's equilibrium will move on E2 where IC1 touches AC budget line. Price consumption curve PCC is obtain by joining all equilibrium points of different curves. SUBSTITUION EFFECT Substitution effect may be defined as a measure of the change in the quantity of goods purchases which is solely due to a change in relative prices, real income of the consumer remaining constant.” Explanation: Income Price X Price Y Budget Line Rs. 10 2 1 AA Rs. 10 1 1 AB In this figure, initial income of consumer is Rs. 10 and price of X=2 and Price of Y=1 and consumer can purchase 5 units of ¥ and 2.5 units of X with equilibrium at £1, When price of X = 1 reduces, the equilibrium of consumer shifted to E2 and the difference between El and E2 is showing the substitution effect. Gi SA GOOD XChapter 5- INDIFFERENCE CURVE Q- Price effect is combination of income effect and substitution effect. Explain and illustrate. Price Effect = Income Effect + Substitution Effect ‘As we known that, when ever prices of good decreases then two effects are incurred on its demand that is income effect and substitution effect. Due to decrease in prices} of good, purchasing power of a consumer increases which is called "INCOME EFFECT". While on the other hand consumer will substitute cheaper good for expensive good, this is called the Substitution Effect. Explanation with The Help Of Diagram: GOODY IC @ GOOD X In the above diagram the basic equilibrium on point El. Where consumer purchases 3 units of X good on budget line “AA”. When prices of X falls then new budget line will be "AB". New equilibrium will be on point E3 and consumer purchasing will be 9 units. In this condition price effect is: Price Effect or Total Effect = x3 - x1 29-3, Price Effect or Total Effect = 6 le le ee ol BT hens mak ow om onlChapter 5- INDIFFERENCE CURVE The Substitution Effect: To determine substitution effect we draw an imaginary budget constraint *CC" which is parallel to AB budget line, and touches to IC1. The consumer will not stay on point EI because X good is cheaper than Y so, consumer will move from El to E2 to purchase more units of good X, this shows the substitution effect. In this case substitution effect will be: x2 - x1 =5-3=2 Income Effect: The change ii ome is due to the change in price of X, which allows a consumer to buy more with in the same budget. Now the equilibrium of a consumer will move from 32 to E3 and consumer increase the purchasing of X good from 5 to 9 as that increase _ in income. So income effect will x3 - x2 =9-5:-4 Price Effect = Substitution Effect + Income Effect 6 2Chapter'6 - Laws Of Return Laws of Return There are three laws of returns known to economists: 1. law of Increasing return 2. Law of Diminishing return 3. Law Of Constant Return Law of Increasing Return: It is defined as: Other things remain the same, if an increase of a variable factor (labor and capital) on fixed factor (land) output will increase. This tendency in production is known as law of increasing returns”. Explanation of Law by Schedule: Variable Factor Total Return (kg) Marginal Return (kg) 1 100 100 2 120 3 140 4 160 6 we} Increasing Return a awe _ a In the above diagram marginal return is measured aA , ‘on y-axis while no. of labor of variable factor on x-axis. Marginal return is increasing from 1 labor to 5th labor. Marginal return curve shows increas- ing return because this curve is upward slopping from left to right. zg Marginal Return 22 ia OP wm Fe Units Of Labor & Capitat iste i ee al TT eee oakChapter 6 - Laws Of Return Law of Constant Return: It is defined as: “Other things remain the same, if an increase of variable factor on fixed factar: output] will increase in the same proportion of every variable factor. Means Marginal Return will remain unchanged". Explanation of Law by Schedule: Variable Factor Total Return (kg) Marginal Return (kg) 1 100. 100, 100 100 100 100 100 230, In the above diagram marginal return is . measured on y-axis while no. of labor of — ha a eh ee variable factor on x-axis. As the no. of Units Of Labor & Capital labors is increased marginal return is increased but in the same proportionate, shows marginal return. ee ae el TT lee te imal om onlExplanation of Law By Schedule: Chapter 6 - Laws Of Return Law of Diminishing Marginal Return Marshall stated the law of diminishing marginal returns in the following words: "An increase in capital and labor applied in the cultivation of land causes in general less than proportionate increase in the amount of produce raised, unless it happens to coincide with an improvement in the art of agriculture". Variable Factor Total Return (kg) Marginal Return (kg) 1 200 200 2 380 180 340 160 680 140 > 800. 120 From the above table we can find out that when the farmer applies first unit of capital * and labor the production is 200 kg. And after that he applies 2nd, 3rd, 4th, and 5th unit similarly. The 2nd column of total return is showing increasing trend as 380,540, 680, and 600 respectively. While 3rd column of marginal return diminishing as the number of labor and capital increased. After applying 3rd unit marginal return is decr- eased again from 180kg to 160kg and so on. Diminishing Rem : Marginat Return 3 Ne In the above diagram marginal return is measured on y-axis while no. of labor of variable factor on x-axis. The downward sloping curve represents the law of diminishing marginal return. ak a Units Of Labor & Capitat i a a aie enChapter 7— PERFECT COMPETITION PERFECT COMPETITION: Perfect competition describes a market structure whose assumptions are extremely strong and highly unlikely to exist in