O2 - Business Economics

Business Economics (Study Text)

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First Edition 2014

Contents developed by a consortium lead by KAPLAN.
Second Edition 2020
Contents updated by the ICMA Pakistan.
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CONTENTS
1 ECONOMIC CONCEPTS 01
2 ORGANISATION 36
DEMAND AND SUPPLY ANALYSIS

3 75
PRICE ELASTICITY OF DEMAND

4 111
5 PRODUCTIONS 152
6 COST BEHAVIOUR 187
7 PROFIT MAXIMIZATION 214

COMPETITION, MARKET EFFECTS AND 255
8 GOVERNMENT MEASURES
9 FUNCTIONS OF THE FINANCIAL SYSTEMS 284
10 DOMESTIC INSTITUTIONS AND MARKETS 340
11 FOREIGN EXCHANGE MARKETS 428

381
12 MACRO ECONOMIC TRADE CYCLES 400
13 MACRO ECONOMIC: THE ROLE OF GOVERNMENT 436
14 INTERNATIONAL CONTEXT 533
15 ANSWERS TO END OF CHAPTER QUESTIONS 587
609

HOW TO USE THE MATERIAL
The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern:
 Detailed learning outcomes. You should assimilate these before beginning

detailed work on the chapter, so that you can appreciate where your studies
are leading.
 Step-by-step topic coverage. This is the heart of each chapter, containing

detailed explanatory text supported where appropriate by worked examples
and exercises. You should work carefully through this section, ensuring that
you understand the material being explained and can tackle the examples and
exercises successfully. Remember that in many cases knowledge is
cumulative; if you fail to digest earlier material thoroughly; you may struggle to
understand later chapters.
 Examples. Most chapters are illustrated by more practical elements, such as

relevant practical examples together with comments and questions designed
to stimulate discussion.
 Self-Test questions. The test of how well you have learned the material is
your ability to tackle standard questions. Make a serious attempt at producing
your own answers, but at this stage don’t be too concerned about attempting
the questions in exam conditions. In particular, it is more important to absorb
the material thoroughly by completing a full solution than to observe the time
limits that would apply in the actual exam.
 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

illusion to think that this provides the same benefits as you would gain from a
serious attempt of your own. However, if you are struggling to get started on a
question you should read the introductory guidance provided at the beginning
of the solution, and then make your own attempt before referring back to the
full solution.

STUDY SKILLS AND REVISION GUIDANCE
Planning
To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need
for each subject you are studying for the Operational Level. Remember that
you need to allow time for revision as well as for initial study of the material.
This book will provide you with proven study techniques. Chapter by chapter it
covers the building blocks of successful learning and examination techniques.
This is the ultimate guide to passing your ICMA Pakistan written by a team of
developers and shows you how to earn all the marks you deserve, and
explains how to avoid the most common pitfalls.
With your study material before you, decide which chapters you are going to
study in each week, and in which week you will devote revision and final
question practice.
Prepare a written schedule summarizing the above and stick to it.
It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole
syllabus.
Tips for effective studying
(1) Aim to find a quiet and undisturbed location for your study, and plan as
far as possible to use the same period of time each day. Getting into a
routine helps to avoid wasting time. Make sure that you have all the
materials you need before you begin so as to minimize interruptions.
(2) Store all your materials in one place, so that you do not waste time
searching for items around your accommodation. If you have to pack
everything away after each study period, keep them in a box or even a
suitcase, which will not be disturbed until the next time.
(3) Limit distractions. To make the most effective use of your study periods
you should be able to apply total concentration, so turn off all
entertainment equipment, set your phones to silent mode and put up
your ‘do not disturb’ sign.

(4) Your timetable will tell you which topic to study. However, before
dividing in and becoming engrossed in the finer points, make sure you
have an overall picture of all the areas that need to be covered by the
end of that session. After an hour, allow yourself a short break and
move away from your study text. With experience, you will learn to
assess the pace you need to work at.
(5) Work carefully through a chapter, note imported points as you go.
When you have covered a suitable amount of material, vary the
pattern by attempting a practice question. When you have finished
your attempt, make notes of any mistakes you make, or any areas that
you failed to cover or covered more briefly.

Business Economics (Study Text) 1
Contents
1. Defining economics
2. Understanding the definition
3. Opportunity cost
4. The nature of profit
5. Rational economic behavior
6. Three basic economic problems
7. Alternative economic systems
8. Economic growth

1. Definition of Economics
Economics is concerned with the creation of wealth and the problems with
scarcity, choice and opportunity cost. Economics has more than one branch
concerned with different phenomena. The more sophisticated the subject
becomes, the greater the number of branches that seem to develop, making it
difficult to provide a simple definition of the economist’s area of interest.
Alfred Marshall, a famous economist, defined economics as ‘the study of man

in the everyday business of life’. This is somewhat vague. Another popular
definition is to describe economics as ‘the study of how society allocates
scarce resources, which have alternative uses, between competing
ends’. This is a version of the definition proposed by Robbins, an influential
English economist in the earlier part of the century. Another way in which
economics often defined is as ‘the study of wealth creation’.
KEY POINT
Economics is concerned with the creation of wealth and the problems with
scarcity, choice and opportunity cost.
2. Understanding the definition
2.1 Resources
By ‘resources’, economists mean all the human, natural and manufactured or
‘manmade’ resources which are at our disposal and which we use to create
wealth
2.2 Wealth and welfare

By ‘wealth’, economists simply mean the goods and services which a nation
creates. This includes consumer goods like cars and food, capital goods like
factories, tools, computers, lorries and roads, and all of the services such as
entertainment, laundries, accounting and legal advice which are available for
consumption. It is to the production of goods and the provision of services that
we devote our resources. We then ‘consume’ these goods and services and
as a result satisfy our material needs and wants.
In many poor countries much of resource allocation is purely concerned with

the satisfaction of basic needs, but in relatively rich economics such as
Britain, Germany or America, a very significant fraction of resources is
devoted to the

production of goods and services which are not absolutely essential i.e.
‘wants’. Economists usually employ the term ‘wants’ to include both.
So, we use resources to produce wealth to consume in order to satisfy wants.
By creating more wealth, and thus satisfying more of our collective wants, the
economic welfare of society will increase. When a nation’s productive
capacity grows over time, it is said to be experiencing economic growth.
2.3 Types of resources

Resources include land, labor, capital and enterprise.
Land
Reward Labor
Rent Reward Capital
Pre-determined Wage Reward Entrepreneur
No risk Pre-determined Interest Reward
No risk Pre-determined Profit
No risk Not predetermined
May be May be
Profit Loss

Land
This includes all of the natural resources that are available for exploitation; for
example, oil, mineral deposits, cotton, wood, water, seeds, sea, wind and
sunlight, i.e. anything provided free by nature which can be employed
productively.
Labor
This includes all forms of human effort, both physical and mental, directed
towards the production of goods and the provision of services, i.e. workers,
lawyers, police officers, waiters, actors, etc.
Capital
Capital includes all manufactured or ‘manmade’ aids to production created by
society, not as an end in themselves, but to improve the quality and quantity
of the goods and services we produce. This includes tools, manufacturing
machinery, warehouses, factories, the road and rail networks, computers, etc.
Economists call this fixed capital. Fixed capital is defined as capital which is
not consumed and does not change form during the process of production.
Another part of the nation’s stock of capital consists of working capital. This
includes partly processed raw materials such as steel, which changes its form
during the production process into, for example, body parts for cars or steel
beams for construction. It is also common practice to include stocks of unsold
goods as part of the working capital of an enterprise.
Note that capital is both a resource and a part of the wealth created by
society.
The entrepreneur – a fourth resource?
An entrepreneur or enterprise is a person or group who will organize

production, taking decisions regarding what to produce, the location of
production and the techniques of production to be employed, in the hope of
making a profit. In a free market or capitalist economic system, production
depends on the willingness of individuals to purchase and organise economic
resources for the purpose of production, motivated by the financial reward.

There is no guarantee that profits will be forthcoming from productive activity.
If not, the entrepreneur must bear the loss. Often, producers must invest
heavily in plant and equipment well before goods and services are sold and
paid for. An automobile manufacturer must spend a great deal of money
equipping itself to produce something it hopes will sell. In this way, the
entrepreneur is vulnerable to uncertainties, risking the possibility that
predicted demand will not materialize. Although many risks, such as accident,
fire and theft can be insured against, the risks borne by the entrepreneur
cannot.
Organisation, managing and risk-bearing are the entrepreneurial functions. In

smaller businesses it is likely that the owners of the enterprise, who bear the
risks and enjoy the rewards, will also run or manage the business. However,
nowadays the functions of the entrepreneur are often shared. Shareholders
bear the risks and the functions of organisation and management are carried
out by professional managers or directors, appointed by the shareholders.
The separation of ownership and control is emphasized by the fact that the
bulk of shares is now held by financial institutions such as pension funds, unit
and investment trusts and insurance companies. Their investment decisions
are made by paid managers, as are the organisational decisions of the
companies in which they invest. Ultimately, however, a significant proportion
of the risk associated with the company’s activities is borne by the individuals
who pay pension contributions, insurance premiums and buy units in unit
trusts, in the hope of higher pensions, profitable endowment returns,
dividends and capital growth. Nevertheless, it would be difficult to say that
these individuals are entrepreneurs in the true sense of the term.
2.4 Factors of production and their rewards

The returns to economic resources are wages, rent, interest and profits.
Resources are also sometimes referred to as factors of production – the
elements or factors used in the process of producing goods and services.
As resources or factors of production are used in the process of wealth

creation, this results in a flow of income payments to the providers of these
factors. These incomes are variously referred to as factor rewards, factor
returns or factor incomes.
KEY POINT
The returns to economic resources are wages, rent, interest and profits/(loss).

The terminologies used to refer to the different incomes which accrue to the
factors are as follows:
Factor Income
Land Rent
Labor Wages / Salaries
Capital Interest (the rate of interest is usually taken
to represent the price of using capital)
Enterprise Profit/(Loss)
2.5 What about ‘money’?

For an economist, money does not qualify as a productive resource, having
no value in itself. The role of money is to act as a means of exchange. The
only value that money has is that it can be used to obtain the wealth which we
produce, using our economic resources of land, labor, capital and enterprise.
Hence money is just a useful device which makes the economic processes of
production, distribution and exchange work more efficiently. In a highly
sophisticated economic system such as our own, people specialize in
thousands of different jobs. We then exchange the ‘fruits of our labors’ and
money is the device we employ to make that exchange.
2.6 The fundamental economic problem
Unlimited/
Multiple wants
Economic
Economic Problem Satisfaction
Activity wants
Scarce Resources

All human societies face a fundamental economic problem. The cumulative total of
all human wants is unlimited but the resources available to satisfy these wants are
strictly limited. Thus, the quantity of goods and services which we can produce to
satisfy our wants is limited. So, relative to our wants, resources are scarce.
Unlimited wants
Psychologists have attempted to explain the unlimited nature of human wants

by differentiating between different levels of wants. In all societies, we have
basic wants which we must satisfy. These are the need for food, clothing and
shelter. Once these basic wants have been satisfied we then attempt to
satisfy another level of wants: comforts, e.g. wanting entertainment, holidays,
a varied diet and a greater choice of clothing. Having achieved satisfaction at
this level, we now move on to another level of wants, namely luxuries, e.g. a
car, a holiday home, etc. This level of wants is never fully satisfied because
once a certain level of luxury wants is satisfied a more sophisticated level is
then desired.
Furthermore, innovation brings new products on to the market and consumers

then want to own these goods. Product modification can also increase wants.
Finally, many wants are of a recurring nature, e.g. food, clothing and holidays.
Having established that human wants are without limit, it then follows that in
order to satisfy wants it would be necessary to have an endless supply of
goods and services available. However, this is not the case because if there
were an endless supply of goods and services, then there would be no need
to economise and all goods would be free, with everybody having as much as
they want.
The reason that there is not an endless supply of goods and services
available is that there is a limited supply of the factors of production or
resources which are required to produce any goods or service. The quantity
of factors available will determine the quantity of goods and services which
can be produced.
The amount of each of the factors of production can be increased over time.
However, at any one time there is a finite quantity of resources available and
therefore there is a limit to the quantity of goods and services which can be
produced.

Scarcity and choice
It can be seen that society has unlimited wants but, because of a scarcity of
the factors of production, there is a scarcity of goods and services available to
satisfy these unlimited wants. It is for this very reason that we must
economise. We cannot satisfy all of our wants, therefore we must choose
which wants to satisfy and which wants will have to remain unsatisfied. We
must allocate our scarce resources between all of the competing ends to
which we would like to devote our available resources.
This concept of choice exists at all levels in our society. The household must
choose between a new set of saucepans or a new kettle. The board of a
manufacturing company must decide upon what products to produce to
maximize company profits. Central government chooses between greater
resource allocation to the health service or improved armed forces.
We have now defined economics as the study of how societies use – scarce
resources, which have alternative uses, to satisfy unlimited wants - how we
decide what quantities of resources should be allocated to all of the
competing end results which we consider desirable or necessary.
MICROECONOMICS AND MACROECONOMICS
There are two branches of economics (a) microeconomics and (b)

macroeconomics Microeconomics focuses on the actions of individual agents
within the economy, like households, workers, and
businesses; Macroeconomics looks at the economy as a whole. It focuses on
broad issues such as growth of production, the number of unemployed
people, the inflationary increase in prices, government deficits, and levels of
exports and imports. Microeconomics and macroeconomics are not separate
subjects, but rather complementary perspectives on the overall subject of the
economy.
MICROECONOMICS
What determines how households and individuals spend their budgets? What
combination of goods and services will best fit their needs and wants, given
the budget they have to spend? How do people decide whether to work, and if
so, whether to work full time or part time? How do people decide how much to
save for the future, or whether they should borrow to spend beyond their
current means?

What determines the products, and how many of each, a firm will produce and
sell? What determines what prices a firm will charge? What determines how a
firm will produce its products? What determines how many workers it will hire?
How will a firm finance its business? When will a firm decide to expand,
downsize, or even close? In the microeconomic part of this book, we will learn
about the theory of consumer behavior and the theory of the firm.
MACROECONOMICS
What determines the level of economic activity in a society? In other words,
what determines how many goods and services a nation actually produces?
What determines how many jobs are available in an economy? What
determines a nation’s standard of living? What causes the economy to speed
up or slow down? What causes firms to hire more workers or to lay workers
off? Finally, what causes the economy to grow over the long term?
An economy’s macroeconomic health can be defined by a number of goals:

growth in the standard of living, low unemployment, and low inflation, to name
the most important. How can macroeconomic policy be used to pursue these
goals? Monetary policy, which involves policies that affect bank lending,
interest rates, and financial capital markets, is conducted by a nation’s central
bank. For the United States, this is the Federal Reserve. Fiscal policy, which
involves government spending and taxes, is determined by a nation’s
legislative body. For the United States, this is the Congress and the executive
branch, which originates the federal budget. These are the main tools the
government has to work with. Americans tend to expect that government can
fix whatever economic problems we encounter, but to what extent is that
expectation realistic? These are just some of the issues that will be explored
in the macroeconomic chapters of this book.
Basic economics school of thoughts

School of economic thought is a group of economic thinkers who share or
shared a common perspective regarding the way economies work. Systematic
economic theory has been developed mainly since the beginning of what is
termed as the modern era which started with the rise of early classical
economists belonging to the mercantilist and physiocrats schools. They were
succeeded by the mainstream classical economists such as Adam Smith,
David Ricardo, JS Mill, Alfred Marshall etc.
Classical Economics

The Classical school, which lasted until 1870 is associated with the 18th
Century Scottish economist Adam Smith, and those British economists that
followed, such as Robert Malthus and David Ricardo. The main idea of the
Classical school was that markets work best when they are left alone because
the price mechanism acts as a powerful ‘invisible hand’ to allocate resources
to where they are best employed as value of every product or service was
determined mainly by scarcity and costs of production. According to them
there is nothing but the smallest role for government as the economy would
always return to the full-employment level of real output through an automatic
self-adjustment mechanism.
New Classical
New classical school of economics emerged during the 1970s and tried to
explain the global macro-economic problems and issues of the period through
reinterpretation of concepts used by the Classical Economists. For example,
Robert Lucas used the concepts of rational behavior and rational expectations
for the 1970s crises.
Modern Economics
The modern definition, attributed to the 20th-century economist, Paul
Samuelson, builds upon the definitions of the past and defines the subject as
a social science. According to Samuelson, “Economics is the study of how
people and society choose, with or without the use of money, to employ
scarce productive resources which could have alternative uses, to produce
various commodities over time and distribute them for consumption now and
in the future among various persons and groups of society.”
3. Opportunity cost
Opportunity cost measures the cost of using resources in terms of forgone

opportunities. It is important to realize at this point that choices involve
sacrifices. If we decide to use our scarce resources in one way, then other
possible alternative uses will have to be forgone. In other words, the real cost
of using resources for one purpose can be measured in terms of
‘opportunities forgone’. Opportunity cost measures the cost of using
resources in terms of foregone opportunities. Hence, if a local authority wants
to build a school and a community center but currently can only afford to build
one or the other, and decides to build the school, we would say that the
opportunity cost of building the school was the community center.

Thus, the opportunity cost of using a resource in a particular way is the benefit
forgone by not using that resource in its next best alternative use.
Looking at the cost of using resources in this way makes sense. The money
cost of resource allocation decisions is really only meaningful once we
consider the alternative uses for that money.
KEY POINT
Opportunity cost measures the cost of using resources in terms of forgone
opportunities.
3.1 The production possibility curve – illustrating opportunity cost
The production possibility curve illustrates the potential output of an economy,

and the opportunity cost of resource allocation decisions.
The production possibility curve or frontier is a useful theoretical device

devised by economists to illustrate the problems of scarcity and choice and
the opportunity cost of society’s decisions.
To understand the idea, we will simplify the economic choices facing a

society. It can produce food or capital goods. With all resources employed,
producing more food can only be achieved by some sacrifice of the production
of machinery, computers and other items of capital. More resources for the
creation of new capital will necessarily involve less food production.
KEY POINT
The production possibility curve illustrates the potential output of an economy,
and the opportunity cost of resource allocation decisions.
We can illustrate the trade-offs facing the nation in a diagram:
Units of capital (000)

.B
20
.A
15
12
15 17 20 Units of food (million)

Figure 1.1

The economy can produce 20,000 units of capital per year if all resources are
allocated to this, or 20 million units of food if all resources are diverted into
food production. Alternatively, and more probably, a combination of both can
be achieved. For example, it can produce 15,000 units of capital and 15
million units of food.
The curve or frontier shows all the maximum possible outputs given the
economy’s existing quantity of resources. It can have any combination of
goods along the line. Point A shows a society which is failing to use all of its
resources to the full, either through inefficiency or unemployment. Point B is
currently unattainable, but might be achieved through economic growth.
The shape of the curve is bowed outwards or concave to the origin. This is
based on the notion that, as society increasingly allocates more resources to
the production of a particular good, the opportunity cost of doing so will
increase.
Suppose the economy illustrated above is currently producing 15,000 units of

capital and 15 million units of food. Raising the output of food to 17 million
units will have an opportunity cost of 3,000 units of capital. However, trying to
raise production of food to 20 million units will involve the sacrifice of a
massive 12,000 units of capital. The basic idea underlying this is that as we
allocate more and more resources to the production of a particular good, the
resources allocated become less and less suitable. To produce more food will
increasingly involve the utilization of land and labor which is less suited to this
kind of production. The same argument is, of course, true in reverse.
3.2 Contrasting opportunity cost and financial cost

Financial accounts do not usually reflect opportunity cost. Consider the
following example.
A business produces accounts for the year ended 31 December 20X4. Its
summarized profit and loss account is:
Rs.
Turnover 100,000
Cost of sales (30,000)
––––––
Gross profit 70,000
Depreciation (5,000)
Other costs (30,000)
––––––
Net profit 35,000

You are given the following information. The depreciation relates to a machine
that cost Rs. 20,000 and is being depreciated over four years, straight line.
The machine is obsolete and has no disposal value. The owner draws no
salary but has been offered Rs. 40,000 to work for a company in a similar
industry.
The profit based on the inclusion of opportunity cost would be as follows:
Rs.
Gross profit (as above) 70,000
Depreciation (Note 1) Nil
Opportunity cost of owner’s time (Note 2) 40,000
Other costs 30,000
––––––
Net profit Nil
––––––
Note 1: The machine has no value and thus costs the business nothing to
use.
Note 2: This is the salary the owner is giving up to run the business (the
opportunity cost of the owner’s enterprise).
It should be clear from the above example that the accountant’s view of cost
and profit are somewhat different to that of the economist. From the economic
viewpoint, it is just worthwhile for the entrepreneur above to continue in
business. Just enough revenue is earned to cover all costs including the
opportunity cost of the entrepreneur (Rs. 40,000).
A business in this position is said to be earning normal profits.
Normal profit is the minimum profit needed to induce an entrepreneur to

remain in his or her current employment or business. It is the opportunity cost
of the services of the entrepreneur.
4. The nature of profit
As stated above, profit is the reward earned by an entrepreneur for bearing

uncertainty. It is unlike rewards to other factors of production in that it
fluctuates more and may be negative. Furthermore, the term ‘profit’ means
different things to an accountant and an economist.

The opportunity costs mentioned so far are fairly easy to quantify, but there is
one which is more difficult. As we have already discussed, when you become
an entrepreneur, you bear risk. The money you earn from your business must
also compensate you for the risk.
KEY POINT
Normal profit is the opportunity cost of enterprise. In economics, the firm
makes supernormal profit by generating revenues which exceed all costs,
including the opportunity cost of the entrepreneur.
4.2 Supernormal profit

Supernormal profit is profit made after all costs of the business, including
normal profit have been taken into account. The possibility of earning
supernormal profit provides a powerful incentive to people to accept the risks
and uncertainties of running their own businesses.
5 Rational economic behavior
Economists base their theories and predictions of human behavior on the

assumption that economic agents, whether it be the individual consumer, the
firm, the local authority or government, make decisions in a rational way.
Individuals try to maximize the satisfaction of their wants through
consumption, the entrepreneur or business tries to maximize the profits it
makes from production, and local and central government try to maximize the
general welfare of their respective populations.
Although it may not always be true to say that we act rationally, most of the
time we do make economic decisions by carefully weighing up or measuring
the costs and benefits of different courses of action. Consumers too will act
mainly in a rational way. When assessing the potential benefits of an
expensive holiday, the consumer will be only too well aware of the opportunity
cost of such a decision. Adjusting your choice to a cheaper holiday because
you feel the opportunity cost is too high, or going ahead with your original
decision because you feel that the benefits merit the extra cost are different,
but equally rational, economic decisions.
6 Three basic economic problems

6.1 What to produce and in what quantities?
The three basic economic problems are deciding what to produce and in what
quantities, how and where to produce it, and how the wealth created will be
shared out.
All societies are faced with a fundamental economic problem: what goods and
services should be produced, and in what quantities, using the scarce
resources at their disposal?
However, having made such decisions, society is faced with a number of

supplementary problems which are equally, and more often, difficult to
resolve.
KEY POINT
The three basic economic problems are deciding what to produce and in what
quantities, how and where to produce it, and how the wealth created will be
shared out.
6.2 How and where to produce what we want?
Societies must make decisions about the technical aspects of production.

That is decided upon the methods of production and combinations of
resources to be used and the locations in which production is to be sited.
There are various criteria for such decisions; the cheapest way is not always
the answer. For example, new government departments may be sited in areas
of high unemployment. Extremely low cost production methods may be
banned because they do not satisfy the standards of safety laid down in
government legislation to protect workers or consumers. In addition, we must
decide how to physically distribute goods and get them to the ultimate
consumer.
6.3 How will the output of goods and services produced be

distributed (shared out) among the population?
Finally, having decided what to produce and how and where to produce, we
must in addition decide how to distribute or share out the output of goods and
services we have produced. This may well be the most insoluble problem of
all. Arguments about the distribution of the nation’s output, in other words, the
distribution of wealth, are a major source of conflict in society.

7. Alternative economic systems
The way in which these problems are solved varies from society to society
depending on the economic system in operation. Whilst there are many
similarities between, for example, Britain, France, West Germany and the
United States, there are also many differences. In the USA, the central
government plays a much smaller part in the provision of health care facilities
than in the United Kingdom. The German government spends more per head
on health than the British government. Basically, the way in which economic
decisions are made depends on the political and moral ideas prevailing within
any given society.
Economic Systems
The free Economic System
The planned
Capitalism The mixed economic System Economic System
Private ownership Co-existence of Socialism

Private and
Public Sector Public / Social
ownership
7.1 The free market economic system

In many countries the system in operation is one whereby individuals, in the
main, have the right to own and control the ‘means of production’ – the
economic resources – and it is not considered immoral to use these resources
for the attainment of private profit. This is achieved by using them to produce
things that other individuals want to buy. Hence private citizens decide how
resources will be used, acting as producers and consumers in the various
markets for goods and services.

An economic system of this kind is called a free enterprise, free market or
capitalist system.
There is no pure example of a free market economy in the world. Later on

we will consider the reasons why the State is likely to intervene to influence
resource allocation.
However, it is useful to begin by asking how, in the absence of government

intervention, the three basic economic problems are likely to be solved.
(1) What to produce?

The answer is that resources would be allocated according to the preferences
of consumers. Left to their own devices and free of State control, individual
citizens would make the major economic decisions about what to produce and
so on, as consumers and producers interacting in the markets for goods and
services.
CONSUMER PRODUCER
(motive – to DEMAND MARKET SUPPLY (motive – to
satisfy wants) make profits)
In addition to the determination of what will be produced and in what

quantities, the interaction of market forces will also result in the determination
of price. Price will depend upon the relative strength of supply and demand
and will fluctuate accordingly, acting as a signal to producers and indicating
the most profitable directions in which to allocate resources. As long as price
is free to fluctuate, we can expect, in theory, that resources will be allocated
exactly according to the wishes of consumers, and any surpluses or
shortages will automatically be eliminated.
We can see the way in which this works by looking at the example below.
Situation
Suppose that the supply of holidays to celebrate the millennium exceeds the
demand of consumers to take such a holiday, at the price being asked by the
travel companies.
Tour operators will be forced to cut the price of these packages.

They will also cut back the supply of millennium breaks and devote more time
and resources to more profitable areas.
Lower prices for a millennium break will encourage more consumers to take
one, and demand will rise.
Gradually, the surplus of holidays will be eliminated.
The market mechanism, then, provides us with an automatic process whereby

consumers’ wants are satisfied as producers seek to meet demands and to
make profits. Any surpluses and shortages are ultimately automatically
eliminated as producers respond to changes in profitability brought about by
changes in market price.
(2) How and where to produce what we want?

In the market economy firms compete with one another for consumers’
attention. As part of the quest to undercut their rivals, they will seek out
production methods and locations which minimize costs. Thus, firms will
constantly try to find ways to cut production costs, for example, taking
advantage of mass production methods or the implementation of new
technology. The location of production will be influenced by factors like
nearness to market, raw materials, and transport networks.
(3) How will the wealth created be distributed (shared out)?

How the nation’s wealth is distributed depends for most people on income. An
individual’s income depends on the relative demand for, and supply of the skill
or quality which the individual possesses. Hence, some earn much more than
others. So, the price mechanism operates in the markets for labor, as it does
in the markets for goods and services; the interaction of demand and supply
determine both the price of a job and the number of people within that
occupation.
This is not, of course, the whole story. Some individuals may enjoy large
shares of the nation’s wealth as a result of inheritance. It does, however,
describe the distribution of wealth for the vast majority of the population who
depend on income from employment or self-employment.
7.2 Advantages and disadvantages of the free market system
Advantages

(i) Consumers’ wants determine what is provided by producers.
Resources will be allocated by suppliers to those goods and services
that consumers are prepared to buy.
This power consumers possess to influence the way in which
resources are used is known as consumer sovereignty.
(ii) By allowing the market mechanism to work without interference, for

example by government, imbalances of supply and demand will be
eliminated through fluctuations in price. Any surpluses or shortages
which occur will eventually automatically disappear.
(iii) Competition between firms in the market economy creates a number of

important benefits for society. Firms will be encouraged to:
(a) be more efficient and find cheaper ways of producing.
(b) charge lower prices to consumers.
(c) produce better and higher quality goods to outdo their
competitors.
(iv) The principle of private ownership leads to a climate of incentive and

hard work, because individuals are free to make profits, in business for
themselves and not the government.
Disadvantages
(i) In the competitive market system, some will make large amounts of
money and others may not. Thus, great inequalities of wealth can occur.
(ii) Producers seeking to make profits produce things which consumers
are willing to pay for. Some consumers may not be able to afford the price
asked in the market since they are poorly paid workers or are
unemployed. In the absence of government intervention they might have
to go without things we take for granted such as healthcare, education or
housing. Healthcare and education are examples of merit goods.
Merit goods are goods (or services) which are meritorious in that their
consumption confers benefits not only upon the consumer, but also upon
the rest of society.
For this reason, many governments take responsibility for ensuring that
basic education and healthcare are available to all, regardless of income.

Merit goods can be encouraged via a mixture of state provision, maximum
price fixing and subsidies to firms to reduce costs.
Furthermore, governments may act to discourage the provision of demerit

goods. These are goods which may have negative repercussions for both
the individual and society. The consumption of certain drugs, excessive
consumption of alcohol and smoking in public are examples. Whilst the
individual’s health may suffer, society bears the additional or external cost
of drug rehabilitation, policing of anti-social behavior and the effects of
passive smoking.
(iii) In a wholly free market system certain goods and services would not
be provided. Profit-seeking producers will only supply goods and services
that can be sold for a price that will yield a profit. Some things cannot be
profitably provided. These are called public goods.
Public goods are goods (or services) which must be provided communally
because their consumption is non-excludable and non-rivalrous.
Examples of public goods are street lighting, defense and the provision of
pavements.
For a profit-orientated firm to provide a good or service, it must be able to

exclude from consumption anyone who is unwilling to pay the price asked.
Clearly, this is simply not possible in the case above. It would be
impossible to patrol the pavements to ensure that people had paid to use
them. If someone chose not to pay a private firm for providing defense
services, they would still be defended along with the rest of the
community.
The other feature of these public goods, which renders them unsuited to
private provision, is that there is no element of rivalry in consumption. At
an art auction, buyers compete to obtain the goods on offer. However,
while one person is using street lighting or is benefiting from defense, the
amount of the good available to others is not reduced.
So, because everybody benefits equally from their provision, there is no

incentive to pay. There is therefore no reward to producers for supplying
these goods unless payment is made compulsory. Thus, government is
forced to intervene to ensure that these goods are adequately provided.

(iv) Competition may give way to monopoly and potential exploitation of
the consumer. If one firm alone controls market supply, it may be able to
price its product well above the cost of producing it. This may involve
restricting output, creating a shortage and driving up price.
In a competitive market system some businesses will prosper but others

will not. Often the assets of those firms which fail are absorbed by the
more successful firms within an industry. The net result of this is that
markets can become less competitive and firms larger, as the survivors
grow via acquisition. The twentieth century saw a fairly consistent trend
towards large firm domination in many sectors of the economy. For
example, in 1909, the 100 largest manufacturers controlled about 16% of
output. By 1990, this had risen to about 42%.
(v) Producers seeking to make profits may not consider the external cost
of their actions. Where producers manufacture chemicals using
techniques that result in environmental pollution, there is a cost to society
in cleaning up the environment. Although chemicals are not necessarily
demerit goods, there is an external cost which society has to bear. Firms
which offend in this way will often be fined or taxed to help cover the cost
and discourage such techniques. Alternatively such products may be
taxed so that the ultimate consumer pays more to make the external costs
internal. Targeting the firm and consumers in this way is an example of
‘the polluter pays’ principle.
Attempts to cut costs and make profits can have negative effects not only
on the environment, but also on the safety of employees and the safety of
the product itself. Automobile manufacturers might not voluntarily
introduce technology to reduce emissions or provide seat belts, and toys
might be less safe in the absence of manufacturing safety codes.
(vi) The notion that a competitive system will benefit consumers is based
on the idea that consumers know what they are buying, and can make
accurate assessments of quality when making purchasing decisions. But
in reality, many consumers are partly or wholly ignorant of products which
they purchase such as wi-fi, cars, personal computers and so on.
(vii) If profits are inadequate then producers may cease to trade, shift
location to other countries or search for new technologies that cut costs,
often at the expense of employment. The competitive nature of the free

market system makes it almost inevitable that there will be some degree of
unemployment from time to time.
7.3 The mixed economic system
The mixed economy, which combines elements of free enterprise and

planning, is the model adopted by most countries.
In view of these difficulties the governments of capitalist countries have been

forced to intervene to influence the allocation of resources. This intervention
takes many forms. For example, in Britain the central authorities ensure
resources are allocated in certain directions: health, education, defense,
postal services and broadcasting. At the same time many goods and services
are provided by private sector businesses pursuing profit.
KEY POINT
The mixed economy which combines elements of free enterprise and planning
is the model adopted by most countries.
This kind of economic system is known as the mixed economy: resource

allocation undertaken partly by the State or public sector, and partly by the
private or non-State sector.
In addition to directly allocating resources to specific ends, the central

authorities will intervene to influence the behavior of the private sector
enterprise in many ways, including the following.
What to produce and in what quantities?
Governments may ban certain forms of production, for example heroin or

cocaine and control the quantity of certain other goods and services like
gaming, public houses and oil exploration, through the selective granting of
licenses.
How and where will production be located?
This is likely to include the imposition of controls on the type of production

techniques employed by firms, to protect employees, consumers and the
environment via, for example, health and safety, environmental pollution and
product safety legislation.
Location decisions might be influenced through financial incentives, such as
tax concessions, grants or low rent premises, designed for example to
encourage private sector firms to set up in areas of unemployment.
Who gets what?
In addition to control of the pay levels of its own public sector workers, the
State will often try to influence private sector wage levels, for example, the
establishment of a minimum wage by the Labor government in the late 1990s.
Government also redistributes income via income taxation, reducing the gap
between higher and lower income earners. Furthermore, the revenue raised is
partly used to provide incomes for the unemployed, via unemployment and
social security benefits.
In addition, the State will sometimes intervene to influence who will produce.
The Office of Fair Trading and the Competition Commission (formerly the
Monopolies and Mergers Commission) exist to ensure that large powerful
monopolistic firms do not use their power to eliminate smaller competitors or
to exploit consumers.
7.4 The planned economic system
The problems of the free market or capitalist economy are largely responsible
for the evolution, in the second half of the twentieth century, of a different kind
of economic system, known as the planned economy.
In this kind of system the State assumes ownership and control of economic
resources and makes decisions about their use on behalf of the population.
Individuals are not free to pursue private profits through the exploitation of
privately owned economic resources. Typically, also, the State attempts to fix
or control the prices of goods and services.
This kind of system is also known as a state controlled command or

collectivist economic system. The best examples of the planned economy in
action are the Soviet Union and China, after the Second World War. However,
the tremendous political and social changes in these countries since the late
1980s have led to dramatic changes in the organisation of these economies,

as the level of planning has diminished and the extent of free enterprise
activity has risen.
In a planned economic system, the major economic decisions are tackled in
the following ways.
What to produce?
Using a hierarchy of planning committees, State planners decide upon

priorities for production and allocate resources accordingly to the various ends
which they desire. Targets are set for each industry to be achieved over some
given time scale. Mainly the setting of targets will be based upon experience –
what had been achieved in the past – but alterations would be made to take
account of changing circumstances such as the availability of extra resources
like new capital.
How and where?
With regard to the technical aspects of production such as the choice of

techniques and resources to be used, many decisions will be part of the day-
to-day running of factories, building sites, farms and so on. In other words,
detailed plans relating to the actual organisation of production will be the
concern of those who actually organise production at a factory, farm or
warehouse level. There will be a factory/works committee or agricultural
cooperative which co-ordinates the efforts of the farming community in a given
area. In practice, individual enterprises play a part in the determination of their
output targets, which will be the result of a negotiation with the ministry
concerned with that particular type of production.
Who gets what?
Although the State effectively controls the distribution of incomes, this does
not mean that individuals earn similar incomes. Different skills are rewarded
differently in the State-controlled economies, and an individual’s income is
dependent upon his contribution, as seen by the State. Nor does this mean
that supply and demand do not influence income. Individuals who possess
skills or qualities which are in short supply will tend to earn more than other
workers with lower degrees of skill.
So, for example, successful musicians, footballers, scientists and medical

practitioners are likely to be better rewarded than others with less skill.

Workers who offer their services to work in hostile environments are likely to
be encouraged via better pay.
7.5 Advantages and disadvantages of the planned economic system
Advantages
(i) The underlying idea of a planned economy is to reduce inequalities of

wealth. Some still earn more than others, but arguably the degree of
inequality is less than would prevail under a market system. The State
can try, by controlling the distribution of incomes, to prevent the serious
inequalities of wealth that characterise capitalism.
(ii) The motivation for the use of resources in a free enterprise system is to
produce goods which yield profit to producers. This can lead to
unemployment in the absence of profitability. Where individual profit is
not the major criterion for the use of resources then, arguably, such
unemployment is less likely.
(iii) Private monopolies, which can exploit consumers, do not exist. Of
course, there is unfortunately no guarantee that publicly owned
monopolies will behave better.
(iv) State control of prices reduces the problem of inflation and can be used
to ensure affordable basic goods for poorer members of society.
Disadvantages
(i) The setting of targets for industries and assessing the amount of
resources to be allocated to them to meet targets, is a very difficult
process and can result in surpluses and shortages, especially of
consumer goods. If the State also tries to fix prices, these imbalances
may be difficult to eliminate.
The USSR operated a five-year plan for many years. However, the
business of setting targets proved to be a most inaccurate exercise.
The history of the Russian plan is characterised by over and under
estimation. Targets were constantly exceeded or not achieved, and
encouraging productivity has been a recurring problem in the command
economies. In addition, even if the targets set were realized, there was
no guarantee that what was produced would be consumed. The reason
for this is that the planning authority attempted to determine production
priorities and to keep close control of prices. In order to avoid the

problem of fluctuating prices, the State attempted to fix them. However
shortages or surpluses which emerge will not automatically be
eliminated through an adjustment in market price.
(ii) Since major plans are made centrally by planning committees involving
large numbers of officials, changing them may prove to be a lengthy
process. There can be a high degree of inflexibility and resistance to
change, once plans have been set in motion. For this reason,
production may fail to respond effectively to the wants of the
population. Allied to price controls, this is likely to contribute to
shortage and surplus conditions in markets.
(iii) Since private ownership of business does not exist, there may be less
incentive for individuals to work hard. The absence of the motivating
influence of profit where workers are employed in State-run
bureaucracies, where payment does not necessarily depend on
success, may stifle enterprise and hard work. Thus, although resources
may be fully employed, they are not necessarily employed efficiently.
(iv) The consumer is ‘relatively’ powerless in determining what is produced.
Of course, consumers still decide whether or not to buy goods, and
may boycott shoddy or poor quality goods. However, the lack of a
competitive mechanism will inevitably lead to reduced choice and
possibly lower quality goods and services.
Moreover, it is highly probable in these circumstances that black

markets will develop, where people can buy goods which are in short
supply by paying very high prices for them.
7.6 Conclusion
No society fits neatly into the category of planned or free market.
On one hand, USA, Canada or UK come relatively close to the

definition of the free enterprise system but at the same time we find a
limited degree of State intervention especially in the provision of basic
health, education and welfare services. On the other hand, in countries
like the former USSR where there was traditionally a strong
commitment to the system of central planning, examples of ‘free
enterprise’ style arrangements for the production of goods and services
had begun to appear well before the eventual collapse of the Soviet
regime at the end of the 1980s. In fact, all countries have systems of

resource allocation which reflect both elements of free enterprise and
central planning. Even in China changes in the organisation of the
economy involving the re-introduction of private exploitation of
resources, and the legal entitlement to pursue private profit, mean it
can no longer be simply labeled as a planned economy. We could
describe virtually every society today as a mixed economy.
The difference between different economic systems then, is the degree

to which the use of resources is planned or alternatively, the degree to
which individuals within society are free to make such decisions on
their own behalf.
8. Economic growth
8.1 Introduction
Economic growth occurs when the productive potential of the economy

grows.
Economic growth is a major issue in economics. It can be defined as

an increase in the productive potential of an economy. We can
illustrate the idea of growth by means of a shift to the right of the
production possibility curve, mentioned earlier.
KEY POINT
Economic growth occurs when the productive potential of the economy
grows.
Using the example in Figure 1.1, economic growth would be

represented by the dotted line in Figure 1.2.
Units of capital (000)

C2
New production possibility curve
C1
Units of food (million)

Figure 1.2 F1 F2
On the basis of the simplifying assumption that there are just two products,
the new production possibility curve shows an increase in the potential output
of both products. It shows an increase in the productive potential or capacity
of the economy.
8.2 Actual and potential output
Of course, although the production possibility curve shows the maximum

output that can be achieved, there is no guarantee that the economy will
manage to achieve this. If resources are unemployed (see point A in Figure
1.1), actual output will be below potential output.
Suppose that the economy is currently experiencing a high level of

unemployment. Due to a rise in demand, the level of production rises and
unemployment begins to fall. But is this better utilization of existing capacity,
leading to a rise in output, to be described as economic growth?
If we use the term economic growth in its purest sense, the answer is no.
Economists normally distinguish between growth of output, occurring as part
of a recovery from a position of under-utilization of resources, and long-term
growth resulting from increases in the productive capacity of the economy. It
is this latter type of increase which is usually referred to as economic growth.
Of course, in practice, it is very difficult to calculate the extent to which a rise
in output should be attributed to improvements in the economy’s productive
capacity as opposed to a fuller utilization of existing capacity. Some estimates
suggest that about 2% of annual growth in the UK is due to increasing
productive capacity.
Use of Graphs and Diagrams

Graphs represent a kind of language. In economics, graphs are used
frequently to explain the laws, theories and other concepts used in
economics. In economics, generally the values used are positive therefore,
first quadrant is used, however if necessary other quadrants are also used.
In mathematics independent variable is measured on x-axis and dependent

variable is measured on y-axis. The same rule is applied in economics while
constructing graphs with the exception of price, which is always treated as an
independent variable in economic laws but is measured on y-axis. Price does

not mean the price of goods only but it also means prices of factors of
production (Rent, Wage, Interest and Profit).
y
Dependent
Variable
Except
(Price)
(Rent)
(Wage)
(Interest)
0 Independent Variable x
Graph for increasing function are upward sloping because the direction of both
variables (independent and dependent) is the same.
0 x
Graph for decreasing function are downward sloping from left to right top to
bottom as the direction of both the variables is opposite.
0 x

Graphs and diagrams as curves
1. All the graphs relation to consumers are convex to origin.
y
decreasing slope
decreasing opportunity cost
0 x
Examples: Demand curve, indifference curve etc.
2. All the graphs and diagrams relating to producers and production are
concave.
0 x
Example: Total product curve, marginal product curve, average product curve
etc.

Summary
• The basic economic problem is how to create and distribute wealth,

with resources that are scarce and have many competing claims on
them.
• In the real world, we see the very different ways in which different
societies have tried to improve welfare and distribute wealth. The
methods range from the highly interventionist command economy to
the free market economy. However, virtually all societies adopt a mixed
economic system with leaning towards planning or the free market,
depending on the prevailing political climate within a particular society.
Self-test questions
Understanding the definition

1 What are the four factors of production? (2.4)
2 What do you call the reward to capital? (2.4)
3 What is the basic economic problem? (2.6)
Opportunity cost
4 What is opportunity cost? (3)
The nature of profit

5 Define normal profit. (4.1)
Alternative economic systems

6 Define a merit good. (7.2)
7 What are the two main characteristics of a public good? (7.2)
8 Give one advantage and one disadvantage of a command economy.
(7.5)

Practice questions
Question 1
In economics, ‘the central economic problem’ means:
A consumers do not have as much money as they would wish
B there will always be a certain level of unemployment
C resources are not always allocated in an optimum way
D output is restricted by the limited availability of resources.
Question 2
Which of the following statements is not true?
A Profit is the reward to the factor of production called enterprise
B In the long run, profit will be the same in all firms that are equally
efficient
C Profit is the reward for risk-bearing
D Normal profit is included in average cost
Question 3
Which one of the following is not a function of profit in a market economy?
A A signal to producers
B A signal to consumers
C The return to entrepreneurship
D A reward for risk-taking

Question 4
Arguments for allocating resources through the market mechanism rather
than through government direction include three of the following. Which one is
the exception?
A It provides a more efficient means of communicating consumer
wants to producers
B It ensures a fairer distribution of income
C It gives more incentive to producers to reduce costs
D It encourages companies to respond to consumer demand
Question 5
Which one of the following best describes the opportunity cost to society of
building a new school?
A The increased taxation to pay for the school
B The money that was spent on building the school
C The other goods that could have been produced with the
resources used to build the school
D The running cost of the school when it is opened
Question 6
In a market economy the price system provides all of the following except
which one?
A An estimation of the value placed on goods by consumers
B A distribution of income according to needs
C Incentives to producers
D A means of allocating resources between different uses

Question 7
In a market economy, the allocation of resources between different productive
activities is determined mainly by the:
A decisions of the government
B wealth of entrepreneurs
C pattern of consumer expenditure
D supply of factors of production.
Question 8
The opportunity cost of constructing a road is:
A the money spent on the construction of the road
B the value of goods and services that could otherwise have been
produced with the resources used to build the road
C the cost of the traffic congestion caused during the construction
of the road
D the value of goods that could have been produced with the labor
employed in the construction of the road.
For the answer to these questions, see the ‘Answer’ section at the end of the
book.
Additional question
Allocation of resources
(a) Explain the meaning and importance of the term ‘the allocation
of resources’.
(b) Describe the mechanisms by which resources are allocated in
mixed economies.
For the answer to this question, see the ‘Answers’ section at the end of the
book.

Contents
1 Introduction
2 Maximizing shareholder wealth
3 Other corporate objectives
4 Objectives of other types of organisation
5 Governance

1 Introduction
1.1 Organisations
Organisations are created to carry out activities that cannot be achieved by

individuals alone. Such activities can be technical, benefiting from economies
of scale and specialization, or they can be social and satisfy human need for
companionship.
There are many definitions of an organisation. A useful one is given by

Watson:
Organisation– Social and technical arrangements resulting from a number of

people being brought together in various relationships in which the actions of
some are planned, monitored and directed by others in the achievement of
certain tasks.
Most definitions broadly follow what is known as the RUGS perspective, that
is they assert an organisation is:
• Rational − consciously designed to employ efficiently various means of
utilizing human, financial and technical resources in order to achieve
the organisation’s end most effectively.
• Unitary − organisational members constitute a recognizable, unified
and discrete body stemming from their mutual dependence in
achieving common tasks.
• Goal seeking − exists to pursue particular aims and objectives that
were given at the outset of its operations or subsequently agreed by
the organisation’s members.
DEFINITION
Organisation– Social and technical arrangements resulting from a number of

people being brought together in various relationships in which the actions of
some are planned, monitored and directed by others in the achievement of
certain tasks.
Every organisation needs to be clear about its goals. As the environment

changes and presents new challenges, organisations need to review and
reassess their goals. Some organisations will discover that their goals are no

longer relevant and they are drifting. Others will find that their goals are clear,
relevant, and effective. Still others will discover that their goals are no longer
even clear and that they have no firm direction. The purpose of developing a
clear set of goals for an organisation is to prevent it from drifting into an
uncertain future.
KEYPOINT
The purpose of developing a clear set of goals for an organisation is to
prevent it from drifting into an uncertain future.
Considerable confusion exists over the use of the terms goals and objectives.
The Oxford English Dictionary includes the following definitions:
• Goal – object of effort or ambition.

• Objective – the point aimed at.
The similarity of these terms causes some writers to use them

interchangeably whilst others refer to them as two specific concepts − one
related to intermediate issues (means) and the other to ultimate purposes
(ends). Unfortunately, there is no consistency as to which term refers to which
concept. We will usually use the terms interchangeably, or else explain
exactly what we mean by them.
1.2 Ownership
Organisations can be classified according to ownership as follows:
(a) The public sector’ – The part of the economy concerned with providing
basic government services and thus controlled by government
organisations.
The composition of the public sector varies by country, but in most
countries the public sector includes such services as the police,
military, public roads, public transit, primary education and healthcare
for the poor.
(b) The private sector’ –The part of a nation's economy that is not
controlled by the government. This sector thus includes businesses,
charities and clubs. Within these will be profit seeking and not-for-profit
organisations.

(c) Mutual organisations’ – these are voluntary not-for-profit associations
formed for the purpose of raising funds by subscriptions of members,
out of which common services can be provided to those members.
Mutual organisations include some building societies, trade unions and some
working-men’s clubs.
1.3 Objectives and stakeholders
It is generally accepted that the primary strategic objective of a commercial

company is the long-term goal of the maximization of the wealth of the
shareholders. However an organisation has many other stakeholders with
both long- and short-term goals:
KEY POINT
The strategic objective of a commercial organization is generally accepted to
be the maximization of shareholder wealth.
• The community at large – laudable, but hardly practical as an

objective for the management of a company. There are also problems
of measurement – what are returns to the community at large? The
goals of the community will be broad but will include such aspects as
legal and social responsibilities, pollution control and employee
welfare.
• Company employees – obviously, many trade unionists would like to

see their members as the residual beneficiaries from any surplus the
company creates. Certainly, there is no measurement problem: returns
= wages or salaries. However, maximizing the returns to employees
does assume that risk finance can be raised purely on the basis of
satisfying the returns to finance providers.
KEY POINT
There are numerous stakeholders in a business, all who may have different,
possibly conflicting, objectives.
• Company managers/directors – such senior employees are in an

ideal position to follow their own aims at the expense of other
stakeholders. Their goals will be both long-term (defending against

takeovers, sales maximization) and short-term (profit margins leading
to increased bonuses).
• Equity investors (ordinary shareholders) – within any economic

system, the equity investors provide the risk finance. In the UK, it is
usually ordinary shareholders, or sometimes the government. There is
a very strong argument for maximizing the wealth of equity investors. In
order to attract funds, the company has to compete with other risk free
investment opportunities, e.g. government securities. The attraction is
the accrual of any surplus to the equity investors. In effect, this is the
risk premium which is essential for the allocation of resources to
relatively risky investments in companies.
DEFINITION
The equity of a company is the issued ordinary share capital plus reserves,
which represent the investment in a company by the ordinary shareholders.
• Customers – satisfaction of customer needs will be achieved through

the provision of value for money products and services.
• Suppliers – suppliers to the organisation will have short-term goals

such as prompt payment terms alongside long-term requirements
including contracts and regular business. The importance of the needs
of suppliers will depend upon both their relative size and the number of
suppliers.
• Finance providers – Providers of loan finance (banks, loan creditors)

will primarily be interested in the ability of the firm to repay the finance
including interest. As a result it will be the firm’s ability to generate cash
both long- and short-term that will be the basis of the goals of these
providers.
• The government – the government will have political and financial

interests in the firm. Politically it will wish to increase exports and
decrease imports whilst monitoring companies via the Competition
Commission. Financially it requires long-term profits to maximize
taxation income.

1.4. The nature of organisations
ORGANISATIONS
WHAT ARE WHY DO WE DIFFERENT

THEY? NEED THEM TYPES
1.5 What is an organisation?
‘Organisations are social arrangements for the controlled performance of

collective goals’. (Buchanan and Huczynski)
The key aspects of this definition are as follows:
(a) ‘Collective goals’ – organisations are defined primarily by their goals. A

school has the main goal of educating pupils and will be organized
differently from a company where the main objective is to make profits.
(b) ‘Social arrangements’ – someone working on his own does not

constitute an organisation. Organisations have structure to enable
people to work together towards the common goals. Larger
organizations tend to have more formal structures in place but even
small organizations will divide up responsibilities between the people
concerned.
(c) ‘Controlled performance’- organizations have systems and procedures

to ensure that goals are achieved. These could vary from ad-hoc
informal reviews to complex weekly gargets and performance review.
For example, a football team can be described as an organisation because:
 It has a number of players who have come together to play a

game.
 The team has an objective (to score more goals than its
opponent).

 To do their job properly, the members have to maintain an
internal systems of control to get the team to work together. In
training they work out tactics so that in play they can rely on the
ball being passed to those who can score goals.
 Each member of the team is part of the organizational structure

and is skilled in a different task; the goalkeeper has more
experience in stopping goals being scored than those in the
forward line of the team.
 In addition, there must be team spirit, so that everyone works

together. Players are encouraged to do their best, both on and
off the field.
Goal comparison between Managers and Shareholders
Stockholders and managers have their own goals for a company. In

an ideal situation, managers' goals will be the same as the goals set
forward by the stockholders via the board of directors. Unfortunately,
this is not always the case. As an owner of a business you need to
acknowledge that the goals set by you and your fellow shareholders
may differ from those of your managers; acknowledging this allows
you to make changes and to bring your goals into alignment.
Managers' Goals
Managers will have specific goals set for them, such as sales levels,
customer satisfaction or increased market share. Additionally,
managers will have their own personal goals. These may include
financial goals, career goals or simply ego-based goals. The goals
that are set for the manager may or may not be in line with the
manager's personal goals.
Stockholders' Goals
 In general, stockholders have one chief goal: increasing the

value of the company. This goal can manifest itself in a variety
of measures, such as stock price, profitability or market share.
Individual stockholders don't set goals, however; they are
ultimately set by the directors chosen by the stockholders. If
you are a majority shareholder in your company, you can
dictate these goals, but otherwise your influence is equal to
your share of ownership.