most real-time and real-world markets. The reali- ty is that most markets are imperfectly competitive. Conditions/ Assumptions/ Features/ Characteristics Of Perfect Competition Perfect competition is said to exist when the following conditions are satisfied. -Number Of Sellers And Buyers Is Very Large:The first condition is that there should be operating in market, a large number of sellers and buyers. “Products are homogenous: The second condition ensures that all firms producing goods » which are accepted by consumer or buyers as homogenous or identical. “Perfect Knowledge About Market: Another assumption of Perfect competition is that the purchaser and sellers should be fully aware of the price that are being offered and accepted. *Free Entry Or Exit: The fourth condition of Perfect competition requires that there must be absolute freedom for the entry of exit of the firms, in the long-run. “Mobilizes Of Factor Of Production: Perfect mobility of factor of production is essen- tial in order to enable the firms to adjust their supply to demand. “No Externalities: No externalities arising from production and/ or consumption which lie outside the market. EQUILIBRIUM OF FIRM A firm is in equilibrium position when it is earning maximum money profit by using its maximum capacity. la ae ee ol BE hens tak ae om oom oo LbChapter 7— PERFECT COMPETITION Equilibrium of Firm In Short-Run Under Perfect Competition Short run is a period in which variable factors like labor can be altered while fixed fact or can not be changed. In short run two costs exist, that is variable and fixed cost. A firm faces three different types of situations in short-run under perfect competition, SUPER NORMAL PROFIT/ ABNORMAL PROFIT: In the condition of super normal profit average total cost ATC is lower than the market prices and the gap between ATC and market price represent profit area. Super normal profit can be explained with the help of diagram. Me arc Pp £ MR =AR = Price | SS a 2 Cast / Revenite @| ouput In the above diagram x-axis represent the total output of the firm while revenue and cost are marked on y-axis. We can extract the following from the diagram: “OM — = Output of firm OP = Price per unit received by selling the units. “OT = Cost per unit "OTQM =Total cost *OPEM = Total revenue “Profit = Total revenue - Total cost “Profit = OPEM- OTQM la ae ee ol BT hens mak owChapter 7— PERFECT COMPETITION Profit Area = TPEQ Point "E" showing the equilibrium point where MC cuts marginal revenue and average cost curve. from below. We can say that in this condition (TR > TC) total revenue is greater than total cost. CONDITION OF LOSSES: Under the condition of loss, the average total cost ATC is greater than market price and gap between ATC and market price represents losses. The position of firm's loss can be illustrated with the help of diagram. Mc mn ate 2 ave AR MR=Price = |e s 5 |/—__ a © ¥ & o }—-}__|_ a_i oe Onput M In the above diagram x-axis represent the total output of the firm while revenue and cost are marked on y-axis. We can extract the following from the diagram: “OM — = Output of firm ‘OP __ = Price per unit received by selling the units. ‘OT = Cost per unit *OTQM =Total cost “OPEM = Total revenue. *Profit. = Total cost -Total revenue. “Profit =OTQM- OPEM le ae ee ol BT Chen ee mak owChapter 7— PERFECT COMPETITION Profit Area = PTQE Point “E" showing the equilibrium point where MC cuts marginal revenue and average cost curve from below. We can say that in this condition (TC > TR) total cost is greater than total revenue. NO PROFIT/ NO LOSS OR NORMAL PROFIT In this condition firm gets normal profit or no profit no loss or at break even point. Be- couse firm's total cost is equals to firm's total revenue. We can explain this condition with the help of diagram. mc s 5 é & g S Ontpat Mf In the above diagram x-axis represent the total output of the firm while revenue and cost are marked on y-axis. We can extract the following from the diagram: ‘OM = Output of firm “OP Price per / Cost per unit. ‘OPEM = Total revenue/ Total cost Total cost = Total revenue Or No Profit No Loss Point “E", showing the equilibrium point where marginal cost cuts marginal revenueChapter 7— PERFECT COMPETITION Equilibrium Of Firm In Long-Run Under Perfect Competition Tn long-run all cost are variable. Because in long run firm can change their fixed factors like land and labor. Under perfect competition, long-run equilibrium occurs when economic profits are zero. In an industry with economic losses some firms will exit. As those firms leave, the market price rises. At zero economic profit firm will stop exiting from market. Long run equilibrium of firm can be explained by the following diagram: AR> MR-Price PR Cost Revenne t ¢ BA Output At price PI firm is earning super normal profit. New firms will enter in the market and supply will increase therefore prices will decrease and super normal profit will also come! down, At price P2 firm is earning zero profit or normal profit where its marginal cost (MC) marginal revenue (MR) average cost (AC) are equal. New firms will not enter in the market and existing firms will not leave, At price P3 where price is low, firm is running into losses. Some firms will exit from the market and supply will decrease and price will increase. So in the long run equilibrium occurs when economic profit are zero or where marginal cost equals to marginal revenue and average cost. ani ah SM htt moChapter 7— PERFECT COMPETITION MONOPOLY The single supplier of a good, service or resource that has no close substitute. Mono- poly arises existence of barriers preventing the entry of new firm. EQUILIBRIUM OF FIRM UNDER MONOPOLY A firm is in equilibrium position when it is earning maximum money profit. The condition of equilibrium is: MR = MC Marginal revenue = Marginal cost Short-Run Equilibrium under Monopoly: Tt is generally a wrong concept that monopoly firm in every situation of market earned Super normal profit. Practically a monopoly firm faces three types of situation: *Super Normal Profit (TR > TC) “Normal Profit (TR=TC) Losses (TR« TC) SUPER NORMAL PROFIT/ ABNORMAL PROFIT: In short run the monopoly firm faces the situation of super normal profit which can easily explained by diagram.Chapter 7— PERFECT COMPETITION In diagram on x-axis the quantity produced and on Y axis revenue and cost curves are measured. The AR & MR curve show average and marginal revenue respectively. AC and MC are average and marginal cost curves of a firm respectively. At point E, MR = MC and condition of equilibrium is fulfilling. From equilibrium point E, a perpendicular is drawn which cuts x-axis , and ‘OP = Price per unit ‘OT = Cost per unit *OM = Output of the firm *‘OPSM = Total revenue ‘OTQM = Total cost Total Revenue > Total Cost Super normal profit = TR - TC ‘TPSQ = Profit area BNO PROFIT/ NO LOSS OR NORMAL PROFIT In short run the monopoly firm also faces the normal profit situation which can easily explained by the diagram. r Ata point where firm total revenue is equal to _-“T total cost firm is achieving normal profit. In other L~ words in this &ituafion firm just covering all it's sl lost. 4r Indiagram the distance OM show equilibrium production and MS show average revenue and average cost. Now: “The area of rectangle OPSM = TR = Total Revenue “The area of rectangle OPSM = TC = Total Cost Ni ms ae Because a single rectangle show the total cost and total revenue so, TR= TC la aiid ee 2 ol lees tah as om oe on ow bl Cost / Revenue Mw OutputChapter 7— PERFECT COMPETITION CONDITION OF LOSSES: In short run the monopoly firm faces the situation of losses which can easily explained Cost Revenue Output MR ‘In diagram on x-axis the quantity produced and on Y axis revenue and cost curves are measured. The AR & MR curve show average and marginal revenue respectively. AC and MC are average and marginal cost curves of a firm respectively. At point E, MR = MC and condition of equilibrium is fulfilling. From equilibrium point E, a perpendicular is drawn which cuts x-axis , and “OP = Price per unit *OT = Cost per unit +OM = Output of the firm “OPSM = Total revenue *OTQM = Total cost Total Revenue < Total Cost PTSQ =. Profit area la ae ee ol BT hens mak owChapter 7— PERFECT COMPETITION MONOPOLY The single supplier of a good, service or resource that has no close substitute. Mono- poly arises existence of barriers preventing the entry of new firm. EQUILIBRIUM OF FIRM UNDER MONOPOLY A firm is in equilibrium position when it is earning maximum money profit. The condition of equilibrium is: MR = MC Marginal revenue = Marginal cost Short-Run Equilibrium under Monopoly: Tt is generally a wrong concept that monopoly firm in every situation of market earned Super normal profit. Practically a monopoly firm faces three types of situation: +Super Normal Profit (TR > TC) “Normal Profit (TR=TC) Losses (TR« TC) SUPER NORMAL PROFIT/ ABNORMAL PROFIT: In short run the monopoly firm faces the situation of super normal profit which can easily explained by diagram. aChapter 7— PERFECT COMPETITION CONDITION OF LOSSES: In short run the monopoly firm faces the situation of losses which can easily explained Cost Revenue Output MR ‘In diagram on x-axis the quantity produced and on Y axis revenue and cost curves are measured. The AR & MR curve show average and marginal revenue respectively. AC and MC are average and marginal cost curves of a firm respectively. At point E, MR = MC and condition of equilibrium is fulfilling. From equilibrium point E, a perpendicular is drawn which cuts x-axis , and “OP = Price per unit *OT = Cost per unit +OM = Output of the firm “OPSM = Total revenue *OTQM = Total cost Total Revenue < Total Cost PTSQ =. Profit area la ae ee ol BT hens mak owChapter 8— MONOPOLISTIC COMPETITION “A market type in which a large number of firms compete with one another by making similar but slightly different products”. Equilibrium Of Firm In Short-Run Under Monopolistic Competition Short run is a period in which variable factor like labor can be altered while fixed factor cannot be changes. In short run two costs exist, that is variable and fixed cost. SUPER NORMAL PROFIT/ ABNORMAL PROFIT: In this condition average revenue (AR) or market price is above than average cost (AC). his can be explained by the following diagram. (C ¢ AC | PRON | The AR & MR curve show average and P ™ marginal revenue respectively. AC and MC are average and marginal cost curves of a AR firm respectively. At point E, MR = MC and condition of equ- ilibrium is fulfilling. From equilibrium point E, a perpendicular is drawn which cuts x- axis Output OP= Price per unit OT= Cost per unit OM = Output OPSM = Total revenue OTQM = Total cost Total revenue > Total cost Profit area = TPSQ la vais ee 2 ol ED ilen me tah owChapter 8— MONOPOLISTIC COMPETITION NO PROFIT/ NO LOSS OR NORMAL PROFIT At a point where firm total revenue is equal to total cost firm is achieving normal profi In other words, at this situation firm just covering all its cost. This situation can be explained by the following diagram. " ATO - if / This can be explained by the following diagram: Ss f SX ~ OP= Price per unit and cost per unit OPSM = Total