Issue related to Principal-Agent
 The principal-agent problem can occur when a principal hires

an agent on his behalf. When stockholders hire managers, they
expect them to act as agents for them, attempting to meet the
stockholders' goals. Adding to this is the fact that stockholders
cannot directly supervise their managers, creating information
asymmetry where the stockholders don't know exactly what the
manager is doing or if it is in line with their goals. For example,
a manager may meet his own goals by awarding a contract to
a company that he owns an interest in, instead of the most
qualified company.
 Stockholders should take care to align their own goals with the
goals of their managers. One of the simplest ways to do this is
to pay managers partially in stock, making them stockholders
themselves who have an interest in seeing the company
succeed. Alternatively, stockholders can set specific goals and
provide bonuses for meeting the goals. Additionally,
stockholders can monitor the managers more closely, for
example hiring outside consultants to evaluate the work
performed by managers.
1.6 Classifying organisation by ownership / control

Public sector organisations
The public sector is that part of the economy that is concerned with providing
basic government services and is thus controlled by government
organizations.
The composition of the public sector varies by country, but in most countries
the public sector includes such services as:
 police
 military
 public roads
 public transit
 primary education and
 healthcare for the poor
Private sector organisations

The private sector, comprising non-government organisations, is that part of a
nation’s economy that is not controlled by the government.
e.g. Within these will be profit-seeking and non-for-profit organisations.

The sector thus includes:
 businesses
 charities and
 clubs
1.7 Why do we need organisations?
Organisations enable people to:

 share skill and knowledge
 specialize and
 pool resources
The resulting synergy allows organizations to achieve more than the

individuals could on their own.
As the organisation grows it will reach a size where goals, structures and
control procedures need to be formalized to ensure that objectives are
achieved.
These issues are discussed in further detail below:
e.g. When families set up and run a chain of restaurants, they usually do
not have to consider formalizing the organisation of their business until
they have five restaurants.
After this stage responsibilities have to be clarified and greater

delegation is often required.
1.8 Classifying organisations by profit orientation
Organisations can be classified in many different ways, including the

following:
Profit seeking organisations

Some organizations, such as companies and partnerships, see their main
objective as maximizing the wealth of their owners. Such organizations are
often referred to as ‘profit seeking’.

The objective of wealth maximization is usually expanded into three primary
objectives:
 to continue in existence (survival)

 to maintain growth and development
 to make a profit
Not-for-profit organisations
Other organizations do not see profitability as their main objective. Such not-
for-profit organizations (‘NFPs or NPOs’) are unlikely to have financial
objectives as primary.
Instead they are seeking to satisfy particular needs of their members or the
sectors of society that they have been set up to benefit.
NFPs include the following:
 government departments and agencies (e.g. HM Revenue and

Customs)
 schools
 hospitals
 charities (e.g. Oxfam, Red Cross, Red Crescent, Caritas) and
 clubs
The objectives of NFPs can vary tremendously:
 Hospitals could be said to exist to treat patients.

 Councils often state their ‘mission’ as caring for their
communities.
 A charity may have as its main objective ‘to provide relief to
victims of disasters and help people prevent, prepare for, and
respond to emergencies’.
 Government organizations usually exist to implement
government policy.
One specific category of NFPs is a mutual organisation. Mutual organisations

are voluntary not-for-profit associations formed for the purpose of raising
funds by subscriptions of members, out of which common services can be
provided to those members.
Mutual organizations include:

 some building societies
 trade unions and
2. Maximizing shareholder wealth

2.1 How can shareholder wealth be increased?
At any point in time, shareholder wealth will be represented by the value of

their investment in the company, i.e. the market value of the shares held. An
increase in shareholder wealth, however, can take two forms – an increase in
market value or a cash payment (such as a dividend). It is important,
therefore, to recognize that a shareholder’s return will be made up of these
two elements:
KEY POINT
An increase in shareholder wealth may result from an increase in the market
value of the share or a dividend payment.
 capital growth
 cash return (dividend yield)
The actual return received will depend on the shareholder’s marginal rate of
income tax paid on the dividend and capital gains tax suffered on the capital
gain.
The best measure of returns to equity investors is dividend yield plus capital
growth. Obviously, in making decisions about the future, it is the anticipated
dividend yield and capital growth that becomes important.
KEY POINT
The actual return received will depend on the shareholder’s marginal rate of
income tax and capital gains tax suffered on the capital gain.
2.2 Earnings per share
A frequently used measure of return to shareholders is the earnings per

share, which divides the earnings available to equity shareholders by the
number of equity shares. However, this can be misleading, as it does not
actually measure the income or other change in wealth of the shareholder.
Whilst there is obviously a correlation between accounting earnings and the

ultimate benefits received by the shareholder, they are not synonymous.
As always, cash measures are seen to be of greater relevance in appraisal of
investments as accounting profit-based figures.
DEFINITION
A frequently used measure of return to shareholders is the earnings per
share, which divides the earnings available to equity shareholders over the
number of shares.
2.3 Risk versus return

So far, we have discussed shareholder wealth in terms of return. However, it
is a fundamental concept of financial management that return cannot be
looked at in isolation from risk. In this context, risk refers not simply to the
possibility of losses, but to the likelihood of actual returns varying (i.e. either
way) from expectations. After all, if this was not the case, no-one would put
money on deposit with a bank or building society, which invariably gives a
lower rate of return in the long run than investment in shares.
DEFINITION
Risk is the likelihood of returns varying from expectations.
Shareholders’ wealth is therefore affected by two main factors: the rate of

return earned on the shares, and the risk attached to earning that return. For
a quoted company, expectations about these two factors will play a major part
in determining the market price of the shares.
Market price will not necessarily be increased by increasing the expected rate
of return, if this is achieved by increasing the risk of the company’s
operations. Indeed many risk-averse shareholders may sell such shares,
causing a drop in market value. There is therefore a trade-off between risk
and return.
KEY POINT
Shareholders’ wealth is affected by the rate of return earned on shares and
the risk attached to earning that return.
2.4 Maximizing shareholder value

A rising share price is evidence that shareholder value is being created but
how does management know if a particular project or division is increasing
value or eroding it?

Attempts to measure and increase shareholder value have focused on
incorporating three key issues:
Cash is preferable to profit
Cash flows have a higher correlation with shareholder wealth than profits.
Exceeding the cost of capital
The return, however measured, must be sufficient to cover not just the cost of
debt (for example by exceeding interest payments) but also the cost of equity
(the return required by shareholders).
Managing both long- and short-term perspectives
Investors are increasingly looking at long-term value. When valuing a

company’s shares, the stock market places a value on the company’s future
potential, not only its current profit levels.
Despite the above comments, most firms seek to increase shareholder wealth
in the short-run by trying to improve return on capital employed (ROCE) and
earnings per share (EPS):
• ROCE is a measure of how well the firm uses its assets to generate
profit and is given by:
ROCE = (earnings before interest and tax / capital employed) × 100%
• EPS is simply the profit available to shareholders expressed per share:
EPS = profits after interest and tax/number of shares
There are a number of different approaches to measure and increase

shareholder value in the long run. The main technique that you need to be
aware of at this stage is the use of ‘discounted cash flows’.
2.5 Short-term measures of financial performance

It is quite possible that financial performance of a business in the short run
could be different to its performance in the long run. Thus measures are
needed both of short-run and long-run financial performance.

Two standard measures of short-run performance are:
(1) the rate of return on capital employed;
(2) earnings per share.
Rate of return on capital employed (ROCE)
To assess the financial performance of companies and make comparisons

over time and between companies, some measure of the return to the capital
employed must be made. The standard way of measuring this is by
calculating the productivity of the capital employed by the business; the rate of
return on capital employed.
This compares:
 profits earned before interest and tax are paid; in effect a measure of
the ability of the organisation to generate net income;
 the value of capital employed averaged out between the beginning and
the end of the year.
ROCE is expressed as a percentage and is measured as:
profit beforeinterest and tax

ROCE = x100%
averagecapitalemployed
Another useful measure of the return to shareholders’ capital is: Return on net
assets which is measured as:
operaing profit (beforeinterestand tax)

Return on net assets = x100%
Totalassetsminus currentlaibilities
The higher the figure for ROCE or the return on net assets is, the more
profitable the company is. However, it should be noted that shareholders will
be more interested in profit after interest and tax rather than the operating
profit figure used in ROCE.
Earnings per share (EPS)
Measure of the productivity of capital employed (ROCE) is a measure of the

company’s ability to generate earnings from its capital. However, potential
shareholders are also interested in how much return they will get from
investing in that company. In this case the potential investor would need to

take into account the price they would have to pay to acquire the shares. Thus
in this case, a comparison must be made between:
 earnings per share;

 the market price of shares.
EPS is measured by calculating profits minus tax, interest payments and

payments of dividends on preference shares, and comparing this with the
number of ordinary shares that have been issued.
EPS is expressed as a monetary value and is measured as:
profit after interest, preferenceshare dividendsand tax

EPS = x100%
number of ordinarysharesissued
2.6 Long-term measures of financial performance
In addition to measuring current financial performance, companies also need

to be able to measure longer-term performance, in particular, in relation to
investment. In this case it is important that a business can be sure that returns
to shareholders are at least equal to the cost of acquiring the capital required
to produce a long-term flow of earnings.
In making these sorts of assessment several problems arise:
 establishing the cost of capital to finance the investment project;

 estimating the flow of income derived from the capital investment over
the whole life of the investment;
 valuing the flow of income.
To solve these problems we calculate the present value of future cash flows
by a process of discounting. This was covered in CO3 but a recap is given
here for completeness.
2.7 The concept of discounted cash flows
Decisions should be based on cash flows rather than profits

This is mainly because there is a higher correlation between
shareholder value and cash flow than there is with profits. Furthermore,
profits can be distorted by accounting policies.
Money has a time value

When considering a decision that affects cash flows over the longer
term (here, over one year), managers need to recognize that cash
received in the future is less valuable than the same sum received
now.
Example
As Rs. 1 million receipt anticipated in 5 years’ time is not equal in value

to Rs. 1 million received now.
The reasons for this are as follows:
(a) Inflation – Inflation erodes the purchasing power of the money.

The Rs. 1 million in 5 years’ time will not buy as much as Rs. 1
million today.
(b) Risk – Rs. 1 million today is more certain than the estimated Rs.
1 million in 5 years’ time.
(c) Interest – Rs. 1 million received today could be invested to earn

interest. In 5 years’ it will have grown to more than Rs. 1 million.
Alternatively, the Rs. 1 million received today could be used to
repay a loan or reduce running finance, thus saving interest.
The above factors are usually combined into a ‘cost of capital’ or

‘discount rate’.
(3) Discounting
The main implication of the time value of money is that cash flows at
different times cannot be compared directly. Instead they need to be
converted to their equivalent value at the same time.

The normal convention for this is to ‘discount’ all future cash flows to
give their ‘present value’ at time zero (now). This is achieved by
multiplying each cash flow by an appropriate ‘discount factor’.
Present value = future cash flow x discount factor

For a one-off cash flow at time t = n, the discount factor = 1/(1 + r)n
For a repeating cash flow at times t = 1-n, the “annuity” discount factor
= [1 – 1/(1 + r)n] x 1/r.
For a perpetuity cash flow at times t = 1 - ∞, the discount factor = 1/r
(4) The net present value (NPV) of future cash flows gives the
impact on shareholder value.
For projects, if NPV> 0, then the project should be accepted but

rejected if the NPV< 0.
ABC plc has 1 million shares in issue with a current price of Rs. 20 per share.
The directors are considering a 3 year project with the following (post tax)
cash flows (Rs.)
Timing t=0 t=1 T=2 T=3
Initial investment (100,000)
Sales 90,000 75,000 45,000
Costs (30,000) (25,000) (15,000)
Scrap proceeds 10,000
________ ______ ______ ______
Net cash flow (100,000) 60,000 50,000 40,000
________ ______ ______ ______
The directors have estimated the company cost of capital at 10%.
Required:
(a) Calculate the net present value of the project cash flows.
(b) Advise whether the project should be accepted.
(c) Estimate the impact on the company share price if the project is
accepted.

Solution
(a) NPV
Timing t=0 t=1 T=2 T=3
Net cash flow (100,000) 60,000 50,000 40,000
Discount factors @ 10% (working) 1 0.909 0.826 0.751
Present values (100,000) 54,540 41,300 30,040
Net present value (NPV) Rs. 25,880
Working: discount factors can either be taken from the tables or calculated as:
DF for t=1 is given by 1/(1+0.1) = 1/1.10 = 0.909
DF for t=2 is given by 1/(1+0.1)2 = 1/1.102 = 0.826
DF for t=3 is given by 1/(1+0.1)3 = 1/1.103 = 0.751
(b) The NPV> 0 indicating that the receipts are worth more than the
outflows so overall the project should increase shareholder wealth. If
we have got the estimates correct, then this project should increase
shareholder wealth by Rs.25,880.
(c) The company is currently worth Rs. 2 million. If the project is

undertaken, then the value should rise to Rs.2,025,880 or
approximately Rs.2.03 per share.
Note: Our answer to part (c) makes some major assumptions:
 Management will communicate all details of the project to the

stock market so investors can factor it into their decisions
whether to buy or sell the shares.
 The market believes the directors’ estimates and that the
company can deliver the projected cash flows:
 The stock market is efficient enough to process the information
so that the change in share price fully reflects the NPV.
e.g. The directors of a company are considering a reorganization

that should result in cost savings of Rs.100,000 per annum.
Estimate the likely impact on the value of the company
assuming that the savings continue.
(a) For ten years

(b) Forever
The company has a cost of capital of 15%

Ignore taxation
Solution
Increase in value of company = NPV of savings
(a) PV = 100,000 x 10yr annuity factor @ 15% = 100,000 x 5.019 =

Rs.501,900
(b) PV = 100,000 x perpetuity factor @ 15% = 100,000 x 1/0.15 =
Rs.666,667
2.8 Share values
The concept of discounted cash flows can be used to explain how press
releases and market rumors can affect the share price.
 Suppose the company announces a new project. If the

market believes that the project will deliver a positive NPV,
then the share price should rise.
 Any information that reaches the market that suggests that
future cash flows will be higher than previously forecast
should result in a share price rise.
 If bad news reaches the market then as well as revising
forecast cash flows downwards, investors may reassess the
investment as having higher risk. This will result in a higher
cost of capital and thus future receipts will be less valuable
than previously estimated. The end result is a fall in the share
price.
Many variables will affect the value of shares. These tend to fall into two
groups:
(1) Factors external to the business which may affect a wide range of
shares; the onset of a recession would tend to depress share
values in general as would a rise in interest rates;

(2) Factors internal to the business that might affect the future flow of
profits such as the failure of a new product, an expected decline
in sales or a significant rise in costs.
3. Other corporate objectives
3.1 Managerial objectives and the principal agent problem
We should not forget that the managers of the firm will have their own
objectives which could conflict with those of the shareholders and other
interested parties. This conflict is an example of the principal agent problem.
The principals (the shareholders) have to find ways of ensuring that their
agents (the managers) act in their interests.
For example, managers could be interested in maximizing the sales revenue

of the firm or the number of employees so as to increase their own prestige
and improve their career prospects.
Alternatively they could be interested in maximizing their short-term financial

return by increasing salaries or managerial perks. It is also important to note
that different groups of managers may be following differing objectives.
Marketing management may be interested in maximizing sales revenue,

whilst production managers may be more interested in developing the
technological side of the firm as far as possible.
Although the firm is owned by the shareholders the day-to-day control is in the
hands of the managers (the divorce of ownership and control) and they are in
an ideal position to follow their own objectives at the expense of other parties.
Whilst in theory shareholders can replace the management of a company by
voting out the directors at the AGM, in practice the fragmented nature of
shareholdings makes this unlikely. However, there have been some recent
examples of situations where shareholders have taken a firm position in
relation to management and initiated changes. Specific examples of the
conflicts of interest that might occur between managers and shareholders
include:
KEY POINT
Management is in an ideal position to follow their own objectives at the
expense of other stakeholders.

• Takeovers – target company managers often devote large amounts of
time and money to defend their companies against takeover. However,
research has shown that shareholders in companies that are
successfully taken over often earn large financial returns. On the other
hand managers of companies that are taken over frequently lose their
jobs. This is a common example of the conflict of interest between the
two groups.
• Time horizon – managers know that their performance is usually

judged on their short-term achievements. In contrast, shareholder
wealth is affected by the long-term performance of the firm. Managers
can frequently be observed to be taking a short-term view of the firm
which is in their own best interest but not in that of the shareholders.
• Risk – shareholders appraise risks by looking at the overall risk of their

investment in a wide range of shares. They do not have ‘all their eggs
in one basket’ and can afford a more aggressive attitude toward risk-
taking than managers whose career prospects and short-term financial
remuneration depend on the success of their individual firm.
3.2 Non-financial objectives
The influence of the various parties with interests in the company results in
firms adopting many non-financial objectives, e.g.:
• growth
• diversification
• survival
• maintaining a contented workforce
• becoming research and development leaders
• providing top quality services to customers
• maintaining respect for the environment
KEY POINT
Some non-financial objectives may be viewed as specific to individual parties
whereas others may be seen as straight surrogates for profit.
Some of these objectives may be viewed as specific to individual parties (e.g.

engineering managers may stress research and development) whereas
others may be seen as straight surrogates for profit, and thus shareholder

wealth (e.g. customer service). Finally areas such as respect for the
environment may be societal constraints rather than objectives.
3.3 Conclusions on corporate objectives
In the real world, organisations undoubtedly follow objectives other than the
maximization of shareholder wealth. The return to equity holders will be an
important consideration in financial decisions but it is unlikely to be the only
one.
It is important, however, not to overplay the above conflicts. Most managers

know that, if they let the shareholders down, share prices will fall and this
could result in difficulty in raising further finance, unwanted takeover bids and
the end of managerial careers. Also the increasing concentration of shares in
the hands of institutional investors such as insurance companies and pension
funds means that the divorce of ownership and control is far from complete.
Institutional investors, because of their large shareholdings, hold great
potential power over company management. Actions of institutions,
particularly in times of takeover bids, can determine the future of the firm and
their objectives must be carefully considered by managers.
Furthermore, developments in corporate governance (see section 5 below)

have also reduced the potential for management to pursue their own aims at
shareholders’ expense.
A compromise view of corporate objectives would be that for a listed company

shareholder wealth will be the most important objective but it will be tempered
by the influences and objectives of other parties.
KEY POINT
For a listed company, shareholder wealth will be the most important objective,
but it will be tempered by the influences and objectives of other parties.
3.4 Stakeholders
Stakeholders are “those persons and organizations that have an interest in

the strategy of an organisation”. Stakeholders normally include shareholders,
customers, staff and the local community.
It is important that an organisation understands the needs of the different

stakeholders as they have both an interest in the organisation and may wish
to influence its objectives and strategy. The degree of interest and influence of
different stakeholder groups. Can vary considerably:
 A well organized labor force with a strong trade union will be able to
exercise considerable influence (e.g. through strike action) over
directors’ plans and will be particularly interested in any plans that
relate to jobs, working conditions and the welfare of staff.
 The residents of a small village might have great interest in the plans of
a major supermarket chain to close the local village store but would
have little power to influence the decision.
Stakeholders can be broadly categorized into three groups; internal (e.g.

employees), connected (e.g. shareholders) and external (e.g. government).
3.5 Internal stakeholders
Internal stakeholders are intimately connected to the organisation, and their

objectives are likely to have a strong influence on how it is run.
Internal stakeholders include:
Stakeholder Need / expectation Example
Employees pay, working If workers are to be given
conditions and job more responsibility, they will
security expect increased pay.
Managers/ status, pay, bonus, job If growth is going to occur, the
directors security managers will want increased
profits, leading to increased
bonuses.
3.6 Connected stakeholders
Connected stakeholders can be viewed as having a contractual relationship

with the organisation.
The objective of satisfying shareholders is taken as the prime objective which

the management of the organisation will need to fulfill, however, customer and
financiers objectives must be met if the company is to succeed.

Shareholders steady flow of income, If capital is required for
possible capital growth growth, the shareholders will
and the continuation of expect a rise in the dividend
the business. stream.
Customers satisfaction of customers’ Any attempt to for example
needs will be achieved increase the quality and the
through providing value- price, may lead to customer
for-money products and dissatisfaction.
services.
Suppliers paid promptly If a decision is made to delay
payment to suppliers to ease
cash flow, existing suppliers
may cease supplying goods.
Finance providers ability to repay the finance The firm’s ability to generate
including interest, security cash.
of investment.
3.7 External stakeholders
External stakeholders include the government, local authority etc. This group
will have quite diverse objectives and have varying ability to ensure that the
organisation meets their objectives.

Community at The general public can e.g. local residents’
large be a stakeholder, attitude towards out-of-
especially if their lives town shopping centers.
are affected by an
organisation’s decisions.
Environmental The organisation does If an airport wants to
pressure groups not harm the external build a new runway, the
environment. pressure groups may
stage a ‘sit in’.
Government Company activities are Actions by companies
central to the success of could break the law, or
the economy (providing damage the environment,
jobs and paying taxes). and governments
Legislation (e.g. health therefore control what
and safety) must be met organizations can do.

by the company.
Trade unions Taking an active part in If a department is to be

the decision-making closed the union will want
process. to be consulted, are there
should be a scheme in
place to help employees
find alternative
employment.
3.8 Stakeholder conflict
The needs / expectations of the different stakeholders may conflict. Some of

the typical conflicts are shown below:
Stakeholders Conflict
Employee versus managers Jobs / wages versus bonus (cost efficiency)
Customers versus shareholders Product quality / service levels versus profits
/ dividends
General public versus shareholders Effect on the environment versus profit /
dividends
Managers versus shareholders Growth versus independence
Solving such conflicts will often involve a mixture of compromise and

prioritization.
To aid such decision making may firms will try to assess the degree of interest
on stakeholders and their power / influence to affect the business. For
example, the government may have high power but may be relatively
uninterested in the affairs of a particular company. On the other hand a major
key customer may have both influence and interest and so must be
incorporated in any significant decisions as a “key player”.
With companies the primary objective of maximizing shareholder value should
take preference and so decision making is simplified to some degree.
However, this does not mean that other stakeholders are ignored.

For example:
 If we do not pay employees a fair wage, then quality will suffer,

ultimately depressing profits and shareholder wealthy.
Some firms address this by seeing shareholders wealth generation as their

primary objectives and the needs of other stakeholders as constraints within
which they have to operate:
 We try to increase profit subject to ensuring good working conditions

for employees, not polluting the environment, etc.
This type of decision is particularly difficult as:
 How do you decide which stakeholder group should take preference?

 Most of the factors being considered are very difficult to quantify (e.g.
quality of life) and
 How do you offset different issues measured in different ways (e.g.
how may extra jobs justify the extra congestion and pollution?
Some public sector organizations try to quantify all of the issues financially to
see if the benefits outweigh the costs (cost-benefit analysis).
For example, congestion will delay people, thus adding to journey times. The
value of people’s time can be estimated by looking at the premium they will
pay for quicker methods of transport such as train versus coach.
4. Objectives of other types of organization
4.1 Objectives of small firms
Most of the above discussion of objectives centers on large stock market of

listed companies. Unlisted companies will differ in two major ways.
• Their owners will often be their managers and hence many of the
problems referred to above will not apply.

• As they are not listed on the stock market the value of shareholder
wealth is not directly observable by reference to share prices. It is
not unreasonable to assume, however, that the objective of the
owners would be the maximization of the owners’ wealth
(tempered perhaps by the desire to remain independent) and
therefore the financial management techniques developed for use
by listed companies should be largely applicable to small firms.
The major problem will be appraising how successful past
decisions have been.
KEY POINT
For unlisted companies:
 Their owners will often be their managers and hence many of the
problems referred to above will not apply.
 As they are not listed on the stock market the value of shareholder
wealth is not directly observable by reference to share prices.
4.2 Objectives of not-for-profit organisations
Organisations such as charities and trade unions are not run to make profits,
but to benefit prescribed groups of people. Since the services provided are
limited primarily by the funds available, the key objective is to raise the
maximum possible sum each year (net of fund raising expenses) and to
spend this sum as effectively as possible on the target group (with the
minimum of administration costs).
KEY POINT
Not-for-profit organisations will wish to demonstrate value for money (as
discussed below) in order to convince potential donors that funds given will be
spent wisely on the organisation’s objectives rather than wasted, say, on
administrative costs.
Not-for-profit organisations will wish to demonstrate value for money (as

discussed below) in order to convince potential donors that funds given will be
spent wisely on the organisation’s objectives rather than wasted, say, on
administrative costs.
Not-for-profit organisations are financed by their accumulated funds rather

than by external shareholders (as is the case for companies).

A fund may be of two kinds, a restricted fund or an unrestricted fund.
Restricted funds are subject to specific conditions, imposed by the donor and
binding on the organisation. Unrestricted funds may be used in whatever way
the organisation chooses.
DEFINITION
A fund is a pool of unexpended resources, held and maintained separately
from other pools because of the circumstances in which the resources were
originally received or the way in which they have subsequently been treated.
Not-for-profit organisations will normally set targets for particular aspects of

each accounting period’s finances such as:
• total to be raised in grants and voluntary income

• maximum percentage that fund-raising expenses represents of this
total
• amounts to be spent on specified projects
• maximum permitted administration costs
The actual figures achieved can then be compared with these targets and
control action taken if necessary.
4.3 Financial objectives in public corporations
This category of organisation includes such bodies as nationalized industries

and local government organisations. They represent a significant part of many
countries’ economies and sound financial management is essential if their
affairs are to be conducted efficiently. The major problem here lies in
obtaining a measurable objective.
For a stock market listed company we can take the maximization of

shareholder wealth as a working objective and know that the achievement of
this objective can be monitored with reference to share price and dividend
payments. For a public corporation the situation is more complex.
There are two questions to be answered:

• In whose interests are they run?
• What are the objectives of the interested parties?

Presumably such organisations are run in the interests of society as a whole
and therefore we should seek to attain the position where the gap between
the benefits they provide to society and the costs of their operation is the
widest (in positive terms). The cost is relatively easily measured in accounting
terms. However, many of the benefits are intangible. For example the benefits
of such bodies as the National Health Service or Local Education Authorities
are almost impossible to quantify.
KEY POINT
Identifying the financial objectives of public corporations causes difficulties

because, whilst the costs of the operations can be measured and evaluate,
the benefits are often intangible.
Economists have tried to evaluate many public sector investments through the
use of cost benefit analysis, with varying degrees of success. Problems are
usually encountered in evaluating all the benefits. Value for money audits can
be conducted in the public sector but these concentrate on monetary costs
rather than benefits. This concept is considered in greater detail below.
Because of the problem of quantifying the non-monetary objectives of such

organisations, most public bodies operate under government (and hence
electorally) determined objectives such as providing a particular surplus,
obtaining a given accounting rate of return, cash limits, meeting budget, or
breaking even in the long run.
KEY POINT
Public corporations may be profit-seeking (e.g. the Post Office) or non-profit
seeking (e.g. the National Health Service). A typical objective imposed on
such corporations is to provide a particular surplus, or operate within
particular cash limits.
Despite these differences in the objectives of public corporations many of the

financial management techniques developed in this book will be applicable in
the public sector as they are concerned with the efficient management of
resources. Financial managers in the public sector, however, are not usually
concerned with raising outside finance but more with budgeting within the
limitations of existing financial resources.

4.4 The value for money (VFM) objective
Value for money (VFM) is a notoriously elusive concept and yet it is assumed
that everyone recognizes it when they see it. The term is frequently bandied
about but rarely defined. It is generally taken to mean the pursuit of economy,
efficiency and effectiveness.
What do the words ‘economy’, ‘effectiveness’ and ‘efficiency’ mean? A
diagram helps to explain.
DEFINITION
VFM is ‘getting the best possible combination of services from the least
resources’, i.e. to maximize the benefits available at the lowest cost to the
taxpayer.
Labor i.e. workforce Services

Management
Process
Materials Services
Finance Services
Economy is a measure of inputs to achieve a certain service or level of

service.
Effectiveness is a measure of outputs, i.e. services/facilities.
Efficiency is the optimum of economy and effectiveness, i.e. the measure of

outputs over inputs.
DEFINITION
Economy is achieving the required standard at the lowest cost.
The three ‘Es’ are the fundamental prerequisites of achieving VFM. Their
importance cannot be over-emphasized, so much so that external auditors in
some parts of the public sector, i.e. local government, are now charged with
the responsibility of ensuring that bodies have made adequate arrangements
for securing economy, effectiveness and efficiency in the use of public funds.

DEFINITION
Effectiveness is the extent to which a programme achieves its stated
objectives.
The problem of accurately measuring VFM cannot be fully resolved in the

public sector. Unlike the private sector, there is no profit yardstick against
which to measure success and, in most areas of public service provision, no
commercial pressure to respond to. Certain indicators have been developed,
the following being a few typical examples:
• Cost of providing a certain service per unit (per week/per 000

population/per mile, etc.) e.g. cost of providing secondary education
per 000 population, or operating expenses per train mile.
• Service provided per unit (per week/per 000 population, etc.) e.g.
home help hours per 000 populations.
• Inputs compared to outputs, e.g. administrative costs per meter of

steel produced.
• Other, e.g. percentage of trains cancelled compared to total

timetable, number of complaints received.
DEFINITION
Efficiency is the relationship between the goods or services produced and the
resources used to produce them.
An efficient operation produces the maximum output for any given set of
resource inputs or, it has minimum inputs for any given quantity and quality of
services provided.
Care must be taken, however, not to derive false meanings from limited data.
Qualitative judgments about services provided must not be attempted from
input information, other factors must be considered.
For example, a chef may have top quality ingredients for a cake but over-cook
and spoil the finished product. Similarly, a government department may have
staff who are well-trained and educated but who are poorly managed and thus
a low standard of service results.

Performance indicators are useful, particularly when making comparisons
between departments/regions/authorities. However, no two areas are identical
and allowance must be made for this and the limitations outlined above.
5. Governance
5.1 The objectives of corporate governance
As the name suggests, corporate governance is concerned with improving the

way companies are governed and run. In particular it seeks to address the
principal agent problem outlined above.
The main objectives are as follows:
• to control the managers / directors by increasing the amount of

reporting and disclosure.
• to increase level of confidence and transparency in company
activities for all investors (existing and potential) and thus promote
growth in the company.
• to increase disclosure to all stakeholders.

• to ensure that the company is run in a legal and ethical manner.
• to build in control at the top that will ‘cascade’ down the
organisation.
Corporate governance should thus be seen as the system used to direct,

manage and monitor an organisation and enable it to relate to its external
environment.
The OECD (Organisation of Economic Co-operation and Development)

identifies five principles of corporate governance:
• the rights of shareholders

• the equitable treatment of shareholders
• the role of stakeholders
• disclosure and transparency
• the responsibility of the board

The benefits of corporate governance should thus include the following:
• risk reduction
• leadership improvement
• performance enhancement
• improving access to capital markets
• enhancing stakeholder support by showing transparency,
accountability and social responsibility.
Test your understanding 1

A queue of people standing at a bus stop is an example of an organization if
they all want to travel to the same place.
True / False
False
Despite having identical individual goals, there is no collective goal that
motivates people to work together in any way. For example, passenger A will
not be concerned if they get the last available place on a bus while passenger
B has to want for the next one.

Which of the following are usually seen as the primary objectives of
companies?
(i) To maximize the wealth of shareholders
(ii) To protect the environment
(iii) To make a profit
A (i), (ii) and (iii)

B (i) and (ii) only
C (ii) and (iii) only
D (i) and (iii) only

While protecting the environment is to be encouraged and is reinforced within
statute to some degree, it is not a primary objective of the company.
Companies exist primarily to maximize the return to their owners.
Which one of the following would not be a stakeholder for a mutual society?
A shareholders
B customers
C employees
D managers

A
Response (A) is the correct answer as a mutual society does not have
shareholders but is owned collectively by its customers, for example
mutual building society is owned by its depositors.
Some building societies have demutualized and become banks with

shareholders. Comment on how this may have affected lenders and
borrowers.
Mutual building societies exist for the benefit of their members. This is
reflected in setting:
 Interest rates for borrowers as low as possible

 Interest rates for savers as high as possible
The aim is not to make a profit so the borrowing and saving rates are moved
as close as possible with a small margin sufficient to cover costs.
Once it becomes a bank the building society must then seek to maximize
shareholder wealth and become profit seeking. This is done by increasing
borrowing rates and reducing saving rates.

Members will thus find that the terms offered by the building society become
less attractive.
However, when demutualizing most building societies give their members

windfalls of shares so members become shareholders, thus benefiting from
dividends and share price increases.

The following is an extract from the accounts of Company ‘A’
Rs. ‘000’
Revenue 500
Cost of sales (200)
Gross profit 300
Distribution costs (100)
Admin. Expenses (50)
____
Operating profit 150
Interest (10)
____
Profit before tax 140
Taxation (30)
____
Profit after tax 110
____
Capital employed 3,000
Share capital (1 hundred thousand shares Rs. 10) 1,000
Calculate:
(a) ROCE
(b) EPS

(a) ROCE = operating profit / capital employed = 150/3,000 = 5%
(b) Eps = profit after tax / no of shares = 110/1000 = 11 paisa per share

RGP plc currently has an eps figure of 100 with 1 million shares in issue. A
proposed new project will increase profit after tax by Rs.25,000 per annum
and will be financed by the issue of a further 400,000 shares.
Calculate the new eps and indicate how shareholders will perceive the
change.

Existing profit after tax = eps x number of shares = 0.10 x 1 million =
100,000.
New profit after tax = (100,000 + 25,000) = Rs. 125,000
New number of shares = 1 million + 400,000 = 1.4 million
New eps = 125,000 / 1,400,000 = Rs.0.089 or 8.9 paisa.
This is lower than before so shareholder reaction will be negative.
Discounting a future steam of income means:
A taking into account possible future falls in the stream of income.

B ignoring yearly fluctuations in income and taking the average.
C reducing the present value of future income streams because
future income is worth less than current income.
D reducing the present value of future income streams to take
account of the effect of inflation.

C
Responses (A) and (B) are concerned with the absolute value of income
streams and not discounting those streams. Response (C) is correct since
discounting is done because future income is worth less now even in the
absence of inflation. Response (D) is a bit trickier to evaluate as one aspect of
the time value of money does relate to incorporating the effects of inflation.
However, interest rates and risk are perhaps more important.
Which of the following is not a connected stakeholder?

A Shareholders
B Suppliers
C Employees
D Customers

C
Employees are “internal” stakeholders.
Summary
• For a profit-making organisation, the primary objective is usually
taken to be the maximization of profit.
• In seeking to increase shareholder wealth, there is a trade-off
between risk and return.
• The objective of profit maximization is not the only possibility.
Managerial objectives and non-financial objectives also play a
part.
• In the public sector, objectives are often expressed in terms of
value for money.
• The three key decisions of financial management are concerned
with investment, finance and dividends.
• General economic factors such as interest rates have an
important effect on the ability to raise finance.
• An organisation’s formulation of policy is hampered by both
internal constraints and external constraints (such as
government regulation).
Self-test questions
1. Give three different types of stakeholders in an organisation.
(1.3)
2. What is the generally assumed long-term objective of a profit-
seeking organisation? (1.3)
3. How should return to equity be measured? (2.1)
4. What is meant by the risk-return trade off? (2.3)

5. Give an example of a financial objective of a not-for-profit
organisation. (4.2)
6. What are the three ‘Es’ that the value for money objective can
be said to be in pursuit of?
Additional question
Private v public sector objectives
Assume that you are a financial manager in a State-owned enterprise that is

about to have its majority ownership transferred from the government to the
private sector and to become a listed company on the London Stock
Exchange.
Discuss the differences in financial objectives that you are likely to face and
the changes in emphasis that are likely to occur in your strategic and
operational decisions as a finance manager.
For the answer to this question, see the ‘Answers’ section at the end of the
book.

Contents
1 Concept of Market
2 Law of Demand
3 Supply and Law of Supply
4 Market Equilibrium
5 Minimum Price and Maximum Price
6 Consumer Surplus and Producer Surplus
7 Summary

1. CONCEPT OF MARKET
1.1 What is a Market
There are many types of market, but the type of market structure truest to the
traditional model of a physical market place is a perfectly competitive market
with the following characteristics:
 Large numbers of sellers and buyers, each acting independently

and exerting no individual monopolistic power.
 Full information; everyone knows what the going price is and
can evaluate the quantity of the good or service being produced.
 Consumers aim to maximize utility (i.e. personal satisfaction)
and firms aim to maximize profits.
 Prices are flexible in all markets.
A. Given these conditions, the market system fulfills the function of

allocating resources between different uses and among different
people. It acts as an equilibrating mechanism between different
uses and among different people. It acts as an equilibrating
mechanism between supply and demand. Prices act as signals
and the price system is the coordinating mechanism that ensures
that markets “clear”; i.e. that supply equals demand in each
market.
B. The market system, also called the price system, performs two
important and closely related functions in a society with
unregulated markets. First, it provides an automatic mechanism
for distributing scarce goods and services. That is, it serves as a
price-rationing device for allocating goods and services to
consumers when the quantity demanded exceeds the quantity
supplied. Second, the price system ultimately determines both
the allocation of resources among producers the final mix of
outputs.

2 Demand
“The demand for anything at a given price is the amount of it, which will be
bought per unit of time at that price.” Or by demand we mean various
quantities of a given commodity or service which consumer would buy in one
market in a given period of time at various prices or at various income. Or at
various prices of related good. It is not merely a wish of the households.
2.1 Market Demand and Individual Demand

The market demand for a good or service is simply the total quantity
that all the consumers in the economy are willing to demand per time
period at a given price. While individual demand for a good or service
is the quantity that the consumer in the market is willing to demand per
time period at a given price.
2.2 Determinants of Demand
The amount of a product that consumers wish to buy in a given time

period is influenced by the following variables:
 Product’s own price

 The price of related products
 Average income of households
 Tastes and references
 Income distribution
 Population
It is difficult to consider the impact of changes in all these variables at

once. Studying each in isolation is only possible in theory, but theory
still improves understanding. Therefore, this module will employ a
convenient assumption called ceteris paribus to focus on the impact of
a single variable at a time (ceteris paribus meaning ‘everything else
remaining constant’).
This simply an illustration of the general relationship between price and

consumption; when the price of a good rises, the quantity demanded
will fall. This relationship is known as the law of demand. The law of
demand states that there is a negative relationship between the price
and the quantity demand of a product. When the price of movie theatre
increases, we buy less.
There are two reasons for this predictable response to a price increase:
A. People will feel poorer. They will not be able to afford to buy so much
of the good with their money. The purchasing power of their income
(their real income) has fallen. This is called the income effect of a price
rise.
B. The goodwill now be dearer relative to other goods. People will thus
switch to alternative or substitute goods. This is called the substitution
effect of a price rise.
Similarly, when the price of a good falls, the quantity demanded will rise.
People can afford to buy more (the income effect), and they will switch away
from consuming alternative goods (the substitution effect). The amount by
which the quantity demanded falls will depend on the size of the income and
substitution effects.
Key Point
A word of warning: be careful about the meaning of the words ‘quantity
demanded. They refer to the amount consumers are willing and able to
purchase at a given price over a given time period (for example, a week, or a
month, or a year). They do not refer to what people would simply like to
consume. You might like to own a Rolls Royce, but your demand for Rolls
Royce will almost certainly be zero.

2.3 The Demand Schedule and the Demand Curve
Demand schedule is one way of showing the relationship between
quantity demanded and the price of a product, other things being
equal. It is a numerical tabulation showing the quantity that is
demanded at certain prices.
Key Point
The price mechanism works as follows: Prices respond to shortages and
surpluses. Shortages cause prices to rise. Surpluses cause prices to fall. If
consumers decide they want more of a good (or if producers decide to cut
back supply), demand will exceeds supply. The resulting shortage will cause
the price of the goods to rise. On the one hand, an increased price will act as
an incentive to producers to supply more, since production will now be more
profitable. On the other hand, it will discourage consumers from buying. Price
will continue to rise until the shortage has been eliminated.
If, contrarily, consumers decide they want less of a good (or if producers
decide to produce more), supply will exceed demand. The resulting surplus
will cause the price of the good to fall. This will act as a disincentive to
producers, who will supply less, since production will now be less profitable. It
will encourage consumers to buy more. Price will continue falling until the
surplus has been eliminated.
2.4 LAW OF DEMAND

Law of demand can be stated as "Other things remaining the same a
rise in the price of a commodity or service is followed by a contraction
in demand and a fall in price is followed by an extension in demand".
That is there is an inverse relationship between price and quantity
demanded. We may write the law of demand as Qd = f(P), where 'Qd'
means quantity demanded and 'P' is price, 'f' means function i.e.,
quantity demanded is a function of price.
Law of demand can be explained with the help of a schedule and diagram:

Price Rs/Kg Quantity Demand in Kg.
200 100
Contraction
Extension
160 200
Rise
Fall 120 ee 300
80 400
40 500
It is clear from the schedule as the price of the commodity falls, demand is
extending. Price has fallen from Rs. 20 per kg, to Rs. 4 per kg and demand
has extended from 100 kg to 500 kg.
Movement along the demand curve
Ext
20 D a ent
ion
b
16 c
Price
Rs. 12 d
Co e
8 ntr
act
ion D
4
O 100 200 300 400 500

Quantity Demanded (kg.)

Demand curve slopes downward from left to right i.e., it has negative
slope, which shows that with a decrease in price demand for that
commodity extends and with an increase in price demand for that
commodity contracts.
A demand curve is a graphical representation of a demand schedule. A

strict and regular relationship between the X and Y entities produces a
straight slope, not the swoop you might expect in thinking about the
‘learning curve’ and similar graphs. When the word ‘shape’ is used abut a
curve, it refers to the direction of the curve – either up or down, in the case
of a simple slope.
The position and shape of the market demand curve depends on the
positions and shapes of the individual consumers’ demand curves from
which it is derived. But it also depends on the number of individual
consumers who consume in that market.
2.3 Assumptions
Law of demand holds under the following assumptions.
1. Homogenous Units
It is assumed that units of a commodity are homogenous
because if the quality of the lateral units purchased is superior
then with an increase in price demand may not contract.
2. Income of the Consumers

If the income of the consumers changes, their purchasing power
will change and with a change in price of the commodities
purchased the use of those commodities will not change.
3. Taste and Fashion

If a commodity is used as a fashion or the taste of the
consumers change, the law does not hold.

4. No New Substitutes are Discovered
If new substitutes are discovered the demand for original
commodity is subdivided and it is the psychology of the people
that they like new substitutes, so the demand for original
commodity decreases without the increase in price.
5. Prices of the Substitutes

It is assumed that the prices of the substitutes do not change. If
the price of the substitute changes the demand for original
commodity will change.
6. No Change in the Expectations

Sometimes the demand for a commodity change due to
expectations. If it is expected that price of a commodity will
change in next few days the demand for that commodity change
without change in price.
7. Climatic or Weather Conditions

The law does not hold good when weather changes. In summer
season demand for ice increases although price is higher and in
winter season even a lower price does not bring raise the
demand.
8. No Change in Population Growth Rate

It is assumed that the population growth rate does not change
because with an increase in population, quantity demanded
increases although price has increased.
2.4 Limitations
1. Danger of being Scarce

If there is a danger that a commodity will become scarce or it will
not be available in future, law of demand will not hold.

2. Use Confers Distinction
If the use of commodity confers distinction and brings superiority,
the rich people will demand more instead of increase in price.
3. Inferior/Superior Goods
If a good is inferior a fall in price will bring further fall in demand

and if a commodity is superior a rise in price will bring further rise
in demand.
4. Necessities of Life
If the price of one of the necessities of life rises the expenditure on

other goods decreases without increase in their prices.
Key Point
Demand curve, being the graphical representation of the demand schedule,
slopes downward. These graphs always have price on the vertical axis and
quantity demanded or supplied) on the horizontal axis, but common, mistake
to reverse the variables.
The graphical representation of the above demand schedule is smooth. But

beware that this is not essential. What is essential is that the curve has
retained a general downward slope: the lower the price, the more you are
likely to buy.
Key Point
Possible explanations for the two stories can be as follows:
1. A rise in the population is shifting the demand curve for rice to the right
as more rice is demanded at each price. This in turn raises the price of
rice.
2. The rising price of rice is causing each individual household to cut back
on its purchase. This causes an upward movement to the left along any

particular demand curve.
2.5 Usual shape of the demand curve
The demand curve is usually negatively sloped explaining the inverse

relationship between price and quantity demanded of a commodity. The
reasons for negative slope of the demand curve include the following:
(i) Substitution effect

When price of a good falls whereas its substitute still commands the
original price, consumers switch from the expansive to the cheaper
good.
(ii) Purchasing power effect

When price of a good falls, consumer’s purchasing power in terms of
this good is increased, therefore, he purchases more of it.
(iii) Law of diminishing marginal utility

Law of diminishing marginal utility states that marginal utility diminishes
with every increase in quantity of a commodity consumed. Since
marginal utility of each unit tends to decline, the consumer will buy the
additional units only if its price also falls.
2.6 Shift in the Market Demand Curve

Now consider what happens if income, tastes, population, and he
prices of all other products remain constant and the price of only one
product changes. As the price goes up, that product becomes an
increasingly expensive way to satisfy a desire. Some consumers will
stop buying it altogether; others will buy smaller amounts; still others
may continue to buy the same quantity. Because many consumers will
switch wholly or partly to other products to satisfy the same desire, less
will be bought of the product whose price has risen. As meat becomes
more expensive, for example, consumers may to some extent switch to
meat substitutes; they may also, forgo meat at some meals and eat

less meat at others.
Conversely, as the price goes down, the product becomes a cheaper method
of satisfying a desire. Households will buy more of it. Consequently, they will
buy less of similar products whose prices have not fallen and as a result have
become expensive relative to the product in question. When a bumper tomato
harvest drives prices down, shoppers switch to tomatoes and cut their
purchases of many other vegetables that now look relatively more expensive.
2.7 Direct Demand and Derived Demand

Demand or direct demand refers to the quantity of a good that
purchasers would buy or attempt to buy, if the price of the good were at
certain level. The demand for goods by the ultimate consumers is
known direct demand.
2.8 Substitutes and compliments
1. Substitute goods are those goods which can be used alternatively for
example chicken and beef, mutton and fish, tea and coffee.
2. Complements are those goods which tend to be bought and used

together, examples cups and saucer, petrol and motor car etc.
(a) If price of article ‘B’, goes up and article A and B are

complements will decrease the demand for article A, because of
low purchasing power at higher price.
(b) If the price of article B, goes up and article A, and B, are

substitutes then the demand for article ‘A’, will increase because
the consumers will shift to substitute ‘A’ which has become
cheaper as compared to article B.

3 Supply
When we refer to the economy of our own country, we find that the economy,
in the most recent year for which statistics are available, produced goods and
services worth million, or billions, or even perhaps trillions in the local
currency. In studying the subject of production, there is a single question that
economists attempt to answer: What determines the quantities of products
that will be produced and offered for sale? Such an attempt requires an
examination of the basic relationship between the price of the product and the
quantity produced an offered for sale as well as an examination of the forces
that lead to shifts in this relationship.
3.1 Supply, Stock and Hoarding
Supply is the portion of the produce offered for sale at specific price
while the total amount of goods available at short notice. The amount
of stock is fixed in the short period and the quantity of stock is not
affected by the price changes of that product. Store is portion of the
produce which will be offered for sale fair prices and unless fair price is
available the goods are stored while hoarding is a stock held for
earning super normal profits or to exploit the consumers.
3.2 Reserve Price
Reserve price is the minimum price below which a supplier would not
be supplying the goods in the market and flour price is also the
minimum price but determined by the government. Government buys
goods from the producer’s if price falls that of flour price.
3.3 Market Period Short Run and Long Run Price
Market period price fluctuates more sharply because it is not possible

to increase supply in the market period (decrease in supply in market
period, is not possible in case perishable goods), in the short run

supply can be increased, therefore price fluctuates less than market
period. In the long period the supply of goods can be increased up to
the maximum possible, limit therefore price is low as compared to short
run’, market period and generally more stable.
3.4 Movements along the Supply Curve
 A change in price results in a movement along a supply curve, resulting

in a change in the quantity supplied.
 A change in the price of a good NEVER shifts the supply curve for that
good.
 In figure an increase in price causes an expansion in supply and a
decrease in price results in a contraction in supply.
Price S1
P3
ion
ans
p
Ex
P1
on
cti
rt a
n
P2 Co
S
O Quantity
Q2 Q1 Q3
Figure 3 Movements along a supply curve
3.5 Supply Curve
A graphical representation of the relationship between the supply of a

commodity and its price (price measured on y-axis and quantity
supplies measured on x-axis). The positive relationship between price
and supply is reflected by the fact that the supply curve slopes upward
from left to right.

3.6 What is quantity supplied?
The amount of a product that firms wish to sell in some time period is
called the quantity supplied of that product. Quantity supplied is a flow;
it is so much per unit of time. Note also that quantity supplied is the
amount that firms are willing to offer for sale; it is not necessarily the
amount that they succeed in selling.
The amount of a product that firms are willing to produce and offer for
sale is influenced by the following important variables:
 Product’s own price

 Prices of inputs
 Technology
 Number of suppliers
The situation with supply is the same as with demand; there are
several influencing variables, and we will not get far if we try to
discover what happens when they all change at the same time. So,
again, we use the convenient ceteris paribus assumption (everything
else remaining constant) to study the influence of the variables, one at
a time.
3.7 Law of Supply
The law of supply explains direct relationship between price of a

product and quantities supplied other things remaining the same i.e.,
more quantities are supplied at higher prices and smaller quantities are
supplied at lower prices.
Statement of the Law
"Price and quantity supplied are directly related, other things remaining
the same" i.e., increase in price of product brings an extension in
quantity supplied of that product and fall in price of product brings

contraction in quantity supplied.
The law of supply can be explained with the help of a schedule and a
diagram.
Schedule
Price Quantity
Rs. Per Kg. Supplied
4 100
8 Extention 200 Contraction
Rise 12 in 300 in
Supply Supply
16 400
Fall
20 500
It is clear from the S

movement along e
schedule that there is a Price the Supply Curve
20
direct or positive relation d
ion
between price of the 8

n
i
to
act
c
ten
ntr
product and quantity

Ex
Co
12
supplied. b
8
a
4
S
100 200 300 400 500

Quantity Supplied (kg.)
3.8 Quantity Supplied and the Law of Supply
We begin by holding all other influences constant and ask how we expect
the quantity of a product supplied to vary with its own price.

A basic hypothesis of economics is that for many products, the price of the
product and the quantity supplied are related positively, other things being
equal. That is to say, the higher the product’s own price, the more its
producers will supply; and the lower the price, the less its producer will
supply.
Whey might this be so? It is true because he profits that can be earned
from producing a product will increase if the price of that product rises
while the costs of inputs used to produce it remain unchanged. This will
make firms, which are in business to earn profits, wish to produce more of
the product whose price has risen.
3.9 The Supply Schedule and the Supply Curve

The general relationship just discussed can be illustrated by a supply
schedule which shows the relationship between quantity supplied of a
product and the price of the product, other things being equal. A supply
schedule is analogous to a demand schedule; the former shows what
producers would be willing to sell, whereas the latter shows what
households would be willing to buy, at alternative prices of the product.
The supply curve represents the relationship between quantity supplied

and price, other things being equal; its positive slope indicates that quantity
supplied varies in the same direction as does price. When economists
make statements about the conditions of supply, they are not referring just
to the particular quantity being supplied at the moment, that is, not to just
one point on the supply curve. Instead, they are referring to the entire
supply curve, to the complete relationship between desired sales and all
possible prices of the product.
Supply refers to the entire relationship between the quantity supplied of a

product and the price of that product, other things being equal. A single
point on the supply curve refers to the quantity supplied at that price.