revenue and Total cost Total revenue = Total cost x 5 é & s So the firm is neither getting profits nor lasses or firm is in normal profit. Oo] Output Mt CONDITION OF LOSSES: In this condition average revenue (AR) or market price is less than average cost (AC). This can be explained by the following diagram: we Are [-—~ OP Price per unit OT= Cost per unit OM = Output OPQM = Total revenue OTSM = Total cost Total revenue< Total cost Loss area = PTSQChapter 8- MONOPOLISTIC COMPETITION In the above case, firm is meeting some part of its expenses i.e. Out of total cost of OANK, it is getting OAML only. Tf firm stops its production, in short run, it will loose much because the firm will have to bear all fixed expenses. In short run firm will cont- inue to do business and shall bear some cost, with the hope of better prospects in future. Equilibrium of Firm In Long-Run Under Monopolistic Competition “Profit encourages new firms to enter market. ‘New entries shift the demand curve for existing firms to the left. +Long-run equilibrium occurs when new firms see no further incentive to enter. ‘Firm cannot continue business in losses in the long period of time. » Price = AR AR= is not equal to MR MR= MC (For determination of output this requirement is a must). This can be explained by the following diagram. x OP= Price per unit and cost per unit. OPQM = Total cost and total revenue a Point "E" shows the equilibrium point where marginal cost cuts marginal revenue, Cost Revenue Output ai ah Sh ttc menoise golesChapter 1— National Income National Income: “The national income of country during a given period of time usually one year, signifies the net monetary value of the output, consisting of goods and services produced. Gene- rally speaking it is the aggregate or sum of income of all factors of production of a country." CONCEPTS OF NATIONAL INCOME Following are the various concepts with which national income is looked upon. 1. Gross Domestic Product: (6.D.P): Gross domestic product is defined as: “The total market value of all final goods and services produced with the help of factor _ of production during one year in any country." Mean the output produced within Pakistan by Pakistani's and foreign firms by using country's resources. “Gross” means that depreciation of capital is not subtracted out _ GDP = GNP - Net factor income from abroad 2. Gross National Product (6.N.P): Gross national product is defined as: “The total market value of all final goods and services produced with the help of national] factors of production of any country inside or outside the country during one year." For example profits of Pakistani citizen owned factories/business operating in Dubai, U.K, op Africa when sent to Pakistan will be included in the GNP of Pakistan. GNP = GDP = Net factor income from abroadChapter 1— National Income 3. Net National Product or'National Income At Market Price (N.NLP): NP can be calculated by deducting depreciation on capital during the year. When charges of depreciation are deducted from GNP, we get net national product. It means the market value of all final goods and services after providing depreciation. It is also called National Income at Market Price. NNP = GNP - Depreciation on capital 4. National Income Or National Income At Factor Cost (N.I): National income at factor cost means the sum of all income earned by factors of prod- uction that is land, labor, capital and organization. The difference between national income at factor cost and NNP arises from the fact that indirect taxes and subsidies cause market price of output to be different from the factor incomes resulting from it. National Income = NNP - Indirect Taxes + Subsidies 5. Personal Income (P.I): “National income is that income which is actually received by all individuals living in an economy during a period of one year from all possible resources." Personal income included all income received whether earned or unearned. Tt can be written as: Personal Income = National Income - Social Security Contribution - Cooperate Income Taxes - Undistributed Corporate Profits + Transfer Payments 6. Disposable Personal Income (D.P.I): After a good part of personal income is paid to government in the form of direct tax or personal taxes like income tax, personal property taxes etc., what remains from personal income is called disposable personal income. Disposable Personal Income ='Personal Income =Personal/Direct taxes la ae ee ol BE hens tak ae om oom oo LbChapter 1— National Income MEASUREMENT OF NATIONAL INCOME To calculate or measure national income the following three methods are generally used: 1. Output or Production Method 2. Income Method 3. Expenditure or Outlay Method 1. Net Output Or Production Method: For calculating national income under this method the net output or the production of various commodities is estimated and evaluated at the market prices. For this purpose we take two steps: Firstly we estimate the monetary value of all goods that are produced internally. The production or output of different sections of the economy i.e. agricultural, manufact- * uring, trade, commerce, transport etc is analyzed after deducting the depreciation charges. Secondly: we consider the foreign business transactions that were performed during the financial year. In this regards we only consider the difference between exports and imports. These two aggregate are then summoned up to get the gross domestic product which in turn is deducted from the total revenue earned to arrive at national income. The production method is the most direct method for calculating national income. It's equation can be written as: National Income = Ne epee on Capitals - Indirect Taxes « Exports - Imports PRECATIONS: * Avoid Double Counting: Double counting should be avoided while calculating national income, because if it is done the value of goods will be counted twice. So national income will be overestimated, la ae ee ol BE hens tak ae om oom oo LbChapter 1— National Income * Depreciation Allowance: While calculating national income, depreciation on capitals should be deducted. * Self Used Product: Goods which are used by the person who produce for himself are not included in national income. For example, shoes by cobblers, furniture by carpent- er etc, 2. Income Method: “According to this method national income is definable. as the total of factor warnings (wages, interest, rent, profit) that are the cost of factor of produ- ction of society final goods." Under this method the national income is estimated by summing up income that arrives factor of production provided by the national residents. The rate at which the national factor is distributed among the various factors of production is estimated. This method of calculating national income is quite complex. - Equation wise the method can represent national income as: National Income = Rental Income + Wages + Interest + Profit PRECAUTIONS: * Double Counting Must Be Avoided: Transfer payments like pension, gifts, zakat are not included. Price received from sale of old house is also not included in national income because these payments already calculated in different times. + Illegal Earning: Income through illegal activities should not be included in national income like smuggling or gambling. 3. Expenditure Or Out Lay Method: The expenditure approach is the most popular national output accounting method. It focuses on finding the total output of a nation by finding the total amount of meney spent. This too is acceptable because like income, th total value of all goods is equal to the total amount of money spent on goods. The basic formula for domestic output is to combines all different areas in which money is spent within the region, and then combining them to find the total output. GDP= C+I+G+(X-M) (Cont...)} le ae ee ol BT Chen ee ak ow oo olChapter 1— National Income Where: C = Household consumption expenditure I = Gross private domestic investment G = Government consumption X= Gross exports of goods and services M = Gross imports of goods and services PRECAUTIONS: * Only final expenditure must be taken into account, initial expenditure are not included. + Government's spending on transfer payments (pension, old age benefits etc.) must be excluded. * International transactions must be adjusted, means received from export should be included and payment for import excluded.Chapter 2— DETERMINANTS OF NATIONAL INCOME Consumption Function: Consumption means the amount spend on consumption at a given level of income, but consumption function or propensity to consume (P.C) means the whole of the schedule showing consumption expenditure at various levels of national income. This shows how consumption varies with the variation in income. It is a functional relationship between total consumption and national income. AVERAGE PROPENSITY TO CONSUME (A.P.C): Average propensity to consume means consumption divided by the disposable income. It is arelationship between total consumption and total income. If income is Rs.100 and out of it Rs.80 are consumed then APC will be as under: A.P.C = Total Consumption Total Income Rs. 80 =0.8 or 80% Rs. 100 MARGINAL PROPENSITY TO CONSUME (M.P.C): Marginal propensity to consume is the ratio of the change in consumption due to change in income. It measures the incremental change in consumption as a result of a given increment in income. If income increases from Rs.100 to Rs.200 and consumption from Rs.80 to Rs.150 then MPC will be:Chapter 2— DETERMINANTS OF NATIONAL INCOME Income (1) | Consumption | APC=CY MPC = © AC/AY 170 170/151 200/200 =1 20/50 = 0.6 =09 23/50=0.5 20/50 = 0.4 200)— — a ee & g CONSUMPTION 300 100 130-200 NATIONAL INCOME ‘In the above schedule we can observe that as income increases consumption also incre: ases but not as equal to income. So we can say that when APC decreases, MPC also de- creases but MPC decreases at a faster rate than APC. 250Chapter 2— DETERMINANTS OF NATIONAL INCOME FACTORS WHICH INFLUENCE CONSUMPTION FUNCTION OR DETERMINANTS OF CONSUMPTION FUNCTION The consumption and saving decision may on the following basis: * Effects of Changes In Expected Future Income: Expected future income is an impo} tant factor affecting consumption and saving decision. For example an individual who is currently not employed but who has a contract of high paying job, will consume more today than another unemployed person. * Wealth: At an individual level, an increase in wealth may raise MPC because less savi - is needed. * Government Policy: By taxation and public spending, the government can influence the| level of consumption. An increase in direct taxation lowers disposable income and there- by reduces the capacity for consumption. * The Rate Of Interest: The cheaper the rate of interest and the greater the availa- bility of credit, the more likely it is that consumption will occur. * Price Expectation: In certain circumstances, when price raises are anticipated, cons- umption might be brought forward. This temporarily raises MPC. * Liquidity Preference: Is people prefer to keep their income liquid form, consumption is reduced correspondingly, * Future Needs: People reduce their present