The position and shape of the market supply curve depends on the
positions and shapes of the individual firm’s supply curves from which it is
derived. But it is also depends on the number of individual firms which
produce in that market.
3.10 Shifts in the Supply Curve

The supply curve will shift to a new position with a change in any of the
variables (other than the product’s own price) that affects the amount of a
product which firms are willing to produce and sell. A shift in the supply
curve means that at each price, the quantity supplied will be different from
before. An increase in the quantity supplied at each price is shown in
Figure 3-7. This change appears as a rightward shift in the supply curve. In
contrast, a decrease in the quantity supplied at each price appears as a
leftward shift. A shift in the supply curve must be the result of a change in
one of the factors that influence the quantity supplied other than the
product’s own price.
Key Point
You might naturally associate ‘rise’ and ‘fall’ with a vertical shift. This
causes no problems in the case of demand. Supply, however, is
counterintuitive in this way.
3.11 Influences on Supply

As indicated before, supply depends on several factors other than a good’s
own price. Changes in these other factors are sources of shifts in market
supply curves, just as happens with the market demand curves discussed
above.
Price of Inputs (Changes in Costs of Production)

All things that a firm uses to produce its outputs, such as materials, labor,
and machines, are called the firm’s inputs. Other things being equal, the
higher the price of any input used to make a product, the less will be the
profit from making that product. We expect, therefore, that the higher the
price of any input used by a firm, the lower will be the amount that the firm

will produce and offer for sale at any given price of the product. A rise in
the price of inputs therefore shifts the supply curve to the left, indicating
that less will be supplied at any given price; a fall in the cost of inputs shifts
the supply curve to the fight.
Technology
At any time, what is produced and how it is produced depends on what is
known. Overtime, knowledge changes; so do the quantities of individual
products supplied. The technological improvements in the computer
industry over the past two decades have led to a rightward shift in the
supply curve.
Number of Firms
If firms that produce for a particular market are earning high profits, other
firms may be tempted to go into that business. When the technology to
produce computers for home use became available, literally hundreds of
new firms got into the act. The popularity and profitability of the Internet
has led t the formation of new service providers. When new firms enter an
industry, the supply curve shifts to the right. When firms go out of business
or exit the market, the supply curve shifts to the left.
Suppose that the price of sugar rises. How does this affect the demand for
ice cream? Sugar is an input into ice cream production. An increase in the
price of an input tends to raise the cost of production and hence to lower
profitability. In response to this increased cost, the ice cream producers will
cut back on their supply of ice cream. At any given price of ice cream, the
suppliers are now less inclined to continue the same amount. As they
produce less, the supply curve for ice cream shifts to the left.
Key Point
When you are told to imagine that income or some other variable has
changed, imagine enormous change. This will help you work out the
effects. If a can of Coke has risen in price, imagine that it has doubled in
price. This way it is easier to see what will happen to the quantity

demanded or supplied for Coke and its substitutes.
3.12 Shift of Market Supply Curve

A change in supply quantity not because of change in its own price but
because of other factors e.g. cost of production changes, technological
changes, changes in govt. policies or natural calamities or because of
new discoveries is known as "rise or fall" in supply.
Outward and Inward Shift in Market Supply Curve

The change in supply because of change in the assumptions/
conditions/ factors/ determinants i.e., other than price cause shift in
supply curve. The shift may be outward or inward. Whenever there is a
change in conditions other than price it may cause outward and inward
shift simultaneously.
The following factors will shift the supply curve:
(i) Change in cost of production.
(ii) Change in the technology or method of production.
(iii) Change in efficiency of factors of production.
(iv) Discoveries and innovations.
(v) Change in indirect taxation.
(vi) Change in price of competitive supply.
(vii) Entry and exist of firms into industry.
MCQ
If the farmers producing wheat must obtain a higher price than they did
previously to produce the same level of output as before, then we can say that
there has been-
A. an increase in quantity supplied.

B. an increase in supply.
C. a decrease in supply.
D. a decrease in quantity supplied.
Answer: C. Draw the supply curve. At the same output level and at a higher

price, place a point. Draw a line parallel to the first supply curve
through this point. The new line (curve) will to the left and above the
initial supply curve – a decrease in supply.
Supply and Demand Together

Having analyzed supply and demand separately, we now combine them to
see how they determine the quantity of a good sold in a market and its price.
4 Market Equilibrium
4.1 Equilibrium
Equilibrium means a state of balance. When forces acting in opposite
directions are exactly equal, the object on which they are acting is said
to be in a state of equilibrium.
4.2 Equilibrium Price and Equilibrium Quantity
Equilibrium price under perfect competition is determined through the

forces of demand and supply. Both quantities demanded and quantity
supplied varies with price. Equilibrium price is determined by the
interaction of demand and supply. By demand we mean the demand of
all the buyers and by supply we mean supply of all the firms. The price
at which quantity demanded is equal to quantity supplied is called the
equilibrium price. Since forces of demand and supply are balanced at
this price, the quantity bought and sold is known as equilibrium
quantity.
Assume that demand and supply of a product at different prices are given
below:
Price Quantity Demanded Quantity
Rs. Per Kg. (Kg) Supplied
(Kg)
200 50 250
160 100 200
120 150 150
80 200 100
40 250 50

It is clear from the schedule that quantity demanded is equal to quantity
supplied at price Rs. 120 per kg., therefore price of Rs. 120 will persist in the
market, because at this level there is no tendency for it to rise or fall.
So at, equilibrium price the

whole quantity of product
offered for sale, will be
purchased by the buyers.
Thus price Rs. 120 per kg. is
the equilibrium price and
150 quintals is the
equilibrium quantity. This
can be shown with the help
of a diagram.
4.3 Market Price Determination
Market price is determined through the quantity of demand and supply

in the market period or very short period. The market period is a period
in which the maximum that can be supplied is limited by the existing
stock. The market period depends upon the nature of the product.
Market price is determined daily by the forces of demand and supply. If
demand is greater than the supply, price increases and vice versa.
4.4 Market Price Determination for Perishable Goods

In case of perishable goods like fish, vegetables, milk etc., the supply
cannot be increased or decreased in a day. Therefore, whole of the
commodity must be sold on the same day, whatever the price may be.
Suppose that the supply of fish in a day is 150 quintals in the market.
Because fish is perishable commodity and cannot be stored for longer
time by ordinary means therefore fish sellers will try to sell all the fish
because it cannot be kept back for the next day. Price determination of
fish can be explained with the help of a schedule and diagram.

Price of Fish Quantity Demand Quantity Supplied
Rs. Per kg kg Kg
140 50 150
120 100 150
100 150 150
80 200 150
60 250 150
It is clear from the schedule that market price is 100 and equilibrium quantity is 150
Quintals
Demand curve DD and supply

curve MPS both intersect at
point E. Therefore equilibrium
price is Rs.100 and equilibrium
quantity is 150 kgs.
4.5 Market Price Determination-Durable Goods

Market price for perishable goods is that where all the quantity offered
for sale is purchased. But if the market price of durable goods falls from
a certain price its supply is stopped and is kept back for the next day. It
can be explained with the help of a schedule and a diagram.
Price Per Chair Quantity Quantity Supplied

Demanded
400 50 10
500 40 20
600 30 30
700 20 30
800 10 30

It is clear from the schedule that demand contracts from 50 chairs to 10 chairs
and quantity supplied 30 chairs but after that supply remained unchanged.
Total number of chairs is 30. As chairs are durable so if the sellers do not get
the reserve price they will stop the supply. In the schedule Rs. 600 per chair is
the equilibrium price.
Quantity demanded and market

quantity supplied is equal at
price Rs. 600 as shown by point
E, therefore, Rs. 600 is the
equilibrium price.
The forces of demand and supply which push to a market to its

equilibrium price and quantity
(a) There is generally market equilibrium i.e., equilibrium price and

quantity will rule if demand and supply conditions do not change.
(b) If the market is in disequilibrium the demand and supply forces

will push prices towards the equilibrium price.
(c) The market will be in disequilibrium when demand and supply

curves change.
Key Point
Be careful not to confuse the rise in supply with a leftward shift in the supply
curve. While the rise in the demand also implies a rightward (upward) shift in
the demand curve, that is not the case in the case of the supply curve. A rise
in supply implies a rightward (downward) shift in the supply curve. And a fall in
supply implies a leftward (upward) shift in the supply curve.

SHIFTS IN DEMAND AND SUPPLY AND EFFECTS ON EQUILIBRIUM
PRICE
Shifts in demand and supply may affect equilibrium price in number of ways
for example:
1. Rise and fall in demand, supply remains unchanged.

2. Rise and fall in supply, demand remains unchanged.
3. Equal rise in demand and supply.
4. Equal fall in demand and supply.
5. Equal rise in demand and fall in supply.
6. Equal fall in demand and rise in supply.
7. Rise in demand is greater than rise in supply.
8. Rise in supply is greater than rise in demand.
9. Fall in demand is greater than fall in supply.
10. Fall in supply is greater than fall in demand.
11. Rise in demand is greater than fall in supply.
12. Fall in demand is greater than rise in supply.
13. Rise in supply is greater than fall in demand.
14. Fall in supply is greater than rise in demand.
Illustration Diagram No. 1:
In the diagram equilibrium price is OP Y D´

and equilibrium quantity is OQ. Demand D S
has increased to D´D´ and equilibrium D´´
price has also increased to OP´, with a
P´ E´
fall in demand to D´´D´´, price has fallen
to OP´´ because new demand line P E
D´´D´´ intersects SS line at point E´´. Price
P´´ E´
D´
D
S
D´´
O X
Q´´ Q Q´
Quantity
(1)

In the diagram equilibrium price is OP Y
D S´´
if supply increases to S´S´ then new
equilibrium point is E´ and equilibrium S
S´
price falls to OP´ if supply falls to
S´´S´´ then new equilibrium point is at P´ E´´
E´´ and equilibrium price increases to P E
OP´´. Price
P´´ E´
S´´
S D
S´ X
O Q
Quantity
(2)
Illustration Diagram No. 3: Y D´

S
D
In the diagram demand and supply curves S´
intersect at E therefore, equilibrium price
is OP and equilibrium quantity is OQ. If E
Price P E´
demand increases to D´D´ and supply
increases to S´S´ equilibrium price is
unchanged but equilibrium quantity has S
D´
D
extended to OQ´. S´
O X
Q Q´
Quantity
(3)
Y D S´
Illustration Diagram No. 4: D´ S
In the diagram equilibrium price is OP
demand and supply curves intersect at E, E´
P E
therefore, equilibrium quantity is OQ. S´S´ Price
curve shows decrease in supply and D´D´
shown decrease in demand, both the
curves are intersecting at E´ which is S´ D
parallel to earlier equilibrium price OP i.e., S D´
equilibrium price is unchanged. O X
Q1 Q
Quantity
(4)

Illustration Diagram No. 5: Y D´ S´
In the diagram equilibrium price is OP, D S
demand & supply curves intersect at E, P´ E´
therefore equilibrium quantity is OQ. S´S´
curve shows decrease in supply and D´D´ P E
shows increase in demand both the Price
curves intersect each other at E´ so the
equilibrium price increases from OP to S´ D´
OP´. S D
O X
Q
Quantity
(5)
Illustration Diagram No. 6: Y
In the diagram equilibrium price is OP, D

S
demand & supply curves intersect at E, D´ S´
therefore equilibrium quantity is OQ. S´S´
curve shows increase in supply and D´D´ Price P E
shows decrease in demand, both the
curves intersect each other at E´ E´
P´
equilibrium price decreases from OP to D
D´
OP´. O X
Q
Quantity
(6)
Illustration Diagram No. 7: D´

Y
In the diagram equilibrium price prior to S
D
changes in demand and supply is OP S´
and equilibrium quantity is OQ but after
increase in demand D´D´ which is P´ E´
greater than increase in supply S´S´ P rice P E
equilibrium price increases to OP´.
D´
S
D
S´
O X
Q Q´
Quantity
(7)

D´
D S
In the diagram equilibrium price and
S´
quantity before shifts in demand and
supply are OP and OQ respectively. After
an increase in supply S´S´ which is P E
greater than increase in demand D´D´ PriceP´ E´
and new equilibrium price is below the
S´
previous equilibrium price.
D´
D
S
S´
O X
Q Q´
Quantity
(8)

S´
S
D
In the diagram original DD demand.
Curve and SS supply curve intersect at E D´
and equilibrium price is OP and quantity
P E
is OQ. New demand curve D´D´ shows PriceP´
E´
greater decrease in demand than smaller
decrease in supply S´S´ but both the new S´
D
curves intersect at E´ and equilibrium
price falls from OP to OP´ and quantity S
S´ D´
from OQ to OQ´. (Please show the curve O X
Q´ Q
OQ´ in the diagram). Quantity
(9)
Illustration Diagram No. 10: Y S´

D
If a fall in supply is greater than fall in D´
demand equilibrium price will increase S
from OP to OP´.
P´ E´
Price P
E
S´
S D´ D
O X
Q´ Q
Quantity
(10)

Illustration Diagram No. 11: Y D´
D S´
If the rise in demand is greater than the E S
fall in supply, there will be a in P´
equilibrium price from OP to OP´ rise. In
the diagram equilibrium price is OP and P rice P E
quantity is OQ before shifts in demand
and supply. After greater decrease in D´
supply to S´S´ than demand D´D´ new S´ D

equilibrium price increases to OP´. S
O X
Q Q´
Quantity
(11)

D
If the fall in demand is greater than the
rise in supply equilibrium price will fall D´ S
from OP to OP´. S´
Price
P E
P´ E
S 
S´ D´ D
O X
Q´ Q
Quantity
(12)

If a rise in supply is greater than fall in D S
demand equilibrium price will fall from D´ S´
OP to OP´.
P E
Price
P´
S 
D
S´ D´
O X
Q Q´
Quantity
(13)
If fall in supply is greater than rise in demand, equilibrium price will rise i.e.,
from OP to OP´.

Y S´
D´
D S
P´ E´
Price
P E
S´ D´
D
S
O X
Q´ Q
Quantity
(14)
The forces of demand and supply which push to a market to its equilibrium
price and quantity:
(a) There is generally market equilibrium i.e., equilibrium price and

quantity will rule if demand and supply conditions do not change.
(b) If the market is in disequilibrium the demand and supply forces
will push prices towards the equilibrium price.
(c) The market will be in disequilibrium when demand and supply
curves change.
5 Interfering with the Law of Supply and Demand

On many occasions, governments and sometimes private firms may decide to
use some mechanism other than the market system to ration an item for
which there is excess demand at the current price. This was often the case in
the former Soviet Union and other communist nations such as China. The
rationale most often used is fairness. This is because the law of supply and
demand, which governs the level at which prices are set, can produce results
that some individuals or groups do not like. For example, it is not ‘fair’ to let
landlords charge high rents, not ‘fair’ for oil companies to run up the price of
gasoline, etc.
The purpose of this section is to study how government policies control prices
and hence market outcomes. We use the tools of demand and supply to

analyze various types of government policies.
The equilibrium price in a free market occurs at the price at which quantity
demanded equals quantity supplied. Government price controls are policies
that attempt to hold the price at some disequilibrium value that could not be
maintained in the absence of the government’s intervention. We begin by
looking into two basic policies: price ceilings, which impose a maximum price
that can be charged for a product, and price floors, which impose a minimum
price. Rent control laws and agricultural support policies are examples of price
ceilings and price floors.
In the case of the ceilings, the control mechanism holds the market price
below its equilibrium value; this creates a shortage, with quantity demanded
exceeding quantity supplied at the controlled price. If the price ceiling is set
above the equilibrium price, it has no effect because the equilibrium remains
attainable. If, however, the price ceiling is set below the equilibrium price, the
price ceiling lowers the price and is said to be binding or effective.
In the case of the floors, the control mechanism holds the price above the
equilibrium price: this creates a surplus, with quantity supplied exceeding
quantity demanded at the controlled price. If the price floor is set below the
equilibrium price, it has no effect because the equilibrium remains attainable.
If, however, the price floor is set above the equilibrium price, it raises the price
floor and is said to be binding or effective.
Consumer Surplus and Producer Surplus

Consumer Surplus
In ordinary sense consumer surplus is the difference between a price the
consumer is willing to pay for a commodity and the actual price paid. In other
words consumer surplus is a measure of excessive utility or benefits or
welfare received by the consumer over and above the consumer pays.
The concept of consumer surplus has been criticized on the following

grounds:

1. It is based on unrealistic assumptions e.g. it is based on utility
and it is not measurable in terms of money.
2. It is assumed that marginal utility of money remains constant
while marginal utility of money never remains constant.
3. It is assumed that utilities derived from different goods are
independent and in fact it is not true because marginal utilities of
various goods are interdependent.
Producer Surplus
Producer surplus is the difference between the price the producer is
willing to accept and the price actually received.
The concept of consumer surplus and producer surplus can be

explained with the help of a diagram.
Consumers may be buying the good at a prevalent price lower than the
price, the consumers were willing to pay. In case of producer surplus,
the producer may be willing to receive price to sell all quantities of the
good at lower than the market price.
6 Minimum Price and Maximum Prices or Price Regulations or

Price Floor and Price Ceiling
Governments might introduce minimum or maximum prices or price floors and
price ceilings or price regulations for the basic two purposes
(i) To establish a minimum price for a good might be a part of anti-

deflationary economic policy or to support the formers to avoid their
exploitation.
(ii) To establish a maximum price for a good might have a part of anti-
inflationary economic policy or to save the consumers from
exploitation.
6.1 Minimum Prices
Determination of minimum price is aimed to ensure that the agriculturist

suppliers earn minimum price for each unit of produce they sell. This
policy have been used in the agricultural policy of the European Union
(EU) with agriculturists being guaranteed with minimum price of their
produce if unable to get fair price of their produce.
Minimum price determination is explained with the help of a diagram

below:
Y
Price
S1
So
E2
P1 Minimum price
E1
P0 E0
Excess supply controlled by

introducing production quotas
Excess supply
}
}
x
O Q2 Q0 Q1 Output

When minimum price is established it is danger that more of the goods will be
produced at minimum price (Qo to Q1) if it is higher than the market price as a
result surplus quantities will be produced and sold at low price. Therefore
production quotas are fixed not to produce more than that (Qo to Q2).
Minimum price is determined by the government to avoid the agriculturists

from exploitation and to avoid deflationary pressure in the economy and also
to avoid unemployment and induce investment in the economy.
6.2 Maximum prices/Price ceilings

Maximum prices are established to avoid the consumers from
exploitation and to avoid inflationary pressure in the economy.
Setting of maximum prices is illustrated with the help of a diagram

below:
Y
Price
D
S
1 S
P2
Black market
price
P0 E0
excess demand
P1 Maximum price
D
O X
Q2 Q0 Q1 Output
If the maximum price is below the price Po there is a danger of excess

demand (Qo to Q1) there will be a shortage of goods and are sold at high price
because of entry of black marketers. Consumption quotas are introduced to
control the excess demand and to maintain the maximum price.
This policy is adopted to control inflationary pressure in the economy.

Note:
(i) Minimum prices are maintained if government successfully
implements the production quotas.
(ii) Minimum prices are always set above the equilibrium price
otherwise these may not have any impact.
(iii) Maximum prices are maintained if government successfully
implements the consumption quotas and also controls the black
marketers.
(iv) Maximum prices are always set below the equilibrium price
otherwise these may not have any impact
Price Floors: The Case of Minimum Wage Laws

Governments sometimes establish a price floor, which is the minimum
permissible price that can be charged for a particular good or service.
Price floors may be established by rules that make it illegal to sell the
product below the prescribed price, as in the case of the minimum
wage. Effective price floors lead to excess supply. Either an unsold
surplus will exist, or someone must enter the market and buy the
excess supply. The consequences of excess supply will, of course,
differ from product to product. If the product is labor, subject to a
minimum wage, excess supply translates into people without jobs. If the
product is wheat and more is produced than can be sold to consumers,
the surplus wheat will accumulate in grain elevators or government
warehouses. Whereas price ceilings are meant to help demanders
(buyers), price floors are meant to help suppliers (sellers). With a price
floor such as the minimum wage, buyers (employers) cannot pay less
than the government-set minimum wage.
6.3 Guaranteed price and deficiency payment scheme

Guaranteed price is the price which the consumers must pay and
producers will receive. To maintain this price government purchases
the surplus quantities of the commodity. Under deficiency payment
scheme consumers are not forced to pay an artificially high price and

the agricultural producers on the other hand are given guaranteed
price. Under this scheme the price is allowed to fall which clears the
market and consumers benefits from reduced price and the farmers are
paid subsidy on the output sold at low prices by the government.
Theory of demand seeks to establish relationship between the quantity

demanded of a commodity and its price. It also offers an explanation for
variations in demand. There are different approaches known to the economists
to the theory of demand.
MCQ
When a price floor is established above the equilibrium price, we can say that:
A. quantity demanded is less than quantity supplied
B. quantity demanded decreases
C. quantity supplied increases
D. all of the above
Answer: ‘D’

Contents
1. Calculating price elasticity of demand
2. Income Elasticity of Demand
3. Elasticity of Supply

1. CALCULATING PRICE ELASTICITY OF DEMAND
1.1 Concept of Elasticity of Demand

Elasticity of demand or price elasticity of demand is the rate at which
the quantity demanded varies with a change in price, or it is the
measure of relative change in amount purchased in response to a
relative change in price on a given demand curve. According to
Marshall "The elasticity or responsiveness of a demand in a market is
great or small according to the amount demanded increases much or
little for a given fall in price, and diminishes much or little for a given
rise in price".
1.2 The formula for price elasticity of demand
The different influences on demand have already been discussed. One

of the most important is price. Here we analyses in numerical terms the
effect on demand of a change in price. This can be done using price
elasticity of demand (often shortened to ‘elasticity of demand’ or (PED).
DEFINITION
Price elasticity of demand (PED) is the degree of sensitivity of

demand for a good to changes in price of that good.
Price elasticity can be defined in a number of ways. One possible

formula is:
PED =

1.3 An alternative formula − point elasticity of demand
An alternative presentation of the formula is suitable for calculations

involving a straight-line demand curve, and is illustrated below.
P
D
P1 (1)
(2)
P2
D
0 Q
Q1 Q2
Q 2 - Q1
x100
Q1
PED =
P2 - P1
x100
P1
Figure 4.1 Point elasticity of demand
This equation calculates the elasticity at point 1 on the demand curve. The
changes in quantity and price are expressed as a percentage of the quantity
and price at point 1.
The example below demonstrates how the equation works and how it relates
to the first equation.

Example
A firm faces the following demand curve.
Price (£)
5
4 (1)
3
(2)
2
1
Quantity
Demand
2 4 6 8 10
Figure 1.2
Work out the price elasticity of demand at point 1.
Solution
The first step is to select any other point on the line to act as a reference
point, point 2. Here point 2 is one step down the line from point 1 but, on a
straight line demand curve, any other point would give the same result.
The price and quantity at point 1 are P1 and Q1 respectively. So P1 = 4 and

Q1 = 2. Similarly, price and quantity at point 2 are P2 and Q2 respectively. So
P2 = 3 and Q2 = 4.
Applying the equation above:

PED = x 100
x 100
So price elasticity of demand at point 1 is −4.

Geometric measure of price elasticity of demand
PED at different points on a straight-line demand curve
This calculation, together with the one done in the previous section,
demonstrates that PED is different at different points on a demand curve. The
first PED calculated was 4 and lay on the upper half of the line. The second
one, 0.67, lay on the lower half. In fact, on a straight-line demand curve:
Price PED = ∞
PED> 1
PED = 1 (mind-point of the line)
PED< 1
PED =0
Quantity
0
Figure 1.3
As shown in Figure 6.4, along the top half of the line, PED is greater than 1.
We say that demand is elastic. Along the bottom half of the line, PED is less
than 1 and we say that demand is inelastic. Exactly halfway along the line,
PED =1; demand is of ‘unitary elasticity’.
1.4 Arc elasticity of demand

As an alternative to calculating the elasticity at a point on a curve or line, it is
possible to calculate the elasticity over a range or arc. This involves referring
to the average value over the range rather than to a point on the range. Thus,
if the extreme values of the arc are (P1Q1) and (P2Q2) as before, the arc
elasticity will be: (1.3)
Notes on PED
(a) As mentioned above, PED for most goods is negative, so the minus
sign is often ignored when talking about PED. For example, we could

say that the price elasticity of demand at point 1 is 4, when strictly
speaking it is −4.
(b) PED is different at different points of a demand curve, even if that

‘curve’ is a straight line. The next section will go into this in more depth.
1.5 The meaning of elasticity and inelasticity
It is important to understand what ‘elastic’ and ‘inelastic’ mean, rather

than simply assign numbers to price elasticity.
If you return to the formulae, you should be able to see that when PED
is greater than 1, a certain (percentage) change in price will give rise to
a greater (percentage) change in quantity demanded. For example,
the first activity in this chapter showed that a PED of 2 means that a
10% rise in price will induce a 20% fall in quantity demanded. In other
words, demand is very responsive to price changes.
Conversely, when PED is less than 1, a given percentage change in

price will result in a smaller percentage change in demand, so demand
is not very responsive to price changes; and when PED equals 1, the
percentage change in quantity demanded equals the percentage
change in price.
KEY POINT
When PED>1, demand is relatively elastic and the quantity demanded

is very responsive to price changes; when PED<1, demand is relatively
inelastic and the quantity demanded is not very responsive to price
changes.
When PED>1, demand is relatively elastic and the quantity demanded is very
responsive to price changes; when PED<1, demand is relatively inelastic and
the quantity demanded is not very responsive to price changes.

Note that, if demand is said to be inelastic, this does not mean that there will
be no change in quantity demanded when the price changes; it means that
the consequent demand change will be proportionately smaller than the price
change. If demand does not change at all after a price change, demand is
said to be perfectly inelastic, and this is a special case as will be seen below.
1.6 Unusual demand curves (Special values of price elasticity of

demand)
There are three types of demand curve that merit special attention –
those of zero elasticity, infinite elasticity and unitary elasticity. These
are the only demand curves for which elasticity is the same at every
point on the curve.
(a) Perfectly Inelastic
Such a curve is called ‘perfectly inelastic’. Given that elasticity is a
measure of the sensitivity of demand to price changes, a zero elasticity
implies that demand is completely unaffected by price; the same
quantity will be demanded, regardless of the price.
P
D
0 Q
Figure 1.4 A perfectly inelastic demand curve
(b) Infinite elasticity
Such a curve is called ‘perfectly elastic’. A small change in price results

in an infinitely large change in demand. So a minuscule rise in price will
result in demand falling to zero; while a minuscule fall in price will
cause demand to rise to infinity.

P
0 Q
Figure 1.5 A perfectly elastic demand curve
(c) Unitary elasticity

Such a curve has a PED of 1 at every point on the curve. It is a
‘rectangular hyperbola’. The name comes from the fact that the area of
any rectangle drawn touching the curve is the same.
P
Rs.10
Rs.5
0 Q
4 8
Figure 1.6 A demand curve of unitary elasticity
The two rectangles drawn in Figure 6.7 have the same area. In fact, the area
of the rectangle actually represents the total sales revenue (P × Q) that
suppliers can expect to earn at different prices. If a firm makes a good with
this type of demand curve, total revenue will remain the same regardless of
the price charged and the quantity sold. Each price reduction will be exactly
matched by a rise in sales, so that total revenue will not change; and vice
versa. In the above example, total revenue is Rs. 40,000 whether price is Rs.
10,000 or Rs. 5,000.
1.7 Factors Influencing Elasticity of Demand

There are several factors which determine the elasticity of demand:

1. Nature of the Commodity
The elasticity of demand for necessities of life is inelastic because due
to increase in price, the demand for that commodity does not contract
proportionately and for comforts and luxuries the elasticity of demand is
elastic because even a smaller change in price brings big changes in
quantity demanded.
2. Availability of substitute
If the commodity has substitutes the elasticity of demand is elastic
because when price increases the substitutes become cheaper and
demand of substitutes increases. While demand for commodity falls
substantially, the response of demand is greater than the change in
price.
3. Share in Total Consumption Expenditure

If the share of commodity in total expenditure is greater to an increase
in its price demand falls more, therefore, demand is elastic and if the
share is less than it does not affect the demand more and demand is
inelastic (for necessities) for normal good it is elastic.
4. Goods Having Several Uses

If a commodity is having several uses, the demand is elastic. If the
price falls it is used even in unimportant uses. i.e., response of demand
is greater to a change in price.
5. Durable Goods
The more durable is good, the greater is the elasticity and is more
perishable is good less is the elasticity period.
6. Price Level
Elasticity of demand for those goods which are either high priced or low
priced is inelastic. Because with a small increase in price poor people
cannot purchase high priced commodity and if the commodity is low
priced then it is already purchased in sufficient quantity so further fall in
price does not cause an increase in demand.

7. Income Level
For rich, elasticity of demand for different commodities is inelastic
because an increase in price does not affect their consumption
expenditure. For poor, elasticity of demand is elastic because even a
smaller change in price brings greater change in demand.
8. Postponement of Demand / Delay in use

A commodity whose demand can be postponed elasticity is elastic
because to a smaller fall in price may bring greater demand and bigger
rise in price may bring smaller contraction in demand.
9. Habit and Fashion or consumer loyalty

A commodity which is liked by the people or it is in fashion, demand is
inelastic because people purchase even at higher price.
10. Number of Compliments or Joint Products

If the good has many compliments the product has more demand. The
elasticity of demand for that product is inelastic.
11. Future Expectations

If price of commodity is expected to rise or fall in future, a small change
in price brings a considerable change in demand. Therefore, elasticity
for those goods is relatively elastic.
12. Consumer adjustment

If consumers are slow to react to a change in price, the amount bought
is largely unaffected and price elasticity is relatively inelastic.
1.8 Measurement of Elasticity of Demand
There are four methods to measure elasticity of demand
1. Total Outlay or Total Expenditure Method

In this method we compare the changes in total expenditure before and
after the changes in price.
(i) If with a change in price total expenditure remains the same, the
elasticity of demand is unit elastic.
(ii) If with an increase in price total expenditure decreases and with
a decrease in price total expenditure increases, the elasticity of
demand is elastic.
(iii) If with an increase in price, total expenditure increases and with

a decrease in price, total expenditure decreases, the elasticity of
demand is inelastic.
1.9 Importance of Elasticity of Demand
The importance of elasticity of demand can be viewed from the following
1. For Finance Minister

Basic job of a finance Minister is to prepare Budget. The concept of
elasticity of demand guides him and he levies more taxes on goods
which are having elastic demand i.e., luxuries and less taxes on goods
where elasticity of demand is inelastic.
2. For Producers
The producers can increase the prices of those goods for which
elasticity of demand is inelastic and avoids increase in prices for those
goods for which elasticity of demand is elastic.
3. Price Discrimination
A monopolist charges higher price from those persons whose income
is high and elasticity of demand is elastic while charges low price from
poor.
4. Determination of Fare
The concept of elasticity of demand is kept in view while determining
fare in transportation e.g. Pakistan Railways charges many types of
fare from different persons depending upon demand elasticity of the
passengers.
5. Joint Demand
In case of goods which are sold, purchased or used jointly, higher price
is charged for goods having inelastic demand and lower price is
charged for goods having elastic demand.

6. For Exporters
Exporters are charging high prices for goods having inelastic demand
and lower price for goods having elastic demand.
7. Increasing Returns Industry

When industry is subject to increasing returns, expansion in production
lowers the average cost of the product. If at the same time the demand
of such product is elastic, the producer can raise his profit by slightly
reducing the price and producing larger quantity.
8. Wages
If the demand for a particular type of labor is inelastic, the labor union
can easily get higher wages from the entrepreneurs for the workers.
9. Paradox of Poverty in Plenty

If the demand for a product is inelastic, its increased production
may result in less profit. Take an example of potatoes. Suppose their
demand is inelastic at a certain period of time. Now if farmers grow
more potatoes, their total income will decrease rather than increase.
So, for them, plenty of potatoes means poverty.
10. The Government
1. Knowledge of price elasticity of demand would be useful

to the government and the policy making authorities in general.
It might be useful to the government in assessing cost or the
likely effectiveness of price support schemes such as those
common in agriculture.
2. Similarly, knowledge of price elasticity of demand would

be useful if it was decided to influence consumption through the
use of taxes or subsidies. For example taxes might be used to
discourage the use of demerit goods, while subsidies might be
used to encourage the consumption of merit goods. Again,
knowledge of price elasticity of demand would provide an
indication of how successful the policy is likely to be and, in the
case of subsidies it would be useful in providing an estimate of
likely cost of the subsidy.

3. For any government considering devaluation/revaluation
of its currency, knowledge of price elasticity of demand is
essential in order to predict the changes in import expenditure
and export revenue following devaluation/revaluation.
11. The Business Sector

Those involved in the business would find that knowledge of price
elasticity of demand is useful if they were considering a price change
for their product. If demand is inelastic, a price rise will lead to a rise in
profits because revenue will rise. In other situations such as price fall,
the effect of profitability depends on the proportionate change in cost
and revenue following a price change. Note, however that the aim of
price fall is to increase sales revenue, it is important that demand is
elastic. Firms might wish to increase sales as to increase their market
share or to enable them to reap important economies of scale.
2. Proportionate or Percentage Method
In this method we compare percentage change in quantity

demanded to a percentage change in price. If the percentage
change in quantity demanded is equal to percentage change in
price, elasticity of demand is unit elastic. If the percentage change
in quantity demanded is greater than the percentage change in
price, elasticity of demand is elastic and if the percentage change
in demand is less than the percentage change in price, elasticity
of demand is inelastic.
The formula to measure elasticity of demand is:

Percentagechangein Demand
Elasticity of demand =
Percentagechangein Price
Note: Mathematically we can measure elasticity of demand. If

price of a commodity increases from Rs. 10 to Rs. 12 and
demand contracts from 96 to 80 units. The elasticity of demand

with the help of formula, elasticity method can be measured as
follows:
ΔQ P
PED = .
ΔP Q
Q = –16 P = 10
P =2 Qd = 96
–16 10
PED = 2 x 96 = – 0.83 or inelastic
Note: The elasticity of demand is always negative, although by

convention it is taken as positive. It is negative because price
and quantity demanded are negatively related. Elasticity is
always less than zero, unless the demand curve is abnormal
i.e., it slopes upward from right to left.
The formula to measure arc elasticity of demand is as follows:
Q1  Q0 P1  P0
Elasticity = x
Q1  Q0 P1  P0
Where Q0 is the original quantity demanded and Q1 is the new quantity

demanded. P0 is the original price and P1 is the new price.
If following is the schedule of demand, elasticity of demand can be

measured with the help of above formula.
Price Per Kg. Quantity Demanded (Kg.)
10 – P 0 100 – Q0
5 – P1 300 - Q1
By putting the values in the above formula we get.

300 – 100 5 + 10
E = 300 + 100 5 – 10 = - 1.5 or elastic
Note: Point elasticity of demand is measured on a single point on a

demand curve while arc elasticity of demand is measured
between two points on a demand curve.
Geometrical Method
If we measure elasticity of demand on a single point on the

demand curve it is geometrical method. Elasticity on a demand curve is
different at different points it may be greater than unity, less than unity
and equal to unity.
The formula to measure elasticity of demand is

Lower part of the demand curve
E = Upper part of the demand curve
Elasticity on a point on the demand curve is measured by drawing tangent on

that point. It can be explained with the help of a diagram.
Y
B
D nity
than,u
ter
grea
RA =
B
E= R
Price D R ity
n un
tha
s
les
ES =
D
S E= S
D
O qd A C
Fig. 2
RA
Elasticity at point 'R' is RB and it is clear that lower portion is greater so
SC
elasticity is greater than unity and elasticity at 'S' is SD and it is clear that
lower portion is smaller than the upper portion so elasticity is less than unity.
Key Point
The formula for determining elasticity utilizes the percentage change,
not the absolute change, in quantity demanded relative to price. In the
upper half of the price range (the lower half of the range of quantity),
any decrease in price is bound to be relatively small in percentage
terms because the base price is relatively high. By the same token, the
corresponding increase in quantity must be relatively high in
percentage terms because the base quantities from which the
percentage is calculated are relatively low. This is illustrated in Figure,

which shows that the upper half of the demand line is elastic, whereas
the lower half is inelastic. At the half point, the demand is unitary
elastic. In fact, as long as the demand is a straight line, as in Figure,
we can state that it will have an elastic half and an inelastic half with
unitary elasticity occurring right in the middle. If the demand curve is
not linear, then the relationship between range of prices and elasticity
does not hold.
Figure
Price elastic (E > 1)
E=1
Inelastic (E = < 1)
Quantity
2. Income Elasticity of Demand
If the change in demand is not due to change in price, but due to change in
income, the elasticity is called income elasticity of demand. It can be written
as:
Percentagechangein quantity demanded
Income Elasticity of demand =
Percentagechangein income
OR
ΔQ y
Y.E.D = x
Δy q
Where '  y is change in income and y is income.
Income elasticity of demand may be unit elastic, inelastic, elastic, positive or

negative.
(i) If the percentage change in demand is equal to percentage change in

income, income elasticity is unit elastic.
(ii) If the change in demand is greater than the change in income, demand
is more elastic.
(iii) If the percentage change in demand is less than the percentage
change in income, demand is inelastic.
(iv) If with an increase is income demand falls, income elasticity of demand
is negative.
(v) If there is no change in demand to a change in income, income
elasticity of demand is perfectly inelastic.
(vi) If there is no change in income but there is change in demand, income
elasticity of demand is perfectly elastic.
Key Point
No good is automatically inferior, normal, or a luxury. For a poor person

gaining income in a distant neighborhood, a bus ride may be a luxury,
while that same bus ride might be inferior for a millionaire. You should
also realize that a luxury – e.g. bubblegum-need not be equated with
high-priced, nor necessity (dental care) with low-priced. Clearly, there
may be a link between income elasticity and price elasticity. Whether a
good has many substitutes may be linked with whether it is considered
a luxury or a necessity.
2.1 Cross-price elasticity
Cross-price elasticity is a measure of the responsiveness of consumers

to changes in the price of a particular good, Good A, relative to changes
in the price of substitute or complementary products, Good B. The
cross-elasticity of demand provides a measure of the degree of
substitutability, or complementarities, between product A and some
other product B.
Cross-elasticity of demand is defined as the percentage change in

quantity demanded of product A, divided by the percentage change in
the price of some product B—

Percentagechange in QA
EAB =
Percentagechange in BA
Where EAB is the cross-elasticity coefficient. The main point here is the sign
(positive or negative of the relationship rather than the magnitude. If it is a
positive relationship, the goods are substitutes; if it is negative, they are
complements. As a secondary issue, the larger (in absolute terms) the
coefficient, the more related are the two goods. For instance, a small
decrease in the price of Pepsi may cause a sizeable decrease in the demand
for Coke (close substitutes) but a smaller decrease in the demand for, say,
tea.
It can be written as:
ΔQA PB
X.E.D. = x
ΔPB QA
Where Ex Ab means, cross elasticity of demand for a good 'A' in respect of

change in the price of good 'B'.  QA means change in quantity demanded of
commodity 'A' and  PB means change in price of commodity B.
2.2 Point Elasticity of Demand

(i) The elasticity of demand on a single point on a demand curve is called
point elasticity of demand. Point elasticity of demand can be measured
in two ways:
Q P
or P.E.D = x
P Q
Lower part of the demand curve

E = Upper part of the demand curve
Note Elasticity can be measured by also taking percentage change in

demand quantity and percentage change in price.

Percentage changein demand
Point elasticity of demand =
Percentage changein price
2.3 ARC Elasticity of Demand
The elasticity at two different

points on the demand curve is
Arc Elasticity of demand, or arc
elasticity is measure of the P1 A
average responsiveness to price Arc elasticity
changes exhibited by a demand B
curve over some finite stretch of
the curve". Price P0 D
The formula to measure Arc
Elasticity of demand is
Q 2  Q1 P2  P1
E= x
Q2  Q1 P2  P 1 O Q1 Q0
Where Q1 is the original quantity Quantity Demand
and Q is the new quantity. P1 is
the original price and P2 is the
new price.
A decrease in price accompanied by a decrease in total revenue indicates an

inelastic demand. When the price changes and there is no change in total
revenue, demand is called unit elastic.
2.4 Price changes, elasticity, and changes in total revenue.
Elastic Inelastic Unitary
Price rises TR falls TR rises No Change

Price falls TR rises TR falls No Change
The concept of elasticity in terms of the impact that price changes will have on
total revenue earned by the sellers. Elasticity can also be measured in a more
precise way by comparing the degree of responsiveness among buyers to
changes in price. This measure is defined as the percentage change in
quantity demanded relative to the percentage change in price. That is:
Percentagechangein Q (Q - Q ) / Q
Ep = = 2 1 1
Percentagechangein P (P - P ) / P
2 1 1

Where Ep = the elasticity coefficient, Q1 = the original quantity demanded, Q2
= the new quantity demanded. P1 = the original price, and P2 = the new price.
If the percentage change in the quantity demand exceeds the percentage

change in price, the elasticity coefficient Ep will have a value greater than one
– it is elastic. If the percentage change in the quantity demanded is less than
the percentage change in price, then Ep will be less than one. This, by
definition, is an inelastic demand. If Ep is equal to one, demand is unitary
elastic.
Key Point
Actually, the value of the elasticity will always be negative because the
change in price is always accompanied by a percentage change in
quantity demanded in the opposite direction. For purposes of analysis,
we drop the negative sign and consider only the absolute value of the
coefficient.
Different Types of Elasticity
Demand responsiveness may be classified in absolute terms as:
a. perfectly elastic Ep =  (infinity),

b. elastic Ep> 1
c. unitarily elastic Ep = 1
d. inelastic Ep< 1
e. perfectly inelastic Ep = 0
Key Point
Recall that elasticity measures responsiveness. The more responsive a

buyer is to a price change, the more elastic is demand and, in absolute
terms, the larger is price elasticity of demand.

3. Elasticity of Supply
Law of supply explains direct relationship between price and supply
quantity of that product. Where price is an independent variable and
supply quantity is a dependent variable i.e., supply shows reaction and
response to a change in price.
The price elasticity of supply or simply supply elasticity is defined as a

degrees of responsiveness in supply to a change in price or a percentage
change in quantity supplied to a percentage change in price. It is explained
with the help of a formula
Percentagechangein supplied
Price elasticity of Supply (PES) =
Percentagechangein price
Since supply curve is positively sloped therefore, supply elasticity is normally

positive.
3.1 Elasticity of Supply and Time
1. Market period supply Market period is so short time period

when even variable factors of production cannot be changed
therefore, market period supply is nearly fixed e.g. supply of
perishable goods (vegetables, fruit, fresh milk etc.)
2. Short period supply Short period is generally known as one

year time period (starting from one day to up to maximum one
year). In this time period only the variable factors of production
can be changed while the fixed factors of production (e.g.,
building, plant & machinery) cannot be changed i.e., supply in
the short period can be increased or decreased only up to the
extent of changes in the variable factors of production.
3. Long period supply Long period is so sufficient period that

even the fixed factors of production become variable. Long
period supply can be increased or decreased up to the extent of
variations in all the factors of production i.e., new firms can enter

into the industry.
3.4 The Determinants of Elasticity of Supply (Factors Influencing

Elasticity of Supply)
1. The Number of Firms in the Industry Generally the greater the

number of firms in an industry, relatively elastic is the industry
supply.
2. The Length of the Production Period If the production

converts input into output in few hours; supply will be relatively
elastic then when several months are involved, as in agriculture.
3. The Existence of Spare Capacity If spare capacity exists and if

variable inputs such as labor and raw materials are available, it
should be possible to increase production quickly in the short
run supply may be elastic.

4. The Ease of Accumulating Stocks If it is easy to store unsold
stocks at low cost, firms will be able to meet a sudden increase
in demand by running down stocks. Likewise, they can respond
to a sudden fall in demand and price by taking supply off the
market and by diverting production into stock accumulation in
both cases supply is elastic.
5. The Ease of switching to other productions Many firms

produce a range of different products and are able to switch
machines and labor from one type of production to another. If
factors of production can be switched in this way, then the
supply of one particular product will tend to be elastic.
3.5 SUPPLY ELASTICITY AND AGRICULTURE
Generally a question arises that (unless a government interferes in the

agricultural markets to stabilize prices of agricultural production, it is
possible that the prices of agricultural production will fluctuate sharply).
Basically there are two give reasons.
(i) Most of the agricultural products have inelastic demand e.g.

necessities of life and basic needs.
(ii) Agricultural products have a perfectly inelastic supply in the very

short period because for more supply we have to wait for the
next crop. It is also difficult to assess the exact production
because of uncertain climatic conditions and winds, earthquakes
and floods, even drought.
There may be poor harvest as well as bumper harvest. It is explained below:

Poor Normal Better / Bumper
Harvest Harvest Harvest
Or Planned
S3 S1 S2
P3 E3
P2 E1
P1 E2
Q2 Q0 Q1
Output
The diagram shows that process fluctuate because of fairly inelastic demand
and bumper and poor harvests.
How agricultural markets function?
It may be explained with the cobweb cycle / cobweb theorem, illustrated below
Price D S
P1
P0
PRICE
P2
Q2 Q0 Q1 Quantity

It is clear from the above diagram if there is disequilibrium in market and
demand appears to be higher. That the agricultural production planned,
supply will be insufficient to satisfy demand at previous price. In the second
scoring session formers plant more crops than Q1 and price falls P2. it is
based on the concept that supply is function of previous year and demand is
function of current time period. If the price fluctuations become smaller and
smaller, the market will coverage to equilibrium otherwise because of bigger
fluctuations in price the market will remain any table.
Exercise No. 1
Product A, currently sells at Rs. 40/- per unit and its demand at this price was
500 units. If price fell to Rs. 35/- P.U, its demand extends to 525 units.
Product B, currently sells at Rs. 70 per unit and its demand at this price was
300 units, it price fell to Rs. 60/- per unit, its demand extends to 400 units.
Required:
(i) Calculate price elasticity of demand for both the products.
(ii) Calculate changes in total revenue if demand is met in full before and
after the change in price.
Solution:
Percentagechangein demand
Price elasticity of demand =
Percentagechangeinprice
Product A:
Changein demand
Percentage change in demand =
Demand
25
Percentage change in demand = x 100  5%
500
Changeinprice
Percentage change in price = x 100
Price
-5
Percentage change in price = x 100 = - 12.5%
40
5
Percentage elasticity of demand = x 100 = -0.4 (inelastic)
- 12.5
Product B:

100
Percentage change in demand = 100  33.3%
300
x 100  14.29
-10
Percentage change in price =
70
33.3
Price elasticity of demand = = -0.807(inelastic)
14.29
Change in Total Revenue for Product ‘A’.

Before change in price Total Revenue = 40 x 500 = Rs. 20,000 (PxQx)
After the change in price Total Revenue = 35 x 525 = Rs. 18,375
Firm’s total revenue will fall as a result of fall in price which is equal to Rs.
1625.
Change in Total Revenue for Product ‘B’.

Before change in price Total Revenue is Rs. 70 x 300 = Rs. 21,000
After the change in price Total Revenue is Rs. 60 x 400 = Rs. 24,000
Firm’s total revenue will increase as a result of fall in price which is Rs. 3000.
Exercise No. 2
(A) Product ‘x’ currently sells at Rs. 550 per unit, the demand of product ‘y’
was 1100 units. If price of product ‘x’ fell to Rs. 500 per unit, the
demand for product ‘y’ increases to 1200 units.
(B) Product ‘x’ currently sells at Rs. 550 per unit, the demand of product ‘y’
was 1100 units. If price of product ‘x’ fell to Rs. 500 per unit, the
demand for product ‘y’ decreases to 1000 units.
Required:
(1) Calculate cross elasticity of demand (XED) for both the situations ‘A’
and ‘B”.
(2) Which situation explains substitutes and which situation explain
compliments.
(3) For substitutes XED, is positive or negative.

(4) For compliments XED, is positive or negative.
Percentagechangeindemandof product' y'

Note: XED =
Percentagechangeinpriceof product' x'
Exercise No. 3
Given the table calculate income elasticity of demand (YED)
Income Demand
(Rs.) (Units)
10,000 720
12,000 750
Percentagechangeindemand
Note: YED =
Percentagechangein income
Exercise No. 4
Product ‘x’ is currently sells at Rs. 96 per unit and its demand at this was price
220 units. If price fell to Rs. 95 per unit its demand increases to 225 units.
Required::
Calculate price elasticity of demand by using percentage method or by using
Q . P
the formula PED =
P Q
Note: ΔQ is the change in demand quantity
ΔP is the change in price
P is the price before it fell
Q is the demand before price fell
Exercise No. 5
Given the table, calculate price elasticity of demand by using A&C elasticity
method.
Price Demand
Per unit Quantity
(Rs.) (Units)
P1600 150 Q1
P2500 250 Q2
Note: Formula for calculating A&C elasticity of demand is PED :
Q2  Q1 P2  P1
.
Q2  Q1 P2  P1
Exercise No. 6
Given the values of price elasticity per unit and supply by using percentage
method.
Price Supply
Per unit Quantity
(Rs.) (Units)
750 125
800 150
Percentagechangeinsuppluy
Note: Formula is: PED :
Percentagechangeinprice
Summary
• In this chapter we learned how to calculate various types of elasticity,

and the factors which influence both the elasticity of demand and
supply. Of particular significance is time.
• Both supply and demand are more elastic in the longer term than in the
short term.
• An appreciation of price and income elasticity of demand is useful to

business and government alike.
– Knowledge of price elasticity will help government to select the

most appropriate goods for taxation, and businesses to make
more rational pricing decisions to achieve higher levels of total
sales revenue.
– Understanding income elasticity will help businesses to select

the most profitable products to produce when incomes are
rising, or to be aware of potential problems if they are not.

Self-test questions
Calculating price elasticity of demand
1. Define price elasticity of demand and state its simple formula.

(1.1)
2. Is price elasticity of demand positive or negative? (1.2)
3. If price elasticity of demand is −2 and price rises by 10%, by

how much will quantity demanded fall? (1.3)
Using price elasticity of demand descriptively
4. Draw a graph showing unitary elasticity of demand. What do you

call this graph? (2.4)
Factors affecting price elasticity of demand
5. What are Giffen goods? (3.1)
6. If a product is habit-forming, would you expect its demand to be

relatively elastic or relatively inelastic? (3.2)
Factors affecting price elasticity of supply
7. Is supply more elastic in the short run or in the long run? (5.2)
Practical uses of price elasticity
8. If demand for a product is relatively elastic and the price of that

product rises, what will happen to the firm’s total revenue? (6.1)
Income elasticity of demand
9. What is a normal good? (7.1)
Cross elasticity of demand
10. Is the cross elasticity of demand for complements positive or

negative? (8.2)

Practice questions
Question 1
Which one of the following statements about the elasticity of supply is not
true?
A It tends to vary with time
B It is a measure of the responsiveness of supply to changes in

price
C It is a measure of changes in supply due to greater efficiency
D It tends to be higher for manufactured goods than for primary

products
Question 2
If the demand for a good is price inelastic, which one of the following
statements is correct?
A If the price of the good rises, the total revenue earned by the
producer increases
B If the price of the good rises, the total revenue earned by the
producer falls
C If the price of the good falls, the total revenue earned by the
producer increases
D If the price of the good falls, the total revenue earned by the
producer is unaffected
Question 3
A shift to the right in the supply curve of a good, the demand remaining
unchanged,
will reduce its price to a greater degree:

A the more elastic the demand curve
B the less elastic the demand curve
C the nearer the elasticity of demand to unity
D the more inelastic the supply curve

Question 4
When only a small proportion of a consumer’s income is spent on a good:

A the demand for the good will be highly price elastic
B the good is described as ‘inferior’
C a rise in the price of the good will strongly encourage a search
for substitutes
D the demand for the good will be price inelastic
Question 5
If the demand for a good is price elastic, which one of the following is true?
When the price of the good:

A rises, the quantity demanded falls and total expenditure on the
good increases
B rises, the quantity demanded falls and total expenditure on the
good decreases
C falls, the quantity demanded rises and total expenditure on the
good decreases
D falls, the quantity demanded rises and total expenditure on the
good is unchanged
Question 6
If the price of a good fell by 10% and, as a result, total expenditure on the
good fell by 10%, the demand for the good would be described as:
A perfectly inelastic
B perfectly elastic
C unitary elastic
D elastic
For the answers to these questions, see the ‘Answers’ section at the end of
the book.
Additional questions

Question 1: Elasticity of demand 1
The following data refer to the UK economy:
Activity
The equations for PES are:
PES = (percentage change in quantity supplied) / (percentage change in

price) and PES = 100 × × 100, where this time Q represents
quantities supplied, not quantities demanded.
As with demand, PES changes at different points on a supply curve, but we
sometimes use the term more loosely, describing supply curves as relatively
elastic or relatively inelastic (see figure).
P P
S
0 Inelastic Q 0 Elastic Q
The reasoning behind the descriptions is the same as that for demand curves.
Price Elasticity of Demand
Price elasticity of demand (P.E.D.) measures the responsiveness of demand

to a given change in price. The P.E.D. coefficient (value) is calculated by use
of either of the following equations

percentage change in quantity demanded
P.E.D. = percentage change in price
Where P is the initial price, QD is the initial quantity demanded and  (delta)
means ‘the change in’.
Price
D
P A
3
2 P
B
1 D
Q
Q
O Quantity
1 2 3 4 5
Figure 1 Calculating P.E.D.
 Under normal circumstances

 The P.E.D. coefficient can be between zero and infinity ().
 If P.E.D. is less than 1, demand is inelastic.
 If P.E.D. is greater than 1, demand is elastic.
 P.E.D. is usually treated as a positive number and any minus signs are
ignored.
Figure 2 show that the gradient (slope) of a demand curve generally reflects
its P.E.D. However, great care should be taken when interpreting the gradient
of a demand curve.