consumption to save resources for old children’s reduction and construction of houses etc. If such needs are more than their present consumption will reduce. la ae ee ol BE hens tak ae om oom oo LbChapter 2— DETERMINANTS OF NATIONAL INCOME SAVING FUNCTION OR PROPENSITY TO SAVE It is the positive relation between household saving and household disposable income. Tt is a function relationship between the total savings and national income. AVERAGE PROPENSITY TO SAVE(A.P.S): Average propensity to save means savings divided by the disposable income. It is rela- tionship between total savings and total income. AP.S= Total Savings Total Income Rs.20 = 02 or 20% Rs.100 MARGINAL PROPENSITY TO SAVE (M.S): This is the ratio of change in saving resulting from a change in income. It is the flip side of the marginal propensity to consume. If income increases from Rs.100 to Rs.200 and saving from Rs.20 to Rs.50 then MPS will be: MPS= ASChapter 2— DETERMINANTS OF NATIONAL INCOME Income (¥) | Consumption | Saving(S) | APS=S'Y MPC = «) as/ay 150 170 -20 -20/150=-1.2 — 200 200 0 2050=04 250 225 2550=0.5 300 245 55; 30/50 =0.6 SAVING & CONSUMPTION so too IS 20020 NATIONAL INCOME a In the above schedule we can observe that as income increases consumption also increases but not as equal to income therefore savings appear. With increase in income APS increases but MPS increases more than MPS. ee ae el TT lee te imalChapter 2— DETERMINANTS OF NATIONAL INCOME FACTORS WHICH INFLUENCE SAVING FUNCTION OR DETERMINANTS OF SAVING FUNCTION * Effects of Changes In Expected Future Income: Anticipation of future income raises the current consumption, so the desired saving will decreases as future income Increases. “Wealth: When wealth is increases some of the extra wealth is consumed which redu- ces the savings. * Government Purchases: When government purchases increases desired national savings falls. Because higher government purchases directly lower the desired national saving. + The Rate Of Interest: Higher interest rates result in greater savings and lower interest rates inclines people to consumer rather than to save. + Liquidity Preference: Is people prefer to keep their income liquid form, saving is increased correspondingly. *Future Needs: If future needs such as old age security, children education, their marriages and construction house etc are more than present savings will be more. la ae ee ol BE hens tak ae om oom oo LbChapter.3 — INVESTMENT INVESTMENT: Investment is the theory of income and employment means an addition to the nation's physical stock of capital like the building of new factors, new machines as well as any addition to the stock of finished goods or the goods in the pipeline of production. Investment includes addition to inventories as well as to fixed capital. KINDS OF INVESTMENT 1. Financial Investment: It is expenditure on the purchase of financial securities such} as stock and shares. Portfolio investment is undertaken by persons, firms and financial institution in the expectation of earning a return in the form of interest of dividends, or an appreciation in the capital value of the securities. 2. Real Investment: Capital expenditure on the purchase of physical assets such as + plant, machinery and equipment, is called real investment. In economic analysis, the term investment related specifically to physical investment. Physical investment creates new assts thereby adding to the country's productive capacity. 3. Autonomous Investment: Investment which is independent of the level of income is called autonomous investment. Such investment does not vary with the level of income. In other words, it is income-in-elastic. National Income Y (Million Investment I, (Million Rs.) Rs.) 30 20 100 20 130 20 200 20 la ae ee ol BE hens tak ae om oom oo LbChapter 3 — INVESTMENT 4, Induced Investment: Investment which varies with the changes in national income is called induced investment. Changes in national income bring about changes in aggregate dem- and which in turn affects the volume of inves- tment. INVESTMENT = Vv 50 «too «1S0 «208 = > bee __ NATIONAL INCOME j_ieaal ae ¥ Million Tavestment I, (Million Rs) 5) 100 10 150 15 200 20 250 25 INVESTMENT 200 : NATIONAL INOME x Mi Be ee al TT 1 lene oa 250Chapter.3 — INVESTMENT FACTORS WHICH INFLUENCE INVESTMENT FUNCTION OR DETERMINANTS OF INVESTMENT FUNCTION * Rate Of Interest: Rate of interest is the cost of production. Higher interest rate reduces profit margin, therefore businessmen do not take interest in investment acti- vities and whereas lower interest rate increases profit margins hence lot of investment is undertaken by the private sector. * Marginal Efficiency Of Capital Or Expected Rate Of Profit: The investment is largely depends on marginal efficiency of capital. If the business expectations are good or if the marginal efficiency of capital is high more investment will be made. * + Technical Progress: Technological progress also affects current level of investment. For example, a new invention may render the capital stock of a firm obsolete and adve- rsely affect its ability to compete. In this case further investment will be made. * Political Stability And Security: Investment is very sensitive. It requires stable political Govt. peace and security. The greater these elements more will be investment and vice versa. MARGINAL EFFICIENCY OF CAPITAL The marginal efficiency of capital is the rate of return on the last unit of capital employed. Investment depends upon rate of interest and MEC, which is also called rate of profit. If the MEC is greater than or at least equal to the rate of interest, then firm will expand the capital stock. la ae ee ol BE hens tak ae om oom oo LbChapter.3 — INVESTMENT Investment MEC Rate of Profit} Rate Of Interest Ox 20% 20% oY OZ 8 : & 8 § 3 x ¥ INVESTMENT When investment increases from OX to OY, prices decreases because more goods are supplied, this reduces the profit margin. The MEC decreases from 20% to 10%. At an interest rate of 20%, only OX investment is worthwhile. A fall in the interest rate to 10% increases the amount to OZ. It means a fall in interest rates will stimulate more investment which in turn will result inja higher level of national income.Chapter 3 — INVESTMENT FACTORS WHICH INFLUENCE MARGINAL EFFICIENCY OF CAPITAL OR PROFIT EXPECTATIONS 1, Rate Of Interest: Rate of interest is most important factor for affecting MEC be-| cause interest is cost of production, if interest rate increases, cost of production in- creases, hence profit margin reduces, therefore investment reduces and vice versa. 2. Non- Economic Factors: Political events such as threat of war, elections and global political rivalries effect business prosperity hence profit margins also changes. 3. Risk Takings: In many cases investment is undertaken on the basis of ad-hoc decis- ions of risky entrepreneurs. In such a situation exact calculations of profit are not possible. | MULTIPLIER: “Income multiplier tells us that a given increase in investment ultimately creates total income, which is many times the initial increase in income resulting from that investm- ent," that is why it is called income multiplier or investment multiplier. Explanation: The multiplier effect denotes that some initial increase or decrease in the rate of investment will bring about more then proportionate increase or decrease in national income. The initial expenditure of one person or institution becomes the income of another person. The second person's expenditure becomes the income of the third person and so on forth. In each round a proportion of additional created income is saved. The saved money leaks from the circular flow of income, failing to get passed on as additional consumption expenditure in the next round. The total savings (which are leakage) equals to the initial increase in spending, hence multiplier process stops and the economy reaches to a new level of equilibrium. FORMULA: 1- MPC la le ee ol BE Chen te tak ae om aoe oo LbChapter.3 — INVESTMENT Schedule showing effect of Multiplier on National Income: Different Levels | Change In Income Change In ‘Change In Savings YRs. ‘Consumption C SRs. Rs. 500 a5 1s 375 281 oF 7 281 zn 70 = 2 iss 158 11 s All Later Figures a5 356 1g 1500 Tatal 2000 300 Here we suppose that MPC of the society is 0.75 or 3 means consumption is 75% of in- come. Then MPS will be 0.25 or 4. » PRINCIPLE OF ACCELERATION When income increases, people spending power increases; their consumption increases and consequently demand for consumer goods increases. In order to meet this enhances demand, investment must increase to raise the productive capacity of the community. So acceleration is a relationship between the induced investment and the rate of change of national income. Acceleration shows the effect of increase in income and thereafter increases in demand for good and services thus putting pressure on investment. Invest- ment will be high when output (income) is growing while there may be low investment when output (income) is falling. Effect Of Multiplier And Acceleration * Suppose change in investment is Rs.500 * Numerical value of K (multiplier) is x4 * Then change in national income (¥) will be — Rs.2000 * Suppose value of acceleration is x5. * Then change in investment (I).will be Rs.10,000: + Then change in national income (¥) will be — Rs.40,000 ani A ah A htt menoChapter 4 — THEORY OF INCOME & EMPLOYMENT Unemployment is the number of adult workers who are not employed and are seeking of jobs. TYPES OF UNEMPLOYMENT: Frictional Unemployment: This is caused by the time individuals spend searching for a suitable job, the time between jobs. For example, having left a job in a certain indus- try, it will take time to find and secure another suitable job. 2.Structural Unemployment: Structural changes in economy cause some workers to become unemployed permanently or for a very long period of time because they cannot find jobs of their particular skills. They cannot find any job that they can do. 3.Seasonal unemployment: Seasonal unemployment comes and goes with seasons of the year in which the demand for particular jobs rises and falls. Summer resort workers usually get jobs in resorts only during the summer season. They are seasonally unemp- loyed in winter. 4,Cyclical Unemployment: When an economy experiences a downturn, or otherwise experiences a fall in AD, Firms will respond with a fall in the demand for labor. This will result in a fall in the average wage level, and a fall in the level of employment. A fall in the level of employment usually lads to a similar rise in unemployment. Alternatively, an economic boom will most likely result in a fall in unemployment levels. This process is known as cyclical unemployment, variations in the levels of unemployment over the economic cycle. AGGREGATE DEMAND Aggregate demand is the sum of the quantities of consumption goods and services de- manded by house halds, investment goods demand by firms, goods and services deman- ded by government and net exports demanded by foreigners. Thus the aggregate dem- and depends on decision made by households, firms, government and foreigners. a ae ee ol BE hone tak ae