P P P
E=O E<1 E=1
D2 D3
D1
O Q O Q O Q
(a) (b) (c)
P P
E>O E=
D5
D4
O Q O Q
(d) (e)
Figure - 2
Figure 2
Demand curves with different price elasticity. In (a) the demand curve is a
vertical line; demand is perfectly inelastic; the P.E.D. coefficient is equal to 0;
and a price rise means no decrease in QD. In (b) the demand curve is a steep
line; demand is relatively inelastic; the P.E.D. coefficient is greater than 0 but
less than 1; and a price rise means a smaller percentage decrease in QD. In
(c) the demand curve is a rectangular hyperbola; demand is unitary elastic;
the P.E.D. coefficient is equal to 1; and a price rise means an equal
percentage decrease in QD. In (d) the demand curve is a shallow line; demand
is relatively elastic; the P.E.D. coefficient is greater than 1 but less than; and
a price rise means a greater percentage decrease in QD. In (e) the demand
curve is a horizontal line; demand is perfectly elastic; the P.E.D. coefficient is
equal to ; and a price rise means consumers buying perfect substitutes.
(i) The slope of a demand curve is not necessarily a guide to price

elasticity. The scale of each axis affects P.E.D.
(ii) On a steep demand curve, P.E.D. at points near the y-axis can be
elastic.

(iii) On a flat demand curve, P.E.D. at points near the x-axis can be
inelastic.
(iv) P.E.D. falls as you move down a linear demand curve.
(v) A demand curve shifting to the left becomes more elastic.
Table 1 Factors influencing price elasticity of demand

Factors The demand for a good is relatively price-inelastic
because
Number of substitutes if there are few substitutes for a good, consumers are
unlikely to switch products
Consumer loyalty if consumers are in the habit of buying a good, they are
unwilling to sue substitutes
Absolute price of the if a good is inexpensive, a large percentage change in
good price represents only a few rupees
Proportion of income if the good takes up only a small proportion of income,
consumers will not react significantly
Number of complements if the good has many complements, the product is
needed if the other items are used
Consumer adjustment if consumers are slow to react to a change in price, the
amount bought is largely unaffected
Price Elasticity of Supply
Price elasticity of supply (P.E.S.) measures the responsiveness of supply to a

given change in price
percentage change in quantity supplied
P.E.S. = percentage change in price
 The P.E.S. coefficient can be between zero and infinity ().

 If P.E.S. is less than 1, supply is inelastic.
 If P.E.S. is greater than 1, supply is elastic.
Figure 3 shows that the gradient of a supply curve generally reflects its P.E.S.

P S1 P S2 S3
Both S3 and S4 are

unitary elastic at
all points
S4
Q Q Q
(a) (b) (c)
P P
S5
S6
Q Q
(d) (e)
Figure 3
Supply curves with different price elasticity. In (a) supply is perfectly inelastic;
the P.E.S. coefficient is equal to 0; and a price fall means no decrease in Q s.
In (b) supply is relatively inelastic; the P.E.S. coefficient is greater than 0 but
less than 1; and a price fall means a smaller percentage decrease in Qs. In (c)
supply is unitary elastic; the P.E.S. coefficient is equal to 1; and a price fall
means an equal percentage decrease in Qs. In (d) supply is relatively elastic;
the P.E.S. coefficient is greater than 1 but less than ; and a price fall means
a greater percentage decrease in Qs. In (e) supply is perfectly elastic; the
P.E.S. coefficient is equal to ; and a price fall means that suppliers halt
production.
It is important to remember that for linear supply curves

 P.E.S. is inelastic at all points when the supply curve intersects the x-
axis first.
 P.E.S. is elastic at all points when the supply curve intersects the y-
axis first.
 P.E.S. is unitary at all points when the supply curve intersects the
origin.

Table 2 Factors influencing price elasticity of supply
Factor The supply for a good is relatively price-elastic because
Time in the long run, firms can adjust all factor inputs to change supply
easily
Production time if a good is manufactured quickly, supplies can be changed easily
Stocks if a firm has a large amount of stocks, supplies can be changed
easily
Capacity if labor and capital are underused, supplies can be changed easily
Factor mobility if resources can move in and out of the industry, supplies can be
changed easily
Income Elasticity of Demand

Income elasticity of demand (Y.E.D) measures the responsiveness of demand
to a given change in income.
percentage change in quantity demanded

Y.E.D. = percentage change in income
 Since Y.E.D. can be negative, it is important to include minus sign.

 If Y.E.D. is negative, the product is an inferior good.
 If Y.E.D. is positive, the product is a normal good.
 If Y.E.D. is positive and greater than 1, the product is a superior good.
An Engel curve shows the amount of a good demanded at different level of

income. Figure 4 show that the slope of an Engel curve reflects it Y.E.D.
Quantity
demanded (QD)
Y.E
ive
.D
sit
. is
po
ne
ga
is
tiv
.
.D
e
Y.E
Income (Y)
Normal good Inferior good
Figure 4. An Engel curve with different income elasticity

Types of Income Elasticity
(a) Positive Income Elasticity (Substitute)

For normal good, an increase in income leads to an increase in
quantity demanded.
(b) Negative Income Elasticity (Complimentary goods)
For inferior goods, an increase in income leads to a decrease in
quantity demanded.
(c) Zero Income Elasticity (Unrelated or independently good)
The quantity demanded for a good does not change as income
changes.
Consumption
Engel’s
Curve
0 Income
Positive Income Elasticity
Consumption Consumption
Engel’s
Curve
Engel’s
Curve
0 Income 0 Income
Negative Income Zero Income Elastic

Elasticity
Factors Affecting Price Elasticity of Demand
a) Percentage of income sent of the good

b) Availability of substitutes
c) The number of uses for a good

d) Time period
Cross Elasticity of Demand
 Cross elasticity of demand (X.E.D.) measures the responsiveness of

demand for good A to a given change in the price of good B
percentage change in the quantity demanded of commodity A
X.E.D. = percentage change in the price of commodity of B
 Since X.E.D. can be negative, it is important to include minus signs.
 If X.E.D. is positive, the two goods are in competitive demand  i.e.
substitutes.
 If X.E.D. is negative, the two goods are in joint demand  i.e.,
complements.
 If X.E.D. is zero, the two products are unrelated  i.e. independent
goods.
Types of Cross Elasticity of Demand
a) Positive Cross Elasticity (Substitute)

A rise in the price of one good causes an increase in the
demand for its substitute.
E.g. butter and margarine
b) Negative Cross Elasticity (Complimentary goods)

A rise in the price of one good cause a decrease in the demand
for its complement.
E.g. tea and sugar
c) Zero Cross Elasticity (Unrelated or independent goods)

If two goods are independent of each other, a rise or fall in the
price of one good will not affects the demand for the other good.
E.g. pen and coffee.
Price Elasticity of Demand and Revenue

The effect of a price change on revenue depends on the elasticity of demand.
Figure 5 shows how a change in price can increase revenue.
 If P.E.D. is elastic, a fall in price increases revenue.

 If P.E.D. is inelastic, a rise in price increases revenue.
If P.E.D. is unitary, a price change leaves revenue unchanged.
...
Revenue gained ..................
P P Revenue lost
P1 A P2 . . . . .. . .. . . . .. K
........................................................................................................
..
..... ................................................................................
. .. . . .. . .... .. . . .B
P2 ................................................................................................... P1
J
........................................................................... .
. . . ..... D1
..................................................................................................
.. .
.................................................................................................. D2
................................... . . .....
. . . . . . .............. Q Q
Q1 Q2 Q2 Q1
(a) (b)
Figure 5
(a) Elastic demand and revenue. Since the price decrease results in a
proportionately larger increase in quantity demanded, revenue rises.
(b) Elastic demand and revenue. Since the price increase results in a
proportionately smaller decrease in quantity demanded, revenue rises.

Contents
1. Firm and basic problems of firms
2. Economics of Scale (EOS)
3. Internal and external economics
4. Small scale production
5. Laws of Returns (Short run)
6. Law of Returns to scale (Long Run)
7. Law of variable Proportions
8. Relationship between Marginal, Average and Total Product.
9. Production functions

1. FIRM AND BASIC PROBLEMS OF FIRM
1.1 What Is a Firm and how a Sole Proprietorship Firm Maximize, Its
Profit
A firm is a decision making unit, which has the power to make decision within
the areas under its control, i.e., a person or group of persons who start
business, manage it and take responsibilities. The basic aim of the firm is to
maximize profits. A firm can maximize its profits in three ways:
(i) By Increasing the Selling Price
(ii) By Decreasing Cost of Production
(iii) By Decreasing Selling Price
Note: Profit maximization is generally the goal of a sole proprietorship firm
and it may not be the objective of a public limited company owned by
shareholders and run by non-shareholding owners.
1.2 Accounting Profits and Economic Profits
Accounting profits are equal to the sales revenue minus explicit costs of the
business e.g., material costs, labor costs, depreciation costs and Profits etc.
while the economic profits consist of total sales revenue minus explicit costs
minus implicit costs or economic profits are equal to accounting profits minus
implicit costs.
Accounting profits = Sales Revenue – Explicit Costs (Accounting Costs)
Economic Profits = Accounting profit – Implicit Costs
2. Economies of Scale
In the long run, the firm can increase output by varying all factors of
production. Economies of scale (EOS) are reductions in long-run costs which
occur from an increase in production.
 Internal EOS occur within the firm as output rises.
 External EOS occur outside the firm and are independent of the size of
the individual firm.
Diseconomies of Scale
Diseconomies of scale (DOS) are increase in long-run costs which occur from

an increase in production.
(i) Internal DOS occur within the firm when increase in output raise long-
run costs. They occur mainly because of managerial difficulties in
oversized firms
(1) managers are unable to exercise effective control or co-
ordination;
(2) internal communications within the company are difficult;
(3) workers feel isolated and out of touch with managers, and
industrial relations decline.
(ii) External DOS occur outside the firm when the long-run costs of all local
firms rise when
(1) local road congestion causes transportation delays;
(2) local land and factories become scarce and rents rise;
(3) labor shortages develop within the area and wages rise.
2.1 Economies of Scale (EOS)

Following are the economies of large scale production:
1. Economies of buying and Selling
The large scale producer purchases raw material in larger
quantities and from the areas where its supply is larger and
price is low and therefore secure favorable terms on account of
its large purchases. He sells its product in the markets where its
demand is greater and price is high.
2. Optimum use of Machinery
Most of the goods of daily use are produced with the help of
modern machinery which produces larger quantities, of superior
quality with lower cost. But modern machinery can be used only
by large scale producer.
3. Division of Labor
Division of labor helps in increasing efficiency of labor. Efficient labor
can produce larger output and of better quality. But division of labor is
only possible in large scale.

4. By-Products
In large scale of production waste is not thrown away but it is utilized
for production of by-products which lowers the cost of production e.g. a
big sugar mill does not throw away the waste, but converts it into hard-
boards and etc.
5. Economies of Overhead Charges
Overhead charges do not change with the output. Overhead charges
per unit of output decreases with an increase in output so the expenses
of administration and distribution are much less in large scale
production that results in lower per unit cost.
6. Economies of Repair or Workshops
Large scale producer being financially strong establishes workshops
within the factory hence, production process continues without any
break and expenses of repair are much less.
7. Analysis of Market Fluctuations
Market fluctuations mean changes in the price level. The organisers
who foresee these fluctuations benefit and for this purpose large scale
producer employs capable and experienced marketing managers who
survey the demand and supply positions in different markets and help
the large scale producer in earning maximum profits.
8. Facing the Adversity

A large concern can face the adversity and depression in a better way
because of his vast resources. He can bear losses even for a longer
period in a hope to earn profits in future.
9. Advertisement and Salesmanship

In the present times none of the firms can introduce its products
without the advertisement and salesmanship. Only a large scale
producer can spend heavy amounts on advertisement and
salesmanship. Thus, he captures the market and increases its
revenue.

10. Cheap Credit
Govt. provides more concessions e.g. income tax holiday, exemption of
excise duty and low custom duties on import. The large scale
producers also get credit facilities at a cheaper rate. Low costs of credit
reduce the cost of production and maximizes the profits.
11. Research and development (R & D)

It is admitted that expenses of development and research repay more.
Successful research and development may lead to a cheap method or
technique of production which in the long run reduces cost of
production. But only large scale producer can afford the expenses of
research and development.
2.2 Diseconomies of Scale (DEOS)
1. Over Worked Management

The large scale producer is mostly involved with import and export
problems, concessions from the govt. and attainment of cheap credit.
Supervision becomes relaxed and there is a wastage of raw material,
leakage of finished goods, mishandling of machinery, inefficiency of
labor, dishonesty etc., and this appears when concern grows.
2. No Personal Element
As the concern grows personal contact between the employer and
employees disappear. The owner is usually absent. The business is
generally managed by paid employees. Personal contact and
sympathy between the employers and the employees are missing and
this sometimes mislead, strikes and lock up of the factory which is
harmful for the business.
3. Individual Tastes are Ignored

Large concerns are run with huge and most modern machinery which
only turn out standardized goods and control the quality. The large
quantities are produced hence, individual tastes, traditions and
customs are ignored.

4. Danger of Depression
If at any time in large scale production supply is greater, then the
demand price goes down, profit rate goes down and if production is
stopped there is a danger of depression because of unemployment.
5. Dependence on Foreign Markets
Large scale producers import raw material and machinery. If the supply
of raw material is cut off by war or due to political unrest in the
exporting countries, production process is disturbed. This makes the
business risky.
6. Cut Throat Competition

Large scale producers have the desire to increase output to earn more
profits. They fight for the markets and there is a wasteful competition
and as a result there may be over production and all the firms may face
losses.
7. Lack of Adaptability
Large scale production in adversity or in depression finds it very difficult
to switch over from one business to another.
8. Danger of Monopolies
Large scale producers do not allow the small scale producers to enter
into the business and if enter, large scale producers lower down price
per unit of output than the cost per unit of small scale producer and
hence, become monopolist and earn super normal profits.
2.3 TYPES OF INTERNAL ECONOMY OF SCALE
Types of internal EOS Description

Specialization Large firms have more scope for the division of
labor than have small firms
Indivisibilities Some machines are of a minimum size which can
only be kept fully occupied by large firms
Increased dimension The cost of capital does not increase in proportion
to the output of each machine

Principle of multiplies Large firms use a machine combination which
eliminates bottlenecks caused by different
machines working at different speeds
Linked processes Bringing together different stages of production in
one factory reduces costs
Managerial Big firms can spread the cost of employing the
best managers over a large level of output.
Managerial costs do not increase in proportion
with output
Financial Large firms offer more security and pay a lower
rate of interest on loans than do small firms. Large
firms can raise capital cheaply through a right
issue
Commercial Large firms buy raw materials and components in
bulk and are therefore given at discount
Marketing Transportation and advertising costs do not
increase n proportion with output
Research and Large firms can spread the cost of improving
development product over a large level of output
2.4 Types of External Economy of Scale
Types of external EOS Description
Infrastructure Proximity to a good transport and communications

network
Ancillary firms Local back-up firms supply specialist support

services or components
Skilled local labor An area may have trained workers looking for jobs
Education An area may have colleges providing specialist

training
2.5 Advantages of Small Scale Production

The merits of small scale production are as follows:

1. Personal Element
In small scale production, the small scale producer has personal
contact with the employees. He can supervise his business himself so
those businesses which require personal supervision can only be
established at small scale.
2. Direct Relations with the Consumers
The goods produced in small scale are generally sold in the nearer
markets therefore; he does not ignore individual tastes and customs of
the people.
3. Better Relations with Labor

In small scale production the numbers of workers are not large
therefore, personal relations develop with the labor and a kind word is
thrown now and then which rules out the possibility of strike or any
other trouble.
4. Prompt Response to a Change in Demand

Another advantage of small scale business is that he can increase or
decrease its production according to rise or fall in demand easily.
5. Prompt Decisions
Small scale producer is capable of prompt and quick decisions about
the output, supply, demand and price. There is no divided
responsibility. He is the sole producer so he finds no difficulty in taking
quick decisions.
6. Better Distribution of Wealth

The small scale business can be started with smaller amount of capital
therefore, small businesses are established which increases circulation
of money and removes concentration of wealth.
7. Does not Require Complicated System of Accounts:

The small scale business does not require complicated system of
accounts there is a strong check to prevent fraud or waste of labor or
material.

8. Non Dependence of Foreign Markets
The small scale manufacturer purchases raw material from the
domestic markets and sells its product in the domestic markets hence,
he is free from external effects and runs business without any fear.
9. Adaptability
The small scale producer can easily switch over to another business
because he is the sole proprietor and need not to consult with his
partners or share-holders.
10. No Danger of Over Production
As the smaller quantities are produced and there are large number of
producers so there is no danger of over production and monopolies.
2.6 Disadvantages of Small Scale Production

The demerits of small scale production are following:
1. Disadvantage of buying and Selling

The small scale manufacturers buy small quantities of raw material and
sells its product in the nearer markets hence, do not enjoy the
economy of buying and selling.
2. Disadvantage of Division of Labor

As the small number of labor is employed hence, he cannot benefit the
economy of division of labor.
3. Disadvantage of by-Products
As the financial resources of the small scale producer are limited so he
cannot use its waste for making by products and has to throw it away.
4. Use of Modern Technology

Lack of financial resources not allow him to use most modern
machinery so, he cannot increase the quantity of output, and cannot
improve the quantity of its product.
5. Cannot Face Adversity

Due to lack of financial resources he cannot face adversity. He cannot
bear losses for the long period so he has to close down his business.

6. No Advertisement/Research and Experiment
Small scale manufacturer cannot spend large sums of money on
advertisement and experiment. Hence, he can neither introduce his
product nor he can improve the quality of his product.
7. High Cost Per Unit of Output

In the small scale production fixed cost or overhead charges do not
spread over large quantities that are why cost per unit is higher.
8. Credit Facilities from the Government

He cannot secure cheap credit because of unstable conditions of his
business and lack of guarantee.
2.7 Internal and External Economies

When goods are produced at large scale, a firm's average total cost starts
decreasing i.e., it benefits from the economies. These economies can be
grouped under two headings:
(A) Internal Economies

(B) External Economies
(A) INTERNAL ECONOMIES

"Internal economies are those economies in production which occur to
the firm itself when it expands its output or enlarge its scale of
production" (K.K. Dewitt). Internal economies are achieved through the
ability and long experience of the entrepreneurs. They are attached to
a specific business. Other entrepreneurs cannot benefit from them.
Internal economies may be of the following types:
1. Administrative or Managerial Economies
When a firm expands its output or enlarges the scale of
production, it follows the principle of division of labor. Specialists
are employed and as a result production process works
smoothly. The entrepreneur gives attention to more important
jobs. The administrative expenditures do not increase
proportionally with the output.

2. Technical Economies
Technical economies may arise due to large size of the plant
because it requires less energy, less staff, and proportionately
less cost of installing the plant. Specialized persons can only be
employed with large machinery and plant.
3. Marketing Economies/Commercial Economies
These economies arise from the purchase of raw material and
sale of finished goods.
4. Indivisibility
We can get total benefit from most of the factors of production
when they are being used at full capacity. If smaller output is
being produced it means that they are not working according to
their efficiency. This may be due to indivisibility.
5. Financial Economies
These may arise due to the reason that large scale firms have
better credit facilities i.e., credit at cheaper rates, concession
from the government for credit.
(B) EXTERNAL ECONOMIES

These economies arise as a result of the expansion of the industry as a
whole when industry expends machinery and raw material is available
to all the firms at cheaper rates. New and better techniques of
production are discovered. Better means of transportation and
communication are available.
The external economies may be of the following types:
1. Transportation and Communication
Concentration of firms provide better communication system for
all, the transport system reduce cost.
2. Skilled Labor
With the concentration of firms skilled labor is available to all the
firms because people living in the nearby areas get technical

training.
3. Facility of Workshops
Concentration of firms provides incentive for the technical
persons to establish their workshops.
4. Helping Industry
This economy arises because of concentration of firms. In local
industry it becomes possible to split up some of the processes
which are taken over by specialist firms.
5. Research and Experiment

In local industry, research and development are centralized.
Each individual firm needs not to spend a separate amount on
research and development.
6. Banking Facility
In a localized industry or business centers, bank opens their
branches and all the firms benefit from banking and credit
facility.
3 Laws of Production or Returns

When the units of variable factor of production are employed on the fixed
factor of production, the marginal product (i.e., the product of every additional
unit employed in a production process) and the average product (i.e., total
product divided by the units of variable factor of production) may increase,
remain constant or may be diminishing. If the marginal Product and average
.product start increasing with the employment of variable factor of production,
the production process is said to be operating under the law of increasing
returns/product or output. And if the marginal product and average product
remains unchanged, the production process is said to be operating under the
law of constant returns and if the marginal product and average product start
diminishing with the employment of variable factor of production the
production process is said to be operating under the law of diminishing
returns.

3.1 Law of Increasing Returns
If with the continuous application of units of variable factors of
production on the fixed factor of production in agriculture, extractive,
industry, minerals marginal and average product start increasing , it is
said that the production process is operating under the increasing
returns or diminishing costs. The main reason of the application of
increasing return is the indivisibility of fixed F.O.P which is utilized
effectively and as a result marginal and average product increases.
The law can be explained with the help of schedule. Suppose that per
unit cost of variable factor of production is Rs. 300.
Per unit Cost

Note: Marginal cost =
Marginalphysicalproduct
Per Unit Cost

and Average cost =
Average PhysicalProduct
Total Marginal Average

Fixed Marginal
Units of Variable Physical Physical Physical Average
Factor of Cost
Labor (FOP) Product Product Product Cost (AC)
Production (MC)
(TPP) (MPP) (APP)
25 acres 1 (Rs. 300) PD 10 10 10 30 30

" 2 “ 30 20 15 15 20
" 3 “ 60 30 20 10 15
" 4 “ 100 40 25 7.5 12

" 5 “ 150 50 30 6 10
It is clear from the table that the quantity of fixed factor of production is
unchanged and the units of variable factor of production are increasing. Law
of increasing returns or diminishing cost can be explained with the help of
figures:

50 MP
40
M.P
A.P 30
AP
20
10
1 2 3 4 5
Units of Variable FOP
Fig. 1
30
24
M.C
A.C 18
12 AC
6 MC
1 2 3 4 5
Units of Variable
FOP Fig. 2
Assumptions
(i) Fixed Factor of production is indivisible
(ii) Homogeneous units of variable Factors of Production
(iii) Perfect Competition in Factors Market
(iv) Factors are substitutes
(v) Only applicable in the short run
(vi) No change in technology / method of production
3.2 Operation of Law of Increasing Returns
Law of increasing returns applies when there is no shortage of factors

of production there is a right combination of factors of production and

the indivisible factors are being fully utilized or in those production
processes where the involvement of human factor is much greater than
the nature e.g. in Industry.
3.3 Law of Diminishing Returns
According to Alfred Marshall an increase in capital and labor applied to

the cultivation of land causes, in general, a less than proportionate
increase in the amount of the production raised, unless it happens to
coincide with the improvement in the art of agriculture. According to
Richer A. Bilas "If the input of one resource is increased by equal
increment per unit of time while the inputs of other resources are held
constant, total product/output will increase but beyond some points, the
resulting output increase will become smaller and smaller".
The law of diminishing return can be explained with the help of a table:
Units of Total Average Marginal

Marginal
Fixed Factor Variable Physical Physical Physical Averages
Cost
Land F.O.P Product Product Product (AC)
(MC)
Labor (TPP) (APP) (MPP)
(Rs.)
25 acres 1 (300) PD 50 50 50 6 6
25 2 " 90 45 40 7.5 6.66
25 3 " 120 40 30 10 7.5
25 4 " 140 35 20 15 8.5
25 5 " 150 30 10 30 10
Note: Per unit cost of variable F.O.P. is Rs. 300 which is assumed to be constant:
(i) Average Physical Product =
Per unit Cost

(ii) Marginal Cost =
Marginalphysicalproduct
(iii) Average Cost = P.U. cost

Average physicalproduct
It is clear from the table that an increase in units of variable factors of

production, average and marginal product are diminishing and marginal and
average cost are increasing. As the cost per unit is unchanged and marginal
and average product are diminishing because of the application of law of
diminishing returns therefore, marginal and average cost are increasing, that
is why the law is also named as law of increasing costs.
The law can also be explained with the help of diagrams:
Y Y
MC
50 10 30
40 8 24
MC
M.P 30 MC
6
A.P
AP ACAC 18
20 4
12 AC
10 MP 2
6
X X
O 1 2 3 4 5 O 1 2 3 4 5
Units of Variable FOP Units of Variable FOP
Fig. 1 Fig. 2
3.4 Assumptions
Law of diminishing returns is based on the following assumptions:
1. No change in the fixed factor of production

The law is based on the assumption that the quantity of fixed F.O.P.
does not change. If quantity of fixed F.O.P. increases the law will not
hold because with the application of extra units of variable F.O.P.
average and marginal products shall increase instead of decrease.
2. Law of increasing returns has actually completed
It is a necessary assumption for the law of diminishing returns that law

of increasing returns has actually completed. Sometimes due to bad
weather or unfavorable conditions the average and marginal product
decrease, but when weather conditions become favorable and
irrigation system is improved, marginal and average product again start
increasing. It does not mean that law of increasing returns has again
applied, but actually law of increasing returns had not completed yet.

3. No change in technology
If new and better methods of cultivation are discovered or pesticides,
urea or best quality seeds are used, marginal and average product will
increase and the law will not hold good.
4. Homogeneous units of variable factors of production
It is assumed that all the units of variable F.O.P. are homogeneous. If
the lateral units are better than the previous one then marginal and
average product will increase instead of decrease.
5. Factors are substitutes
It is assumed in the law that the factors of production are substitutes of
one another i.e. we can substitute variable with fixed factor of
production.
3.5 Application of law of diminishing returns
The main reason of the application of diminishing returns is the wrong
combination of F.O.P. When units of variable F.O.P. are increased, the
quantity of fixed F.O.P. remains the same, the variable F.O.P. cannot
show its efficiency. The second reason is that factors are not perfect
substitutes of one another.
3.6 Importance
1. Basis for the Malthusian Theory of Population
According to Malthus, Population increases at a faster rate than the
food production because law of diminishing returns applies in
agriculture.
2. Basis for Ricardian Theory of Rent
According to Ricardo, Rent is paid because less fertile lands are
cultivated as law of diminishing returns applies in the more fertile lands.
3. Optimum Size of Business
The optimum size of the business is that when law of increasing return
has completed and law of diminishing returns has not yet started. With
the help of this law we can determine this optimum level.

3.7 Compatibility of Increasing Returns and Diminishing Returns
It was argued in the past by the classicists that law of diminishing
returns applies only in agriculture and other extractive industries and
law of increasing returns applies in manufacturing industry. The
modern economists differ with the above argument of classicists and
they are of the views that the law of diminishing returns both applies in
agriculture and industry. The only difference is that it starts operating
earlier in agriculture and at some lateral stage in industry.
3.8 Why Law Operates More in Agriculture?

The law of diminishing returns applies more where nature's
interference is greater than the human beings. In industry the
interference by the nature is less and the entrepreneur with his ability
can postpone the law of diminishing return for a longer period, but in
agriculture the nature's interference is greater. In agriculture there is no
better check because of vast area of agricultural land, so economies of
large scale cannot be reaped in agriculture. Weather conditions play
important role and if weather conditions are not favorable marginal and
average product decrease. Another reason for the application of
diminishing returns is that the principle of division of labor cannot be
adopted.
3.9 Operation of The Law of Diminishing Returns in the Industrial

Sector
It was said in that past that the law of diminishing returns applies only
in agriculture and law of increasing returns applies in industry only on
the basis that all those sectors where the human being, law of
diminishing returns applies and where many of the charges can be
made with the involvement of human being, law of increasing returns
applies. The modern economists are of the view that the law of
diminishing returns not only applies in agriculture but also in the
industrial sector especially in those industrial units where the fixed
factors of production cannot be increased or substituted with the other
variable factors of production. In agricultural sector law of diminishing
returns applies quite earlier as compared to industry as units of fixed

factors of production cannot be changed proportionately with variable
factors of production.
We can conclude that one of the most important reasons for the
application of laws of diminishing returns is the wrong combination of
fixed factors of production and variable factors of production because
fixed factors cannot be increased proportionately with the variable
factors such as labors and raw materials.
The law of diminishing returns will not apply at any stage of production
if the factors of production become perfect substitutes.
3.10 The Law of Constant Returns or The Law of Constant Costs

Other things remaining the same when the additional units of variable
factors of production are applied on the fixed factor of production, there
arises a proportionate increase in total output is called the law of
constant returns.
It applies to those industries which represent a combination of
manufacturing as well as extractive industries. In manufacturing
industries, additional investment of labor and capital (variable FOP)
may result in more than proportionate increase. In the amount of goods
produced. While in extractive industries an increase in investment is
variable factors of production may result in less than proportionate
increase in the amount of goods produced. If the increased marginal
productivity is balanced with the diminishing productivity in the other
industries, we may state that the law of constant return is applying.
Conditions of the Law (Assumptions)

(i) No increase in the prices of raw material in the industry.
(ii) No change in the price of factors of production.
(iii) The supply of factors of production is perfectly elastic.
(iv) Indivisibility of fixed FOP.
(v) Productive services are not fixed.

The law of constant returns can be explained be with the help of a schedule.
Variable FOP Total Marginal Average

Fixed Average
(Units) Labor Physical Physical Physical Marginal
POP Cost
(RS 300/= Product Product Product Cost (MC)
Land (AC)
P/day) (TPP) (MPP) (APP)
25 acres 1 50 50 50 6 6
 2 100 50 50 6 6
 3 150 50 50 6 6
 4 200 50 50 6 6
 5 250 50 50 6 6
In the above schedule it is shown that the proportion of marginal physical

product and average physical product remains the same. On the other side
proportion of marginal cost is also equal to the proportion of average cost.
P.U. Cost
Note: MC = P.U.Cost and AC = A.P
AP
The law can be explained with the help of diagrams.
3.11 Law of Variable Proportions/Non Proportional Variables

Law of variable proportions explains that with a given technology when
units of variable factor of production are employed on the fixed factor of
production, marginal and average product increases in the beginning

but when the fixed F.O.P. is utilized fully or utilized more units of
variable F.O.P. gives less and less marginal and average product.
According to Bentham, "As the proportion of one factor in a
combination of factors is increased, after a point, first the marginal and
then the average product of that factor will diminish". According to P.A.
Samuelson, "An increase in some inputs relative to other comparatively
fixed inputs will cause the output to increase but after a point the extra
addition resulting from the same addition of input will decrease the
income".
3.12 Assumptions
The law of variable proportion is based on the following assumptions:
1. No Scientific Improvement
It is assumed that the state of technical knowledge is given and remains

unchanged, otherwise the marginal and average product will be increasing
instead of decreasing.
2. Fixed F.O.P. does not Change
The law holds only when fixed F.O.P. does not change i.e., only one
factor is variable, other factors being held constant.
3. Substitution of Factors of Production
It is assumed that factors are imperfect substitutes. It is only possible to

vary the proportions in which various inputs become variable.
4. Homogeneous Units of Variable (FOP)
All units of variable F.O.P are homogeneous. i.e., all the workers are
equal in physical health and mental capabilities.
5. For the Short period only
It assumes that the period is short run, because in the long run all
inputs become variable.
The law can be explained with the help of a schedule and a diagram:

Schedule:
Suppose that fixed factor of production is 10 acres of land.
Total Marginal
Units of Variable Physical Physical Average Physical
factors of Product Product Product (Quintals)
production (Quintals) (Quintals) (APP)
(TPP) (MPP)
1 5 5 5
2 15 10 7.5
3 30 15 10
4 40 10 10
5 45 5 9
6 45 0 7.5
7 40 -5 5.7
It is clear from the table that until 3rd unit of variable F.O.P. marginal
and average product are increasing it is the stage 1, that represents
increasing returns. From 4th to 6th unit, the average product is
diminishing, it is the second stage. With the employment of 7th unit of
variable F.O.P, the marginal product is negative, it is 3rd stage i.e., of
negative returns.

Y
45 e f
d g
40
TP
35
MP 30 c
AP
TP 25
20
i
15 b
h p
10 J q
n r
k s
5 a AP
l
X
0 1 2 3 4 5 6 7
–3 m FOP
Units of Variable MP
In the figure, up to 3rd unit marginal and average product are

increasing. At 4th unit marginal product curve and average product
curve intersect each other i.e., marginal product is equal to average
product. At 7th unit marginal product is negative. From 1st unit to 3rd
unit marginal product and average product are increasing. It is first
stage which represents increasing returns. This stage is not so
important for the firm because there is an incentive for the firm to
employ more units of variable F.O.P., from 4th to 6th unit average
product and marginal product are diminishing, it is the 2nd stage. It
represents diminishing returns. This stage is the most important for the
firm. In this stage efficiency of variable F.O.P. is decreasing while the
efficiency of fixed F.O.P. is still increasing because total product is still
increasing. At 7th unit marginal product is negative and this stage is of
least importance for the firm because none of the firm can bear losses.
So the firm is not concerned with this stage. In this stage marginal
product is negative and total product is also diminishing. This stage
shows that both the variable and fixed factors of production are not
being used efficiently.
3.13 Importance
The second stage is known as the variable proportions or non-variable
proportions. Law of variable proportions shows the efficiency of factors

of production in the production process. It also shows the technique of
production. Production process continues till total product is increasing
and production process is stopped when total product start diminishing.
4 Relationship Between Marginal Physical Product & Total

Physical Product
As the total physical product is addition of marginal physical products

therefore, as Marginal Physical Product is increasing, Total Physical Product
will increase and when Marginal Physical Product = 0, Total Physical Product
is maximum and when Marginal Physical Product becomes negative, Total
physical is zero product starts diminishing.
4.1 Marginal Physical Product and Average Physical Product:
Average Physical Product is derived dividing the total physical product

by units of variable Factors of Production and Total Physical Product is
the addition of the marginal physical product therefore, the behavior of
Marginal Product and the Average Physical Product will be the same
however the increasing and diminishing rate of marginal is always
faster than the average i.e., average increases or decreases at a slow
rate.
The relationship between marginal physical product and total physical

product, marginal physical product and average product can be
explained with the help of a schedule:

Units of Variable Total Physical Marginal Physical Average Physical
F.O.P. Product Product Product
(TPP) (MPP) (AP)
Qtls Qtls Qtls
1 5 5 5
2 15 10 7.5
3 30 15 10
4 40 10 10
5 45 5 9
6 45 0 7.5
7 40 –5 5.7
4.2 Relationship between Marginal Physical Product and Total

Physical Product:
1. When marginal physical product is positive, total physical
product is increasing. In the table marginal physical
product is positive up to 5th unit and total physical product
is increasing from 5 to 45.
2. When Marginal physical Product is zero, total physical
product is maximum. In the table marginal product is zero
at 6th unit and total physical product is maximum i.e., 45.
3. When marginal physical product is negative, total product
diminishing. In the table marginal physical product is
negative at 7th unit and total physical product has fallen
from 45 to 40.
4. Total physical product is the addition of the marginal
physical products.
5. Marginal physical product is the rate of change in the total
physical product. Per unit of variable factors of production
4.3 Relationship between Marginal Physical Product and

Average Physical Product:
1. When average physical product is increasing, marginal physical
product is also increasing. In the table average physical product
is increasing up to 3rd unit i.e., from 5 to 10 and marginal
physical product is increasing from 5 to 15 but average physical
product is increasing at a slower rate while marginal physical
product is increasing at a faster rate as evident from the gap.
2. When average physical product is maximum, marginal physical

product is equal to average physical product. In the table
average physical product is maximum at 4th unit i.e., 10 and
marginal physical product is also 10.
3. When average product is diminishing, marginal physical product

is also diminishing. In the table from 5th unit to 7th unit average
physical product is diminishing and marginal physical product
has also diminished from 5 to –5, but average physical product
is diminishing at a slower rate while marginal physical product is
diminishing at faster rate.
4.4 Short-Run Production Curves
In the short run, firms can increase output by adding extra units of labor
to a fixed amount of capital.
 The addition to output made by each extra worker is called

marginal product of labor (MPL).
 Output per worker is called average product of labor (APL).
 The concept of returns compares the percentage change in labor

(%L) with the resulting percentage change in output (%Q).

Table 1 Types of return
Type of return Description Marginal

product
Increasing returns %L is smaller than the resulting is rising

%Q
Constant returns %L is equal to the resulting %Q is constant

Decreasing %L is greater than the resulting is falling
returns %Q
 The law of diminishing returns states that, as extra units of a

variable factor are combined with a given amount of a fixed
factor, the marginal product of the variable factor will eventually
fall.
 If only diminishing returns are referred to, this is taken to mean

diminishing marginal returns.
Output (Q)
A
MPL APL
Labour (L)
Figure Q/L. A is the point of

diminishing returns; B is the point of diminishing average returns.
4.5 The Law of Costs / The Law of Returns

The law of returns can also be expressed in terms of law of costs. We
have studied that marginal cost is diminishing during the operation of law
of increasing return, marginal costs remain the same during the

operation of law of constant returns and the marginal costs start
increasing during the operation of the law of diminishing returns.
If the cost incurred on each unit of variable FOP is the same say Rs.
100/= P. day because of perfect competition in the factors market, the
above law can be explained with the help of a schedule.
Units of
Fixed variable
Marginal Physical
FOP (Rs. 300/=) Marginal Costs
Product (TPP)
Land FOP
(Labor)
25 1 10 30
25 2 20 t 15 diminishing
25 3 30 stage I 10 costs
25 4 30 10 constant
25 5 30 10 costs
25 6 Stage II 15 increasing
25 7 20 stage III 30 costs
10
The law expresses the experience of the production process. Initially it is

operating under the law increasing return or diminishing costs, then it is
operating under the law of constant returns and constant costs and finally it
is operating under the law of diminishing returns or increasing costs. The
law of costs can be explained with the help of a figure
MC

The law of returns can also be explained with the help of a diagram.
Y
Constant returns
Marginal
Marginal
Physical
Product
Product
MPP
O Units of Variable FOP X
5 Law of Returns To Scale

Diminishing marginal productivity applies when there is a fixed factor of
production, either the workers or machines. However, when the fixed factors
of production can be varied, diminishing marginal productivity does not strictly
apply. We approach to the concept of economies of scale which is generally
referred to as returns to scale. When both fixed factor (capital K) and variable
factor (labor) are allowed to vary simultaneously there can result a
proportionate, more than proportionate or less than proportionate increase in
output.
A. Increasing returns to scale

(i) Which may be a result of increase in productivity of input
because of increased specialization and division of labor as
scale of production expands.
(ii) Another cause of increasing returns to scale that expanded
scale of production often does not require a proportionate
increase in inputs.
B. Constant returns to scale is said to be prevailing when

proportion of increase in output is the same as of increase in
inputs. As economies of scale are exhausted a phase of

constant returns to scale may set in for an operation. It may
happen because identical production units at different location
could be established to produce the same product/output. It will
follow that doubling all inputs by establishing a new production
unit of the same size as the existing one will exactly double
output.
Economies of scale are the increase in input productivities that
result from division of labor and economies in materials when
the scale of production is increased by a firm.
C. Decreasing returns to scale
If output increases less than the proportion in increase of inputs,
decreasing return is said to be prevailing i.e., when the
economies of the scale are less than offset by the difficulties and
added (factors of productions) inputs requirements of managing
an organisation as it expands.
5.1 Laws of Returns are Showing Input – Output Relationship in The

Long Run
It is generally assumed that the output shows proportionate change to
a change in inputs i.e. if all the productive resources are doubled,
output will double but in fact there are three possibilities of change in
output to a change in inputs. For example, if inputs are doubled, it is
not necessary that the output will double. Change in output to same
change in inputs may be equal, less than or greater than the change in
inputs. Main difference in law of returns and the law of returns to scale
is that in law of returns to scale fixed factors production also became
variable. The behavior of output to a change inputs can be illustrated
with the help of a schedule and a diagram.

RETURNS TO SCALE
Total Marginal
Returns Returns
Variable (FOP) Fixed (FOP) (Units) (Units)
10 workers + 10 acres of land 100 100 Stage - I

20 workers + 20 acres of land 250 150 increasing
returns
30 workers + 30 acres of land 450 200 to scale.
40 workers + 40 acres of land 750 300
50 workers + 50 acres of land 1250 500 Stage - II
60 workers + 60 acres of land 1750 500 Constant returns
to Scale
70 workers + 70 acres of land 2000 250 Stage - II
80 workers + 80 acres of land 2150 150 Decreasing
returns to Scale
90 workers + 90 acres of land 2200 50
From the above table it is clear that with double inputs, output is greater than
double i.e. stage-I of increasing return. In stage – II, marginal return remained
constant at this stage of production a firm in the long run is experiencing
constant returns to scale. Additional increase in input does not yield equal
marginal returns as in stage – III, marginal returns starts decreasing with the
increase in variable and fixed factors of production. It is clear from the table
that there are three phases of returns to scale as shown in the table and in the
diagram below:

Constant Returns to Scale
500
450 Increasing returns to Decreasing
scale returns to
400 scale
350 Stage - II
300
250
200
150 Stage – I Stage III
100
50
0 10 20 30 40 50 60 70 80 90
Inputs (Units)
From the figure, it is derived that from 10 to 50 units there is increasing

returns to scale i.e. stage – I, from 50 to 60 units there is constant returns to
scale i.e. stage – II and from 70 to 90 units, have of decreasing returns
applies i.e. stage – III.
This behavior in output can be summarized as below:-
(a) If output increases more than the inputs, law of increasing returns to
scale is applying which is a result of economies of scale.
(b) If output increases in the same proportion as inputs, law of constant

returns to scale is in application.
(c) If output increases less proportionately to a change in output, law of

decreasing returns to scale is applying.
Note:
(i) During decreasing returns to scale inputs have to more than double to
double the production.

(ii) Determination of returns to scale requires empirical studies of particular
industry.
(iii) The achievable returns to scale depend on the production function.
(iv) The law of returns to scale describes the output-input relationship in

the long run.
5.2 Returns to scale and scale economies
Returns to scale Description Scale Slope of

economies LAC curve
Increasing returns to %L&K is smaller Economies of Falling

scale than the resulting scale
%Q
Constant returns to %L&K is equal to Constant Horizontal

scale the resulting %Q
Decreasing returns %L&K is greater Diseconomies Rising

than the resulting of scale
%Q
5.3 Production Function
The production function relates input and output relation. It explains the
technological relation between what is feed into the productive process by
way of raw materials and the inputs of factors of production services and what
is the relation in terms of output or production.
The production function can be explained and written as below in a

mathematical notation.
Q = f(L.K)
Where Q is the quantity of output per unit of time, ‘L’ is labor employed in
production function, ‘K’ is units of capital services used, and f stands for
functional relation that links q to L & K.

A production function may be of two types:
(i) Linear homogeneous Production function in which the output would

change in exactly the same proportion as the change in inputs. Such a
production function expresses constant returns to scale.
(ii) None homogeneous production functions of degree greater or less
than one. The former relates to increasing return to scale and the later
to decreasing returns to scale.
The production function exhibits technological relationships between
physical inputs.

Contents
1. Cost of Production
2. Long Run Cost Curves
3. Minimum efficient scale (MES)
4. Total revenue

1. COST OF PRODUCTION
By cost of production means that all those expenditures incurred during the
production process either these are directly related with the production of
output, or indirectly related with the production of output, these include the
rent paid to the land owners or other property used, wages of labor, interest
on capital, profits of the entrepreneur, cost of raw materials and replacement
and repairing charges of machinery. Cost of production i.e., rewards of factor
of production, selling costs e.g. advertisement and other costs e.g. insurance
charges, rates and taxes.
1.1 Fixed Costs/ Supplementary Costs/ Indirect Costs/Sunk Costs and
Variable Costs/ Direct Costs/ Prime Costs/ Floating Costs/
Relevant Future Costs
Fixed costs are also called the supplementary costs or indirect costs.
Fixed costs are all those costs which have to borne even when the
output is zero or temporarily stopped. Fixed costs do not vary with the
output. Fixed costs include cost of plant and machinery, rent of land or
building, salaries of permanent administrative staff and interest on
capital. Fixed costs are independent of output. Generally fixed cost is
incurred in hiring factors of production whose amount cannot be altered
in the short period. Fixed costs are necessary to start production
process but these are not directly involved in the production process
that is why these costs are also called the indirect costs.
Variable costs are also called the direct or prime costs. Variable costs
are those expenditures of production which vary directly with the output.
Variable costs increase with the increase in output and decrease with
the decrease in output and when output is zero, variable costs are zero
e.g. cost of raw materials (primary and finished), electricity expenses,
gas charges, water telephone expenses and transport expenses. If
output increases these expenditures increase and with a decrease in
output these expenditures decrease.

The difference in fixed costs and variable cost is only in the short period
because costs become variable costs in the long period.
1.2 Short Period and Long Period Costs

Short run is a period with in which the firm cannot vary fixed factor of
production such as plant and machinery, rent of land and building,
salaries of permanent staff, overhead charges and interest or capital. In
the short period a firm can only vary the variable factors of production
such as raw materials, water, telephone and transport expenses. The
costs incurred on variable factors of production in the short run called
the short run costs. Long period is a period within which the firm can
vary not only the variable factor of production but also the fixed factor
of production. If profit increase in the short period the firm can increase
production only by hiring services of more labor and buying more raw
materials but it cannot alter the size of plant, and machinery or it can
build a new plant. In the long run a firm can increase or decrease the
amount of variable as well as fixed factor of production. The costs
incurred on the variable as well as on the fixed factor of production are
called the long run costs.
Total Costs
The total expenditures incurred in producing a specific quantity of

output are called the total costs or total cost is equal to total fixed costs
plus total variable costs or given the fixed costs of firm total cost is the
addition of marginal cost or total cost is equal to average total cost
multiplied by units of output produced. (In the short period only
derived).
Average Total Costs (ATC)
It is the cost per unit of output, it may be derived as ATC = TC/Q where
Q is the output and TC is the total cost or average total cost is equal to
the addition of average fixed costs average and the variable costs.
i.e., ATC = AFC + AVC

Where AFC is average fixed cost and AVC is average variable cost.
Average Variable Cost (AVC)
It is the variable cost per unit of output. It may be derived as AVC =

TVC/Q where Q is output and TVC is the total variable cost. OR
average variable cost = average total cost (–) average fixed cost.
i.e., AVC = ATC – AFC
Average Fixed Cost (AFC)
It is the fixed cost per unit of output. It may be derived as AFC =

TFC/Q. Where Q is the output and TFC is the total fixed cost. OR
average fixed cost = average total cost – average variable cost
because fixed cost = total cost (–) variable cost.
i.e. AFC = ATC – AVC
Marginal Cost (MC)
The cost incurred in producing one more unit, next unit or the last unit is
called the marginal cost. It is the addition made to the total variable cost
by the employment of one more unit of variable factor of production.
(Fixed cost remaining the same).
Fixed Costs (F.C)
It is the portion of the total cost which does not vary with the output
such as cost of machinery and plant, rent of land and building, interest
on capital etc. It is also called the indirect or supplementary cost.
Variable Costs (V.C)

It is the portion of total costs which varies directly with the output. If
output is maximum, variable cost is maximum and when output is zero
variable cost is zero. It is also called direct cost or prime cost.

1.3 Relationship of Mc, ATC and AVC
The concept of total costs, average total costs, average fixed costs,
average variable costs and marginal costs can be explained with the
help of a schedule and diagram. Fixed cost of the firm is 100.
I II III IV = II + III V VI VII VIII

Units of TFC TVC TC AFC AVC ATC MC
Output
Q
No Out 300 - 300 300 - 300 -

put
1 300 300 600 300 300 600 300
2 300 400 700 150 200 350 100
3 300 450 750 100 I 150 250 I I 50
4 300 500 800 75 125 200 50 I
5 300 600 900 60 120 180 100 I
6 300 720 1020 50 II 120 170 II 120
7 300 890 1190 43 127 170 II 170 II
8 300 1100 1400 37.5 137.5 175 210II
9 300 1350 1650 33 III 150 183.3 III 250 III
10 300 1700 2000 30 170 200 III 350
It is clear from the above schedule that the fixed cost is unchanged
throughout i.e., 300 but A.F.C. is diminishing because when output
increases, the fixed costs spread over the total output and hence, AFC
is diminishing due to law of increasing returns.
Relationship between MC. ATC and AVC

1. It is clear from the table that from 1st unit to 6 th unit average total
cost (ATC) is diminishing and marginal cost is also diminishing.
Marginal cost at 7th unit is equal to ATC.
2. Average total cost is increasing from 8th unit to 10th unit and
marginal cost is also increasing but average total cost is
increasing at a slower rate than the marginal cost.

3. Average variable cost is diminishing from 1st unit to 5th unit
4. Average variable cost is diminishing till 5th unit and marginal cost
is equal to A.V.C. When A.V.C. is minimum. i.e., at 6th unit of
output.
5. Average variable cost is increasing from 7th to 10th unit and
marginal cost is also increasing but marginal cost is increasing at
a faster rate than the A.V.C.
The behavior and inter-relationship between cost curves can be explained

with the help of diagram.
400
MC
350
300
MC
AVC 250 ATC
ATC
AFC 200 AVC
150
100
50
AFC
0 X
1 2 3 4 5 6 7 8 9 10
Units of Output
Explanation:
In the diagram units of output have been measured on x-axis and

marginal cost, average variable cost and average total cost and AFC
have been measured on y-axis. A.T.C. is average total cost curve. It is
diminishing up till 7th unit it touches minimum value at 7th unit and then

starts increasing. A.V.C. is the average variable cost curve. It is
diminishing until 5th unit and it is minimum at 6th unit and then starts
increasing, average variable cost curve (AVC) remains below the
A.T.C. and the difference between A.T.C., A.V.C. and AFC is
diminishing because FC spreads with the increase in output but AFC is
never zero as FC in the short period is never zero i.e., why both the
curves will not intersect. M.C. curve is above the A.T.C. and A.V.C.
when both are increasing and remains below when ATC and AVC are
falling: We can conclude from the above.
1. When A.T.C. is falling, M.C. is also falling and MC is less than

A.T.C. that is why M.C. curve remains below the A.T.C.
2. At a minimum point of ATC curve, MC curve intersects A.T.C.

curve from below that is when A.T.C. is minimum M.C. is equal
to A.T.C.
3. A.T.C. curve is increasing from 8th to 10th unit and M.C. curve
is above the A.T.C. curve, which shows that A.T.C. curve
increases at a slower rate than the M.C. curve that is why M.C.
curve is above the A.T.C. curve.
4. When A.V.C. is falling, M.C. is also falling and MC is less than

AVC curve. In the figure until 5th unit A.V.C. curve is falling and
M.C. curve is below the A.V.C. curve.
5. The A.V.C. curve is at minimum on 6th unit and M.C. curve is

intersecting A.V.C. from below when it is minimum that is M.C.
is equal to A.V.C. at its lowest point.
6. A.V.C. curve is increasing from 8th unit to 10th unit and M.C.
curve is above the A.V.C. curve which shows that when A.V.C.
increases, M.C. also increases but AVC increases at a slower
rate than M.C.

1.4 Cost of Production
Table 2: Types of cost
Term Symbol Definition Equation
Total cost TC The amount spent on TC = FC + VC

producing a given output
Variable costs VC Production expenses VC = TC FC

dependent on the level of
output
Fixed costs FC Production expenses FC = TC VC

independent of the level of
output
Average cost AC The amount spend on AC = TC Q

producing each unit
Average variable AVC Unit variable costs dependent AVC = VC  Q

cost on the level of output
Average fixed cost AFC Unit fixed costs independent of AFC = FC  Q

the level of output
Marginal cost MC The amount spent on MC = TCQ

producing one extra unit
 Accountancy and economic definitions of costs are different.
 Economists use the concept of opportunity cost when calculating

production costs.
 If resources are owned by the firm, the imputed (estimated) transfer

earnings of the factor is included as a cost.
1.5 Short-run Cost Curves:
There are two methods of illustrating short-run cost curves.
In Figure 2:
 MC curve rises given diminishing returns.

 AC curve rises if MC is greater than AC.
 MC is made up entirely of changes in VC.
 Optimum output is where AC is lowest (point A).
In Figure 3:
 TC curve rises if output increases.
 VC curve rises if output increases.
 FC stay constant as output increases.
1.6 Fixed costs and average fixed costs

Costs in the accountancy sense are the payments made by a firm in
return for the inputs required for the production process. Some of these
costs are fixed. This means that they do not vary in direct relation to
changes in the level of output. Examples are the rent paid for the use
of land or buildings, interest paid for the use of money, salaries to
managers and so on.
Key Point
Fixed costs do not vary in direct relation to level of output.

In Figure 4.1 fixed costs are Rs. 40,000 whether 1 or 12 units are produced.
Total
Fixed
Cost TFC
Output units
Figure 4.1
In Figure 4.2 Average fixed cost falls as the number produced

increases;
Average
fixed
cost
AFC
Business Economics (Study Text) Output (units) 196

Figure 4.2
1.7 Variable costs and average variable costs

Variable costs change in direct relation to output. Such costs include
payments for materials used in producing goods, fuel used in driving delivery
vehicles, postage and packing costs if goods are sent by mail, as well as
some wages, where wage payments are based on piece rates (payment in
accordance with the amount of work performed).
Key Point
Variable costs vary in direct relation to level of output.
Total
Variable
cost
TVC
Output (units)
Figure 4.3
It is unlikely, however, that variable cost per unit (average variable
cost) will be constant. If the firm expands output, and as a
consequence employs more people, it is likely that variable cost per
unit (that includes some labor costs) will actually fall.
This is due to the principle of specialization. At first, as more people are
employed, worker productivity (output per worker) will rise. As workers
specialize, they will become more efficient as they can be matched to
tasks that exploit particular skills. Furthermore, time spent moving
between tasks is reduced or eliminated.

Eventually, however, if the firm continues to expand output it will begin
to experience diminishing marginal returns, and variable cost per
unit will start to rise.
1.8 Diminishing marginal returns
The law of diminishing marginal returns suggests that, if a firm

continues to add increasing inputs of factors (resources) when at least
one factor is held constant (i.e. this firm is operating in the short run),
then the additional benefit gained from extra inputs will eventually start
to fall. Thus, if a firm has one factory building and a set number of
machines, continued recruitment of labor will at first produce more than
proportional extra benefits but, eventually, the benefits to be gained
from each extra worker will start to fall.
A point will be reached whereby adding more labor will increase wages
by proportionally more than output. There is clearly a limit to the extent
to which the firm can take advantage of specialized labor processes in
the short run. This means that average variable cost (shown in Table
4.1) will eventually start to rise.
1.9 Marginal costs

Marginal cost is the increase in total cost which results from the
production of each additional unit of output.
Definition
Marginal cost is the increase in total cost which results from the production of
each additional unit of output.

Quantity units Total costs Marginal costs
produced
Rs. (000) Rs. (000)
1 54 10
2 64 6
3 70 10
4 80 15
5 95 23
6 118 27
7 145 39
8 184 63
9 247 93
10 340 0
The marginal costs fall at first and then rise. The fall is a result of increased
efficiency caused by specialization as output is increased. The rise is caused
by the rise in unit variable costs caused by diminishing returns.
1.10 Average costs
The next table (Table 4.3) again uses the unit quantity column and total cost
column of the earlier tables. Average cost is found by dividing the total cost by
the number of units produced (i.e. the second column by the first).
Quantity units Total costs Marginal costs

Rs. (000) Rs. (000)
1 54 54
2 64 32
3 70 23.3
4 80 20
5 95 19
6 118 19.7
7 145 20.7

8 184 23
9 247 27.4
10 340 34
Table 4.3
Notice that in the early stages as the output (quantity) increases the average
cost is falling. This is because fixed costs at Rs. 40,000 represent a high
proportion of total costs (half or more up to 4 units). At this stage, the average
fixed cost element is bringing the total average down very forcefully (see
Figure 4.2). Average variable cost is also falling due to increased
specialization. However, as output rises, the decline in average fixed cost
slows down, while attempts to raise output by employing more people will lead
to higher average variable cost. Since average total cost is made up of
average cost variable and average fixed cost, average total cost will fall at first
but will begin to rise beyond a certain point.
1.11 Short-Run Cost Curves

There are two methods of illustrating short-run cost curves.
In Figure 1
 MC curve rises given diminishing returns.
 AC curve rises if MC is greater than AC.
 MC is made up entirely of changes in VC.
 Optimum output is where AC is lowest (point A).
In Figure 2
 TC curve rises if output increases.
 VC curve rises if output increases.
 FC stay constant as output increases.

£
£
MC TC
AFC
AC VC
A AVC FC
FC
Q Q
Figure 2: Unit cost curves Figure 3: Total cost curves
1.12 Why Is Short-Run Average Cost Curve (Sac) U-Shaped?

Short run average cost curve is U-shaped because of the following reasons:
(i) Average fixed cost starts falling as the level of output starts
rising.
(ii) Total variable costs vary with the output.
(iii) If average fixed cost is falling and average variable cost is
constant, the average total cost will be falling too as output rises.
(iv) The average variable costs start rising beyond a normal capacity
level. As average variable costs increase as output increases,
the average total cost per unit will rise too.
(v) In the short period the fixed factors of production do not change,
only the variable factors of production can be changed therefore
change in average cost curve is only because of variable factors
of production and it becomes U-shaped.
(vi) It falls and rises at a faster rate and becomes U-shaped
because of constancy of fixed cost.
(vii) In the short period if output decreases after a certain limit the
average variable costs start rising.
(viii) In the short period technology or the method of production does
not change therefore average cost curve after certain limit starts
rising and AC curve become U-shaped.

(ix) The factor combination in the short period is not optimum
because fixed factors cannot be changed therefore, AC curve
falls and rises rapidly (i.e. because of application of diminishing
return).
1.13 Past Costs / Sunk Costs And Relevant Future Costs (Opportunity
Costs)
It is an admitted and accepted phenomenon by the accountants and

economists that the decision making costs are future costs. Past costs
or Sunk Costs are not used for decision making as these are generally
unchanged and have already been incurred in a production process.
Relevant future costs are actually the opportunity costs of the factors of
production (Commonly crown as inputs resources) used.
2. Long Run Cost Curves

Long run is the period which is long enough for a firm to be in a position to
vary quantities of all inputs. Therefore, in the long run there is no fixed cost.
Because in the long period fixed factors of production also become variable. A
firm can easily build up any size of land and scale of production. Long run is
the addition of the short run so the behavior of the long run average cost
curve is the same as of short run cost curve. Short run average cost curve
decreases first due to increasing returns, it touches minimum level and then
starts increasing due to due to diminishing returns. As the long run is the
addition of the short periods so the long run average cost curve first
diminishes, touches minimum and then starts increasing. Suppose that a
firm's short run average cost curves are given in the diagram below:

Long run average cost curve can be drawn from the addition of short period cost
If short run average cost curve of the

firm is SAC2 then the optimum level SAC 1 SAC 2 SAC 3 LAC
of output is OQ2 because cost at this S 1

P1 S 3
output is minimum i.e., S2Q2. P3 S2
P2
Suppose that a firm intends to
increase its output up to OQ3 in the
short period it has average cost of
O Q1 Q2 Q3
S 3 Q3 because the scale of
production in the short period is fixed.
But in the long run a firm adopts many
alternative techniques of production of
producing goods or it can change the
size of the plant. In the long run a firm
can produce OQ3 of output at P3Q3
average cost while in the short period
it was only possible for a firm to
produce at S2Q2 average cost. A firm
in the long run can adopt three
different scales of production i.e., it
may be increasing returns or return.
curves or if a tangential curve is drawn on all the short run cost curves we
get the long run average cost curve or (L.A.C.) is given by a curve tangent
to all the short run average cost curves.
The long run average cost curve shows the minimum per unit output
cost at each level of output when desired scale of production can be
build.
2.1 Why LAC is Flatter

The short run average cost curve is U-shaped. The shape of the LAC is
the same that first it decreases, touches the minimum level and then
starts increasing but it decreases and increases at a slower rate and
when it touches the minimum points it remains for a longer period and
the LAC becomes saucer shaped. The reason is that fixed factors of
production become variable in the long run and the ratio of variable
costs increases while that of fixed cost decreases and fixed cost per
unit of output decreases and it becomes flatter.
The size of the firm increases due to increase in the fixed cost of the
firm and the firm takes advantage of large scale and average costs
curve remains at minimum level for a longer period.
In the short period if output increases after a certain limit, the average
variable cost starts increasing but in the long. run the size of the firm
can also be increased therefore, average variable costs do not
increase at a faster rate as in case of short period.
The factor combination in the long period becomes optimum, trained
and efficient labor becomes available, capital at lower interest rate may
be available and therefore, average costs diminish at a slower rate.
2.2 Causes of Rising Long Run Average Cost Curve:

1. When size of the firm increases it may not be managed well and
average cost starts increasing (i.e., diseconomies of large scale).
2. The selling cost (and the transportation cost) increases as the
market extends and average cost starts increasing (diseconomies
of scale).
2.3 Relationship Between SAC Curve and LAC Curve:

1. The short run average cost curve is U-shaped while the long run
average cost curve is saucer-shaped.

2. The long run average cost Y
curve never intersects the short

run average cost curves but it
Average Cost
becomes tangent to them.
3. The long run average cost
LAC
curve keeps the short run
average cost curves within itself O X
Output
that is why it is also called
Envelope curve.
4. If the technology changes in the
long run the shape of LAC
becomes L-shaped as shown in
diagram below:
2.4 Long-Run Cost Curves
 A short-run average cost curve (SAC) shows the unit cost associated
with a given size of plant.
 A long-run average cost curve (LAC) shows the minimum unit cost of
producing each level of output, allowing the size of plant to vary.
 A LAC curve is founded by drawing a line tangential to each SAC

curve.
 Each SAC curve shows the unit cost from plants of different size.
 The size of plant associated with SAC2 is the smallest needed to

minimize unit cost  i.e., minimum efficient plant size (MEPS).
 The slope of the LAC curve is determined by internal EOS.
 The position of the LAC curve is determined by external EOS.

SAC4 LAC
SAC1
D
A SAC2 SAC3
B C
Economies of Constant-scale Diseconomies

scale economies of scale
Q1 Q2
Figure 4 Long-run average curve
The concept of returns to scale compares the percentage change in

labor and capital (%L&K) with the resulting percentage change in
output (%Q). Table 1.4 explains the relationship between returns to
scale and economies of scale.
Impact of long run costs on the industry
Long run is the time period when the industry is in a position to change
the fixed factors of production for example plant and machinery, land
and building etc. and in the very long run (Secular time period) the
industry is in a position to control over the market.
In the long run industry enjoys economies of scale that is unit costs
decreases with the increase in output. The economies of scale are of
two types internal economies and external economies. (detailed
discussion on economies is included in chapter 5)
Long run costs have a great impact on
1. Output decisions
2. Expansion of industry
3. Technological changes
4. Sales decisions
5. Marketing decisions
6. Decisions regarding transportation
7. Material costs
8. Costs of energy resources
9. In the long run indirect taxes have a great impact on cost of
production which restricts the expansion of industry.

10. Changes in the rewards of the factor services (rent, wages,
interest) have a greater impact on cost of production in the long
run which affects the supply of industrial goods.
11. In the long run high inflation rates also effects the cost of
production which is a handicap for industrial expansion.
12. In the modern times the services of specialized personals are
hired and heavy costs are incurred on advertisement which has
a greater impact on cost of production which in turn affects the
industrial development.
3. Minimum efficient scale (MES)

The minimum efficient scale (MES) is the level of output on the LRAC curve at
which average costs first reach their minimum point. Costs have fallen to their
lowest point, after which costs will be constant or may even eventually start
rising or MES is at which economies of scale start reaping the level of output
differs from industry to industry.
Definition
The MES is the level of output on the LRAC curve at which average costs first
reach their minimum point, and it represents a natural barrier to entry in some
industries.
Cost
Rs
Output
MES
Figure 4.9
The MES is important because it represents one of the natural barriers to

entry in certain industries.

• If the MES is high relative to the size of the total market demand, this
will tend to limit the number of firms that can enter and exist in that
market. For example, if the total market demand is five million units and
the MES is one million, then such a market cannot support more than
about five producers.
• If the MES is high in absolute terms this may indicate a high level of
capital investment. The high cost may deter new entrants.
4. Total revenue
Total revenue is the amount received by selling total specific amount of output
per unit of time or total revenue is equal to price per unit multiplied by the
amount of output sold (i.e. Total Revenue = Average Revenue or Price x
Output sold)
Average revenue is the total revenue divided by the number of units of the
product that are sold.
Shape of the revenue curves under perfectly competitively market and under
imperfect competition.
Definition
Marginal revenue is the rate of change in total revenue which results from
the sale of one more unit of output.
MR = dTR
DQ
Under perfect competition all the firms are price taker none of the firms can
influence the price but can adjust their output. Therefore, marginal revenue is
equal to average revenue is equal to price i.e. demand curve under perfect
competition is perfectly elastic.
P
MR = AR =P
Q
Under imperfect competition the revenue curves output (MR& AR) ae
downward sloping as the firms are price markets. However, the revenue are
elastic in monopolistic competition and inelastic in monopoly market.
AR
MR
Q
4.1 Profit-maximizing conditions
To find the maximum profit-making level, consider marginal revenue and
marginal cost. If marginal cost is lower than marginal revenue it will pay to
increase output. To do so will increase revenue more than cost. Figure 4.10
shows the marginal cost and marginal revenue curves.
1. Under perfect competition 4.7

2. Under imperfect competition 4.8
MC
MR M
Q1 Q2 Q
Summary
• Of particular importance for understanding the behavior of firms in

different types of market, is the concept of the profit-maximizing
output. This always occurs at that level of output where marginal
revenue equals marginal cost.

Self-test questions
The short run and long run
1. What is the difference between the short run and the long run?
(1)
Short-run costs
2. Distinguish between a fixed cost and a variable cost. (2.1, 2.2)
3. What happens to average fixed cost as output rises? (2.1)
4. State the law of diminishing returns. (2.3)
5. At what point of average cost is marginal cost equal to average cost?

(2.7)
Revenue
6. Define marginal revenue. (4.3)
7. If average revenue is falling, will marginal revenue be more or

less than average revenue? (4.3)
Profit-maximizing conditions
8. At what point of output will a firm maximize its profits? (5)
Practice questions
Question 1
The minimum price needed for a firm to remain in production in the short run
is equal to:
A average fixed cost
B average variable cost
C average total cost
D marginal cost

Question 2
Marginal cost is best defined as:
A the difference between total fixed costs and total variable costs
B costs that are too small to influence prices
C the change in total costs when output rises by one unit
D fixed costs per unit of output
Question 3
Which one of the following would be a variable cost to a firm?
A Mortgage payments on the factory
B The cost of raw materials
C Depreciation of machines owing to age
D Interest on debentures
Question 4
According to the traditional theory of the firm, the equilibrium position for all
firms will be where:
A profits are maximized
B output is maximized
C revenue is maximized
D costs are minimized
Question 5
The ‘law of diminishing returns’ can apply to a business only when:
A all factors of production can be varied
B at least one factor of production is fixed
C all factors of production are fixed
D capital used in production is fixed

Question 6
Economies of scale:
A can be gained only by monopoly firms
B are possible only if there is a sufficient demand for the product
C do not necessarily reduce unit costs of production
D depend on the efficiency of management
Question 7
Decreasing returns to scale can only occur:
A in the short run
B in the long run
C if there is one fixed factor of production

D if companies have monopoly power
Question 8
The long-run average cost curve for a business will eventually rise because
of:
A the law of diminishing returns
B increasing competition in the industry
C limits to the size of the market for the good
D diseconomies of scale
Question 9
The benefits to a company when it locates close to other companies in the

same industry include all of the following except which one?
A The benefits of bulk buying
B The provision of specialist commercial services
C The development of dedicated transport and marketing facilities
D The supply of labor with relevant skills

Question 10
Which one of the following is not a source of economies of scale?
A The introduction of specialist capital equipment
B Bulk buying
C The employment of specialist managers
D Cost savings resulting from new production techniques
the book.

Contents
1. Business structures in a mixed economy
2. Public structures in a mixed economy
3. Forms of market structure and competition
4. A perfectly competitive market
5. Overview of analysis
6. The demand curve of the individual firm
7. The effect of changing demand on the firm’s supply decisions in the short run
8. The supply curves of the firm and the market in perfect competition in the
short run
9. The effect of changing demand on the market in the long run
10. The market’s long-run supply curve
11. Is perfect competition desirable?

1. Business structures in a mixed economy
1.1 Introduction
A mixed economy is one where private enterprise exists alongside the public
sector. Private enterprise can take on many forms.
1.2 Sole traders

A sole trader is a person who sets up in business on their own. The type of
person who does this is often someone with a good marketing idea, or
perhaps an invention. Alternatively, it may simply be a person who prefers the
freedom of being their own boss. Although the business is an accounting
entity that is separate from its owner, it does not have a separate legal
personality. The owner is therefore responsible for all the debts of the
business. In fact, it is not unusual for the owner to mortgage their house to
raise money when starting out, which means that, if the business fails, the
house is lost.
The compensation for unlimited liability is that the sole trader does not have to
have an audit or file accounts at Companies House. Companies must file an
audited set of accounts each year where they can be seen by any member of
the public who wishes to obtain them. This provides some safeguard to those
outside the company who lend it money, such as creditors or banks, in that
they can check the company’s position before committing themselves.
1.3 Partnerships
Partnerships are one step up from sole traders. Partnerships are businesses
run by a number of people (generally between 2 and 20) with the same or
complementary expertise or profession. The partners contribute the capital of
the partnership and, as its owners, share in its profits. They do not have
limited liability, so they are responsible for the partnership’s debts, and should
it go bankrupt, creditors can turn to them for funds. The activities of the
partnership are regulated by a legal document, the partnership deed. The
partnership does not have to be audited nor does it have to file accounts.

Probably the most well-known partnership is the John Lewis Partnership. All
its members of staff are partners, so it is considerably larger than average.
1.4 Companies
A company is owned by shareholders, the minimum number of shareholders
is two, each of whom owns part of the company. The shareholders contribute
the capital of the company and have limited liability.
DEFINITION
A company is a business organization regulated by the Companies Acts.
Owners of a limited company provide the capital for the company by buying
shares when the company is first set up. If the company subsequently goes
bankrupt, the owners are not liable for its debts; they may not recover the
capital they put in at the beginning, but they will not lose any more. In other
words, the owners have ‘limited liability’ for the company’s debts.
1.5 Private limited companies

A private company is one that is not allowed to sell its shares to the general
public. In fact, private companies are often small family firms, with members
of the family owning the shares and running the business.
Private companies can be identified by the fact that their names are followed
by the word ‘Limited’ or ‘Ltd’ (which refers to the shareholders’ limited liability).
In exchange for the limited liability, the company has to prepare audited
accounts each year, which are filed at Companies House and are available for
anyone who cares to look at them.
1.6 Public limited companies

The word ‘public’ refers to the fact that, unlike private limited companies, they
are allowed to sell their shares to the general public for example on the
London Stock Exchange. They identify themselves by putting the letters ‘plc’
after their names.

Although the shareholders own the company, they rarely actually run it.
Managers usually run it on their behalf. Strictly speaking, all shareholders
have a say in how the managers act by voting at meetings, but in practice a
small group of shareholders tends to dominate. The controlling shareholders
will often be institutional shareholders, such as pension funds or insurance
companies.
Public limited companies are large. They have to comply with certain
requirements as to size, the number of shares offered to the public and the
reporting of their results. They may have complex capital structures. One very
common feature is the ‘group structure’ that many plc’s adopt. Here, a number
of different companies involved in complementary or diverse businesses are
joined together by another company that holds a controlling interest in them
all. The company that controls them is the ‘holding company’, they are the
holding company’s ‘subsidiaries’, and the whole organisation is a ‘group’.
Although the subsidiaries maintain a certain amount of independence and
identity, the holding company can control their activities should it wish to do
so. Often the holding company will take responsibility for financial matters,
such as investment decisions, but will allow managers of individual
subsidiaries to retain control in other areas. The extent of holding company
involvement varies from group to group and depends on the management
style and strategy of the main board.
Public companies must be audited, so that shareholders, creditors, bankers

and other interested outside parties can be sure that the stewardship of the
assets is being carried out competently and well.
In practical terms, other than being called ‘plc’ or ‘Ltd’, public and private
companies mainly differ in size and contact with the public. Private ones are
usually small and owned by the people that run them; public ones are usually
large, owned by many different individuals and run by professional managers.
This is not always the case, however. There are a small number of plc’s
(Public Limited Companies) which are still dominated by the family which

originally set up the business, Sainsbury’s and Cadbury’s being good
examples.
1.7 Co-operative retail and wholesale societies

The aim of the co-operative is to cut out middlemen in the production and
distribution chain, providing greater returns for the producers and cheaper
prices for the consumers. The first co-operative was set up in 1844, its
members combining small sums of money to enable them to buy directly from
producers. This not only cut out middlemen, but also reduced prices by
making bulk buying possible. This type of co-operative is a ‘consumer’ co-
operative.
Producers can also form ‘producer’ co-operatives, joining together to sell their
output directly to the consumer.
The rewards to each member of the co-operative depend on the amount of

trade they do through it, not on the amount of capital they have invested in it.
To become a member you buy a share for a nominal sum, in exchange for
which you get a right to vote. The management committee is elected from
amongst the members. Although the people working for the co-operative need
not be members, they usually are, particularly in producers’ co-operatives.
Cooperatives are not profit-motivated as are other types of private enterprise.
They are more democratic, more paternalistic towards their workers, and
more politically orientated.
The first co-operative spawned others and the movement grew. As it grew,
other wholesalers and retailers became hostile to it, as they were losing trade.
They tried to prevent the competition by stopping producers from selling to the
co-operatives.
The co-operatives retaliated by forming ‘wholesale’ cooperatives, which

produced their own goods. A further development was their involvement in
the education and welfare of their members. They realized that they would
benefit if their members could obtain a better understanding of business

through education, and believed that they had a responsibility towards their
members which extended beyond the workplace.
The force behind the growth of the co-operative movement was the perceived
lack of protection of the more vulnerable members of society when market
forces are allowed to rule. This is particularly evident nowadays in the Third
World, where farmers’ co-operatives are trying to overcome the problems
created by their huge national debts and often corrupt governments. The
developed world is becoming more aware of their problems and it is possible
to go to shops in Britain where all profits on sales go directly to producers.
1.8 Public structures in a mixed economy
There are a number of government bodies, called variously commissions,

boards, authorities and corporations. They are often known by the general
term ‘quasi government bodies’. In addition to these bodies are the local
authorities, that are responsible for the more day-to-day aspects of
government within particular areas, and government departments such as
defense or law and order. All these structures have a specially designated
responsibility, for which they are answerable to Parliament: local authorities
are responsible for street lighting, libraries, refuse collection and the like; the
responsibilities of government departments are clear from their titles; and the
quasi-government bodies are responsible for various industrial and non-
industrial matters.
1.9. A Firm
A firm is a decision making unit, which has the power to make decision within
the areas under its control, i.e. a person or group of persons who start
business, manage it and take responsibilities. The basic aim of the firm is to
maximize profits. A firm can maximize its profits in three ways:
(i) By Increasing the Selling Price
(ii) By Decreasing Cost of Production

Cost-Volume-Profit Analysis
In cost-volume-profit analysis — or CVP analysis, for short — we are looking

at the effect of three variables on one variable: Profit. CVP analysis estimates
how much changes in a company's costs, both fixed and variable, sales
volume, and price, affect a company's profit. This is a very powerful tool in
managerial finance and accounting. It is one of the most widely used tools in
managerial accounting to help managers make better decisions.
Here is a step-by-step method you can use to do cost-volume-profit analysis:
Contribution Margin and Cost-Volume-Profit Analysis
First, take a look at the contribution margin income statement. The

contribution margin is the difference between a company's sales and its
variable costs. Calculating the contribution margin income statement shows
the separation of fixed and variable costs. Simply stated, it can fit into this
simple equation:
Operating Income = Sales - Total Variable Costs - Total Fixed Costs
In order to better your understanding, this basic equation can be expanded:
Operating Income = (Price x #Units Sold) - (Variable Cost Per Unit X

Number of Units Sold) - Total Fixed Costs
Gross Margin vs Contribution Margin
It is important for a financial manager to understand that the gross profit

margin and the contribution margin are not the same. The gross profit margin
is the difference between sales and cost of goods sold. Cost of goods
sold includes all costs — fixed costs and variable costs. The contribution
margin only considers variable costs. Calculating both can give the financial
manager valuable, but different, information.
Contribution Margin Ratio
Determining your contribution margin ratio is as simple as determining what

percentage your contribution margin is of your total sales. In this formula, you
use the total contribution margin, not the unit contribution margin. Calculating
this ratio is important for the financial manager as it addresses the profit
potential of the firm. For example, if your contribution margin is $40,000 and
you have $100,000 in sales, your contribution margin ratio is 40 percent. This
means that for every dollar increase in sales, there will be a 40 cent increase
in the contribution margin to cover fixed costs.

Calculating the Breakeven Point in Units
In analyzing CVP, a powerful function is to calculate the breakeven point in

units for the firm. You can calculate the breakeven point in dollars by
multiplying the sales price for your product by the breakeven point in units.
Breakeven point in units is the number of units the firm has to produce and
sell in order to make a profit of zero. In other words, it is the number of units
where total revenue is equal to total expenses.
If operating income equals zero, then the breakeven point in units has been
reached. If the operating income is positive, the business firm makes a profit.
If the operating income is negative, the firm takes a loss.
If you are observant, you can see that the variables in this equation resemble
the variables you have already used in the cost-volume-profit equation.
One of the focuses of CVP analysis is breakeven analysis. Specifically, CVP

analysis helps managers of firms analyze what it will take in sales for their firm
to break even. There are many issues involved; specifically, how many units
do they have to sell to break even, the impact of a change in fixed costs on
the breakeven point, and the impact of an increase in price on firm profit. CVP
analysis shows how revenues, expenses, and profits change as sales volume
changes.
1.10 Introduction
We will begin to analyses the behavior of the firm in perfect competition by

building up a picture of how its costs will behave as the level of output is
varied. Then we will show how its production or output decisions are
dependent upon the relationship between revenues and costs, and can be
affected by changes in demand.
Weekly production figures
Units Total Total Average Average Average Total Marginal

Produced variable fixed variable fixed total cost cost
cost cost cost cost cost
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
0 N/A 2400 N/A N/A N/A 2400 N/A
1 2000 2400 2000 2400 4400 4400 2000
2 3600 2400 1800 1200 3000 6000 1600
3 4800 2400 1600 800 2400 7200 1200
4 6400 2400 1600 600 2200 8800 1600
5 8500 2400 1700 4.80 2180 10900 2100
6 10680 2400 17.80 400 2180 13080 2180
7 12950 2400 18.50 3430 21930 15350 2270
8 1520 2400 1900 300 2200 17600 2250
9 1800 2400 2000 2670 22670 20400 2800
10 2100 2400 2100 240 2340 23400 3000
Table 8.1 Weekly production figures
Notes on table:
(a) Total fixed cost stays constant for all levels of output, by
definition. It includes normal profit.
(b) Average variable and average fixed costs are computed by
dividing each total cost by the number of units produced.
(c) Average total cost is the sum of average variable and average
fixed costs. Note that average total cost is often just referred to
as average cost.
(d) Total cost is the sum of total variable and total fixed cost. It can
also be computed by multiplying average total cost by the
number of units produced.
(e) Marginal cost is the increase in total cost at each level of
production.
(f) Note that average variable cost initially falls as output increases,
and then rises due to diminishing returns.
(g) Average fixed cost falls as the Rs. 2400 is divided by
successively larger production quantities.

Graphical representation of cost curves
Figure 8.2 shows average variable, average total, and marginal costs (AVC,
ATC and MC respectively).
45
40
35
MC
30
25
20
15
10
5
0
0 2 4 6 8 10
Figure 8.2 Quantity
Note the shapes of the curves; in particular, the way in which marginal cost
cuts the other two curves at their minimum points.
Figure 8.3 shows a smoother version of Figure 8.2, which will be used for the
analysis.
£
£
MC TC
AFC
AC VC
A AVC FC
FC
Q Q
Figure 2: Unit cost curves Figure 3: Total cost curves
Figure 8.3
2. DEFINITION OF MARKET
Generally by market we mean a place or an area where goods are exposed
for sale or anybody of persons who are in intimate business relations and

carry on extensive transaction in any commodity. But the word 'market' is
used in wider since in economics. "According to Cournot" Economists
understand by the term market not any particular market place in which things
are bought and sold but the whole of any region in which buyers and sellers
are in such free intercourse with one another that the price of the same goods
tends to equality easily and quickly. It is not necessary that the buyers and
sellers have personal contacts. The free intercourse of buyers and sellers
may be by means of telephone, telegraph, postal service, newspapers, radio,
TV, internet or any other mean. The necessary conditions of market are:
(a) Existence of commodity which is dealt with.
(b) The existence of buyers and sellers.
(c) Price knowledge to the buyers and sellers.
(d) Place, area, certain region or the whole world.
2.1 Size of the Market/Extension of Market
Size of market depends on several factors. Size of the market means

whether demands for a commodity comes from nearer places or from
far of places. If the demand of a commodity is low, the commodity will
be sold in nearby places and its market will be limited and if the
demand comes from far of places, the market of that commodity will be
wider.
1. Nature of Demand
If the demand for a commodity is more, the market is wider and if the
demand for a commodity is low, the market is limited. A commodity
which is in universal demand. will have a wider market.
2. Character of the Commodity (Perishable & durable)

The market for those goods which are durable, portable and are
suitable for sampling and grading is wider. The market for perishable
goods and those commodities which are not suitable for sampling and
grading, the market is limited.

3. Means of Transport and Communication
The size of the market also depends on means of transport and
communication. If the means of transport and communication are
developed the market is wider and if the means of transport and
communication are under developed the market will be limited.
4. Peace and Security

Extent of market depends on peace and security in and outside the
country. Goods cannot be transported to the far of places of the
country unless there is peace and security.
5. Weight and Value

The market for those goods which have more weight and less value,
the market is limited. The market for those goods which have more
value and less weight, the market is wider.
6. Scale of Production
If the goods are being produced at large scale and principle of division
of labor is adopted the market is wider and if goods are produced on a
small scale, the market is limited.
7. Policy of the State (Trade & Taxation)

If the state does not impose restrictions on free import and export of
goods, the market is wider and if state imposes higher import and
export duties, the market is limited. If the progressive taxation system
is adopted the market will be limited.
8. Currency and Credit System

The size of market depends on currency and credit system. If the
currency and credit system are developed the market is wider because
marketing can be easily, conveniently and profitable to be carried on
over longer distances.
2.2 PERFECT AND IMPERFECT MARKETS

Perfect market is that market which fulfills these conditions
(a) Very large number of buyers and sellers.

(b) Units of goods sold are homogeneous.
(c) Consumers are aware of the market situation.
(d) Perfect mobility of factors of production.
(e) Free entry and exist of firms.
(f) Transportation cost is negligible and as a result price of all the
units of a commodity sold is the same and it is minimum.
2.3 CONDITIONS OF PERFECT MARKET
(i) Very Large Number of Buyers and Sellers

One of the conditions of pure market is that there are very large
number of buyers and sellers so that none of the seller or buyer
will be able to influence the market price. Perfect competition
exists when each seller intends to sell more and more of its
output and charges minimum price. The sellers will try to reduce
cost of production to charge minimum price.
(ii) Homogeneous Goods

Pure competition in the market, can only exist when all the firms
are producing homogeneous units of a commodity i.e., the units
are standardized or identical in their characteristics.
(iii) Free Entry and Exit of Firms

Pure competition can only exit in the market when there are no
barriers for new entry of firms and exit.
(iv) Knowledge of Market Situation (Market intelligence)
Another condition of perfect competition is that buyers and
sellers are aware of the market prices. If the buyers are not
aware of prices prevailing in the market same price cannot rule
in the market for the same commodity.
(v) Perfect Mobility of Factors of Production

Same price can rule in the market for the same commodity when
there is perfect mobility among those factors of production which
are producing that commodity. If the demand of factor will move
to that industry and in other case the factors of production will

back out from that industry hence the rewards of factors of
production in one industry will be equal and cost of production
being equal each firm in the pure competition will charge the
same price.
(vi) Absence of Transportation Cost

Same price can only rule in the market for the same commodity
when there is no transportation cost. In the presence of
transport cost the prices must differ to that extent in the different
areas, places and sectors of the market.
2.4 Conditions of Imperfect Market
(i) No Knowledge of Price

In imperfect market consumers are not aware of the prices.
They do not search for the low priced product and buy from
nearly areas at high price.
(ii) Differentiated Product
Another feature of imperfect market is that all the units of
commodity are not homogeneous but are differentiated hence,
same price cannot exist in the market.
(iii) Shortage of Firms
In imperfect market, in case of monopoly there is only one firm,
in case of oligopoly there are few firms and in case of
monopolistic competition there are many firms but not large.
They can sell their goods by means of agreements, contracts
and price cartels and hence, can charge high price.
(iv) Factors are not Perfectly Mobile

As the factors are not perfectly mobile hence cost of production
for the same commodity differs indifferent markets and
producers charge different prices.
(v) Price Policy

In perfect competition firms follow the price policy but under
imperfect market each firm has its own price policy. i.e., under
perfect competition firms are price taker and under imperfect
market firms are price maker.
(vi) Demand Curve

The demand curve under perfect competition is perfectly elastic
while in imperfect market it is responsive to changes in price.
Maximizing profit
In the exam you need to be able to use tables and graphs to identify
the optimum price. This is best seen through an example.
e.g. The following table show the output, price, total revenue (TR) and
total cost (TC) figures for a new product.
Output Q Price Total Total Total

Revenue Cost Profit
TR TC TP
0 9 0 40 -40
10 8 80 70 10
20 7 140 100 40
30 6 180 140 40
40 5 200 180 20
50 4 200 200 0
From the table we can see the following:

 Total revenue (TR) doesn’t always keep rising when more units are
sold. The price cut to generate the extra business can more than
offset the gain in volume obtained.
 The maximum profit appears to be at quantities of 20 and 30 units
and we suspect it might lie somewhere between these two.
 Maximum revenue and maximum profit do not occur at the same
price and quantity.
This can also be seen graphically. Profit maximization will then occur when
total revenue (TR) exceeds total cost (TC) by the greatest amount. The

shaded area represents the levels of output within which profits are made.
The maximum profit is shown by the greatest difference between total
revenue (TR) and total cost (TC) and total cost (TC), which is at output level
30.
B C
TC
Cost/revenue
TR
A
Zone profit
Maximum profit
10 20 30 40 50 Output
Note that on the graph we can identify the following points:

A A break-even point (profit = 0)
B Maximum profit.
C Maximum revenue.
D A second break-even point.
2.5 Market Failure

Introduction
In theory market forces should result in allocation of resources in a way
that maximizes the utility (benefits) for consumers. However, in some
circumstances, markets can lead to sub-optimal allocation of
resources, leading to under or over-production of certain goods and
services.
This inability of a market to allocate resources in a way that maximizes

utility is called market failure.

Government can then have a role to intervene to ensure that a market
functions efficiently.
2.6 Public goods

Without government intervention some goods would not be provided at
all by a market economy. These are often referred to as public goods.
Public goods have the property of non-excludability, i.e. a person can
benefit from the good without having to pay for it (the free rider
concept). Provision of the good for one member of society
automatically allows the rest of society also to benefit.
Furthermore they have the property of non-rivalry, i.e. consumption of

the good by one person does not reduce the amount available for
consumption by others.
As a result a market for this type of goods does not exist and so must
be provided by the state.
e.g. Imagine you needed a street light outside your home. You might
ask your neighbors to share the cost as they too will benefit from its
installation. If they refuse and you go ahead, paying for it all yourself,
you cannot stop them from benefiting from its presence.
Under such circumstances, in which you have to bear all the costs but
benefit no more than any other resident in the street, would you go
ahead and buy the light?
In these circumstances consumers are very unwilling to purchase

goods and services and there is a role for government to provide them
centrally, funded out of general taxation.
Other public goods include defense, a police force and lighthouses.
Key Point
Pure public goods are goods:
A which are produced by the government.
B whose production involves no externalities.

C whose consumption by one person implies less consumption by
others.
D where individuals cannot be excluded from consuming them.
As the government is providing public goods on a nationwide basis, it can

benefit from economies of scale. This could lower costs and the industry
would strive for technical efficiency. There is no allocated efficiency because
consumers do not have choice the services, such as police, prisons, fire, are
provided whether they like it or not. However, a consumer who seeks more
protection could buy additions in the market place, like burglar alarms,
underground concrete bunkers, security men, etc.
3. Externalities
Externalities are social costs or benefits that are not automatically included in
the supply and demand curves for a product or service.
Social costs arising from production and consumption of a good or service are
described as negative externalities and social benefits as positive
externalities.
Supply and demand curves only take into account private costs and benefits,
i.e. the costs that accrue directly to the supplier or the benefits that accrue
directly to the consumer.
e.g. If you smoke, drive a car or drink alcohol, who actually pays the cost of
the product? In part you do in the form of the price you pay for each packet of
cigarettes, liter of fuel or bottle of wine. These are the private costs.
However, there are other costs. They are social costs that are met by society
as a whole – the cost of healthcare for smokers, the environmental damage of
burning fossil fuels and the cost of Accident and Emergency treatment for
drunk drivers. These could all be described as “negative externalities”.

Some would argue that one of the roles of government is to ensure that such
externalities get incorporated into decision making, for example by fining
polluters (“polluter pays policies”) or high taxes on alcohol.
e.g. One way of reducing negative externalities such as pollution would be

to tax the supplier concerned, thus adding to their costs.
This would shift the supply curve to the left (S1 to S2), resulting in an
equilibrium with higher prices (P to P2) and lower quantity (Q to Q2):
D S2
S1
P2
P
Q2 Qs Quantity
Supplementary reading – externalities

An externality occurs when the costs or benefits of an economic action are not
borne or received by the instigator. Externalities are, therefore, the spill-over
effects of production and consumption which effect society as a whole rather
than just the individual producers or consumers.
 Externalities created by nationalized industries can be good and

bad. For example, the railways may be beneficial by relieving
roads of congestion and maintaining communications for isolated
communities, but may be detrimental in terms of noise and air
pollution.
 The pricing policies considered so far have been based purely on

private costs. If any pricing policy was to maximize net social

benefit (or minimize net social cost) then costs would need to
include such externalities.
 Calculate social costs. These would indicate the true cost to
society of production to incorporate into decision making. However
externalities are very difficult to calculate as they are not always
attributable, for example noise, and their impact is not universally
identical.
 Use indirect taxes and subsidies. Where private costs of
production are below social costs, an indirect tax could be
imposed so that price is raised to reflect the true social costs of
production. Taxes on alcohol and tobacco can be justified on
these grounds. Subsidies to home owners to install roof insulation
will reduce energy consumption and help conserve a scarce
resource for wider social benefit.
 Extend private property rights so that those suffering negative
externalities can charge the polluters for the harm they are
causing. If the right level of charges are made then this should
result in a socially efficient level of production being achieved.
Emission charges on firms discharging waste are an example of
this approach.
 Regulations. A government can set maximum permitted levels of
emission or minimum levels of environmental quality. The
European Union has over 200 pieces of legislation covering
environmental controls. Fines can be imposed on firms
contravening these limits.
 Tradable permits. A maximum permitted level of emission is set for
a given pollutant, for example carbon emissions, and a firm or a
country is given a permit to emit up to this amount. If it emits less
than this amount, it is given a credit for the difference, which it can
sell to enable the buyer to go above its permitted level. Thus the
overall level of emissions is set by a government or regulatory
body, whereas their distribution is determined by the market.

Despite the many measures to deal with externalities, the issue of achieving
the socially optimal level of production remains unresolved. Problems of
calculating externalities and the correct level of taxation; issues of avoidance
and enforcement; administrative costs can all mean that market failure and
how to deal with it has yet to find an optimum solution.
Key point
Which of the following statements are true or false?
A The cost of packaging for cigarettes is a negative externality.
TRUE / FALSE
B The benefits to society from education are a positive externality.
TRUE / FALSE
C The fine incurred for polluting a watercourse is a negative externality.

TRUE / FALSE
D Damage to pine forests from pollution is a negative externality.
TRUE / FALSE
3.1 Merit goods

Merit goods are goods which it is generally agreed should be made
available to all irrespective of whether everyone can afford to pay for
them. They are different from public goods in that their under-provision
can result from ignorance, lack of information and (perhaps) irrationality
as well as prices being too high. Some consumers possess the means
and the willingness to buy merit goods, such as education and
healthcare.
Government provision is made in the interests of the general well-being
of the nation. However, the private sector provides alternatives,
although these are often seen as ‘different’, or even superior goods /
services, for example, private school education, private health
schemes,. In the case of state-provided merit goods, economies of
scale can often be achieved. The cost of education per student is about
three times cheaper in the state sector than in the private sector.

4. Equilibrium of the Firm and Industry under perfect completion
A firm is said to be in equilibrium position when there is no incentive for a firm
either to expand or to contract its output. The basic aim of the entrepreneur is
maximum profits therefore, it will expand its output when a higher profit are
expected and contracts its output when it considers that increased output will
decrease the profits.
Before explaining firm's equilibrium we make the following assumptions
1. The basic aim of the entrepreneur is to maximize profits.
2. Firm is producing only a single commodity.
(1) There are two methods for calculating maximum profit total cost
and total revenue.
(2) Marginal cost and marginal revenue.

Total revenue and total cost approach
Profitis the differencebetween total
Revenue and total cost of firm or

Profit = Total Revenue – Total Cost
T = TR - TC
Every firm therefore, tries to make this difference maximum. For this purpose.,
it adopts such policy, which reduces cost and increases revenue. In table, the
total revenue and total cost of a firm are given:
Output Price TR TC MR MC Profit

Q P (PXQ) (TR – TC)
0 10 0 3 - - -3
1 10 10 18 10 15 -8
2 10 20 28 10 10 -8 Loss
3 10 30 35 10 7 -5
4 10 40 40 10 5 0 Break-even
5 10 50 44 10 4 6
6 10 60 49 10 5 11
7 10 70 56 10 7 14
8 10 80 66 10 = 10 14 Profit max.
9 10 90 80 10 14 10

10 10 100 100 10 20 0 Break-even
11 10 110 130 10 30 -20 Loss
We have taken the example of a firm operating under perfect competition, so

that the price and marginal revenue remain the same at all levels of output.
We find that the firm would go up to eighth unit of output only. When it
produces 8 units, the difference between total revenue and total cost is
maximum which is 14. This is the highest profit.
Profit maximization may also be explained in a diagram. Fig. 14.1 (a)

represents perfect competition while fig. 14.1 (b) shows a monopoly firm.
Figure (a) Perfect Competition (b) Monopoly
Cost TC TC
&
TR
Rev
E2 A E2
A
TR
TR
TC
E1 B
O Q1 Q3 O Q1 Q3
Q2
Output Output
TC and TR are the total cost and total revenue curves. Up to OQ 1 level of
output, TC> TR and the firm has to bear loss. At OQ 1, TR and TC are equal.
So E1 shows first break-even point (zero profit). When the firm produces more
than OQ1, it starts earning profits. When output reaches OQ2, the distance
between TR and TC curves becomes greatest, i.e. the profit reaches the
maximum. This level of output TR and TC increase at the same rate. This is
indicated by the fact tangents at A and B become parallel and have same
slope. If the firm produces beyond OQ2, the profit starts diminishing. At OQ3,
there is again zero profit. So E2 is next break-even point.
4.1 The Optimum Output (Profit Maximizing Output)
Firm's optimum output is at a point where marginal cost is equal to

marginal revenue. In perfect competition marginal revenue is always
equal to average revenue because price of each unit sold is the
homogenous. In perfect competition none of the firm can influence the
price. It can only adjust its output. Therefore, MR and AR (i.e., price)
curves are parallel to x-axis. Marginal cost curve is the supply curve of
the firm and average revenue curve is the demand curve for a firm.
Equality of MC and MR MC > MR MC = MR

MC
The equality of MC and MR MC = MR MC > MR
R S
is necessary but not Price & MR
Cost.
sufficient, for profit
maximization.
O M R Q Output
In the figure there are two levels of output where MC = MR i.e., OM

level of output and OQ level of output. Towards left of point R, MC is
greater than MR and towards right of point S, again MC is greater than
MR. Therefore, firm will not produce less than OM output or greater
than OQ output.
If a firm choose OM level of output although MC = MR yet total profits

can to not be maximum because a firm will be selling a smaller output.
At OQ level of output firm's MC is the same as at OM level of output
while firm's output is greater than OM level of output. As the basic
objective of a firm is to maximize profits therefore, a firm will produce
OQ level of output Which proves that optimum level of output, or
maximizing profit will be a point when MC = MR and MC cuts MR from

its below.
In between R and S although MR is greater than MC but a firm would
not produce because there is a tendency for more profits. It is
explained in below example.
Suppose OM output is 50 units and OR output is 125 units and OQ
output is 200 units. If price is Rs. 100/- which includes normal profit of
Rs. 20/- per unit then the total profits at OM output are Rs. 1,000/-, at
OR output Rs. 2,500 and at OQ level of output, firms total profits are
Rs. 4,000 which proves that total profits are maximum when MC = MR
and MC cuts MR from its below ‘X”
Key Point
Do firms Really Maximize Profits?
In economic theory, it is usually assumed that firms seek to maximize profits.

This assumption of a single objective is not fully true. It is only a useful
simplification of reality. Sometime the firms follow different motives e.g.
maximization of sales. Similarly, many business executives might prefer to
control the largest firm rather than the most profitable one.
Complete the table and indicate
Q TR TC Profit MR MC
1 10 12 -2 - -
2 19 19 0 9 7
3 27 24 3 … 5
4 34 28 - … …
5 40 32 - … …
6 45 37 - … …
7 49 44 - … …
8 52 54 - … …
9 54 70 - … …

Rule For Maximum Profit
TC TR
Competitive Firm TR A
TC
IF Then
(Price =) MR > MC Increase Output
(Price=) MR = MC Maintain Output Q

(Profit Maximized) E MC MR
TR
(Price =) MR = < MC Decrease Output TC
TC
Monopolist Firm TR A
TC
IF Then
TR
B
MR > MC Expand Output
MR = MC Maintain Output Output

Q
(Maximized Profit) MC
MR MC
MR < MC Reduce Output E
Q Output
Profit
Output
TO achieve the objective of profit maximization

(a) If MC is less than MR, profits will be increased by making and selling
more.
(b) If MC is greater than MR, profits will fall if more units are made and
sold.
(c) If MC = MR, the profit maximizing output has been reached.

4.2 Profit Maximization For A Firm Under Perfect Competition
In short run under perfect competition a firm can earn super normal
profits because firm can only change variable factor of production so if
price increases due to increase in demand, firms can increase supply
up to some extent as the new firms cannot enter into industry therefore,
firms in the industry can earn super normal profits.
(a) Super Normal Profits
In the figure MR = AR = P Super Normal Profits

MC
ATC
Minimum of ATC curve is
SNP
below the AR curve. MC curve
Cost & Revenue

E
cuts ATC curve from its below P MR = AR
Price
and minimum. MC curve cuts S R
MR curve at E. Optimum level

of output is OQ.
O Q
Total cost and total revenue of Output
the firm are given below:
TR = OQEP
TC = OQRS
Profit = TR – TC
Profit = OZE P(-) OQRS
Profits = SREP

(b) Normal Profits under Perfect Completion
This situation is explained with the help of a figure below:
MC ATC
Cost E
& P MR = AR = Price
Revenue
MC = ATC = Price
O Q
Output
Total Cost = OQEP

Total Revenue = OQEP
Total Revenue = Total Cost
Profit = Normal
Long-Run Normal Profit

A firm under perfect competition in long run is in equilibrium when its
marginal cost is equal to price and price must equal to average cost. In
case the firms in industry are incurring losses some of the existing
firms will exit the industry and as a result supply quantity will decrease
and price of output will again reach on a position where firms in
industry are earning normal profits.
Equilibrium of firm under perfect competition in long run can be

understood with the help of a diagram.

Optimum level of output of the firm is OQ. The equilibrium price is OP. At
price OP firm's total cost and total revenue are as under:
Total Cost = OQEP
Total Revenue = OQEP
For the answers to these questions, see the ‘Answers’ section at the end of the book.
Additional question
Revenue and costs
The following data refer to the revenue and costs of a firm.
Output Total revenue Total costs
0 − 110
1 50 140
2 100 162
3 150 175
4 200 180
5 250 185
6 300 194
7 350 219
8 400 269
9 450 325
10 500 425

(a) Calculate the marginal revenue for the firm and state which sort of
market it is operating in.
(b) Calculate the firm’s fixed costs and the marginal cost at each level of
output.
(c) What level of output will the firm aim to produce and what amount of
profit will it make at this level?
(d) Describe and explain the effect on the firm’s output and profits of the
entry of new producers into the industry.
For the answer to this question, see the ‘Answers’ section at the end of the book.
5. Monopoly in the short and long run
The analysis of a monopolistic firm is somewhat easier than that of perfect

competition. There is no need to differentiate between the individual firm and
the market, since the firm is the market. There is also no need to differentiate
between the short and long runs. The crucial difference between them for
perfect competition was that, in the long run, firms could enter and leave the
market at will. With monopoly, firms cannot enter the market, so the long run
has no particular significance.
5.1 Monopoly
Monopoly may be defined as a condition of market where there is only
one seller or producer and there are no close substitutes of the
commodity which is being sold or produced by the monopolist and
there are barriers to new entry.
5.2 Profit maximizing Monopoly

If monopoly market marginal revenue and average revenue curves
slope downward. The revenue curves are inelastic.

Short Run Maximizing
Monopoly S.N.P. MC
MC is the marginal cost curve AC
which intersects MR curve from T
P
its below at point E and it also
Cost & Revenue

S R
intersects ATC curve from its
below. Total cost and total AR
revenue of the firm are
E
Total Cost = OQRS
MR
Total Revenue = OQTP
O Q
Therefore, super normal profits Output
of the monopolist are equal to
SRTP.
Y
Long Run Profit Maximizing LMC
Monopoly T LAC
P
In the long run monopolist can AR
S R
change the size of plant in order
Cost
to earn super normal profits as and E
explained below. Revenue
In the figure MR
Total Cost = QROQ

O Q Output X
Total Revenue = OQTP
Total Revenue > Total Cost
Profits = TR – TC
Profits = OCTP – OQRT
Profits = SRTP
6. Monopolistic Competition/Imperfect Competition/ Imperfectly

Competitive Market
Definition
Monopolistic competition refers to a market situation where there are many

sellers of a differentiated product. "There is competition which is keen, though
not perfect, between many firms making very similar products". No seller can
have any perceptible influence on the price output policies of the other sellers

nor can be influenced much by their actions. Thus, monopolistic competition
refers to competition among a large number of sellers producing close but not
perfect substitute products.
(a) Super Normal Profits

In figure (1) the short run marginal cost curve (SMC) cuts the marginal
revenue curve at E. This equilibrium point establishes the Price (OP), and
output OQ. As a result, the firm earns super normal profits represented by the
area SRAP.
Total Cost = OQRS

Total Revenue = OQAP
Total Revenue > Total Cost
Super normal profits = SRAP
Fig. I
(b) Normal Profit

Figure (2) indicates the same equilibrium point price and output. But in
the case the firm just covers its short run average unit cost as
represented by the tangency of demand curve. (D) and the short run
average unit cost curve (SAC) at A, it shows normal profits.
Total Cost = OQAP

Total Revenue = OQAP
OQAP = OQAP
Therefore, Normal Profits

6.1 Long-Run Normal Profits
Assuming entry and exit of firms in a monopolistic competitive industry
as under pure competition, the adjustment process will ultimately lead
to the existence of only normal profits. This is a realistic assumption for
the long run, no firm can earn either super normal profits or incur
losses, since each firm produces a similar product.
Each firm will be earning only normal profits in the long run. The
situation is represented in the Figure given below:
Y
Cost LAC
& R
P
Revenue
E AR
MR
0
Q Output X
Total Cost = OQRP

Total Revenue = OQRP
Total Revenue = Total Cost
 Therefore normal profits.
6.2 Profit Maximization In Imperfect Competition
 Monopolists do not automatically earn abnormal profits.
 The ability of monopolists to exclude competition allows them to

earn abnormal profits in the long run.
 The intersection of the MC and MR curves give the profit-

maximizing level of output.
 In Figure 4, abnormal profits equal the area (P1 P2)  Q1.
 In Figure 5, normal profits only are being earned.