oe oe oo LbChapter 4 — THEORY OF INCOME & EMPLOYMENT AGGREGATE SUPPLY The total of all goods and services produced in an economy less exports, plus imports. Prior to Keynes it was believed that national income was determined by aggregate supply. Keynes shifted the emphasize on to aggregate demand with supply. Q- When aggregate demand equals aggregate supply, equilibrium level of national income is determined. Prove. Or Q-How equilibrium level of income is determined? In this equilibrium achieved only at full employment level Discuss Or B Q- Explain Keynesian theory of income and employment KEYNES EQUILIBIRUM OF NATIONAL INCOME (Aggregate demand and aggregate supply method) According to Keynes employment is a function of income, greater the level of national income, greater will be volume of employment in economy. This means that every measure, should be adopted to increase level of Y. National income can be increased provided there is greater employment, thus both ¥ and employment are inter-dependent. National income and employment again depend on Aggregate demand and Aggregate supply. There- fore demand as well as supply of goods should be increased. Equilibrium of ¥ and employ- ment is determined at a point where A.D and A.S are equal. Consumption depends upon level of consumers income and their propensity to consumer. A high propensity to consu- mer is good for employment level because higher PC increases demand in economy. Inve- stment activity is very sensitive. Investment depends upon rate of interest and prospec- tive rate of profit. Prospective rate of profit is also called marginal efficiency of capital.Chapter 4 — THEORY OF INCOME & EMPLOYMENT. CHE cH AGGREGATE DEMAND N ¥ z a National Income = Bmployement = Ousput Tn graph investment level is a difference between C and C+I means expenditure on con sumption goods by public and investment expenditure of firms on plant and machinery, construction of building etc. this is total demand for goods and services that is availa- ble at different levels of Y. In the above diagram point M showing the equilibrium of national income (Y) , where aggregate demand (C+ I) equals to aggregate supply AS. Equilibrium at M is called point of Effective Demand, which determines level of income and employment in economy. INFLATIONARY GAP Inflationary gap. means excess of total money spending or-aggregate demand-at the full employment level of real national income (i.e..output of goods and services). As it is not] possible to increase output further, the excess demand causes prices to rise. The real output remains the same but the money value of that output inflates. To counter and to control'this excess spending, government adopts Fiscal Policy as wellas Monetary Policy. ee ae el TT ET ee te imalChapter 4 — THEORY OF INCOME & EMPLOYMENT. Full Real National | Aggregate ‘Sagregate Excess Employment Income Supply Of | Demand For | Demand Or Level Goods & Goods & Inflationary Services Services Gap OA OA aK AW Wk NATIONAL INCOME BUSINESS CYCLES OR TRADE CYCLES Business cycles, trade cycles or business fluctuations are repetitive patterns of an economy activity characterized by alternating periods of expansion and contraction. Trade cycle is the whole course of business activity, which passes through all phases of prosperity and adversity. Economic circumstances change over a long period of time. The periods of business prosperity alternates with the period of adversity. After every boom in the economy there comes slump and depression and this depression changes into prosperity. It is a swing in total national output, income.and employment, lasting for a period of 7 to 10 years, marked by widespread expansion or contraction in most sectors of the economy. Business cycles are not uniform in size or in length. Ae ae el TT ee te takChapter 4 — THEORY OF INCOME & EMPLOYMENT BUSINESS CYCLES OR TRADE CYCLES Business cycles, trade cycles or business fluctuations are repetitive patterns of an economy activity characterized by alternating periods of expansion and contraction. Trade cycle is the whole course of business activity, which passes through all phases of prosperity and adversity. Economic circumstances change over a long period of time] The periods of business prosperity alternates with the period of adversity. After every boom in the economy there comes slump and depression and this depression changes into prosperity. It is a swing in total national output, income and employment, lasting for a period of 7 to 10 years, marked by widespread expansion or contraction in most sectors of the economy. Business cycles are not uniform in size or in length. TIME PERIOD During the second phase of recovery aggregate output and real income rises and em- ployment rate increases. Since the cost of production is low some curious businessmen start their production activity and then slow and gradually economic activity starts improving.Chapter 4 — THEORY OF INCOME & EMPLOYMENT DEFLATIONARY GAP Deflationary gap means excess of total supply or aggregate supply at the full employ- ment level of real national income .As it is not possible to increase output further, the excess supply causes prices to fall. The real output remains the same but the money value of that output depreciates. To counter and to control this excess demand, gove- rnment adopts Fiscal Policy as well as Monetary Policy. Full Real National | Aggregate Aggregate Excess Employment Income Supply Of | Demand For | Demand Or Level Goods & Goods & Inflationary Services Services Gap OA OA AK AW WK NATIONAL INCOME le ae ee ol BT hens mak ow