P
MC
AC
P1
P2
D = AR
MR
Q
Q1
Figure 4 Abnormal profits in imperfect competition
P
MC
AC
P1
Q
Q1
Figure 5 Normal profit in imperfect competition
6.3 Rules For Profit Maximization

Rule No. 1
A firm should not produce at all if, for all levels of output, the total
variable cost of producing that output exceeds the total revenue
derived from selling it or, equivalently, if the average variable cost of
producing the output exceeds the price at which it can be sold.
Rule No. 2
Assuming that it is worthwhile for the firm to produce, the firm should
produce the output at which marginal cost equals marginal revenue.
Rule No. 3
For output where marginal cost equals marginal revenue to be profit
maximizing rather than profit minimizing, it is sufficient that marginal
cost be less than marginal revenue at slightly lower outputs and that

marginal cost exceed marginal revenue at slightly higher outputs.
E-Business
The growth in the internet has affected business in many ways including:
 Cheaper and more efficient procurement. For example, there, there

is greater availability of information upon which to choose suppliers,
compare prices and negotiate lower costs. Online ordering gives
more efficient procurement allowing lower levels of inventory to be
held.
 New businesses might become possible. For example, auction sites
and photo album sites.
 The industry structure can be changed. For example, in the music
business it can be argued that the large CD publishers have less
power because music can be self-published on the internet.
 IS/IT can provide an organisation with competitive advantage by
providing new ways of operating. For example, airlines save money
by encouraging internet bookings.
 Barriers to entry have been eroded. For example, if you wanted to
enter the banking industry twenty years ago you would have had to
acquire premises at significant cost. Now you can open an online
bank with much lower initial costs.
 Information concerning competitors is much easier to access
resulting in greater price transparency.
 Reducing variable costs to near zero – see next section.
Note that many of these trends in e-business have eroded the traditional
advantages gained by larger firms.
Impact of E-business on transaction costs
A transaction cost is a cost incurred in making an economic exchange (i.e. the

cost of participating in a market).
For example, consider buying a CD from a store. To purchase the CD, your
costs will be not only the price of the CD itself, but also:

 the energy and effort it requires to find out which CD you want, where
to get the CD and at what price;
 the cost of travelling from your house to the store and back;
 the time waiting in line, and the effort of the paying itself.
Transaction costs are all the costs beyond the cost of the CD.
E-business is driving down the costs of transactions, as it is relatively easy to

obtain reviews and customer feedback to decide which CD you want, then to
check availability, prices and finally to transact a deal online. A more recent
trend is now not to buy a physical CD but to download the songs digitally.
The result of this is the restructuring of various retailing sectors such as those
for books, CDs, DVDs, software and computer games where online retailers
now dominate and high street premises are being closed.
Furthermore, from the seller’s prospective the internet has enabled variable
costs to be reduced dramatically and in some cases to near zero.
Consider how much extra it costs i-tunes, say, if ten additional customers buy
and download a particular song-other than royalties to original artists there are
no variable costs. Similarly with online booking and check-in, airlines have
reduced variable costs per passenger.
A combination of high fixed and low variable costs puts more pressure on
firms to win new customers and to dominate markets. Internet marketing is
seen as key here.
Key Point
Which of the following is not a recognized consequence of the growth in e-

business:
A A reduction in barriers to entry in some industries
B An increase in transaction costs
C Greater price transparency
D More efficient and cheaper procurement
6.4 Pricing Decisions

Having looked at cost behavior this section considers how firms should set
their prices.

1. Pricing considerations
When setting a price, businesses will take into account four factors,
known collectively as the “4Cs”.
 Costs
In the long run a firm will want to set a price that covers its
average total cost per unit.
Note: In the short run a firm will continue to trade providing its
revenue covers variable costs as it would have to pay its fixed
costs even if output was zero. If revenue falls below variable
costs, then the managers should consider stopping production
immediately and avoiding those costs. In the long run it must
cover both variable and fixed costs.
 Customers
A firm will need to set a price that its target customers are willing
to pay. Most firms have to reduce prices if they want to sell more
units (i.e. they face downward sloping demand cures) so have to
balance the link between price and quantity sold.
 Competitors
The pricing decision needs to be consistent with the competitive
strategy chosen, so a cost leader would usually set a price equal
to or slightly lower those competitors, whereas a differentiator
might set a price at a premium.
 Corporate objectives
In most exam questions the objective will be to set a price that
maximizes profit. However in reality there are other objectives
including price to maximizing revenue, dropping prices to
penetrate new markets and / or setting high prices to reinforce a
high quality image.
7. Globalization
Globalization brings new market opportunities, for example in China, giving
scope for higher revenues and even greater economies of scale for
multinational firms. These cost reductions bring even greater cost advantages
to larger firms.

However, the opening up of markets also exposes those firms to higher
competition in their domestic markets from foreign firms (for example Chinese
firms expanding into Europe), resulting in downward pressure on prices.
Globalization has also resulted in greater standardization of products and the

cost advantages that go with that.
Globalization is discussed in more detail in Chapter 6.
7.1 Emerging economies
Four of the fastest growing economies in the world are the so called
“BRIC” economies – Brazil, Russia, India and China. In early 2011
China became the second largest economy in the world, overtaking
Japan and in March 2012 Brazil overtook the UK to become the 6 th
largest economy. This presents western firms with both major
opportunities and major threats.
Traditionally Western firms have taken advantage of lower costs in

emerging economies either through outsourcing or off-shoring. For
example, many clothing items are manufactured in Asia. Historically
there was seen to be a cost advantage to doing this but now many
Chinese firms can offer higher quality and lower costs.
This is having a profound impact on firms in the West who are finding
their traditional competitive advantage eroded. While some have been
forced out of business, others have moved into more differentiated high-
tech market segments and others have outsourced to cut costs.
Self-test questions
Monopoly: output, prices and efficiency
1. What are the two conditions for a monopoly to exist? (2.1)
2. What kind of demand curve does a monopolist face, and why?

(2.3)

3. Draw the equilibrium position of a monopolist, showing
supernormal profit. (2.4)
Barriers to entry
4. How can economies of scale be a barrier to entry to potential

competitors? (3.5)
Price discrimination
5. Define price discrimination. (5.1)
Monopolistic competition: output, prices and efficiency
6. Name three ways in which a firm operating under monopolistic

competition can practice product differentiation. (7.2)
7. Draw a graph showing long-run equilibrium in monopolistic

competition. (7.4)
Oligopoly: output, prices and efficiency
8. What is the significance of the small number of firms operating

in a oligopolistic market for the decision making of each
individual firm? (8.2)
9. Explain briefly the kinked demand curve. (8.3)
10. What is a cartel? (8.4)
Practice questions
Question 1
Which of the following is not a feature of monopolistic competition?

A A large numbers of firms in the industry
B A homogeneous product
C No barriers to the entry or exit of firms
D Product differentiation
Question 2
Which of the following is not normally a characteristic of an oligopolistic market?

A Heavy expenditure on advertising

B Abnormal profits in the long run
C Barriers to the entry of new firms
D Severe price competition
Question 3
Which one of the following would not normally be a feature of an oligopoly market?
A Competition through product differentiation
B The creation of barriers to entry
C Competition through price wars
D A tendency for producers to collude
Question 4
Which of the following statements is true under conditions of monopolistic

competition?
A Each firm fixes its price irrespective of other firms
B There is no freedom of entry into the industry in the long run
C Buyers and sellers have perfect information
D Firms tend to rely heavily on product differentiation
For the answers to these questions, see the ‘Answers’ section at the end of the
book.

Chapter learning objectives
Upon completion of this chapter, students should be able to understand:
 Market Structure
 Imperfect competition
 Regulations
 Public verses private provision of goods and services

1. Introduction
Competition is an extremely important topic in your ICMA studies for two
reasons:
(1) Competitive rivalry
All firms face competition but some markets are more competitive
than others. To be profitable firms need to understand the degree and
nature of competition and formulate a suitable competitive strategy in
response.
There are many factors affecting the level of rivalry, for example
 The extent to which competitors are in balance – roughly equal
sized firms in terms of market share or finances often lead to
highly competitive marketplaces;
 The stage of the industry or product life cycle – during market
growth stages all companies can grow naturally whilst in
mature markets growth can only be obtained at the expense of
someone else;
 Difficulties in differentiating your product emphasizes price as a
key aspect.
Within economics we are particularly interested in looking at the
number of firms in market and what that means in terms of
competition, prices and profitability.
(2) Market failure and government regulation
In the last chapter we considered market failure and the need for
government intervention. The final market failure to be addressed is
the problem posed by large business. The argument is that
unchecked, market forces may result in powerful companies who can
abuse their market power and charge excessively high prices to
consumers.
Government intervention is thus needed to ensure that consumers
are protected from such abuses.

2. Market structures
2.1 Markets
The world ‘market’ is used in many contexts. In economic theory a market is
where goods and services are bought and sold, although it may not be an
actual place.
For instance, foreign currencies are bought and sold through international
telephone deals and telex transfers between bank accounts. The buyers and
sellers must be in contact and in modern societies the exchange is via the
medium of money. The traders involved are willingly participating in the
exchange and usually require information on the price of the goods /
services involved.
Most market in practice are unorganized and decentralized. Governments

may influence markets generally through legal constraints but they do not
decide how much is traded. This is usually determined by price, which acts
as a signal and as an incentive.
2.2 Forms of market structure

The purpose of this section is briefly to describe the main characteristics and
assumptions which define each form of market. The detailed operation of
each form is considered in the next section.
There are two extreme and largely theoretical forms of market: perfect
competition and monopoly, which are polar opposites. In between, under the
broad heading of imperfect competition, there are three other structures
which have more grounding in reality. These are monopolistic competition,
oligopoly and duopoly. All of these market structures are defined largely in
terms of the number of suppliers in the market:

Number of
firms in the
in dustry
100
---- Number of
7 firms varies for
oligopoly in
Monopolistic competition
6 different
in dustries
Perfect competition
5
4
Oligopoly
3
2
1 Monopoly
Monopoly
0
Imperfect
Competition
2.3 Discussing market structures
These will be discussed in more detail below using the following approach:
 Structure
This is defined in terms of concentration, the number of firms, type of
product and the existence or otherwise of barriers to entry.
 Conduct: pricing behavior
How much freedom does the firm have to set any price it wants – is
the firm a price taker or maker?
How is price related to the firm’s average total cost at the chosen
level of output?
 Efficiency
See below
 Profit
Is the firm making just enough profit to justify staying in the industry
rather than moving elsewhere (so called “normal” profit) or can it
make more than this (“super-normal” or “abnormal” profit)

2.4 Efficiency
This much-used (and-abused) term has various adjectives applied to it in
economics. However, it is possible to discern three general meanings and
associate descriptors with each aspect of economic performance.
 Technical efficiency – production at the lowest cost (the
‘optimum’ level of output). This is usually used to describe the
efficiency of a firm in the production of a good.
 Allocative efficiency – the best use of resources to produces
goods and services which people want. The idea is to
maximize the welfare of consumers. When each market in an
economy operates so as to maximize consumer satisfaction,
there is said to be economic efficiency. This general meaning
relates the use of resources to consumer satisfaction.
 X-inefficiency-this considers the gap between the theoretical
best practice ATC curve and the typical firm’s actual ATC
curve. If the market has barriers to entry, then the firm is likely
to be X-inefficient and if no barriers are present it is likely to be
x-efficient.
The issue is further complicated by time. The most efficient firm at one point
in time may not be so at a later date. For example the relative technical
efficiency of one firm may change over time as a result of investment.
Similarly, people’s preferences for goods may change and so utilities alter,
thereby affecting allocative efficiency.
The result of such changes is that identification of productive and economic
efficiency for the whole economy at a macro analysis.
Test Your Understanding 1

A lack of barriers to entry in an industry is likely to result in firm being X-
efficient.
True/False
3. There are many markets in all types of modern economy, ranging from
large-scale and official, for example, the Stock Exchange, to small and

illegal, like a drug addict buying heroin from a street pusher. Some
markets are very specialized, for example, the copper exchange on the
London Metal Exchange. Markets tend to by dynamic, expanding and
becoming more sophisticated to meet particular needs. Thus, not only
can major commodities be bought and sold at prevailing prices (spot
market), they can also be purchased now for an agreed price to be
supplied at a future date. Such a futures market meets industry’s need to
plan future production.
Markets are also segmented. They can be divided by:
 Geography. The market for primary products may be international,

national, regional or local depending on the suppliers and customers
involved.
 Time. Demand and supply conditions can change, particularly when
services are sold. For instance, travel on the railways may be cheaper
from Monday to Thursday (than on Friday) for the same service. Such
price discrimination between off-peak and peak times makes the
market less homogeneous.
 Customer type. Suppliers may discriminate between their customers.
For instance, large regular customers may get preferential quantity
discounts off the listed prices, which other consumers pay.
 Economic analysis needs to simplify the understanding of all these
diverse markets. Thus we shall consider the product or goods markets.
These markets refer to newly produced goods and services, and avoid
the pricing of second hand goods.
4. Market Concentration
The growth of firms has increasingly led to greater domination of
individual markets by few firms. This is referred to as market
concentration and describes the extent to which the largest firms in an
industry control their output, sales and employment. Concentration
ratios can take two forms.

 Market and seller concentration
This measures the share of production, sales or employment of the
largest few firms in an industry or market. Often a five-firm
concentration ratio is used. Traditionally, manufacturing industries are
the most concentrated. In 2004 the United Kingdom had five-firm
concentration ratios of over 85 percent in car, cement, steel and
tobacco production. There is also increasing concentration in service
industries such as accountancy, advertising, banking and food retailing.
The growth in five-firm concentration ratios is driven by the desire to
exploit economies of scale.
High concentration ratios are associated with a high degree of market

or monopoly power by the largest firm in industry or market sector.
Sometimes concentration ratios overstate the extent of market power in
an industry held by the leading five firms. This occurs when there is a
significant amount of competition from imports. However, concentration
ratios may also understate the true level of market power held by the
leading five firms where local or regional monopolies exist, as in the
case of supermarkets.
 Aggregate concentration ratio

This measures the share of total production or employment contributed
by the largest firms in the whole economy. The oldest concentration
ratio used in the United Kingdom is the 100-firm ratio used in
manufacturing. This measures the share of the largest 100 private
firms in total manufacturing net output.
Increases in firm size implicit in the rise in concentration ratios have
occurred more by takeovers and mergers than by internal growth of the
leading firms. We will examine the effect on market competition and
structures later.
5. Firms grow through internal expansion and integration. A firm may
expand by producing and selling more of its existing products or by
extending its range or products. Thus, the general retailer Boots started
off as Josse Boots, a Nottingham chemist shop. Such successful firms

have often developed through enterprising management, which has
utilized a willing workforce, unused capacity and available finance.
Integration occurs when firms joint together, by either merger or

takeover. A merger is an amalgamation of at least two firm into one
organization, for example, Astra Zeneca. It is usual for shareholders in
the old firm to exchange their old share for shares in the new firm in
agreed proportions.
A takeover differs from a merger in that the initiative for acquisition

comes from the offering company and the board of the targets company
is opposed to, or not fully in favor of, the bid. With mergers there is
usually willing co-operation between the two firms. Takeovers are
financed either with cash and /or an offer in shares in the acquiring
companies, with maybe a cash adjustment. The price offered is nearly
always higher than the current Stock Exchange valuation. The Stock
Exchange has a Takeover Panel which vets the procedures to ensure
fair and equal treatment for all the shareholders of the target company.
The general objective of mergers and takeovers is to increase profits,

usually in the short run, and earnings per share. This has been criticized
as short sighted as it may reduce longer-term product development and
market development.
There are three main types of integration: horizontal, vertical and
diversification.
6. Horizontal Integration
Firms is the same industry and at the same stage of production join
together. Horizontal integration is common in manufacturing industries.
The reasons for such integration include:
 To obtain the benefits of economies of scale. A big retailer will have
much more buying power than two smaller retailers and so will be
able to lower their input costs. The increased financial muscle
enables the large retailer to negotiate better terms with their

suppliers. In manufacturing industry, horizontal integration was
justified in the 1960s as a ‘synergy’ between companies on the
basis ‘2+2=5’
 To reduce competitive rivalry. By taking over rivals a firm can
reduce competition, possibly allowing it to increase prices and
margins. An extreme case of this would be a duopoly where one
firm acquires the other, thus becoming a monopoly.
 To increase market share. If a takeover reduces competition, the
acquiring company can probably raise its market share. In retailing,
mergers usually mean more outlets through which to sell the
products of the two companies.
 To pool technology. The wasteful duplication of research facilities
can be avoided and the beneficial sharing of technical ‘know-how’
can be developed when manufacturers integrate, for example
Renault – Nissan.
7. Vertical Integration
Vertical growth occurs when one firm moves into another stage of
production, which might otherwise be independent, in the same
industry. This integration may be backwards towards the source of
supply.
 The elimination of transaction costs. This will increase cost
efficiency between the various stages of production, by reducing
delivery costs and eliminating the profits of middlemen. This partly
explains the mergers in the brewing industry.
 Increasing entry barriers. By gaining more control over supplies
and/or sales, it will become more difficult for new competitors to
enter the market.
 Securing supplies. By controlling its own sources of supply as a
result of backward integration, a firm can achieve more flexible
production.
 Improving the distribution network with better market access.
Forward integration into marketing enables a firm to control the
conditions under which its goods are sold.
 Gaining economies of scale; these benefits are common.

 Making better use of existing technology. To vertical and horizontal
integration.
8. Diversification
This occurs when one firm expands into an industry with which it was
previously unconnected, for example, Virgin record into travel. Some
mergers are classed as lateral where the good being newly produced
by the expanding firm have a close link with their main products, for
example, cars and Buses.
However, increasingly integration creates conglomerates, that is,

groups of companies pursuing different activities in different industries.
The mergers of the 1980s led to many of Britain’s most successful
enterprises, for example, Hanson Trust, becoming financial holding
companies, rather than integrated producers of goods and services.
These organizations sell off the inadequate part of underperforming
companies and develop those with potential. The conglomerates thus
behave like investment bankers.
The reasons, other than short-term profit motives, for diversifications are:
 To minimize risks. If its main line is subject to trade fluctuations or
going out of fashion, a firm may diversify into an expanding area to
protect itself.
 To make full use of expertise. Dynamic management can use the
expertise residing in a company in seemingly unconnected areas. Thus
Centrica, initially a company selling gas, took over the AA, a motoring
organization, so as to fully utilize its large customer data base and sell
a greater range of products.
 To achieve economies of scale. Particularly in administration. Thus a
merger might lead to the fuller utilization of, and greater return form,
departments such as data processing, accounts and exports.
However, mergers are not always successful. Sometimes diseconomies of

scale occur when merged managements experience personality clashes
and become divided. Rationalization does not always lead to lower cost

production and may alienate customers and workers. The same is true of
takeovers which lead to asset stripping and to less production and
redundancies. Landed, some have argued that the costs to society outweigh
the private gains; thus the proponents of a merger should have to ‘prove’ its
virtue rather than the critics have to demonstrate its ‘guilt’ (against the public
interest) as happens now.
2.5 Perfect Competition
Definition
Perfect competition is an idealized model of a competitive market and has
the following characteristics:
 Many buyers and sellers, so no one individual, can influence price by
their actions.
 Buyers and sellers have perfect information about the product.
 The product is homogenous. Hence there is no brand differentiation.
 There are no entry barriers. Buyers and sellers are free to enter and
leave the market and there is no government interference in the
market.
 Perfect mobility exists in the market both for products and factors of
production.
 Normal profits are earned in the long run as any abnormal profits /
losses are removed by competitive forces.
Example
In reality, perfect markets rarely exist. An approximation is the Stock
Exchange or local farmers’ markets.
Implications
 There is one market price that all suppliers sell at. These suppliers
can sell their entire output at this price so they have no incentive to
cut prices. However, any attempts to increase prices are doomed as

customer will switch to one of their many competitors who sell
identical products. All firms are thus “price takers”.
The firm The industry
Price Price D S
P D P
0 Q1 Q2 Q3 O Qt
Quantity Quantity
The degree of competition forces firms to operate at their minimum cost,

implying technical efficiency.
 Furthermore the level of rivalry has resulted in the lowest prices
possible, implying allocative efficiency. This also means that firms are
only just making the minimum profit they need for it to be worth
staying in the industry (“normal profits”).
Even though we are dealing with a theoretical extreme, this model

does suggest that high level of competition are “good” for consumers
(minimum prices) and good for the economy (firms operating at
minimum cost).
However there are some potential issues here
 A lack of choice consumers
If firms are only making normal profits, then they may not be able to
afford to spend additional sums on “discretionary” expenditure such as
staff welfare, product innovation or protecting the environment. (note: a
firm facing perfect competition has a high incentive to develop new and
different products, precisely to get away from the current market).

MCQs
Q.1 In perfectly competitive market, all producers charge the same price
because:
A They are all profit maximisers
B They have the same cost
C The product is homogeneous
D All firms are small
Q.2 Which One of the following comes closest to the model of a perfectly
competitive industry?
A Oil refining
B farming
C motor vehicle manufacture
D banking
10 Monopoly
Definition
A monopoly is when a market has a single producer of a food with no close
substitutes.
This is usually due to barriers preventing other firms from entering the market.
Barriers to entry can take a number of forms, including:
 Legal barriers, e.g. patents or the award of a state monopoly to a utility
company.
 Natural barriers reflecting the cost structure of an industry, e.g. high

start-up costs.
 Integration in which monopolists control production, distribution and

retail aspects of the industry making it very hard for a new entrant to
become established.
Note: As we shall see later, in practice British legislation identifies a firm in

the private sector as holding a monopoly if its market share exceeds 25%.

Example
In 1989 the water industry in England and Wales was re privatized in the form
of 10 regional monopolies.
Implications
In a pure monopoly the firm is the industry, and thereby controls market
supply. Rather than market forces setting an equilibrium price where supply
equals demand, the monopolist can choose where they want to be one the
demand curve:
 Either they fix the price and let demand determine the amount
supplied, or
 Fix supply and let demand determine the market price.
The effectively means that the monopolist has a vertical supply curve
The firm = the

industry
Pric
e S
Q Quantity
The monopolist will choose a position that maximizes their profit, which
usually means the following:
 The firm makes ‘supernormal’ profits – i.e. higher than the minimum
needed to stay in the industry. The ability to secure such profits is the
result of restricting output so that prices are raised.
 The price is likely to be higher and the quantity supplied lower than
would be seen under perfect competition.
 The firm may not be operating at minimum cost.

 This mean that we have neither technical nor allocative efficiency.
Taken together, this would suggest that monopolies are bad for both
customers and the economy and so represent a market failure requiring state
intervention.
However, the situation is not so clear cut:
 Since the monopoly is making supernormal profits, then they can afford
to spend additional sums on “discretionary” expenditure such staff
welfare, product innovation or protecting the environment.
 However, you could argue that the monopolist has little incentive to
develop new products as they already have a captive market. If
anything, it may restrict choice by elimination uneconomic brands.
 Furthermore, monopolists can keep out potential competitors by setting

very low prices if necessary (“limit pricing”). Some firms try to set prices
so low to kill off existing rivals in order to become a monopoly
(“predatory pricing”).
 A monopolist may be able to achieve significant economies of scale

that mean that its cost of production is lower than that under perfect
competition, even if the monopolist is not forced operate at their
minimum cost.
 Continuing this argument, the resulting price may be lower than that
under perfect competition, even though the monopolist has higher
margins.
On balance however, most governments feel they need to act to prevent

abuses of market power by large organizations.

Which one of the following would not discourage entry of new firms into an
industry?
A Perfect consumer knowledge
B Economics of scale
C High fixed costs of production
D Brand loyalty
Test your Understanding 5

Which of the following is a natural barrier to firms entering an industry?
A Large initial capital costs
B The issuing of patents
C A government awarded franchise
D The licensing of professions
Supplementary reading – Further comments on monopolies

In a capitalist economy, a monopolist would be a profit maxi miser. However,
in a planned economy it is unlikely that state monopolies would have such a
goal. In the United Kingdom mixed economy the previously nationalized
industries operated like monopolies and sought large profits, for example, gas
and electricity. Although facing competition from one another in the market for
energy, each had a monopoly in its own fuel since there were entry barriers
which limited the ability of new firms to enter the market. However, the law
creating the sole supplier rights of such public monopolies is not sacrosanct.
The government sets price controls on their operation and opened them up to
competition and eventual full privatization.
Supplementary reading – Price discrimination

A monopolist may be able to subdivide one market into two or more sectors,
and then set different prices (price discriminate) between different customers,
although selling the same product. There are several ways to discriminate:

 By time – a golf club will charge non-members a higher green
fee to play at weekends than during the week;
 By customer – a golf club will charge members playing with a

member less than non- members would otherwise pay;
 By income – a hairdresser may charge a pensioner less than a

breadwinner because the former has a lower income;
 By place – a hairdresser may charge extra for providing the

service at the customer’s home, as opposed to what would be
charged at the salon.
These pricing strategies are likely to be successful if several conditions are

fulfilled:
 Al least two distinct markets with no seepage between them so
that a higher price can be charged in one of the markets. If there
was seepage then enterprising consumers could buy the good in
the lower-priced market and then resell it in the other market,
perhaps undercutting the discriminating monopolist;
 A market imperfection, such as transport costs, which gives the

supplier a monopoly and thus keeps out competitors who might
undercut him in his high-price market;
 Differing demand elasticity’s so that the monopolist can gain

extra profit from his price discrimination. A higher price would be
set in the more inelastic market.
3. Imperfect Competition
Between perfect competition and monopoly, several forms of market exist,
exhibiting some of the characteristics of the two extreme structures.
3.1 Monopolistic competition

Monopolistic competition is characterized by:
 Large number of producers who supply similar but not
homogeneous products.

 Products are differentiated in style, image and price.
 There is not one prevailing market price. Firms may compete on

price to try and gain market share at the expense of rivals.
 Consumers lack perfect knowledge but have a choice of

products. This choice may be extended it new firms enter the
industry perhaps attracted by the prospect of abnormal profits.
 There are no entry barriers; new firms can enter the industry and
existing firms can leave at little cost. The lack of barriers to entry
would suggest that in the long run only normal profits can be
made.
 Prices are likely to be higher than under perfect competition but

the customer now benefits form more choice.
 For example, the market for greetings cards.
3.2 Oligopoly
An oligopoly is characterized by:
 A few large firms with a high concentration ratio.
 The behavior of firms is often dependent on their rivals’ actions

and hence the market has a degree of uncertainty about it. A
firm is not certain how rivals will respond to action initiated by
itself. Consequently, there is interdependence in decision
making.
 Consumers in oligopolistic markets lack detailed market

information and are susceptible to the market strategies of the
suppliers.
 New firms are unlikely to enter an oligopoly. The entrenched

dominance often involving economies of scale enable them to
fight off new competition. However, advances in technology and
the financial power of transnational corporations mean that
existing oligopolies can be challenged today.

There are a number of strategies which an oligopolistic firm might adopt:
 Co-operate with the other large firms. In such a collusive
oligopoly, a common policy is agreed on pricing and market
sharing and joint profit maximization is the objective. The market
structure then resembles the monopoly model. However, this
may not be possible in practice because of restrictive practices
legislation. This is considered under completion policy later in
this chapter.
 Make their own decisions and ignore their rivals. A firm could
estimate its demand curve and set a price. The effect of this
depends upon other prevailing prices for what are broadly
similar goods/services, and how the rivals react. A higher price
may lower sales and lead to a fall in market share if rivals do
nothing. A lower price may increase sales if rivals do nothing but
lead to lower profits (as demand tends to be inelastic). If rivals
follow suit when the firm initiates a price rise, it becomes the
market leader. This position is akin to that of a monopolist, who
can make price changes with impunity. If rivals copy a price cut,
there may be price warfare. Each firm is seeking to maintain its
market share and protect its profits. The price cuts will benefit
the consumer, as may some of the non-price competition.
 Become a price follower by awaiting the action of the price

leader. (This strategy makes the firm a price taker)
 Avoid price based competition. A firm may feel any change in its
price would be disadvantageous because of the reasons
outlined above. Price Stability is often associated with
oligopolistic behavior as firms choose not to raise or lower prices
as they cannot be sure how rival firms will react to any such
price changes. This is why there is often substantial non-price
competition with oligopolies, for example, by advertising. Firms
often produce several branded goods in the same market.
Hence products are not homogeneous.

As long as collusion and price fixing do not occur, it could be argued that
consumers may benefit from an oligopoly though a wide range of branded
goods, price stability and after sales serving. In addition if price stability
facilitates accurate forward planning by producers, then consumers might gain
form better products and lower costs of production in the long run.
Note: A duopoly is just one example of an oligopoly and hence all of the
comments above hold.
Under monopolistic competition, excess profits are eliminated in the long run
because of:
A The lack of barriers to entry
B The effects of product differentiation
C The existence of excess capacity
D The downward sloping demand curve for the product

Company G operates in an industry with the following characteristics:
 Four large firms who control 80% of the market, along with many
smaller firms
 Significant barriers to entry
 Similar but not homogenous products
 Long run price stability
Which of the following market structures best describe the above scenario?
A Monopoly
B Oligopoly
C Monopolistic competition
D Perfect competition

Answer the following questions based on the preceding information. You can
check your answers below.
(1) What is a market?
(2) What are the main assumptions of perfect competition?
(3) In a monopoly, if a firm fixes the price, what determines the

amount supplied?
(4) Imperfect competition can be divided into three submarkets.

What are they?
(5) What is allocative efficiency?
4. Regulation
4.1 Competition policy
As markets have become more heavily concentrated among fewer firms and
competition has become more imperfect, so more controls have been applied
to restrictive trade practices and pricing. The economic justifications for such
a policy are fairly clear.
 Collusion by suppliers and the operation of cartels usually lead to
higher prices and/or monopoly profits and possibly lower output.
 These in turn reduce consumer welfare.
 Furthermore, they are a diminution in elective efficiency. However, it

must be remembered that extra profits any lead to investment in
research, which could eventually consumers via new products.
4.2 Scope of regulation

There are there aspects to this which involve government regulation:
(i) Consideration of merges which might create monopolies. These
are generally undesirable, as explained earlier, because they
lead to allocative inefficiency.
(ii) Investigation of restrictive trade practices which reduce

competition within a market and undermine consumer
sovereignty.

(iii) Regulation of state created regional monopolies, such as
utilities.
4.3 The European Commission

The Commission of the European Union can use its powers, directly
derived from the Treaty of Rome, to control the behavior of monopolists
and to increase the degree of competition across the European Union.
It has long had powers, similar to those now adopted by the United
Kingdom in the 1998 Competition Act, to prohibit price fixing, market
sharing and production limitations, In this context they do not allow
‘dual pricing’.
This is a system whereby exports to other EU countries are not allowed

to be charged at different prices. For instance, Distillers sold whisky at
higher price in France and tried to restrict British buyers form
purchasing the whisky more cheaply in England for resale at lower
prices in France. The European Court adjudged that Distillers was
distorting competition by trying to prevent its dual pricing being
undermined.
4.4 Specific industry regulators

As privatization of large nationalized industries usually transformed
public monopolies into privet monopolies, the government accepted the
need to create regulatory watchdogs. These bodies, such as the Office
of Telecommunications (OFTEL) to supervise British Telecom, were
performing a role which government departments did formerly.
On 28 December 2003 the Office of Communication (OFCOM) was

established. It is now the regulator for the media and
telecommunications industries and replaces five other regularity bodies
including OFTEL. OFCOM will regulate standards of taste and decency
on all TV and radio channels. IT will license commercial TV and radio.
It will also oversee the telecommunications industry, where OFTEL was

seen to have performed poorly particularly in relation to the regulation
of BT and the deregulation of directory inquiries.
The role of specific industry regulators (SIRs) is essentially two-fold.

 First, when large state monopolies were privatized, they lacked
effective competition. SIRs can introduce an element of competition by
setting price caps and performance standards. In this way consumers
can share in the benefits of competitive behavior even if competition
does not actually exist in the market.
 Second, SIRs can speed up the introduction of completion in such

markets by reducing barriers to entry for new firms.

Company L is a large manufacturer of very high quality wi-fi equipment. In a
recent newspaper article it was accused of putting pressure on small retailers
to stock its full range of products (or it wouldn’t be allowed to stock any), to
charge the full recommended price with no discounts and even insisting that
rival products were not stocked.
Which aspect of government regulation would seek to investigate and address
this behavior?
A Takeovers and mergers regulation
B Restrictive trade practices regulation
C Predatory pricing monitoring
D Regulation of state monopolies through industry-specific

regulators
5 Public verses private provision of goods and services

5.1 Public – private partnerships
Public-private partnerships (PPP, of which the best known example is the
private finance imitative (PFI), describes any private sector involvement in
public services including the transfer of council homes to housing

associations using private loans, and contracting out services like rubbish
collection to private companies. The PFI refers to a strictly be fined legal
contract for private consortiums, usually involving large construction firms, to
design, build, finance and manage a new public project, typically a school or
hospital, over a 30-year period. The building is not publicly owned but leased
by a public authority.
The perceived advantages of the PFI are:

 Finances public projects without the need for government borrow
funds or raise taxes.
 Risk is transferred to the private provider. If the private

consortium misses performance targets, it will be paid less.
 Introduces private sector qualities such as efficiency and

innovation into the public sector, thereby, raising the quality of
provision.
Critics of PFI, however, point out:

 The methods of financing used to make public projects more
expensive. The Edinburgh Royal Infirmary cost £180 million to
build but will cost £900 million over its £ 30-year contract. This
includes the operating costs but, as government has access to
cheap funds, it would still have been cheaper to build and
manage using traditional public sector funding.
 There is also a question mark over how much risk is genuinely

transferred to the private sector given the government’s record
of bailing out private companies managing troubled public
services.
 Efficiency savings have been made at the expense of quality

deterioration in the service, for example hospital cleaning.
However it will take a much longer period of time, when the first PFI
contracts have been completed, before the real costs and benefits of this
form of PPP can be judged.

Q.10 Test Your Understanding 10
Answer the following questions based on the preceding information. You can
check your answers below.
(1) Give three arguments for nationalization.
(2) What were three reasons for privatization?
(3) How do merit goods differ from public goods?

Which one of the following is not a valid economic reason for producing a
good or service in the public sector?
A The good is a basic commodity consumed by everyone
B It is a public good
C There is a natural monopoly in the production of the good
D It is a merit good

Which of the following statements about a policy of privatizing a public
sector industry are true?
(i) It will permit economies of scale.
(ii) It is a means of widening share ownership.
(iii) The industry would become more responsive to the profit

motive.
(iv) It is a source of funds for the government.
A (i) and (ii) only
B (i), (ii) and (iii) only
C (i) and (iii) only
D (i), (iii) and (iv) only

TEST YOUR UNDERSTANDING ANSWERS
True
The lack of barriers to entry will mean that new firms can easily enter the
market (if the wish), increasing the level of competition. While some firms
will survive by finding a niche or through being differentiations, many will be
under pressure to find cost efficiencies or exit the market. In the long run
such firms will have to become X-efficient to survive.

C
You may feel that all four answers have some merit. However, the key
reason is the fact that all suppliers have exactly the same product and so
cannot avoid the competition or carve out a niche for themselves. In perfect
competition if a product is homogeneous, all suppliers will sell it at the same
price. There is no benefit to be gained from cutting price, as demand is
infinite at the current market price. Raising price will lead to total loss of
demand due to perfect consumer knowledge and a lack of economic friction.

B
A perfectly competitive industry must have many producers none of which
can have any dominance in the market. They are all price-takers. You might
feel that applying these concepts is tricky because the extent of the industry
is not clearly defined – are we discussing a particular country or considering
a global market or a typical one? However, if we look closely at the specific
industries given we can see that A, C and D are typically characterized by a
small number of major companies, leaving answer B.
A
Economies of scale and brand loyalty will both deter new firms from entering
an industry as they would be competing against firms who are already
operating with these benefits.

High fixed costs of production will also make it difficult for new firms to break
into the market as they will have to raise substantial amounts of finance
against a nil track record.
A
Only A is a ‘natural’ barrier to entry, not legally created.
A
New firms are attracted into the market by the existence of supernormal
profits, and are able to enter because of the lack of barriers to entry.
B
An oligopoly is mainly characterized by a small number of firms controlling
most of the market. The long run price stability would indicate that firms are
choosing non-price competition (e.g. through advertising) to avoid the
problems of interdependence and uncertainty.

(1) A market is where goods and services are bought and sold.
(2) The assumptions of perfect competition are:
 many buyers and sellers;
 homogeneous product;
 perfect information;
 freedom of entry and exit.
(3) Demand for the product.
(4) Imperfect competition can be subdivided into monopolistic
competition, oligopoly and duopoly.
(5) Allocative efficiency refers to the best use of resources producing
goods and services which people want.

B
This is an example of restrictive trade practices as L is accused of restricting
the trade of other firms, here its retailers.

(1) Nationalization can be justified because it provided low costs of
production, uneconomic services which otherwise might not exist and
strategic control over key resources.
(2) Three reasons for privatization are funds for the Treasury, greater
economic freedom for producers and improved efficiency within the
organization.
(3) Public goods are freely provided by the government as there is non-
rivalry and non-exclusivity in their use. Merit goods are provided by the
government as it is believed they should be made available to all
irrespective of the ability to pay.

A
Because a commodity is consumed by everyone (e.g. food), it does not
follow that it has any special features such that it cannot be produced
efficiently in a competitive market in the private sector. All other responses
are valid reasons why a good or service should be produced wholly, or
partly, in the public sector.

D
Privatization does not produce larger firms and often leads to smaller firms
when public sector monopolies are broken up into smaller companies (e.g.
railways) on privatization. Thus the privatization process cannot increase the
scope for economies of scale. All other responses are valid reasons for
privatization.

Contents
1 Introduction
2 Capital markets
3 Types of Business Finance
4 Open End Mutual Funds
5 Capital Market Instruments
6 Derivatives
7 Money Market
8 Financial System
9 Liquidity Surpluses and Deficits

1 Introduction
The financial markets are not actually a sector of the economy but rather
‘places’ where borrowers and lenders can meet. They consist of primary
markets and secondary markets.
KEY POINT
Primary markets deal in new issues of loan able funds. Secondary markets
do not provide new funds, but allow existing holders of financial claims to sell
them to other investors.
Primary markets deal with new issues of shares or loan stock and provide a
focal meeting point for borrowers and lenders and investors and those wishing
to raise equity. The forces of supply and demand should ensure that funds
find their way to their most productive usage.
Secondary markets allow holders of financial claims to realize their
investment before the maturity date by selling them to other investors. They
therefore increase the willingness of surplus units to invest their funds. A well-
developed secondary market should also reduce the price volatility of
securities, as regular trading in ‘second-hand’ securities should ensure
smoother price changes. This should further encourage investors to supply
funds.
The major financial markets in the Pakistan are the capital markets and the
money markets.
The capital markets are concerned with trading in financial claims with lives
of more than one year and extending into the very long term. The bulk of this
business is conducted on the Local Stock Exchange.
KEY POINT
The capital market and money markets are not places where financial
instruments are traded but rather a process or set of institutions that organise
and facilitate the buying and selling of capital instruments.

The money markets provide finance for the short term, i.e. a period of up to
about five years. Most of their financing is for much shorter periods of about
one year.
The capital markets and money markets are not places where financial
instruments are traded but rather a process or set of institutions that organise
and facilitate the buying and selling of capital instruments.
The chart showing sources of finance is repeated below.
2. Capital Markets
2.1 MEANING
The money market is not a market in the usual sense of the term. It
does not mean a single trading place or trading organization dealing in
money. In fact, the term money market refers to institutional
arrangements and facilitating for borrowing and lending or short-term
funds. The period of borrowing and lending in the money market is one
year or less against different types of highly marketable liquid debt
instruments such as bill of exchange, the treasury, bills etc. Various

financial institutions, which deal in short-term loan, can be called the
members of money market. These institutions generally are the central
bank, commercial banks, discount houses, bill brokers and acceptance
houses.
In simple words
All institution, which are providing or receiving loans for a short period
are known as money market. Central bank is the controller of money
market. Money market deals with various credit instruments such as
short-term bonds, deposit certificates, Stock certificates bill of
exchange etc. It is consisting of commercial banks, saving banks etc.
Definition
According to G.Crowther
“The money market is the collective name given to the various firms
and institutions that deals in various grades of near money.”
According to S.M. Goldfield and L.V. Chandler
“In which short-term debt obligations are traded.”
2.2 INSTITUTIONS OF MONEY MARKET

The various financial institutions which deal in short-term loan in the
money market are its members. They comprise the following types of
institutions.
1. Central Banks
The Central Bank of the country is guardian of the money market and
increases or decreases the supply of money and credit in the interest
of stability of the economy. It does not enter into direct transactions.
But controls the money market through variations in the bank (or
discount rate) and open market operations.
2. Commercial Banks
Commercial Banks also deals in short-term which they lend to business
and trade. They discount bills of exchange and treasury bills, and lend
against promissory notes and through advances and overdrafts.

3. Non-Bank financial Institutions (NBFI’s)
Besides the commercial banks, There are non-bank financial
institutions which lend short-term funds to borrowers in the money
market. Such financial institutions are savings banks, investment
houses, insurance companies, provident funds, and other financial
corporations.
4. Discount Houses and Bill Brokers
In developed money markets, private companies operate discount
houses. The primary function of discount houses is to discount bills on
behalf of others. They, in turn, form the commercial banks and
acceptance houses along with discount houses. There are bill brokers
in the money market who act as intermediaries between borrowers and
lenders by discounting bill of exchange at a nominal commission. In
under developed money markets, only bill brokers operate.
5. Acceptance Houses
(They act as agents between exporters and importers and between
lender and borrower traders. They accept bills drawn on merchants
whose financial standing is not known in order to make the bills
negotiable in money market By accepting a trade bill they guarantee
the payment of bill at maturity). However, their importance has declined
because the commercial banks have undertaken the acceptance
business.
All these institutions which comprise the money market do not work in
isolation but are interdependent and interrelated with each other.
2.3 INSTRUMENTS OF MONEY MARKET
Basically it has three most important instruments which are as follows:
1. Promissory Notes
It is a written promise on the part of a business man to pay to
another a certain amount of money at an agreed future date.
Usually, a promissory note falls due for payment after 90 days
with three days of grace. A promissory note is drawn by the
debtor and has to be accepted by the bank in which the debtor

has his account to be valid. The creditor can get it discounted
from his bank till the date of recovery. Promissory notes are
rarely used in business these days except in USA.
2. Bills of Exchange
The bill of exchange which is similar to the promissory note,
except in that it is drawn by the creditor and is accepted by the
bank of the debtor. The creditor can discount the bill of
exchange either with a broker or a bank. Promissory notes and
bill of exchange are known as trade bills.
3. Treasury Bills
This is the major instrument of the money market. It is issued for
varying periods of less than one year. These are issued by the
government and are payable at the central bank. Treasury Bills
are negotiable, non-interest bearing securities with an original
maturity of one year or less.
2.4 FUNCTIONS OF MONEY MARKET

An organized money market performs a number of functions in an
economy.
1. It provides short-term funds to the public and private institutions
including commercial bank to meet their short-term liquidity.
Thus in this way money market helps the development of
commerce, industry and trade within and outside the country.
2. It provides an opportunity to banks and other financial
institutions to use their surplus funds profitably for a short
period.
3. It allocates savings into investment and tends to obtain an
equilibrium between the demand for and supply of loan able
funds. In this way the money market helps in more rational
allocation of resources.
4. It promotes liquidity and safety of financial assets and there by
encourages savings and investment. This is important in
developing countries where savings and investments habits are

rather poor. In many rural areas of developing countries, savings
too often comprise land and gold-holdings rather than the
holding of financial assets which could channel savings into
productive investment.
5. A money market promotes financial mobility by enabling the
transfer of funds from one sector to the other. Such flow of funds
is essential for the development of the economy and commerce.
6. The existence of a developed money market. It removes the
necessity of borrowing by the commercial banks from the central
bank at a higher rate. If the former find their reserves short of
cash requirements they can call in some of their loans from the
money market.
7. The money market provides the government in borrowing short-
term funds at a low interest rates on the basis of treasury bills.
On the other hand, if the government were to issue paper
money or borrow from the central bank, it would lead to
inflationary pressures in the economy.
8. A well-developed money market is essential for the successful
implementation of the monetary policy of the central bank. It is
through the money market that the central bank is in a position
to control the banking system and thereby helps in the growth of
commerce and industry.
9. The money market deals in near money assets and not money
proper. It helps in economizing the use of cash and provides a
suitable and safe way of transferring funds from one place to
another.
2.5 CHARACTERISTICS OF A DEVELOPED MONEY MARKET

The developed money market is a well organised market which has the
following main features.
1) A Central Bank
A developed money market has a central bank at the top which

is the most powerful authority in monetary and banking matters.

It controls, regulates and guides the entire money market. It
provides liquidity to the money market, as it is the lender of the
last resort to the various constituents of the money market.
2) Organised Banking System

An organised and integrated banking system is the second
feature of a developed money market. In fact, it is the pivot
around which the whole money market revolves. It is the
commercial banks which supply short term loans, and discount
bill of exchange. They form an important link between the
central bank in the money market.
3) Specialized Sub Markets
A developed money market consists of number of specialized

sub markets dealing in various types of credit instruments.
There is the call loan market, the bill market, the treasury bill
market, the collateral loan market and the acceptance market,
and the foreign exchange market.
4) Existence of Large Near Money Assets
A developed money market has a large number of near money

assets of various types such as bill of exchange etc. the larger
the number of near money assets, the more developed is the
money market.
5) Integrated Interest Rate Structure

Another important characteristic of a developed money market is
that it has an integrated interest rate structure. The interest rates
prevailing in the various sub markets are integrated to each
other. A change in the bank rate leads to proportional changes
in the interest rates prevailing in the sub markets.
6) Adequate Financial Resources

A developed money market has easy access to financial
sources from both within and outside the country. In fact such a
market attracts adequate funds from both sources, as is the
case with the London money market.

7) Remittance Facilities
A developed money market provides easy and cheap remittance
facilities for transferring funds from one market to the other. The
London money market provides such remittance facilities
through the world.
8) Miscellaneous Factors
Besides the above features a developed money market is highly

influenced by factors such as restriction on international
transaction, crisis, boom or depression etc.
2.6 ROLE OF CAPITAL MARKET IN ECONOMIC DEVELOPMENT
Capital market is the heart and soul of the financial sector. It is a

vehicle whereby capital is deployed from sources where it is in excess
to the sources where it is short in supply. The capital market facilitates;
(i) mobilization and intermediation of private savings, and (ii) allocation
of medium and long-term financial resources for investment through a
variety of debt and equity instruments of both private and public
sectors. It plays a crucial role in mobilizing domestic resources and in
channeling them efficiently to the most productive investments. The
level of capital market development is thus an important determinant of
a country’s level of savings, efficiency of investment, and ultimately of
its rate of economic growth. An efficient capital market can also provide
a wide range of attractive opportunities for both the domestic and
foreign investors.
Capital market plays a very important role in the economic
development of a country. As they facilitate mobilization of medium and
long term resources help efficient allocation of recourses. A healthy
capital market can greatly help in financing the development efforts of
both the private and public sector. Our capital market suffers from a
number of weaknesses.
Main role played by the capital market.
1. Creating of an enabling policy environment specially a level

playing field to enhance competition.
2. Strengthening governance, institutions, regulation and
supervision of the securities market.
3. Improving and modernizing market infrastructure and its linkage.
4. Developing the corporate debt market.
5. Reforming mutual fund industry.
6. Developing leasing industry.
7. Performing contractual savings through reforms of the insurance
sector and pension and provident fund.
2.7 INSTITUTIONAL SOURCES OF CAPITAL MARKET
There are number of financial institutions which are directly involved
with real investment in the economy. These institutions mobilize the
savings from the people and channel funds for financing the
development expenditure of the industry and govt. of the country. The
financial institutions take maximum care in investing funds in the
projects where there is a high degree of security and income is certain.
The main institutional source of capital market are as follows:
Insurance Companies
Insurance companies are financial intermediaries. They call money by
providing protection from certain risk to individual and firms. The
insurance companies invest the funds in long term investment and
corporate bonds.
Pension Funds
Pension funds are provided by the both employees and employers.
These funds are utilized in the provision of long term loans for the
industry and govt.
Building Societies
Building societies are now actually engaged in providing funds for
construction purchases of building for the industry and houses for the
people.
Investment Trusts

The investment trusts mobilize savings and meet the growing needs of
corporate sector. The income of investment trusts depends upon the
dividend it receives from shares invested in various companies.
Unit Trusts
The unit trusts collect small savings of the people by selling units of the
trust. The holder of unit can resell the units at the prevailing market
value to the trust itself.
Saving Banks
Saving banks collect savings of the people. The accumulated savings
are invested in mortgage loans, actively corporate and bonds.
Commercial Banks
Commercial banks are now activity engaged in the provision of medium
and long term loans to the industrialists, agriculturist, specialized
financial institution etc.
Specialized Finance Corporations
Specialized finance corporation is being established to help and
provide finance to the private sector in the form of medium and long-
term loans or foreign currencies.
Stock Exchange
The stock exchange in a market in existing securities (Shares,
Debentures, Securities) the stock exchange provide a place for those
person who wish to sell the shares and also wish to buy them. Stock
exchange thus helps in the raising of funds for the industry.
2.8 SEGMENTS OF CAPITAL MARKET

Capital market divides in two segments.
1. The Non-Securities Market.
2. The Securities Market.
The Non-Securities Market
It provides non-negotiable medium and long term debt funds through
financial institution such as Development Finance Institutions (DFI’s),

Commercial Banks and contractual saving institutions which mobilize
savings and then provide these funds directly to business and
industries.
The instruments of non-securities market
 LOANS
 MORTGAGES
 LEASES
 SALES AND LEASE BACK
The Securities Market
The security market provide medium and long term equity and debt
funds in negotiable form which are used by corporations and govt.
through financial institutions such as merchant banks. Investors are in
this way are able to sell their securities in the security market and also
through equities they are able to participate in financial risk of the
enterprises.
The institutions and the individuals in the capital market can also be
classified into the main categories, which are:
(1) Participants such as the individuals, corporations and
government entities financial institutions and intermediaries
provide the capital to the users from savers.
(2) Govt. bodies which assist in supporting, and regulating the
actuaries of participants.
2.9 FUNCTIONS OF CAPITAL MARKET

It helps to accelerate the rate of economic development by increasing
the production of goods and services together with the increase in per
capita income. However, broadly speaking, they can be classified in
the following functions.
1. On the demand side, it provides funds to commercial banks to
meet their long term liquidity requirements.
2. On the supply side, it provides the financial institutions to use
their funds profitably for a long period of time.
3. The saving of the people are allocated to the investment, this

assists to bring out the equilibrium in the demand and supply
of the loan able funds from medium and long term.
4. Capital market promotes the safety of financial assets.
5. It provides long term loans to the govt. to finance the
development projects under taken by the govt.
6. It assists and promotes financial ability and stability.
ECONOMIC FUNCTIONS OF STOCK EXCHANGE

Stock exchange plays a very important role in the capital market
of a country. The main functions and importance of the stock
exchange are as follows:
1. Organized ready market:
Stock exchange provides an organized ready market
where the shares of enlisted joint stock companies are
freely bought and sold through brokers and jobbers. It
facilitates the marketability of shares.
2. Turning investment into cash:
When a person purchases shares, he wants assurance
that in time of need his investment will be turned into
cash at a shot notice. The stock exchange provides this
facility to the security holders to encash their investment
at a short notice. The easy marketability of shares
increases their liquidity. The liquidity in turn increases the
value of the shares.
3. Proper channelization of capital:
The stock exchange is the central source of information
on market activity and trends in securities. The general
index of share prices motivates the investors to purchase
securities in order to earn a regular-income from their
savings.
4. Aid to capital formation:
The economy of every country moves on the wheels of
capital. The establishment of efficient and economic

business units requires large amounts of capital. The joint
stock companies pool the resources of large sum of
individuals with the liability limited to the extent of their
shares. The persons who have invested in the securities
are sure that their investment can be turned into cash
through the stock exchange. The resources of the people
are thus mobilized for carrying on the productive activity
on a large scale. Stock exchange thus contributes
considerably to the capital formation.
5. Proper evaluation of securities:
The prices of the shares are determined through free the
forces of demand and supply in the share market. The
function of the stock exchange is to exhibit daily the
prices of securities for the information and guidance of
buyers and sellers.
6. Profitable use of capital:
The market data of value of the securities provided by the
stock exchange enables the investors to shift the capital
from non-profitable concerns to the profitable ones. This
is really a great service from the investor’s point of view
provided by the stock exchange.
7. Loan opportunity:
The securities purchased through the stock exchange
can be used as security for taking loans from the
commercial banks. (generally 80% loan facility is
available against securities).
8. Investment by banks:
The stock exchange also provides opportunity to the
commercial banks to invest their funds in the purchase of
shares. As these securities are easily marketable and can
be encashed at any time, the banks are, therefore, able
to maintain profitability as well as liquidity.
9. Facilities for speculation:

Stock exchange enables genuine speculators to
speculate and earn profit through fluctuations in prices.
10. Riba free mode of investment:
The equity investment is a riba free mode of investment.
As such there is a growing popularity of equity in all the
countries of the world now. It is considered hedge against
inflation because the yield on equity investment is
comparatively higher than on prevailing deposit rates.
Factors governing Prices in Stock Exchange:

The prices of securities are determined by the forces of demand
supply of shares in the stock market. The factors, which affect
the demand for and supply of securities resulting in their price
fluctuations are as follows:
1. Political conditions:
The prices of shares are directly affected by the political
developments taking place both at home and abroad. The
political instability in the country, the fear of war with
neighboring countries, the danger of spreading war on
international level, bring a setback in prices of securities.
If there is political stability at home and abroad, the prices
of shares move up.
2. Business conditions:
Political stability brings economic stability in the country.
If a government carries on economic policies in a planned
manner, it then establishes strong industrial base in the
country, the prices of the shares tend to move up. In
case, there are rapid changes in the economic policies
and budget are announced and revised time and again;
the prices of the securities go down.
3. Fear of Nationalization:
If a government adopts a policy of end nationalization of

industries, the investment on the part of the private sector
will be at the lowest end. The prices of the securities are
bound to go down. In case the private sector is
encouraged for investment by giving them due
concessions, the prices of the securities shoot up.
4. Trade activities:
The prices of the securities are directly influenced by the
conditions of boom and slump. In the days of business
prosperity, the prices of the securities move up. If the
depression is hovering over the country, it leads to a fall
in the security prices.
5. Monopoly:
If a firm has monopoly in the production of a commodity,
the share prices of that firm will go up. In case, there is
still competition by the competing firms for the production
of a particular commodity, there will be a decline or a
nominal rise in the stock prices of the competing firms
depending on the situation. The share prices of that firm
will go up.
6. Bank rate:
Bank rate exercises a powerful influence on security
prices. If the interest rate on the short term loans falls, the
speculators borrow money and purchase securities which
leads to the rise in the prices of shares. When the money
is dear, there is a fall in the prices of securities.
7. Distribution of Dividend:
If a company enjoys a reputation of distribution dividend
regularly to the shareholder, the share prices of that
company rise up. In case, the dividend in not distributed
and the financial position of the company is weak, the
prices of the shares go down.
8. The stock exchange zoo:
The Stock Exchange Zoo which consists of Bulls, Bears

and Stags (speculators) also influence the security prices.
When they run for the purchase of securities, the prices
of the stocks move up and vice versa.
9. Inflation and Deflation:
When the prices are rising in the country, the
industrialists make profit. The prices of the shares go up.
When the country is in the grip of deflation, the prices of
the shares go down.
10. Action of underwriters:
The underwriters of shares are also responsible for
causing fluctuations in the share value. The purchase of
shares by underwriters tends to raise the prices of shares
and vice versa.
11. Market Psychology:
The prices of the securities sometimes also fluctuate
without any valid reason. The people who deal
insecurities are very sensitive. They sometimes behave
like a herd of sheep. A purchase of large shares by an
investor or a vague rumor may stimulate the persons to
run for the purchase of shares. Similarly, there may take
place a race to sell the shares without any valid reason,
causing the prices of shares to go down.
12. Equity investment:
If equity investments gains popularity in the financial
markets due to higher gains as compared to the fixed
income securities, the prices of the shares go up in the
market.
13. Miscellaneous factors:
The stock exchange is very sensitive even to remotely
connected event in the country. For example, if there is
slight ethical or religious disturbance in any part of the
country or strikes, or rumors about the health of the head
of the Government, the price of shares is affected.

23. GLOSSARY OF STOCK MARKET TERMS:
(i) Bear:
An investor who anticipates a falling market and, therefore, sells
the security in the hope of buying it back at a lower price.
(ii) Blue Chip:
A large well-established company with a history of profitable
operation.
(iii) Bonds:
Fixed-income securities, which entitle the holder to a pre-
determined return during their life and repayment of principal at
maturity.
(iv) Bull:
An investor who anticipates a rising market and, therefore, buys
the security in the hope of selling it later at a higher price.
(v) Capital Gains Tax:
Tax payable on profit arising from appreciation in value of
investment, realized at the time of selling or maturity of
investment.
(vi) Carry-over Trades:
Equity repurchases transactions, better known, as “Badla”;
these are an established form of transactions used in the stock
market for temporary financing of trades by speculators and
jobbers.
(vii) Dividend:
That part of a company’s profits which is distributed among
shareholders, usually expressed in rupee per share or
percentage to paid up capital.
(viii) Earnings per share (EPS):
A profitability indicator calculated by dividing the earnings
available to common stockholders during a period by the
average number of shares actually outstanding at the end of that
period.

(ix) Equity:
The owners’ interest in a company’s capital, usually referred to
by ordinary shares.
(x) Floatation:
The occasion when a company’s shares are offered on the stock
market for the first time.
(xi) Fund managers:
A company, which invests and manages investors’ money, with
the aim of maximizing capital growth.
(xii) Initial Public offering (IPO):
The offering of equity shares of a company to the general public
for the first time.
(xiii) Insider trading:
The purchase or sale of shares by someone who possesses
‘inside’ information on a company’s performance which
information has not been made available to the market and
which might affect the share price. In Pakistan, such deals are a
criminal offence.
(xiv) Investment companies:
A company, which issues shares and uses its capital to buy
securities and shares in other companies.
(xv) Listed company:
A company whose securities are admitted for listing on a stock
exchange.
(xvi) Long position:
When an individual purchases securities of a company he is
said to have a long position in the company’s shares. For
example an owner of shares in PTCL is said to be “Long PTCL”
or “has a long position in PTCL.” If you are long, you would like
the share price to go up.
(xvii) Market capitalization:
The total value of a company’s equity capital at the current

market price.
(xviii) Nominee:
A person or company holding securities on behalf of others, but
who is not the owner of such securities.
(xix) Option:
The right (but not the obligation) to buy or sell securities at a
fixed price within a specified period.
(xx) Ordinary shares:
The most common form of shares, which entitle the owners to
jointly own the company. Holders may receive dividends
depending on profitability of the company and recommendation
of directors.
(xxi) Portfolio:
A collection of investments.
(xxii) Price/earnings ratio (P/E ratio):
The P/E ratio is a measure of the level of confidence (rightly or
wrongly) investors have in a company. It is calculated by
dividing the current share price by the last published earnings
per share.
(xxiii) Primary market:
Where a company issues new shares, either for the first time, or
at the time of issuing additional securities.
(xxiv) Privatization:
Conversion of a state-owned company to a public limited
company (plc) status.
(xxv) Private company:
A company that is not a public company and which is not
allowed to offer its shares to the general public.
(xxvi) Public limited company (plc):
A company whose shares are offered to the general public and
traded freely on the open market and whose share capital is not
less than a statutory minimum.

(xxvii) Rights Issue:
The issue of additional shares to existing shareholders when
companies want to raise more capital.
(xxviii)Securities:
A broad term for shares, corporate bonds or any other form of
paper investment in capital market instruments.
(xxix) Settlement:
Once a deal has been made, the settlement process transfers
stock from seller to buyer and arrange the corresponding
exchange of money between buyer and seller.
(xxx) Short Selling:
The act of borrowing stock to sell with the expectation of price
reduction with the intention of buying it back at a cheaper price.
(xxxi) Stockbroker:
A member of the stock exchange who deals in shares for clients
and advises on investment decisions.
(xxxii) Stock Market:
The market place where shares of publicly listed companies are
bought and sold.
(xxxiii)Unit trust:
An open-ended mutual fund that invests funds in securities and
issues units for sale to the public. It can repurchase these units
at any time.
(xxxiv)Yield:
The aggregate return earned on an investment taking into
account the dividend/interest income and its present capital
value.
The securities market: is studied under two heads:
(a) The new issue market and;
(b) The stock exchange.
(a) The new issue market:

The new issue market is concerned with the
purchase of newly issued shares of public
company.
(b) Stock exchange:
The stock exchange is a market for the resale of
second hand securities. Stock exchange is an
organized and regulated market for the purchase
and sale of listed shares for investment or for
speculative purposes. In the words of “Garg”, A
stock exchange is an association of persons
engaged in the buying and selling of stocks,
bonds, shares for the public on commission and is
guided by certain rules and regulations.”
3. TYPES OF BUSINESS FINANCE

The financial requirements of a business, on the basis of time duration, are
classified under three main heads.
(1)Short term credit
(2)Medium term credit
(3)Long term credit
3.1 Short term finance. (Short term debt financing)
Short term funds are required for meeting the day-to-day expenses of
business or for purchase of raw material, payment of wages, gas,
electricity bills, maintaining inventories of raw material etc. The short
term funds have a maturity date of less than one year.
Sources of short term finance.
These sources are discussed in brief.

1. Commercial Banks
The major portion of short term capital is provided by the
commercial banks. The banks offer wide variety of loans to meet
the specific current requirements of business. The banks
provide loans in the following forms:
i) Loans
ii) Cash Credit (Now replaced by revolving finance)
iii) Overdrafts (OD)
iv) Discounting of bills
2. Trade credit and discount

Trade credit is an important source of short term finance. Trade
credit is given by one firm to another firm which buys goods.
Trade credit which usually ranges from 15 days to 3 months is
granted on the basis of financial standing and goodwill of the
purchaser.
3. Installment credit
Another source of short term credit is the installment credit. The
concern gets the facility of purchasing requirements on
installments.
4. Advances (Token money)
Sometimes the reputed business houses take advance money
from the customers for the supply of goods. The remaining
amount is received on the supply of the commodity.
3.2 Medium term financing: (Intermediate Debt Financing)

Medium term finance range from one to five years. They are mostly
raised through borrowed capital. The main Cases of medium term
loans are as under –
Sources of Medium term Loans

The medium term sources of raising funds for a company are
1. Debentures
Debenture includes (a) debenture stock (b)bonds (c)
participation Term Certificates (PTC) and (d) any other security
(other than shares) which constitute a charge on the assets of
the company.
2. Loans from commercial banks

The commercial banks are now coming forward for providing
medium term finances to the businesses. The amount of loans
to be advanced depends upon the creditability of the
businesses.
3. Loans from industrial finance institutions

There are various finance institutions which provide medium
term loans to the companies. The major Institutions which give
finance are IDBP Insurance companies etc.
4. Leasing
3.4 Long term Finance

The long term finance is required by the business for the purchase of
fixed and non-current assets at the start of business. It is also needed
for modernization and expansion of business.
The company raises long term funds through owned capital and
borrowed capital. Owned capital is raised by issue of ordinary shares
and ploughing back profits. Borrowed capital is obtained by issuing of
debentures and loans from industrial and commercial institutions.
3.5 Sources of long term finance
(1) Share (Owners finance) / Certificates

Equity or ordinary shareholders are the real owners of the company.
The company raises maximum amount of capital through the sale of
shares. The Companies Ordinance 1984 allows the company to issue
only fully paid up equity or ordinary shares.
(2) Ploughing back of profits (Owned capital)

‘Ploughing back of profits’ is a reinvestment of surplus earnings in a
business. A company retains a part of profits every year and ploughs
back or reinvests it in business for meeting its long and medium term

capital needs. It is an internal source of financing and is used for
expansions, modernization, replacement redemption of loans etc.
(3) Debentures (Borrowed capital)

A company also raises long term finance through borrowing. These
loans are raised by the issue of debentures. A debenture is an
Instrument issued by a company to acknowledge the loan taken by the
company under its common seal, under certain terms and conditions
which are endorsed on the back of the document. The terms of
conditions are the rate of interest, the mode of payment of principal
sum and interest, the security if any offered etc. A debenture holder is
creditor of the company.
(4) Loans from industrial and financial institutions

A company also meets its long and medium term capital requirements
from the industrial and financial institutions like IDBP, PICIC, NIT etc.
Such financial institutions help in promoting new companies, expanding
and development of existing companies, providing underwriting facility,
provision of local and foreign currency for the purchase of machinery
etc.
KEY POINT
Types of Business Finance
Long term Medium term Short term
(a) Equity Shares (a) Debentures (a) Commercial banks
(b) Ploughing back of (b) Commercial and (b) Trade credit

profits Industrial Institution
(c) Debentures (c) Loans from (c) Installment credit

Commercial Banks
(d) Loans from financial (d) Leasing (d) Advances (Token)

and industrial
institution
Finance for Firms:

As already stated above that strength and soundness; pf business depends
on the availability of finance and competency with which it is used. The
abundance of finance can do wonders can its scarcity are ruin even a well-
established business. Finance increases the strength and viability of
business. It increases the resistance capacity of a business to face losses and
economic depression. It is just like a lubricant, the more it is applied to the
business, the quickly the business will move.
1. Starting Business:
Finance is the first and fore most requirement of every business. It is
the starting point of every business, industrial project etc. Whether you
start>a sole trading concern, a partnership firm, a company or a charity
institution, you need ample supply of finance. It is equally important for
profit seeking and non-profit activities. It is also equally important for a
multinational organisation or for a free dispensary
2. Purchase of Assets:
Finance is needed to purchase all sorts of assets. Even if credit is
available some down payment has to be made. Mostly fixed assets
are needed at the start of business. These fixed assets consume a
large amount of initial investment of the entrepreneur, so he may face
liquidity difficulty in running every day affairs of the business.
3. Losses:
No business attains high profit on the first day of commencement.
Some losses are normal before the business reaches its full capacity
and generate enough revenue to match cost. Finance is necessary so
that these initial losses can be sustained and business can be allowed
to progress gradually.
4. Services of Specialized Personals:

Certain business needs services of specialized personals. Such
personals have a rich experience in specialized fields and they can
provide useful guidance to make business profitable. Nevertheless
these services are costly. Finance is always needed so that services of
such professional consultant can be hired.
5. Modern Technology:
Business is always exposed to change. New innovations and
emergence of new technologies push old techniques out of market. So
in order to remain in the market, it is needed to keep the business well
equipped with all emerging tools and techniques. This needs finance.
New technology is always expensive as it is better than others. So
finance is needed to purchase new equipment and keep business
running.
6. Information Technology:
It has now changes the geography of the business battle field. The
home market has now extended virtually to other corner of the world.
The whole world can be your customer or competitor. To face such a
fierce competition, IT is needed. Skills and competency in IT can
perform miracles. But finance is again the decisive factor. It is very
much needed to incorporate, expensive IT products in the business.
7. Advertisement:
The advertisement and promotion have now become vital elements for
the success of business. The way a businessman approaches a
customer and convinces him to purchase his product has become
more important than the quality of product. With advertisement on
International media, a businessman can reach to the minds of millions
of people around globe. However, advertisement is a luxury which all
business can’t afford. Huge finance is required to pay off advertisement
expenses.
8. Resource Management:
Finance is very essential for efficient resource management.
Resources here include all capital and human resources. Maintenance
of point and equipment and training of employees all need finance.

Establishment of new industrial units, expansion of plant capacity,
hiring of well learned, skillful laborers ......... all these factors can drive
in huge revenue but at the first place they need finance to start with.
9. Purchase of Raw materials:
These investments are those which are made to hold ample stock of
raw materials in hand.. Bulk purchase of raw materials is profitable in a
sense that huge purchase discount can be attained and there is no
danger of production halts. So company is most often holding huge
amount of stocks and raw materials. But such an investment can be
made-only if a company has sufficient capital or finance to carry out its
daily operations easily besides holding huge stock.
10. Risks:
Everything is exposed to one or more risks. A business is also exposed
to variety of risks. These risks include natural hazards, imposition of
any huge liability, loss of market or brand name etc. Finance is need to
make business powerful, so that it can sustained occasional losses and
liabilities.
Sources of Business Finance:
Sources of business finance can be studied under the following heads:
(A) Short Term Finance:
Short-term finance is needed to fulfil the current needs of business.
The current needs may include payment of taxes, salaries or wages,
repair expenses, payment to creditor etc. The need for short term
finance arises because sales revenues and purchase payments are not
perfectly same at all the time. Sometimes sales can be low as
compared to purchases. Further sales may be on credit while
purchases are on cash. So short term finance is needed to match
these dis-equilibrium.
Sources of short term finance are as follows:
1. Bank Overdraft:
Bank overdraft is very widely used source of business finance.
Under this client can draw certain sum of money over his
original account balance. Thus it become easier for the

businessman to meet short term unexpected expenses.
2. Bill Discounting:
Bills of exchange can be discounted at the banks. This provides
the holders of bill with liquid cash which can be used anywhere.
3. Financial Institutions:
Several financial institutions such as House Building Finance
Corporation, Industrial Development Bank, etc., also provide
medium and long-term finances. Besides providing finance they
also provide technical and managerial assistance on different
matters.
4. Debentures and TFCs:
Debentures and TFCs (Terms Finance Certificates) are also
used as a source of medium term finances. Debentures is an
acknowledgement of loan granted to the company. It can be of
any duration as agreed among the parties. The debentures
holder enjoys return at a fixed rate of interest. Under Islamic
mode of financing debentures has been replaced by TFCs.
5. Insurance Companies:
Insurance companies have a large pool of funds contributed by
numerous policy holders. Insurance companies grant loans and
make investments out of this pool. Such loans are the source of
medium term financing for various businesses.
(B) Long Term Finance:
Long term finances are those that are required on permanent basis or
for more than five years tenures. They are basically desired to meet
structural changes in business or for heavy modernization expenses.
These are also needed to initiate a new business plan or for a long
term developmental projects.
Following are its sources:
1. Equity Shares:
This method is most widely used all over the world to raise long
term finance. Equity shares are subscribed to public to generate

the capital base of a large scale business. This method is safe
and secured, in a sense that amount once received is only paid
back at the time of wounding up of the company.
2. Retained Earnings:
Retained earnings are the reserves which are generated from
the previous year’s excess profits. In times of need they can be
used to finance the business project. This is also called
ploughing back of profits.
3. Leasing:
Leasing is also a long term finance. With the help of leasing,
new equipment can be acquired without any heavy outflow of
cash. (Details of leasing can be found in relevant chapter).
4. Financial Institutions:
Different financial institutions such as H.B.F.C., PICIC, S.B.F.C.,
also provide long term loans to business houses.
5. Debentures:
Debentures and PTCs are also used as a source of long term
financing.
Conclusion:
These are various sources of finance. In fact there is no hard
and fast rule to differentiate among small and medium term
sources or medium and long term sources. A source for
example commercial bank can provide both a short term and a
long term loan according to the needs of client. However, all
these sources are frequently used in the modern business world
for raising finances.
Equity Finance
It means the owner own funds and finance. Usually small scale
business such as partnerships and sole proprietorships are
operated by their owner through their own finance. Joint stock
companies operate on the basis of equity shares, but their
management is different from shareholders and investors.
Sources:

Following are the sources of equity finance.
1. Equity Shares: Joint stock companies raise their capital from the
issuance of equity shares. This method is suitable for very long term
financing. The shareholders are paid dividends out of the profit of the
company. A major advantage of this finance is that it is to be repaid
only in case of liquidation.
2. Retained Profit: Retained profit can also be used as a source of
financing. This process is also called ploughing back of profits. By
using retained profit the company can easily handle short term
structural requirements of business.
3. Reserves and Provisions: Big companies always carry provisions
and reserves. Some reserves are of capital nature, called capital
reserves. Others are called revenues reserves. These reserves and
provision can be used to meet any unexpected heavy expenses or
liabilities. Further they can also be used to finance business
requirements.
Merits:
Following are the merits of equity finance:
1. Permanent in Nature: Equity finance is permanent in nature. There is
no need to repay it unless liquidation occurs. Shares once sold remain
in the market. If any share holder wants to sell those shares he can do
so in the stock exchange where company is listed. However, this will
not pose any liquidity problem for the company.
2. Solvency: Equity finance increases the solvency of the business. It
also helps in increasing the financial standing. In times of need the
share capital can be increased by inviting offers from the general public
to subscribe for new shares. This will enable the company to
successfully face the financial crisis.
3. Credit Worthiness: High equity finance increases credit worthiness. A
business in which equity finance has high proportion can easily take
loan from banks. In contrast to this companies which are under serious
debt burden, no longer remain attractive for investors. Higher
proportion of equity finance means that less money will be needed for

payment of interest on loans and financial expenses, so much of the
profit will be distributed among shareholders.
4. No Interest: No interest is paid to any outsider in case of equity
finance. This increases the net income of the business which can be
used to expand the scale of operations.
5. Motivation: As in equity finance all the profit remains with the owner,
so it gives him motivation to work more hard. The sense of inspiration
and care is /eater in a business which is finance by owner’s own
money. This keeps the businessman conscious and active to seek
opportunities and earn profit.
6. No Danger of Insolvency: As there is no borrowed capital so no
repayment have to be made in any strict time schedule. This makes the
entrepreneur free from financial worries and there is no danger of
insolvency.
7. Liquidation: In case of winding up or liquidation there is no outsiders
charge on the assets of the business. All the assets remain with the
owner.
8. Increasing Capital: Joint Stock companies can increases both the
issued and authorized capital after fulfilling certain legal requirements.
So in times of need finance can be raised by selling extra shares.
9. Macro Level Advantages: Equity finance produces many social and
macro level advantages. First it reduces the elements of interest in the
economy. This makes people free of financial worries and panic.
Secondly the growth of joint stock companies allows a great number of
people to shares in its profit without taking active part in its
management. Thus people can use their savings to earn monetary
rewards over a long time.
Demerits:
Following are the demerits of equity finance:
1. Decrease in Working Capital: If majority of funds of business

are invested in fixed assets then business may feel shortage of
working capital. This problem is common in small scale

businesses. The owner has a fixed amount of capital to start with
and major proportion of it is consumed by fixed assets. So less is
left to meet current expenses of the business. In large scale
business, financial mismanagement can also lead to similar
problems.
2. Difficulties in Making Regular Payments: In case of equity

finance the businessman may feel problems in making payments
of regular and recurring nature. Sales revenues sometimes may
fall due to seasonal factors. If sufficient funds are not available
then there would be difficulties in meeting short term liabilities.
3. Higher Taxes: As no interest has to be paid to any outsider so

net income of the business is greater. This results in higher
incidence of taxes. Further there is double taxation in certain
cases. In case of joint stock company the whole income is taxed
prior to any appropriation. When dividends are paid then they
are again taxed from the income of recipients.
4. Limited Expansion: Due to equity finance the businessman is

not able to increase the scale of operations. Expansion of the
business needs huge finance for establishing new plant and
capturing more markets. Small scales businesses also do not
have any professional guidance available to them to extend their
market. There is a general tendency that owners try to keep their
business in such a limit so that they can keep effective control
over it. As business is financed by the owner himself so he is
very much obsessed with chances of fraud and embezzlement.
These factors hinder the expansion of business.
5. Lack of Research and Development: In a business which is

run solely on equity finance, there is lack of research and
development. Research activities take a long time and huge

finance to reach a new product or design. These research
activities are no doubt costly but eventually when their outcome
is launched in market, huge revenues are gained. But problem
arises that if owner uses his own capital to finance such long
term research projects then he will be facing problem in meeting
short term liabilities. This factor discourages investment in
research projects in a business financed by equity.
6. Delay in Replacement: Businesses that run on equity finance,

face problems at the time of modernization or replacement of the
capital equipment when it wears out. The owner tries to use the
current equipment as long as possible. Sometimes he may even
ignore the deteriorating quality of the production and keeps on
running old equipment.
Debt Finance
Debt financing means to borrow funds or to arrange for
investments from external sources. Large scale businesses,
organisations are not able to run all their affairs from their own
capital so it is usual to take loans for them. The most prevalent
example of this type of finance is the loans taken from banks.
The amount of the loan is to repaid in agreed installments along
with interest at a specified rate.
Sources:
Sources of debts financing are as follows.
1. Loan:
Loans can be obtained from commercial banks NBFIs,
Financial Intermediaries and specialized credit
institutions. Loans are advanced against different
securities such as land, building, stock in trade etc.
2. Debentures:
Companies can also raise finance by way of debentures,

PTCs or TFCs.
3. Leasing:
Leasing is also a source of long term finance. Through
leasing the business organisations can remain equipped
with latest technological equipment without making any
heavy outflows of cash.
Merits:
Following are the merits of debt finance:
1. Scope for Expansion: Debt financing allows business to
expand its operations. New branches can be opened in other
cities and countries. New lines of business can be adopted to
increase revenues. The easy availability of credit encourages
entrepreneur to take new risks and float new products. It also
enable businessman to increase the scale of their operations
and to upgrade their products in time.
2. Research and Development: Debt financing allows the process
of research and development. Loans taken from banks can be
used to accelerate research activities. Earning potential of the
company will increase once the research product are floated in
the market. The new innovation besides increasing companies
reputation also reduces its cost of production.
3. High Profit: Due to expansion of business and use of new
techniques the revenues and profits of the business also grow.
Huge revenues means that there will be a room for further
expansion of the business. Higher profit can also be used to
repay the bank loans. Thus increasing the solvency of business.
4. Ease of working Capital: Debt financing helps in maintaining
adequate working capital of the business. It also provides a room
for making regular payments easily.
5. Revival of Sick Units: Debt financing may be used to revive the
sick industrial units. The loan of sick unit can be rescheduled.
New credit can be advanced to such units so that they can start
their production. Besides providing finance, proper supervision

and guidance should also be given. All this will rehabilitate the
sick units and leads to improvement of living standards.
6. Saving from Insolvency: Debt financing may be used to save
the business form insolvency. In case any essential payment is
to be made and there are not enough funds then a loan can be
taken to make payments and to save the business from
insolvency.
7. Tax Advantage: As the interest charge is subtracted from net
income before applying tax rate, so this leads to lower tax
liability.
Demerits:
Following are the demerits of debt financing:
1. Interest Payments: Very huge amount out of net profit of the business
have to be paid on account of interest on borrowed capital.
2. Depression: If a business comes in to depression and losses occur
the payments of interest could become a great problems due to
inadequacy of funds.
3. Suit Against Business: Creditor can file suits against business if
business fails to make payments as agreed.
4. Seizing of Collaterals: If the business fails to pay interest on capital
amount of loan the bank could seize the collaterals or mortgage
property.
5. Risky Investment: If a business is already running on the huge
borrowed capital, further investment in a business becomes risky. This
risk discourages investors. Banks also hesitate to grant loans to such
business which is already under debt burden.
Conclusion:
From the above stated merits and demerits of equity and debt finance. It can
be concluded that they are the part and parcel of today’s business world.
However, the answer to the question that which form is better depends on
circumstances. A huge loan may be beneficial for such a company who has
resources to utilize it in a profitable way. But it may be dangerous for a middle

scale business which can’t utilize it successfully. So it is not only the type of
financing that matters in a success of business, the resources available,
competency of management and proficiency also decide that what should be
the way of financing.
Finance for Government:

1. The finance for government is basically used to develop basic
infrastructure that is means of transportation and communication, health
and education.
2. It is also used for development of large scale manufacturing, engineering
units and overall large scale industry where the time period required is
long enough and the private sector is not having sufficient capital.
3. It is also used for the development of agricultural sector by developing
irrigation system, water channels, drains to control water logging and
salinity.
4. Development of energy sectors especially the power sector which includes
hydel power, atomic energy, thermal power and solar energy etc.
5. Discovery of natural resources especially oil and gas and other precious
metals and non-metals.
6. Construction of dames, bridges, ports, dries ports and motor ways etc.
3.6 SOURCES OF FUNDS AVAILABLE TO A CORPORATE ENTITY
The sources of funds available to a corporate entity are as follow:
1. Commercial banks
Commercial banks are the major source of medium term
finance. They provide loans for different time period against
appropriate securities. At the time of termination of terms the
loan can be re-negotiated if required.
2. Hire Purchase

Hire purchase means buying on installments. It allows the
business house to have the required goods with payments to be
made in future in agreed installments.
3. Equity Shares
This method is most widely used over the world to raise long
term finance Equity shares are subscribed to public to generate
the Capital base of a large scale business. This method is safe
and secured in a sense amounts once received is only paid
back at the time of winding up of a company if left.
4. Retained Earnings
Retained earnings are the reserves which are generated from
the previous year’s excess profits. In times of need they can be
used to finance the business profit. This is also called ploughing
back to profits.

4. OPEN-END MUTUAL FUND AND CLOSE-END MUTUAL FUND
Open end mutual funds have unlimited number of shares which means
whenever someone comes to buy shares, new shares are issued. The other
hand when someone sells his holding of mutual funds share, these are
cancelled by the mutual fund management.
While close-end mutual funds are those whose shares are listed on stock
exchange. Therefore, there are a limited number of shares in the market and
it cannot buy unless someone is willing to sell.
The main advantages of Mutual funds

(i) Low risk investment.
(ii) Capital gain and capital growth.
(iii) Long term profits.
(iv) Dividends on investment.
4.1 TYPES OF MUTUAL FUNDS
(i) Open end funds. Meaning that the fund will redeem
outstanding shares immediately upon request. Thus the number
of a given mutual fund is not fixed but fluctuates as new shares
are sold to investors and outstanding shares are redeemed.
(ii) Close end Mutual Funds. Generally have a fixed number of

shares outstanding and are traded on the counter market.
(iii) Balanced Funds. Seeking both growth and income, may

invest in stocks, bonds and other financial instruments.
(iv) Sector Funds. Put all their funds in corporations in one area of
business, such as the automobile industry or Oil and Gas sector,
or in one country of region of the world.

4.2 DIFFERENCES BETWEEN A “SHARE” AND A “DEBENTURE”
Share Debenture
1. Dividend is paid to the Interest is paid to the debenture
shareholders. holder.
2. Dividend is paid to the Debenture interest must be paid
shareholders out of the whether a company makes profit
profit. or not.
3. There is no definite time Debentures are issued for a
period for shares. definite time period between 10
to 40 years.
4. Shareholders cannot force Debenture holders can force
for liquidation and rank after LIQUIDATION and rank ahead
the debenture holders. of all shareholders in their claim
in the company assets.
5. Share increase equity of the Debenture increase the loans on
company. the company.
6. Share are only repaid in Debentures are repaid even
case of liquidation. before liquidation.
5. Capital market instruments

5.1 Ordinary shares
Companies usually try to obtain as much money as possible through
shares because the immediate cost can be low (if shareholders accept
a low rate of dividend in the expectation of rising share values in the
future) and because dividend payment is not guaranteed at any definite
rate. Failure to keep forecasting dividends does, of course, damage a
company’s reputation and make it difficult to raise any further money.
Also, it is often only possible to issue new shares when capital markets
are favorable, i.e. when share prices are generally high. Unfortunately,
many companies may then be queuing up to make issues. For an
existing public company it is normal to make a new issue of ordinary
shares through a rights issue. This means that the new shares are

first offered to existing shareholders at a favorable price. If the
shareholders do not wish to buy the shares they can sell their ‘rights’ to
others through the capital market. The reason for this is that any
increase in the number of shares dilutes the value of existing shares
because the future profit has to be shared out more thinly. It is only fair,
therefore, to compensate the shareholders for this dilution by offering
them some immediate benefit.
5.2 Preference shares

These pay a fixed dividend but, in a period of inflation, they are not
popular unless there are definite taxation advantages. There are
circumstances when preference shares are suitable but under modern
conditions they are not now in common use. They are divided into
cumulative and non-cumulative preference shares as described in
Table 19.1 below.
5.3 Debentures
This general term covers any loan from the public that can be
exchanged on much the same conditions as shares. Today there are
secured and unsecured loans and also loans that carry a right to be
exchanged for ordinary shares under agreed conditions. The firm has
the advantage of a fixed rate of interest which becomes progressively
cheaper during inflation and payment of interest is made before
calculation of profit for tax purposes − it is an expense which is
allowable against tax. On the other hand, the interest has to be paid
regardless of profit and debenture holders can sue for unpaid interest
and insist on any secured property being sold. In practice only large
companies can issue unsecured loan stock. As investors have
continued to suffer from inflation, fixed interest investments have
declined in popularity.

5.4 Summary of capital market instruments
Types of Security or voting Income Amount of

capital rights capital
Ordinary Usually have voting Dividends payable The right to all
shares rights in general at the discretion of surplus funds
meetings of the the directors after prior
company. Rank after (subject to claims has been
all creditors and sanction by the met.
preference shares in shareholders) out
liquidation. of undistributed
profits remaining
after senior claims
have been met.
Amounts available
for dividends but
not paid out are
retained in the
company on
behalf of the
ordinary
shareholders.
Cumulative Have the right to vote A fixed amount A fixed amount
preference at a general meeting per year at the per share.
shares only when dividend is discretion of the
in arrears or when it directors subject
is proposed to to sanction of the
change the legal shareholders and
rights of the shares. in accordance with
Rank after all rules regarding
creditors but usually dividend
before ordinary payments; arrears
shareholders in accumulate and

liquidation. must be paid
before a dividend
on ordinary shares
may be paid. Note
that, unlike other
forms of debt, the
dividend paid on
preference shares
is not corporation
tax deductible.
Noncumulative Likely to have some A fixed amount A fixed amount

preference voting rights at all per year, as per share.
shares times rather than in above; arrears do
specified not accumulate.
circumstances as in
the case of
cumulative. Rank as
cumulative in
liquidation.
Secured The charge is on one A fixed annual A fixed amount
debentures or more specific amount, usually per unit of loan
and loan stock assets, usually land expressed as a stock or
and buildings, which percentage of debenture.
are mortgaged − or a nominal value.
floating charge over
all assets. On default,
the assets are sold;
any surplus adds to
the assets of the
company available for
the satisfaction of
creditors; if there is a

deficit, the company
is liable for the
unsatisfied balance.
No voting rights.
Unsecured None, holders have A fixed annual A fixed amount
debentures the same rights as amount, usually per unit of loan
and loan stock ordinary creditors. No expressed as a stock or
voting rights. percentage of debenture.
nominal value.
Table: Capital market instruments
6. Derivatives
Derivatives are instruments that derive from another instrument – typically an
equity share. An option is a typical derivative.
An option is a right to buy or sell shares at a specified price at any time up to
a specified date in the future.
There are two groups of options that can be bought or sold – traditional
options and traded options. Only traditional options are described here, as
derivatives are rather marginal as far as this syllabus is concerned.
Traditional options, as their name implies, have existed since the early days of
the Stock Exchange. The two main types are described below.
6.1 Put option
An investor who buys a put option buys the right (but not the obligation)
to sell shares at a given price (the exercise price) until the expiry date
of the option. The two parties to the option are known as the giver and
the taker; the giver buys the right to ‘put’ the shares onto the taker who
is usually an institution. The exercise price or striking price will be the
market-maker’s bid price at the time the option was agreed.
6.2 Call option
Under this option the giver would be able to ‘call’ on the taker to supply
the shares; in other words, the giver would buy the right to buy shares

at the exercise price. In this case, the exercise price would be the
market-maker’s offer price at the time the option was agreed.
7. The money markets

7.1 Introduction
The money markets are a number of inter-connected wholesale
markets for short-term funds. No physical location exists, transactions
being conducted by telephone or telex.
The major participants are the Bank of England, the banks, local
authorities, building societies and large industrial and commercial
companies.
7.2 Money market instruments
Loans and overdrafts
Two of the most common forms of borrowing are loans and overdrafts.
The main difference between them is that overdrafts are (or should be)
of a short term nature and fluctuate in amount, whereas loans are
arranged for specific periods, generally short to medium-term, and are
for specific amounts. Overdrafts are an extremely expensive way of
borrowing and should be avoided. Loans generally carry a lower rate of
interest than do overdrafts.
8. The Financial System

8.1 The financial system
The financial system’ is an umbrella term covering the following:
 Financial markets – e.g. stock exchanges, money markets;

 Financial institutions – e.g. banks, building societies, insurance
companies and pension funds;
 Financial assets and liabilities – e.g. mortgages, bonds, bills and
equity shares.
8.2 Financial markets

The financial markets can be divided into different types, depending on the
products being issued / bought / sold:
 Capital markets which consist of stock-markets for shares and

bond markets.
 Money markets, which provide short-term (<1 year) debt financing
and investment.
 Commodity markets, which facilitate the trading of commodities
(e.g. oil, metals and agricultural produce).
 Derivatives markets, which provide instruments for the
management of financial risk, such as options and futures
contracts.
 Insurance markets, which facilitate the redistribution of various
risks.
 Foreign exchange markets, which facilitate the trading of foreign
exchange.
8.3 Financial intermediaries

Within each sector of the economy (household, firms and governmental
organizations) there are times when there are cash surpluses and times when
there are deficits.
 In the case of surpluses the party concerned will seek to invest /
deposit / lend funds to earn an economic return.
 In the case of deficits the party will seek to borrow funds to
manage their liquidity position.
Faced with a desire to lend or borrow, there are three choices open to the
end-users of the financial system:
(a) Lenders and borrowers contact each other directly.
This is rare due to the high costs involved, the risks of default
and the inherent inefficiencies of this approach.
(b) Lenders and borrowers use an organized financial market
For example, an individual may purchase corporate bonds from a
recognized bond market. If this is a new issue of bonds by a
company looking to raise funds, then the individual has effectively
lent money to the company.
If the individual wishes to recover their funds before the
redemption date on the bond, then they can sell the bond to
another investor.
(c) Lenders and borrowers use intermediaries

In this case the lender obtains an asset which cannot usually be
traded but only returned to the intermediary. Such assets could
include a bank deposit account, pension fund rights, etc.
The borrower will typically have a loan provided by an intermediary.
8.4 Financial intermediaries have a number of important roles.

 Risk reduction
By lending to a wide variety of individuals and businesses, financial
intermediaries reduce the risk of a single default resulting in total loss
of assets.
 Aggregation
By pooling many small deposits, financial intermediaries are able to
make much larger advances than would be possible for most
individuals.
 Maturity transformation
Most borrowers wish to borrow in the long-term whilst most savers are
unwilling to lock up their money for the long-term. Financial
intermediaries, by developing a floating pool of deposits, are able to
satisfy both the needs of lenders and borrowers.
 Financial intermediation
Financial intermediaries bring together lenders and borrowers through
a process known as financial intermediation.
Key point
Most lenders wish to offer their funds for the short term whereas most
borrowers want to borrow over the longer term. Resolving this mismatch is
known as:
A risk reduction
B aggregation
C maturity transformation
D pooling
Key point
The linking of net savers with net borrowers is known as:
A the savings function
B financial intermediation
C financial regulation
D a store of value.
9. Liquidity surpluses and deficits

The lack of synchronization between payments and receipts, has a variety of
origins and affects individuals, businesses and governments.
9.1 Individuals
The lack of synchronization in payments and receipts for individuals
can occur in the short, medium and long term.
Receipts
 wages and salaries

 income from investments, property and savings
 social security and pension payments
The common feature of these is that the flow of such income tends to
be regular, but not continuous. Typically wages and salaries are paid
monthly (and bonuses annually) as are social security and pension
payments. Income from investments may be monthly, but are more
commonly bi-annually or annually.

Payments
Payments Dealing with a lack of

synchronization
Short Consumption expenditure is Households can:

term typically more or less
 retain a stock of cash to meet
continuous and irregular. day-to-day expenditure;
Most households spend some
 use credit such as credit cards
money every day but rarely and overdrafts facilities;
exactly the same amount.
 save in periods when receipts
exceed payments to finance
periods when the reverse
Some payments may match
happens.
receipts, for example monthly
In all of these cases, households
direct debits and monthly
use the services of financial
salaries but this relates only
intermediaries; bank accounts,
to certain types of
credit cards and overdrafts.
expenditure.
Note: there will also be times when
individuals have a surplus of funds
and would thus look for
opportunities to invest and earn a
return. There are a wide r age of
Medium deposit accounts available with
term different yields, time periods and

conditions over withdrawal (e.g.
The infrequent purchase of
notice periods)
expensive items such as:
The solutions for households are
 consumer durables,
broadly twofold:
including cars
 to save over a period of time
 holidays and
prior to the purchase;
 medical bills.
 to borrow and repay over a
period of time.
Again these expenditure flows
Again both of these require
are unrelated to the flow of
appropriate financial instruments; in

income. the first case efficient means of
saving such as deposit accounts,
and in the second case, cost
effective means of borrowing,
including bank loans and consumer
credit.
Long Even in the long term there A range of specialist mortgage

term may be a mismatch between products have been developed to
payments and receipts. This enable people to buy property.
arises from the very long-term
nature of some income and A range of specialist pension
spending decisions. products have been developed to
help people to generate income for
Examples of this include; when they retire and no longer
 housing property; receive a salary.
 savings for pension.
9.2 Business
As with individuals, businesses will find that flows of payments and
flows of receipts rarely match. This is often referred to as the cash flow
problem and can occur in the short, medium and long run.
Receipts
Receipts for the business come mainly from sales revenue. The pattern
of receipts will depend on the nature of the business (e.g. whether
there a seasonal aspect to trade), the system of invoicing (e.g.
monthly), credit terms and whether customers stick to the payment
terms.

Payments
Payments Dealing with a lack of synchronization
Short All business have day-to-day For businesses the solutions to this
term costs to meet: cash flow problem are:
 wages and salaries  retaining a large stock of cash to
 regular flow of physical inputs meet periods of low or delayed
such as energy raw materials income;
and components.  access to credit, for example trade

In effect, businesses need credit of various kinds to pay for
working capital. physical inputs;
 access to overdraft facilities with

their banks.
Of course when receipts are lower
than payments businesses need
access to credit and overdraft
facilities, but when the reverse
happens secure, and preferably
profitable, savings instruments are
required.
Medium Cash flow issues might arise in Businesses thus require medium-term
term the medium term for businesses. finance, typically 2-3 years, to meet
Examples where this may arise these medium-term financial
include: problems.
 sales revenue is received

long after the first costs are
incurred such as in building
and construction activity,
shipbuilding and aerospace;
 where contracts specify part

payments long before
delivery;
 reorganization costs are

incurred before benefits from
lower costs or increased
revenues are achieved.
Long Most long-term financing These activities may involve very

term problems in business arise out of large capital outlays with the prospect
their investment activities. This of increased incomes delayed well
may take a variety of forms: into the future. Businesses thus need
 investment in physical long-term finance and have three
capital; main options:
 investment in long-term  the use of internally generated
Research and Development funds;
programs (R&D);  equity capital through the issue of
 take-overs and mergers of shares;
existing businesses.  debt capital including mortgages,

bank borrowing and bonds.
In the latter two cases, businesses
need access to the capital market as
sources of funds for long-term
investment.
9.3 Government
Receipts
The government may have some income from profitable state industries or
charges made to consumers for state-provided services, but the vast bulk of
its income comes from taxation. The main sources of taxation revenue are:
 a range of indirect taxes (sales taxes) such as value added tax

and excise duties on alcohol, petrol and tobacco products;
 direct taxes on individuals most importantly income tax and
social security taxes;
 direct taxes on business organizations such as corporation tax.
Some of these flows of taxation revenue are quite regular, such as
income tax paid through the pay-as-you-earn system in the United

Kingdom, but many are not. The flow of receipts from corporation tax,
for example, can be very uneven with significant payments towards the
end of the tax year. This, as with households, implies a problem of
synchronization of payments and receipts.
Payments
Payments Dealing with a lack of

synchronization
Short In the short term, Most of these payments are spread

term governments must finance over the financial year and are
their day-to-day activities such relatively stable from one month to
as: another. It is therefore difficult to
 payments of wages and match tax revenue to the payments
salaries to government made for these items.
employees;
 payment of social Thus the government, like

security and state households, needs short-term
pensions to the financial facilities so that it can
unemployed and the meet its day-to-day running
retired; expenses. The credit and savings
 payments to providers of needs of government in this
goods and services to respect are often met by the
enable the day-to-day central bank, one of whose
running of the functions is to act as banker to the
government activities. government and to manage the

government’s finances.
Medium Government also have These expenditures are not likely

term medium-term financial to be evenly spread over the years.
commitments that largely Indeed, governments may
arise from investment deliberately concentrate such
activities in the public sector. expenditures in some years rather
Governments engage in than other as part of a fiscal policy
investment when they finance designed to manage the trade
such as: cycle.

 school and hospital
building; In this case, government will raise
 construction projects for such expenditure in recessions
the economic exactly when receipts from taxation
infrastructure, for are likely to be low as consumer
example motorway and incomes and spending fall. Thus
railway construction; governments may run budget
 loans to private sector deficits which have to be financed
activities to help finance by borrowing from the private
investment by those sector.
organizations; this
typically occurs in high
technology and risky
activities such as
aerospace.
Long Governments often take Since it is possible for

term responsibility for financing governments to be net savers or
very long-term investment net borrowers over very long
projects in the development of periods of time, they may need the
the infrastructure of the services of financial intermediaries
economy, for example nuclear over that period.
power and It is more likely that governments
telecommunications. will be net long-term borrowers:
 given that the projects such as

nuclear power are
investments, not current
consumption, borrowing is an
acceptable means of finance
for these projects;
 governments can continue to

borrow in the very long run as
long as there is sufficient

taxation income to finance the
subsequent debt.
Even if governments do not
engage in additional long-term
borrowing, all have debts
accumulated from the past – the
national debt. This must be
managed as there is no real
possibility of repaying it. Thus
governments need the services of
financial intermediaries to manage
and renew this debt.
Practice Questions
Question 1
Which of the following does not engage in the buying and selling of shares in
other companies?
A Investment trusts
B Stock exchanges
C Insurance companies
D Pension funds
Question 2
Which of the following is not a function of stock exchanges?
A Providing a market in existing securities
B Directly funding the start-up costs of new companies
C Acting as a market for government securities
D Advertising the prices of stocks and shares
Question 3
Venture capital is best described as:
A investment funds provided for established companies
B short-term investment in euro-currency markets

C capital funds that are highly mobile between financial centers
D equity finance in high-risk enterprises
Question 4
Other things being equal, all of the following would lead to a rise in share
prices except which one?
A A rise in interest rates
B A reduction in corporation tax
C A rise in company profits
D A decline in the number of new share issues
the book.

Contents
1 Defining Commercial Bank
2 Major Financial Intermediaries
3 Credit Creation
4 Central Banking
5 Monetary Policy
6 Role of State Bank in the Pak Economy
7 Capital Adequacy

1. Defining Commercial Bank
A commercial bank is something with which every one of us is familiar.

However different bankers and economists have defined it differently.
Prof. G. Crowther:
Says “The bankers business is to take the debts of the other people to offer
his own in exchange and thereby creates money.”
Kent: says
“An organisation whose principal operations are concerned with the
accumulation of the temporarily idle money of the general public for the
purpose of advancing to others for expenditure.”
According to Dr. Harts:
“A banker is one who in the ordinary cause of his business, receives money
which he repays by honoring cheques of persons from whom or on whose
account he received it.”
Banking Companies Ordinance 1962:
“Banking means the accepting for the purpose of lending or investing of
deposits of money from the public repayable in demand or otherwise and
withdrawal by cheques, draft order or otherwise.”
1.1 Types of Banks

Commercial banks today perform variety of functions. They play the role
everywhere in the economy. They have an extremely vast scope and scenario
of their working and functions.
However banks can be classified in various types according to the areas of
their functioning and performance.
1. Central Bank:
The need of central banks was felt after the world war I in order to solve the
problem of bank failures. Now, almost all countries have their central banks
working in the best national interests. A central bank is a specialized
institution whose customers are commercial banks and govt. Central bank
supervises the whole banking infrastructure, chalk out plans towards self-
sufficiency and reducing foreign reliance and take measures to achieve full

employment of country’s productive & creative resources.
2. Commercial Banks:
These are the ordinary banks that deal in money and credit. Infect these are
the financial intermediaries who borrow surplus fund form the public and
channel them to productive uses. They are also engaged in the performance
of agency and general utility functions.
3. Industrial Bank:
Such banks perform the functions of specialized credit providing institutions.
They meet the credit and finance requirements of the industrial sector. Such
banks provide medium, short and long term loans to various industries. They
provide finances for the setting up of new industrial units.
In Pakistan, Investment Corporation of Pakistan (ICP), Industrial Development

Bank of Pakistan, (IDBP) are the examples of such banks.
4. Co-operative Banks:
The co-operative movement started in the sub-continent towards the end of
19thcentury. Then afterwards it gained great importance in the economic uplift
of the people living in rural areas.
Co-operative Banks are the banks that are setup by inhabitants of the
particular areas. The purpose behind this is to provide credit facilities to the
residents of that area or to a particular class of people.
In Pakistan co-operative banks mean a banking society registered under the
cooperative societies act 1912.
5. Agricultural Bank:
These are the banks that are engaged in the financing of agriculture and rural
sector. Agricultural banks mainly satisfy the credit needs of farmers and
villagers. They also help in the growth of agro based, small scale and cottage
industry. Such banks have the sole object of promoting macro-economic
growth in the rural areas.
Zarai Taraqiati Bank Limited (Formerly Agricultural Development Bank of
Pakistan), Federal Land Bank of USA are the examples of such kinds of bank.

6. Savings Banks:
Savings banks are established for the purpose of promoting savings habits in
the middle and working class of the economy. These banks help in the
accumulation of the savings of the low income group. Ordinary commercial
banks also provide the services like that of a saving bank. The post office
saving bank & national saving centers are an example of such a bank.
7. Investment Banks:
Investment banks are those which provide finances for the sale and purchase
of stocks and shares. Their aim is to keep capital market alive and
responsive. They also help in the under writing of shares and debentures of
new companies
Banker’s Equity Limited (BEL), Investment Corporation of Pakistan (ICP) are
examples of such banks.
8. Exchange Bank:
Bank branches with their head offices abroad are called exchange banks.
These banks have the primary function of dealing in foreign exchange. Also
these banks finance foreign trade. In addition to this, they also finance internal
trade and thus play an important role in the economy.
At the time of partition. Pakistan had 7 exchange banks working here.
Afterwards Chinese, German, Dutch and American Banks opened their
branches here.
9. Consortium Bank:
It is such a bank that is formed and run by some, other banks. The financial
reserves are pooled by the member banks mutually. Such banks satisfy the
long term requirements of big business houses and large organisations. At
present there are about 30 consortium banks working in England. Orion bank,
Scandinavian bank and British Middle East Bank are some examples of
Consortium Banks.
10. Mortgage Banks:
Mortgage banks provide finance against lands and buildings. The finances
may be short, medium and long term. Such banks normally grant loans for the
agricultural sector.

In Pakistan we do not have any specialized mortgage bank. However House
Building Finance Corporation is doing the job similar to that of Mortgage bank.
The examples include Mortgage bank of America, Mortgage bank of Spain etc.
11. Scheduled / Non-Scheduled banks:
According to the State Bank of Pakistan Act 1956, Scheduled banks are those
which have paid up capital reserves of at least Rs. 5 million in Pakistan. Non-
schedule banks are those which are not included in the 2 nd Schedule of the
State bank of Pakistan Act 1956.
1.2 FUNCTIONS OF COMMERCIAL BANKS
The primary function of every Commercial Bank is to receive or accept
deposits and advances to loans (credit creation) for variety of purposes. The
bank performs different functions for their clients and while doing so they act
as an agent of their clients. Such functions are called Agency functions and
they are as follows:
1. Collection of Dividends
Bank acting as an agent of their clients to collect dividends and interest on
stocks and shares. The bank charges a nominal commission against the
provision of such services.
2. Collection of Cheques
Commercial bank act as an agent of its clients while collecting and making
payments of bills, cheques etc.
3. Selling & Purchasing Securities
Commercial bank sometimes purchases or sells securities or shares on behalf
of its clients.
4. Obeying Standing Instructions
Sometimes clients order the bank to make payments of regularly recurring
nature directly. Such payments may include subscription fees of clubs or
journals, annual membership fees etc. The bank charges a minute amount for
the execution of such instructions.
5. Executor or Trustee
A client may direct his bank to act as an executor or trustee in dealing with
other business parties or while setting business disputes with other parties.

He may ask his bank to provide technical knowledge or assistance on certain
particular matters. The bank shall perform such functions in the interest of his
client. The bank charges a small fee for providing such services or technical
assistance. Bank can also undertake the administration of estates as executor
or trustee.
6. Funds Transfers
Commercial banks can transfer funds from one bank or branch to another.
This gives an ease to the clients and in a way increases the liquidity of the
money deposited in the bank. A client can use his cheque book even at a
place where his bank has no branch.
7. Agent, Representative
A commercial bank may act as an agent of his client in dealing with other
banks or financial institutions. A bank can also be a representative and
correspondent of his client as required by the circumstances.
8. Providing Lockers
Commercial banks provide lockers for their clients. This is a mean of providing
safe custody to the valuables of the clients. This has minimized the risk of
losing valuables due to robbery or dacoity.
9. Issuance of Credit Instruments
Commercial banks issue various forms of credit instruments and through this
they play a unique role in increasing the liquidity power of their clients.
Commercial banks issue Travelers Cheques (TCs), Draft etc. which are now
considered more convenient and safe substitute for cash.
10. Providing Trade Information
Certain famous commercial banks have a separate panel of experts. This

panel provides necessary trade information as required by different clients.
Also some banks publish journals that contain information about ongoing
economic situation. Such information help the clients in deciding that whether
it is a right time to invest or purchase or it is better to wait.

11. Underwriting Services
Commercial banks underwrite shares and debentures of companies. They

also underwrite loans raised by joint stock companies or government. Banks
also play role in carrying out of different public private affairs.
12. Financing Foreign Trade
Commercial banks discount foreign bills of exchange. While performing this

function they play their role in foreign trade and in facilitating exports. This not
only produces good effects on the national economy but also acts as an
important source of income for a bank.
13. Export Promotion Cells
Export earnings or the volume of exports has now become an important factor
in deciding the economic fate of numerous people. Commercial banks are well
aware of this fact and they play their required role in order to boost exports.
Several banks have export promotion cells working under competent experts.
Such cells provide necessary information about exports to prospective
exporters.
14. L/C Operations
Commercial bank plays an important role in foreign trade by performing L/C

operations. L/C is a guarantee that ensures a reliable import/export deal.
1.3 ROLE/IMPORTANCE OF BANKS

Banks play an extremely useful role in modern economies. The whole of
economic activity in the form of trade, investment consumption, exchange,
prices and economic development is dependent upon the working of banks.
The close relation between economic property and banking facilities is proved
when we see that all advanced countries, without exception, possess a
developed banking system. Poor countries, along with other common
features, have insufficient and undeveloped banking system. The following
points show that a modern and prosperous economy is impossible without
existence of adequate banking facilities.

(1) Encourage The Habit of Saving
Banks encourages the habit of saving. It is the banks, which collect the
small-scattered savings and make them huge funds for investment. In the
absence of banks, a large part of peoples’ incomes would either be hoarded
or consumed. Both ways it will be less useful for the economy. For rapid
economic development, a country like Pakistan should have more and more
saving and investment.
(2) Increase Mobility of Capital
Banks increase mobility of capital. They bring the borrowers and lenders close
together. They receive money from those who cannot use it and give it to
those who can.
(3) Encourage Trade and Commerce
Banks encourage trade and commerce by providing them short-term loans. All
kinds of business need credit. Banks provide this facility and help to promote
business. Successful businessmen work in cooperation with banks.
(4) Play Vital Role in Exports and Imports Activity
Banks also play a vital role in export and import activity. They provide loans,
open letters of credit, give information and arrange payments. They handle
foreign bills of exchange. Without banks it is not possible to carry on trade
with customers at far off places in four corners of the world.
(5) Promote Capital Formation
Banks promote capital formation and increase the rate of economic
development. They provide finance to industry, transport and agriculture for
medium term and long term projects. Almost the whole of large scale industry
is dependent upon borrowed funds.
(6) Help In Optimum Utilization of Resources
Banks help in optimum utilization of resources. There is competition among
various sectors for funds. For example, textile industry, engineering industry,
construction, transport and agriculture sectors all need funds. Through the
agency of banks, a country’s resources are distributed among the most
productive investments in various fields.

(7) Help To Promote New Joint Stock Companies
Banks help to promote new joint stock companies (limited companies). Joint
stock companies need huge funds, which they cannot raise from sale of
shares only. So they borrow funds from banks to implement their investment
projects.
(8) Loans To Business And Industry
By providing loans to business and industry they help to reduce the rate of
unemployment. Skilled persons, who have no capital, can get the help of
banks to establish some business of their own.
(9) Balanced Growth of Region
Commercial banks help in the process of balanced regional growth.
Commercial banks open branches over a large area. This creates opportunity
for the development of backward areas of a country. It also helps in the
channeling of resources and funds from developed areas to under developed
areas.
(10) Financing Priority Sectors
In order to increase the pace of economic development and to meet current
challenges commercial banks have to frame new advanced policies.
Commercial banks in this regard finance those special sectors which produce
direct effect on the basic economic indicators. Commercial banks policies are
a mirror that reflects the economic priorities and fiscal targets of the country.
(11) Implementation of Monetary Policy
Commercial banks help the central bank and other economic authorities in
order to implement the monetary policy. Commercial banks enjoy an
important and strategic position in the financial set up and without their co-
operation the monetary targets can’t be met. Commercial banks channel the
nation’s resources in the best national interest seeking guidance from
monetary policy given by central bank and responsible economic authorities.
(12) Growth of Right Industries
Each country’s economic set up has different fiscal and social priorities
according to the traditions, customs or monetary agenda. Commercial banks
help in the growth and development of right type of industries which are
directly related with raising the living standards of local people. Also

environment friendly industries are encouraged by commercial banks.
(13) Research & Development
Commercial banks do sometimes provide finances for research and
innovations. This aspect leads to amelioration of products and up lifting of
living standards over time. Also commercial banks advance loans to different
research institutes.
2. MAJOR FINANCIAL INTERMEDIARIES

Clearing banks
Also known as commercial banks, primary banks or retail banks, these are the
familiar high street banks that provide a payment and cheque-clearing
mechanism. They offer various accounts to investors and provide large
amounts of short- to medium-term loans to the business sector and the
personal sector. They also create credit as explained later.
DEFINITION
The term ‘ intermediation ‘refers to the process whereby potential borrowers
are brought together with potential lenders by a third party, the intermediary.
Merchant banks or secondary banks
These bring together borrowers and lenders of large amounts of money and
usually deal with businesses rather than individuals. Few companies of any
size can now afford to be without the services of a merchant bank. Such
advice is necessary to obtain investment capital, to invest surplus funds, to
guard against takeover or to take over others. Increasingly, the merchant
banks have become actively involved in the financial management of their
clients.
Savings banks
The National Savings Bank operates through the Post Office system and is
used to collect funds from the small personal saver that are then mainly
invested in government securities. The Trustee Savings Bank fulfils a similar
role but, in the last few years, has expanded its role until its operations more
closely resemble those of the clearing banks.

Building societies
These take deposits from the household sector and lend to individuals buying
their own homes. They have recently grown rapidly and now provide many of
the services offered by the clearing banks. They are not involved, however, in
providing funds for the business sector.
Finance companies
These come in three main varieties:
(i) Finance houses, providing medium-term installment credit to the
business and personal sector. These are usually owned by business
sector firms or by other financial intermediaries. The trend is toward
them offering services similar to the clearing banks.
(ii) Leasing companies, leasing capital equipment to the business sector.
They are usually subsidiaries of other financial institutions.
(iii) Factoring companies, providing loans to companies secured on trade
debtors, are usually bank subsidiaries. Other debt collection and credit
control services are usually on offer.
Pension funds
These collect funds from employers and employees to provide pensions on
retirement or death. As their outgoings are relatively predictable they can
afford to invest funds for long periods of time.
Insurance companies
These use premium income from policyholders to invest mainly in long-term
assets such as bonds, equities and property. Their outgoings from their long
term business (life assurance and pensions) and their short-term activities
(fire, accident, motor, etc.) are once again relatively predictable and therefore
they can afford to tie up a large proportion of their funds for a long period of
time.
Investment and unit trusts
Investment trusts are limited liability companies collecting funds by selling
shares and bonds and investing the proceeds, mainly in the ordinary shares of
other companies. Funds at their disposal are limited to the amount of
securities in issue plus retained profits, hence they are often referred to as

‘closed end funds’. Unit trusts on the other hand, although investing in a
similar way, find their funds vary according to whether investors are buying
new units or cashing in old ones. Both offer substantial diversification
opportunities to the personal investor.
Others
Many other intermediaries exist. For example, the 3i Group provides equity
and debt finance to medium-sized firms. The Export Credits Guarantee
Department provides insurance products and short-term finance for exporters.
2.1 Role of financial intermediaries
Financial intermediaries have a number of important roles.
Aggregation
By pooling many small deposits, financial intermediaries are able to
make much larger advances than would be possible for most
individuals.
Maturity transformation
Most borrowers wish to borrow in the long term whilst most savers are
unwilling to lock up their money for the long term. Financial
intermediaries, by developing a floating pool of deposits, are able to
satisfy both the needs of lenders and borrowers.
Financial intermediation
Financial intermediaries bring together lenders and borrowers through
a process known as financial intermediation.
Diversification
By giving investors the opportunity to invest in a wide range of
enterprises it allows them to spread their risk. This is the familiar ‘Don’t
put all your eggs in one basket’ strategy. For example, an individual
can invest in a unit trust which in turn invests in many different
instruments and companies.
Risk shifting
There are various types of security on the financial markets to give
investors a choice of the degree of risk they take. For example

company loan stocks secured on the assets of the business offer low
risk with relatively low returns, whereas equities carry much higher risk
with correspondingly higher returns.
2.2 Hedging
Financial markets offer participants the opportunity to reduce risk
through hedging that involves taking out counterbalancing contracts to
offset existing risks.
DEFINITION
Hedging is the reduction or elimination of risk and uncertainty.
3. Credit Creation
Creation of credit is one of the most important function of commercial banks.
Because of this function commercial banks are sometimes called the factories
for the manufacturing of credit and money.
In simple words credit creation means the multiple loaning by commercial
banks. A single bank can’t create credit. But banks in multi banking system
can grant several loans out of a single deposit.
3.1 Assumptions
First take certain assumptions. These assumptions will be further

discussed in the last part of this question.
1. All banks are required to hold 20% of the demand deposit

liabilities as reserves with the central bank.
2. The system has a developed banking infrastructure. People

have got mature banking habits and all payments and receipts
are made through cheques. Also the loan advanced by one
bank is deposited by the borrower in his bank.
3. Normal circumstances are prevailing in the economy. There is

neither too much nor too low credit.
4. No credit control policy is being acted upon by the central bank.

Mathematical Application
The process of credit creation can also be explained with the help of a
simple mathematical series as follows:
Creation of Credit = [,00,000 + 80,000 + 64,000 + 5,1200 + ……… + nth]

2 3
4 4 4
cc = [1,00,000+(1,00,000)5 + (1,00,000) 5 + (1,00,000) 5 + (1,00,000)
   
4 n
4 4
5 +(1,00,000) 5 ]
   
4 4 4 4 4
OR Credit creation = 1,00,000 (1 +( 5) +( 5)2 + (5)3 +( 5)4 + ……… + ( 5 )n]
The term inside the bracket is a geometric progression for infinity. The formula
to solve a G.P. is:
a
G.P. = where ‘a’ is the first term and = 1
1r
4
Loan advanced is 80% i.e., 5
4
Creation of Credit = 1,00,000 (1/1 5) = 100,000 x 5 = 500,000
3.2 Limitations on the Process of Credit Creation
The limitations on the process of credit creations are as follow
1. Currency Drains
All receipts and payments are made by cheques. A borrower may wish
to take cash instead of cheques. This will reduce the lending potential
of the commercial banks.
2. Excess Reserves
It is assumed that banks hold only 20% reserves and rest of the
amount is leant out. However in reality no commercial bank works like
that. Banks always tend to have huge reserves with the central bank
and with themselves also.
3. Primary Depositor
The credit creation process depends on the availability of primary
deposits. If banks have adequate primary deposit only then they can

create credit. There is a direct relation between primary deposits and
credit creation. The larger the funds banks have got at their disposal in
the form of primary deposits, the greater will be their capacity to create
credit.
4. Cash Reserves Ratio

Another constraint on the lending potential of the commercial banks is
the reserves ratio. If reserve ratio is high it will act as a constraint on
lending power of commercial banks as they will be left with less
reserves to lend or to create credit.
5. Economic Circumstances
Commercial banks can’t create credit on their own or according to their
will and wish. They can only make it when borrowers demand loans.
The economic circumstances and monetary situation effect the credit
creation potential.
6. Monetary Policy
The extraordinary or unnecessary credit expansion may prove harmful
of the economy. If there is too much credit expansion in the economy,
the central bank, may increase the required reserve ratio which will
reduce the lending powers of the commercial banks.
7. Different Types of Deposits

Commercial banks accept three main different types of deposits which
are Demand Deposits, Savings Deposits, Fixed deposits. We have
assumed that all deposits received by the banks are demand deposits.
The reality is not so. Banks normally have greater proposition of
savings deposits. This factor also hinders the credit creation process.
Three aims of Commercial Banks
• Liquidity. A bank needs liquid assets to satisfy the demand for
cash withdrawals from its customers and to settle its accounts with
other banks in the clearing system. However, the notes, coins and
operational balances needed for these purposes earn no interest
and so are unprofitable.

• Profitability. Like any other commercial organisation, a bank has
an objective of trading profitably. In pursuit of this aim it may pursue
lending opportunities that offer relatively high rates of interest, e.g.
long term rather than short-term lending, or lending to high-risk
customers rather than low-risk customers. However, both of these
choices reduce the security of the bank’s assets, and possibly its
liquidity as well.
• Security. Despite some well-publicized write-offs for bad and
doubtful debts, in general banks are expected to act prudently in
order to safeguard the interests of their depositories and their
shareholders. However, as indicated above, pursuit of this objective
may reduce the opportunities for profitable lending.
4. CENTRAL BANKING
4.1 Definition
Central bank is a unique and special institution whose customers are

commercial banks and state. Central bank supervises the whole
banking structure, ensures healthy infrastructure, maintains steady rate
of economic growth, takes measure to achieve full employment and
efficiency while at the same time giving profit a secondary
consideration.
In words of Prof. Dekock
“The guiding principle of the central bank is that it should act
only in the public interest for the welfare of the country as a
whole and without regard to profits as a primary consideration.”
In words of Lipsy
“A bank that acts as a banker to the commercial banking system

and often to the government as well. In the modern world
usually a government owned and operated institution that
controls the banking system and is the sole money issuing
authority.”

4.2 Central Banking Principles/Objectives
Following are the principles/objectives of central banking.
1. Safeguarding Financial Stability

The main objective of the central bank is to protect and
safeguard economical and financial stability. It is established in
order to design and implement policies to avoid depression and
unwanted fluctuations in the economy.
2. Working in Public Interest

Central bank works in the best interest of the economy and
public. It does not give advances, nor it allows interest on
deposits. It performs its functions without any consideration of
profit.
3. Supervision of Banking System

Central banking object is to have supervision and effective
control over commercial banks structure. Central bank sets
guidelines for commercial banks. It defines parameters in which
commercial banks are allowed to perform their operations. This
overall supervision ensures stability and also helps in steady
growth of banking infrastructure.
4. Control of Credit & Money Supply

Central bank’s object is to exercise effective control over credit
and currency supply in the economy. It has a sole monopoly
over note issue and it constantly keeps an eye on the supply of
currency in the economy. Another important objective is to
watch the credit creation by commercial banks. In case of any
emergency, it uses its special powers to restrict commercial
banks from spending credit beyond unnecessary limits.
5. Accommodating Commercial Banks

Another object of Central bank is to save commercial banks
from bank runs and panics. In case commercial banks find any
difficulty in meeting their liabilities, the central bank comes to
their help.

6. Ensuring Economic Development
Central banks while analyzing and supervising the whole

banking structure ensure economic development. The object of
central bank is to direct finances towards important sectors of
the economy and to ensure that credit requirements of such
important sectors are fulfilled.
4.3 Functions of Central Bank

Central banks perform a variety of functions. These functions vary
according to the nature of economy and state of banking structure.
However following are important functions of Central bank.
1. Issuance of Currency
According to Prof. Dekock
“The privilege of note issue was almost everywhere associated
with the origin and development of central banks. In fact until the
beginning of the twentieth century, they were generally known
as the bank of issue.”
Issuance of currency was the first factor that formed the basis of
central banking. Now in almost all countries of the world, central
bank enjoys complete monopoly over note issue and this is by
far the most important function and feature of the central bank.
2. Banker to the Government
As already mentioned, central bank is a special bank whose
customer is government. Central bank relation with the
government is similar to that of commercial banks with its
clients. It gives all those services to the government that the
commercial banks give to his clients. It receives payments on
the behalf of government and holds all cash balances of the
government. It holds all tax revenue and receipts. Furthermore it
is also involved in the collection of cheques, drafts on the behalf
of government. It, in time of need, may grant short and medium
term loans to the government. Such loans are usually granted
against government securities. It also pays pensions and other

transfer payments on the behalf of government. As it is a non-
profit organisation so it does not charge nay fee for its services
and it also does not give any interest on deposits.
Agent to the Government

Central bank also functions as the agent of the
government. It represents government on various
economic issues and monetary matters. It also
enjoys the responsibility of making all sorts of
adjustments regarding conversion or redemption of
government loans. The underwriting of the
securities of government is also one of the
essential responsibilities of Central bank. As an
agent it can issue new treasury bills on behalf of
government. In matters of foreign exchange
business and exchange control, central bank acts
as financial agent of government.
Advisor to the Government

Central bank enjoys extraordinary powers, rights
and authorities. It also enjoys special control in
monetary and fiscal matters. From time to time, it
advises government on different financial and
economic matters such as devaluation deficit
financing, economic planning, development and
fiscal and monetary policies. Besides this a central
bank is the most well informed body about
economic indicators so it can best help the
government in planning new economic policies for
the uplift of economy.
3. Banker to Commercial Banks (Lender of the last resort)

We know that all commercial banks hold some reserves with the

central bank and further the central bank provide commercial
banks very nearly the same services as those provided by
commercial banks for their clients. Thus central bank can very
rightly be called Bank of commercial banks. It advances loan to
commercial banks and rediscounts their bills of exchange. It
guides commercial banks and other elements of banking world
in the best interest of the nation and economy. It helps
commercial banks in times of economic difficulty and ensures
their free and smooth functioning during monetary fluctuations
and crises.
4. Clearing House
Meaning
Clearing house refers to the function whereby commercial banks
settle claims that they have against each other.
“A process by which bankers exchange and settle for cheques,
bills of exchange, drafts and other banking instruments drawn
against each other received by them for collection and clearance
from their customers.
In simple words clearing house is a place where both the
debtors and creditors are different commercial banks and they
settle their claims. At those places where central bank has no
offices, any representative bank of central bank performs the
clearing house function.
Merits
(a) Safety
As in this method there is least involvement of cash, so
this method is safe.
(b) Flexibility
It brings flexibility in banking transactions. Banks are not
needed to hold excessive cash reserves with the central

bank. Also there is no need to move bulk of cash from
one bank to another.
(c) Credit Facility
As due to this function, banks are not compelled to hold
excessive cash reserves so they can lend money to
investors.
(d) Cooperation
In case of financial difficulties and recession, banks can
cooperate with each other. Such as payments can be
delayed to overcome timely difficulties.
(e) Quick Payments
This function brings quickness in the process of receiving
and making payments.
(f) Checking of undesirable Competition
The clearing house function also helps to prevent
undesirable competition among commercial banks.
5. Controller of Credit
The most important function of the central bank is to control
credit in the economy. Excessive or too low supply of credit can
equally cause many economic difficulties. So central bank keeps
on visualizing the credit situation of the country and credit
creating potential of commercial banks. If commercial banks are
not timely checked then, they may produce extraordinarily high
credit supply for the sake of private profit. But this can cause
serious inflationary trends in the economy. On the other hand,
excessive credit contraction can cause deflationary trends. So
central bank ensures the proper and appropriate supply of credit
by controlling the credit creating potential of commercial banks.
This is done though the tools of monetary policy which will be
discussed later.
6. Lender of the Last Resort

Central bank job is to examine and guide the banking system in
best national interest. In case commercial banks face any panic
and suspect any bank run, then central bank immediately comes
to their help. In case, when commercial banks face any shortage
of reserves and feel difficulty in fulfilling financial obligations,
they can receive help from central bank. The central bank
increases the liquidity of commercial banks by rediscounting
their bills of exchange and thus it plays an important role in the
free and smooth flow of economy.
7. Custodian of Foreign Exchange Reserves

Foreign exchange reserves are the most precious assets of any
country. These reserves are needed to pay for the imports.
Further the amounts of these reserves indicate the strength of
the economy. Central bank has the responsibility to take care of
foreign exchange reserves of the country. It ensures that
adequate foreign exchange reserves are maintained. Further
central bank also keeps a close eye on capital movement.
Capital movements relate to the flow of heavy, long term
investments in and out of country. Central bank also constantly
observes the level of foreign investment in domestic assets.
8. Development Role
Central bank is the most important monetary authority of the
country. Thus it plays a very significant role in the overall
economic development and planning of the country. It ensures
smooth running of the economy by providing and directing
finances towards various needy sectors of the economy. It takes
care of the country in widespread depression and recessions
and helps the economy in avoiding cyclical monetary
fluctuations.

9. Other Functions
Besides these functions, there are some other duties that are
performed by central banks.
These are as follows:

1. Central bank provides training facilities for less
experienced staff working in different banking
organisations.
2. It holds relation with different international
agencies e.g. IBRD, WB, IMF, IDB, ADB etc.
3. It issues reports about various economic and fiscal
indicators (e.g. weekly, quarterly).
4. It conducts different surveys, programs meetings
for creating economic awareness.
5. It publishes annual report containing all details of
economic operations of the whole year.
5. Monetary Policy
5.1 Definitions
According to Hanson
“Monetary policy is concerned with deciding how much money the

economy should have or perhaps more correctly deciding whether to
increase or decrease the purchasing power of money.”
According to S.A. Meenai
“Monetary policy may be defined as the regulation of the cost and the
availability of money and credit in the economy. It is effectuated by the
various instruments in the hands of central bank.”
It can be defined as:

“Monetary policy can be used as a means towards achieving the
ultimate economic objectives example inflation, the balance of
trade, full employment and real economic growth.”

5.2 Objectives of Monetary Policy
As discussed earlier the basic aim and objective is to check and control
the credit supply. However, based on nature and prospective of the
economy the monetary policy has diversified objectives.
The objectives of monetary policy could be distinguished on the basis

of developed and underdeveloped countries.
5.3 The objectives of monetary policies for UDC’s are as follow:
1. To Achieve Full Employment Developing countries have

under-utilized and free resources. There is also great room for
expansion and development. So the basic objective of monetary
policy is to achieve full employment of resources.
2. To Have High Efficiency Underdeveloped countries are less

efficient. There are wastage and misallocations in the economy.
So monetary management is made with a view to have high
level of efficiency.
3. To Have Large Scale Resource Mobilization Monetary

Management and policy is used to achieve the goal of large
scale resource mobilization in developing countries. Resource
mobilization refers to the process of generation of savings and
its usage in productive process. A developing and under
developed countries have low rate of capital formation and
accumulation, so monetary techniques are used to increase
resource mobilization.
4. To Increase Exports Low developed countries are in need of
high exports as it brings them precious foreign exchange. So the
central bank handles monetary policy with a view to increase
exports.
5. To Have High Investments: Investments are the lifeblood for
underdeveloped countries. They increase the living standards,
per capita income and leads to efficient utilization of country’s
productive resources. So monetary policy in developing

countries is aimed at increasing investments.
6. To Provide Price and Exchange Stability A most basic aim of
monetary policy is to provide price and exchange stability.
Fluctuations in general price level and exchange rate discourage
investment and capital inflows. So monetary policy is used to
produce stability in the economy.
7. To Have Efficient Allocation and Utilization of Resources

Efficiency in allocation and utilization of productive resources
are the hallmarks of any economy. Resources when efficiently
allocated and used produced the best possible output that
increases the pace of prosperity and development. Monetary
policy aims at optimal allocation of resources and their usage in
productive ways.
8. To Accelerate Economic Growth Monetary policy is a key to

accelerate the pace of economic growth. It can be used to
increase credit and investment that leads to economic growth
and development.
9. To Rise Living Standards Living standards are generally poor

in low developed countries. Monetary policy can be used to
raise living standards and to make more people better off
without making anyone worse off.
Note: Pakistan is also a developing country. So the objectives of

monetary policy for low developed countries also apply to
Pakistan. However, the basic objectives of monetary policy of
SBP are those that are mentioned in SBP act 1956.
5.4 In developed countries the objectives of monetary policy are as

under:
1. To Have High AD without Inflation Aggregate demand, when

increases, gives stimulus to the supply side of the economy top
produce and supply more. These results in the larger allocation
of resources, increase in general price level and employment
opportunities.

2. Remove Inflationary and Deflationary Gaps Monetary Policy
is used to eradicate inflationary and deflationary gaps. For
inflationary gap a contractionary and for deflationary gap an
expansionary monetary policy is used.
3. High Research and Development Developed countries give

much importance to research and innovations. So monetary
tools are used to channel resources towards these fields.
4. Providing Assistance to Other Countries It is a well-known

practice that developed countries provide loans, aids and
monetary grants to under developed countries. So they design
their monetary policy in a way so that this function could be
carried out easily.
5. Gaining Monetary Control over Others Today developed

countries have achieved a great hold over low developed
countries. This is largely because of their economic and
monetary policies. They use tools of monetary policy to pave the
way of their dominance on others.
5.5 Tools of Monetary Policy

Central Bank as a Controller of credit.
Tools of monetary policy are the instruments that the central bank uses
to achieve desired objectives. They are explained below:
I. Quantitative Tools (Traditional tools)

II. Qualitative Tools (Non-traditional tools)
Quantitative Tools These tools are of such nature that they produce
effects on whole of the economy without any distinction. They directly
affect the total amount of credit supply in the economy. These are as
follows:
I. Open Market Operations (OMO’s)
Open Market Operations may be defined as purchase and sale
of government securities in the open market by the central bank.
This is basically done with the objective of influencing the

monetary situation.
The government issues securities in order to raise capital and
finance. These securities are traded in “gilt market” which is a
part of capital market.
Central Bank while trading these securities aims at influencing
the supply of credit in the economy. The functioning is as
follows:
Purpose of Open Market Operations

As discussed earlier the basic purpose of Open Market
Operations is to control credit supply and quantity of money in
the economy. By controlling quantity of money, the central bank
also ensures price stability. Other purposes of Open Market
Operations are as follows
1. To administer and maintain the prices of government
securities.
2. To create suitable climate for the floatation of new loans.
3. To activate the money market.
4. To manage gold inflows and outflows.
5. To create climate in which other tools of monetary policy
i.e., bank rate could be used effectively.
6. To avoid sudden fluctuation in the money market.
7. To support government credit.
II. Bank Rate/Discount Rate

Bank rate is the rate at which central bank is willing to
rediscount first class bills of exchange of commercial banks or is
willing to advance loans against approved securities. This rate is
also called discount rate.
When the discount rate is increased, the discounting becomes

costly. The commercial banks have to pay high rates of discount
in order to discount their bills. This also increases the interest

expenditure of commercial banks that they have to pay to
central bank on the loans and advances.
III. Cash Reserve Requirements (CRR)

It is a well-known fact that every commercial bank is required to
hold certain amount of cash reserves with the central bank. This
amount is expressed as a certain percentage of banks time and
demand deposit liabilities. This percentage is called cash
reserve ratio. (CRR)
The changing of the reserves ratio produce effects on surplus

funds which the commercial banks can use to create credit.
When the reserve ratio is raised commercial banks have to keep

more cash reserves with the central bank. Thus their surplus
funds decrease and credit potential contracts.
The opposite happens when reserve ratio is lowered.

Commercial banks will have more surplus funds to grant loans.
IV. Liquidity Ratio

The liquidity ratio is defined as follows:
It means the percentage of total demand and time
liabilities which commercial banks must keep in the form
of cash, gold or approved securities.
The liquidity ratio ensures that certain proportion of commercial

banks demand and time deposits exist in the form of
government securities or gold.
V. Special Deposits
Meanings Besides reserve requirements, the central bank may
call additional reserve from commercial banks. Such deposits
are called special deposit and they are expressed as a
percentage of bank’s liabilities. These deposits are other than
operational deposits and some interest is paid on these
deposits.
5.6 Qualitative Controls (non-traditional controls)

Quantitative weapons which have been just discussed are of such
nature that they produce effects in the whole of banking system. They
affect the whole economy without any distinction. Apart from these
controls, there are some other weapons which can be used in such a
way that only certain required sectors of the economy are affected.
Such weapons are called selective or qualitative credit control
weapons. Selective controls have two fold purposes. They are used
when central bank requires reducing credit supply to a particular sector
of the economy and when credit expansion is needed in specific
avenues. Such controls directly affect lenders and borrowers. Selective
credit controls may be of the following types.
I. Credit Rationing
We know that central bank’s one function is to accommodate

commercial banks in times of difficulty. Central bank does so by
rediscounting bills or by providing loans and funds. Credit
rationing can be used to control credit supply. Under this method
central bank can adopt following ways:
1. It can restrict the amount of loan that a commercial bank

can obtain from central bank.
2. It may refuse to rediscount bills beyond certain amount.
II. Credit Ceiling
Credit ceiling is another selective credit control weapon. Under

this central bank specifies the maximum supply of credit to the
economy during a particular period. The maximum limit of
supply is called credit ceiling and it becomes obligatory for all
banks to follow this.
This method is adopted when credit expansion could result in

serious damage to the economy. So in such case central bank
simply impose ceiling i.e., under any circumstances what so
ever credit supply will not exceed a certain limit. If any
commercial bank fails to follow this order of central bank, then it
can be charged with high penalty.

III. Moral Persuasion
A friendly and polite type of credit ceiling is called moral

persuasion. Here instead of specifying a particular limit and
imposing penalties, central bank requests the commercial banks
to follow the general monetary policy and credit control
guidance.
IV. Direct Action

Direct actions are the coercive measures of the central bank by
which it restricts commercial banks from expanding credit. Direct
action can be taken in any of the following ways
 Central bank may refuse to rediscount bills of exchange
of the guilty commercial banks.
 Or it may not provide direct financial assistance,
advances and loans to such commercial banks which do
not follow the general monetary policy.
V. Advertisement
From time to time for general as well as for specific purposes,
the central bank publicities the ongoing monetary objectives and
goals. This can also increase the efficiency of the whole banking
and economic infrastructure.
6. Role of State Bank in The Pak Economy

The role of a central bank in a country’s economy has generally two aspects
(i) Regulatory role i.e., to supervise, control and stabilize the banking and
monetary system of the country.
(ii) Promotional and Developmental role i.e., to expand the scope of

banking operations create specialized institutions and provide
funds for development programs in agriculture, trade, transport
and industry.
So far as the State Bank of Pakistan is concerned, it gives us satisfaction to

note that the bank has been playing very active and significant role on both
accounts. The State Bank was established in 1948 to issue currency and

supervise banking system. In 1956 and 1972, the powers and responsibilities
of the bank were greatly enlarged. A summary of the achievements and
performance of the State Bank is given below:
1. Sound Currency System
Economic development leads to expansion of markets and increasing

specialization. The State Bank of Pakistan has been aware of this fact
and has been adopting necessary measures to cope with the problems
arising out of growth of the economy. It has regulated the money
supply so as to avoid inflation on the one hand and depression on the
other. By means of controlled expansion of credit, the State Bank has
tried to ensure economic growth with stability.
2. Expansion of Banking System
At the time of independence of the country there were only two Muslim
banks i.e., Habib Bank and Australia Bank. These too had a few
branches, which were quite incapable to meet the banking needs of
Pakistan’s expanding economy. The State Bank took up the challenge
and extended every help in establishment of new banks and increasing
the scope of their operations. It sponsored National Bank of Pakistan in
1949. The efforts of the State Bank for expanding commercial banking
facilities have been so successful that compared to only 81 branches of
banks in 1948, now there is a network of 7900 branches spread all
over the country. These include 130 branches in the foreign countries.
Under the instructions of the State Bank, the commercial banks are
opening branches in rural areas.
Since 1991, in consultation with the State Bank the government has
allowed to establish many commercial banks in private sector, e.g.
Indus Bank, Cress Bank, Askari Bank, Soneri Bank. Some government
owned banks have been sold to private sector e.g. Muslim Commercial
Bank, Allied Bank. Ltd., UBL Ltd. and HBL Ltd.
3. Establishment of Specialized Institutions (DFIS)
To promote development in various sectors of the economy, the State

Bank of Pakistan has extended valuable help in establishment’ of

specialized institutions. These include Agricultural Development Bank
of Pakistan (ZTBL), ‘Industrial Development Bank of Pakistan (IDBP),
Pakistan Industrial Credit and Investment Corporation (PICIC), House
Building Finance Corporation (HBFC), Investment Corporation of
Pakistan (ICP) etc. The State Bank has provided adequate funds to
these institutions.
4. Development Finance
In order to encourage and accelerate industrial development, the State
Bank has taken a number of steps. After the increase in the powers of
the State Bank, it is now authorized to provide medium and long-term
loans to commercial banks. It can also purchase and keep bills and
debentures of any public company and provide it funds.
5. Price Stability
A very important function of the bank is the control of price line to

provide monetary stability. Pakistan has also faced inflation. Yet
compared to other countries, our inflation rate has not been so high. In
the efforts to check price rise, the role of the State Bank is most
prominent. It has adopted measures such as raising discount rate and
discouraging loans for speculation (DR is 1400 points i.e. 14%).
6. Balanced Distribution of Credit
Under the guidance and control of the State Bank, the pattern of
lending by commercial banks has undergone considerable change.
There was a time when 60% of the credit was given to trading and only
18% to industry. Now the situation is different. Trade and commerce
are getting 30%, while industry is provided more than 50% of bank
credit. This is a good sign for the country’s development.
7. Wider Distribution of Credit/Reduction in Concentration of Loans

In the past, Pakistan has also faced the problem of concentration of
bank credit in few hands. A limited number of industrial groups and
families obtained the major part of loans. The State Bank has also
acted to change this trend. Consequently, much larger number of,

industries now avail of bank loans. Commercial banks now provide
enough amounts for smaller loans. The State Bank helps in
implementing the Governments’, Annual Credit Plan.
8. Special Financing Schemes

The State Bank has introduced many schemes, which aim to provide
special financial facilities to small enterprises in agriculture, business
and industry.
9. Training
Training of staff is a pre-requisite for growth of banking. The State
Bank had realized this fact from the very beginning. Thus, it has
imparted training in banking practices to a large number of its own
personnel as well as from other commercial banks.
10. Promoting of Banking Habit

In order to promote banking habit among the people and for mobilizing
savings, the bank has set up Banking Publicity Board.
11. Islamic Banking

The State Bank has been actively cooperating in the government policy
of introduction of Islamic banking. To achieve this end, interest free
banking (PLS accounts) has been started. The amount collected under
Zakat Fund is held by the Bank.
12. Establishment of Money Market and capital market

A well-developed money market performs very useful function for the
financial stability and economic development of a country. In the
beginning, there were no stock exchange markets, bill markets or
capital markets. So, no facilities were available for the purchase and
sale of bills, securities and shares. The State Bank (i) established stock
exchanges at Karachi and Lahore, and now at Islamabad, (ii) has
established an auction market for
short term Treasury Bills and for long term Federal investment Bonds.
(iii) A large number of authorized dealers have been allowed to deal in
foreign exchange, bearer bonds or dollar bonds.
13. Developmental Role of State Bank of Pakistan

The scope of Bank’s operations has been widened considerably by
including the economic growth objective in its statute under the State
Bank of Pakistan Act 1956. The Bank’s participation in the
development process has been in the form of rehabilitation of banking
system in Pakistan, development of new financial institutions and debt
instruments in order to promote financial intermediation, establishment
of Development Financial Institutions (DFIs), directing the use of credit
according to selected development priorities, providing subsidized
credit, and development of the capital market.
Examples of Monetary Policy
Instrument Intermediate target Ultimate target Objective
Funding Banks’ liquid assets Volume of bank Inflation

credit
Base rate Structure of interest Exchange rate Current account
rates
Special Bank’s liquid assets Interest rates Inflation
deposits
Open market Structure of interest Volume of bank Employment
operations rates credit
6.1 Monetary Policy Targets

(i) Growth of the money supply.
(ii) The level and structure of interest rates.
(iii) The exchange rate. A government may seek to influence
exchange rates by altering interest rates, and buying and selling
currencies.
(iv) The total volume of spending which can be influenced by, e.g.,
changes in interest rates.
(v) The volume of bank credit. The commercial banks’ ability to
create credit can have a significant impact on the money supply.

6.2 Control of Credit Creation (How a Central Bank Controls Credit
Creation)
The (SBP) is responsible for carrying out the government’s monetary
policy. The following measures restrict the ability of banks to create
credit, although some have not been used by recent governments.
(i) Open market operations, where the SBP sells short-term

government securities and bills, thereby reducing commercial
bank’s liquid assets and raising interest rates.
(ii) Funding, where the SBP issues more long-term securities and
fewer short-term securities, thereby reducing commercial banks’
liquid assets.
(iii) The Minimum Lending Rate (MLR) is the rate, announced in

advance, at which the SBP will lend to the discount houses.
MLR influences other market interest rates. An increase in MLR
discourages borrowing and so reduces the ability of banks to
create credit.
(iv) Interest rate policy The SBP may operate a number of

undisclosed interest rate bands at which it will discount bills,
raising or lowering these bands to influence the structure of
interest rates in the money market.
(v) Special deposits are when the SBP calls for compulsory loans
from the commercial banks, thereby reducing commercial banks’
liquid assets.
(vi) An increase in the liquid asset ratio requirement reduces the

amount of liabilities a commercial bank can have from a given
volume of liquid assets.
(vii) Quantitative controls on lending involve the SBP setting an

upper limit on the volume of bank lending.
(viii) Qualitative lending guidelines involve requesting banks to

direct lending to particular groups and/or restrict lending to other
groups.

(ix) Moral suasion The SBP can informally try to persuade
commercial banks to change their lending policy.
(x) Monetary base control involves the SBP regulating base

money.
Over funding occurs when the SBP sells to the non-bank sector
more government securities than is necessary to finance the
current PSBR.
7. Capital Adequacy
7.1 Introduction
Capital adequacy effectively determines the ability of a bank to absorb
operating losses or shrinkage in asset values. Banking supervisory
bodies have for years defined adequacy in terms of target levels of
primary capital and secondary capital that should, at all times, be
maintained by commercial banks to meet the claims of creditors,
including depositors.
Capital adequacy is measured by the ratio of a bank’s capital to the

value of its assets. There are two main ratios and these are examined
below.
DEFINITION
7.2 Capital adequacy
Capital adequacy is the ability of a bank to absorb operating losses or
shrinkage in asset values. Banking supervisory agencies have for
years defined bank capital in terms of target levels of primary capital
and secondary capital that commercial banks should maintain at all
times to meet claims of creditors, including depositors.
7.3 Capital ratios

A capital ratio is a key financial ratio measuring a bank’s capital
adequacy. As a general rule, the higher the ratio the more sound the

bank. A bank with a high capital-to-asset ratio is protected against
operating losses more than a bank with a lower ratio, although this
depends on the relative risk of loss at each bank.
Two main ratios are standard measures of capital adequacy:

• primary capital to assets ratio – this is primary capital divided
by average total assets plus an allowance for loan and lease
losses.
• total capital ratio – this is primary capital plus secondary
capital divided by average total assets plus allowance for loan
and lease losses.
Primary capital consists essentially of ordinary equity share capital plus
retained earnings plus preferred share capital.
Secondary capital consists of primary capital plus debentures and

other loan stocks plus certain provisions against losses on loans.
The uniform capital guidelines adopted in 1988 by bank regulatory
agencies (known as the Base I Account) set the minimum capital level
as a capital-to assets ratio. At least 4% of the capital must be primary
capital and 4% must be secondary capital.
Summary
This chapter has examined what money is, the control of the money
supply and the institutions in the financial environment.
Self-test questions
Financial intermediaries
1 Give five examples of financial intermediaries. (2.6)
The commercial banks and the creation of money
2 How do banks create money by their lending activities? (3.2,

3.3)

The State Bank of Pakistan
3 State any five functions of the State Bank of Pakistan. (5.2)
Capital adequacy
4 How is a bank’s capital adequacy assessed? (6)
Insurance
5 What are the main insurance products sold? (8.2)
6 What is the main risk issues facing insurance companies? (8.3)

Practice questions
Question 1
Which of the following is most likely to lead to a fall in the money supply?
A A fall in interest rates
B Purchases of government securities by the central bank
C Sales of government securities by the central bank
D A rise in the amount of cash held by commercial banks
Question 2
The real rate of interest is:
A the rate at which the central bank lends to financial institutions
B bank base rate
C the difference between the money rate of interest and the rate of
inflation
D the annualized percentage rate of interest
Question 3
Which one of the following is not an asset of a commercial bank?
A Balances at the central bank
B Money at call
C Customers’ deposits
D Advances to customers

Question 4
Which of the following are functions of a central bank?
(i) Issuing notes and coins
(ii) Supervision of the banking system
(iii) Conducting fiscal policy on behalf of the government
(iv) Holding foreign exchange reserves
A (i), (ii) and (iii) only
B (i), (ii) and (iv) only
C (i), (iii) and (iv) only
D (ii), (iii) and (iv) only
Question 5
Which one of the following would appear as a liability in a clearing bank’s

balance sheet?
A Advances to customers
B Money at call and short notice
C Customers’ deposit accounts
D Discounted bills
Question 6
Which one of the following is not a function of a central bank?
A The conduct of fiscal policy
B Management of the national debt
C Holder of the foreign exchange reserves
D Lender of the last resort
the book.

Contents
1 The foreign exchange market
2 Foreign Exchange Market
3 Exchange Control
4 Devaluation and Depreciation of Currency
5 Barriers to free International Trade (Protectionist Measures)
6 Purchasing Power Parity Theory
7 International Institutions

1 The foreign exchange market
1.1 The market

The foreign exchange market is the term used for the institutions that buy
and sell foreign currencies. Those institutions mainly consist of the banks,
often dealing on behalf of private or corporate clients, and the Bank of
England. The market is a highly sophisticated one, with participants linked
together by telephone, telex, computer and satellite.
Central banks operating on the exchanges may well have excess market
power, manipulating prices at will. Nevertheless, it is sometimes argued that
this power does not really exist, and that governments are unable to affect
market forces when they are moving strongly in a particular direction.
2 FOREIGN EXCHANGE MARKET
Definition
It is a market in which the currencies of different countries are traded against

each other. It is just like an ordinary market. The only difference is that in
ordinary markets you purchase goods for money however in foreign
exchange market you purchase money for money. The money purchased is
of some other country and you make payment in your country’s currency.
In foreign exchange market it is one country’ money that is exchanged for
country money.
In words of Kindle Berger

“Foreign exchange market is a place where foreign money is bought and
sold.”
Foreign exchange market is the place where exchange rates are
determined. It is the place where nation’s legal tenders are exchanged.
2.1 FUNCTIONS OF FOREIGN EXCHANGE MARKET

The most important function of the foreign exchange market is the
determination of exchange rate.
This is explained below:
I. Determination of Exchange Rate (Modern Theory) / Demand

Supply theory
Exchange rates are determined in the foreign exchange market. Like
other markets, we can apply one demand/supply technique to
understand functioning of this market. Take the case of two
currencies, Pak rupees and UK pound.
Demand Side
The demand for rupee will come from the following sources.
(a) Pak Exports

One important reason for the demand of Pak rupee in
international foreign exchange market is our exports. This
demand comes from those people who wish to purchase our
exported goods. A British who wishes to purchase a Pakistani
Carpet, an American sports Academy who wishes to purchase
footballs from Sialkot, a German textile mill planning to buy raw
cotton from Pakistan _ All these are the sources of demand for
rupees.
(b) Capital Inflows
The second source comprises those people, firms who wish to
purchase Pakistan’s assets. In order to buy any asset in
Pakistan, they first have to convert their currencies in rupees.
So capital inflows are accompanied by the demand for local
currency.
(c) Reserve Currency
Government often holds and accumulate foreign exchange
reserves. Just as we people hold savings account. The
government of some countries say “Turkey” may decide to
increase her holdings of “Rupees”. Then in this case, she will
be demanding rupees.

Supply Side
The supply of rupee will come from the following sources.
(a) Imports
The main source of supply of ‘rupee’ is the imports to Pakistan.
Suppose I wish to purchase a Japanese radio. Then I will be
supplying ‘rupees’ and purchasing Japanese Yens.
(b) Capital Outflows

Capital outflows will also result in the supply of rupees. For
instance, a Pakistani citizen may wish to purchase assets in
UAE. Now he will be supplying rupees to purchase Riyals.
Determination of Exchange Rate
Aggregate Demand & Supply

The sum total of all the sources of demand gives us aggregate demand
for rupees.
Similarly the sum total of all the sources of supply gives rise to
aggregate supply. The diagram above presents a simple model of
exchange rate in equilibrium.
AD is the aggregate demand for rupees.
AS is the aggregate supply of rupees. In case where there is no
government interventions exchange rate corresponding to the value
where two curves cut each other will prevail in the market.
If the exchange rate is e\, demand (determined by the demand curve)
will be at di and supply (determined by supply curve) will be at Si. As
quantity demanded exceeds quantity supplied so there will be
appreciation of rupee to attain equilibrium.
II. Transfer of value Function

The foreign exchange market transfers the purchasing power. If at
same level of exchange rate and general price level, a currency has
more purchasing power at home than aboard, then the people will try
to accumulate local currency to take advantage of local cheaper
goods.
However, if a currency has low purchasing power at home, people will
try to collect foreign currencies. And hence there will be a downward
pressure on local currency. This is how purchasing powers are
transferred.
III. Credit Function (Settlement of foreign payment)

This refers to the working of foreign exchange bills. By this, the
exchange market provides credit to the debtors or importers. During an
international trade, the exporters can draw the bill of exchange on
importers. On acceptance of this bill of exchange, the exporters can get
the payment at the time of maturity of the bill or they can discount them
also.
Summing Up
Foreign exchange market is a simple market where currencies of
different countries are traded for one another. But any significant
change in this market effects the overseas business dealings and stock
exchange market in the country. Also the foreign exchange rates have
direct influences over the economic and business situation of the
country.
2.2 FACTORS INFLUENCING FOREIGN EXCHANGE

Foreign exchange market is a very sensitive market so are the foreign

exchange rates. A variety of factors have their direct influence on
foreign exchange market and the exchange rates which are determined
in these markets.
As the exchange rates are determined through demand and supply
forces in the foreign exchange market so any factor that brings about a
change in either demand or supply will ultimately influence the
exchange market.
Following are some of the important factors which have their direct
influence on exchange rates.
1. Changes in Price Level (Inflation and deflation)
Price level of a country plays a significant role in determining the
trends of exchange rate. If the price level in Pakistan rises due
to inflation, this means that our goods have now become more
expensive. This will affect the demand for our goods in the
international market and will result in the reduction of demand
for our exports.
2. Capital Movement
Capital movements across borders of countries exert strong
influences over exchange rates. In a country where capital is
flying in at a high rate, the currency appreciates. On the other
hand, the currency of the country from where the capital flies
out. depreciates also if any country attracts investments from
aboard then the currency of the country will appreciate.
3. Speculations (Stabilizing and Destabilizing effect)
Uncertainty about future exchange rate induces people to
speculate about them. This also influences exchange rates. If
foreigners expect ‘rupee’ to appreciate, they will rush to buy
Pakistani assets, and goods that are denominated in rupees.
This will increase the current demand for rupees and hence
rupees will appreciate. On the other hand, if investors suspect
that ‘rupee’ is going to depreciate in future, they will not buy or
invest in Pakistan assets. This will result in fall of demand of

rupees and hence ‘rupee” will depreciate.
4. Exports and Imports

Volume of exports and imports of a country also produce
significant changes on exchange rates. If exports of a country
are higher than its imports, then this means that demand for the
currency of this country is also high. If exports further increase,
then the demand for the currency also increases which in turn
leads to appreciation of currency. The converse happens when
the imports are greater than exports. This results in the increase
in supply of the domestic currency which finally leads to the
depreciation of currency.
5. Structural Changes
Structural changes refer to the changes and improvement in the
state of technology, innovations, inventions of new products and
new ways of producing old products. All these advancements
lead to the change in the pattern of comparative advantage.
Innovations and advancements results in the production of new
and improved products which attracts thousands of new
customers. Thus the demand for such products increases both
nationally and in the world market. This consequently leads to
increase in exports and appreciation of currency.
6. Political Stability
Political stability, sound infrastructure and security, these factors

play significant role in the determination of exchange rate. If
there is political stability in a country, returns are healthy, future
is predictable, and then such country attracts investments from
all over the world. Investors rush to invest there and capital flies
in. All these factors leads to the appreciation of currency.
On the other hand, if there is political instability and weak

infrastructure, then such country loses capital funds which
eventually leads to depreciation of currency.

7. Exploration of Natural Resources
When a country explores more natural resources, it takes a
further step towards self-sufficiency and independence which
means less reliance on other. This also affects exchange rates.
8. Influence of Discount Rates

The banking operations and variations in the discount rate also
influence exchange rates. If discount rate is high, borrowing will
be expensive and funds from outside the country will flow in to
earn high return. This will lead to the appreciation of currency.
Converse happens when discount rate is low and borrowing is
cheap.
9. Stock Exchange Influence

Working and status of stock exchange markets also influence
exchange rates. If is a country, there is an active capital market
and active and healthy business of stocks, shares, debentures is
going on than funds will flow in to take advantage of these
factors. This will produce good and favorable effects on
exchange rate and it will appreciate. On the other hand if
business is sluggish and passive, then investments will not flow
in and there will be depreciation of currency.
3. EXCHANGE CONTROL
3.1 Meaning
Broadly speaking the Exchange Control refers to those actions which a
government of country adopts to effect exchange rates. In narrow
sense, exchange control means imposing restrictions on free buying
and selling of foreign exchange in the country.
3.2 Objectives of Exchange Control
Exchange controls are basically implemented to safe guard the interest
of whole of the economy. There basic aim is to maintain the exchange
value of the local currency, but they also help in curing other economic
and fiscal ills.

1. Stabilization of Exchange Rate
The basic object is to stabilize and maintain exchange rate such
controls help the central bank to maintain exchange rates
without spending precious reserves on buying and selling of
local currency.
2. Foreign Payment
Exchange controls are exercised with the intention to
accumulate enough funds for making foreign payments.
3. Protectionism
Exchange control is an important tool of protectionism policies.
They are used to protect and flourish the home industry against
foreign competitive firms. By this objective the exchange control
also supplement the import substituting policy of the
government.
4. Balance of Payment
Exchange controls are used to turn the balance of payments
favorable. Exchange control policy may be aimed at increasing
inflows and reducing outflows thus reducing BOP deficit.
5. Safeguarding Foreign Exchange Reserve

Government hold foreign exchange reserves, just as we people
hold bank deposits and saving certificates, Such foreign
exchange reserves are of vital importance for the government.
They are used to finance trade or to buy essential products (oil,
weapons etc.) in times of emergency. Exchange control policy is
used to safeguard these reserves.
6. Watch Eye on Capital Movements

Capital flights in and out of the country are of vital importance.
Sometimes the economic situation is such that the returns are
not healthy and future is non-predictable. In such cases the
capital flies outside the country. However to stop this process,
exchange controls are implemented by government.

7. Forming Cartels
Exchange controls can be used mutually by group of countries
to form cartels for their mutual benefits. Under cartels, the group
of some countries gains economic advantages at the expense of
others. In the modern world as no country is self-sufficient and
specialization is chased in all areas, cartels have gained great
importance.
8. Under Valuation
It means to fix a rate, lower than it would be in a free floating
exchange system. The basic aim for under valuation is the
protection of local industry and favor of local exporters. Under
valuation encourages exports and discourages imports.
9. Overvaluation
This is appreciation i.e., the exchange rate is fixed over and
above its normal level. This policy is adopted in following cases.
 When a country has a massive foreign debt an

appreciation will lessen the burden of debt.(In terms
of domestic currency)
 When supply of local currency is extra ordinary
higher than its demand.
 When country is facing high inflation
 When the BOP shows extremely unfavorable
situations.
10. Source of Income

Exchange controls are also source of income for the
government. Since during exchange controls, the government
directly retains the foreign exchange and as foreign exchange is
directly sold by government so difference between buying and
selling rate goes to the government as income.

4. DEVALUATION AND DEPRECIATION OF CURRENCY
Devaluation is lowering of the value of home currency in terms of foreign.
OR Devaluation means official decrease in the external value of currency.
4.1 OBJECTIVES OF DEVALUATION

Devaluation has three main objectives (i) To encourage exports (ii) To
discourage imports (iii) To correct the deficit in Balance of payments.
4.2 WHEN DEVALUATION IS PROFITABLE
The process of devaluation is profitable for those countries.
(a) Which are having zero foreign debt or minimum foreign debt
balance.
(b) Exportable surpluses which may be needed because of fall in
export prices and increased demand in international market.
Should be available for country which has devalued its currency.
(c) Fall in demand for imports due to rise in prices of imports as a
result of devaluation. It the quantity demanded for imports does
not decrease, it will deteriorate the balance of payments of
country.
(d) Devaluation is profitable when new markets for exports can be
explored and exportable surpluses are available to the increased
demand.
(e) If inflation rate or retail price index (RPI) is low as compared to
other countries. Otherwise export prices may not fall in trading
countries also devalue their currencies it may not yield good effect
on balance of payments and is possible that impact may be
negative.
(f) If competitive countries do not devalue their currencies, if the
counter international market and because of inflation imports
become attractive for the residents of the country and for the
exporters, that country will become heaven.

4.3 IMPACT OF DEVALUATION (LIMITATIONS)
(i) The objectives set for devaluation of currency cannot be
achieved because of following reasons.
Competition with the competitive counties
(a) If the exports are not competitive with the developing as well as
developed countries. It could only increase the import prices and
therefore, resulted in increase in cost of imported goods (Import
cost push inflation).
(b) It causes inflationary pressure in the economy because exports

become cheaper and imports become costly. If we heavily depend
on imports of capital goods and raw material as well as raw
material of consumer goods it will increase the domestic prices.
(c) The debt burden in terms of rupees will increase which will affect
the balance of payment.
(d) Because of import cost-push inflation (due to rise in import

prices) there will be increase in smuggling.
(e) Defense expenditures will increase as developing countries

heavily depend on import of defense material of the currency.
(f) It may stimulate the speculation and there will be frequent fall in
external value.
(i) Secondly due to devaluation, the exports of the country

increases. This is because due to devaluation, the foreign prices
of local goods decrease and they become attractive in the world
market. However such increase in exports increases the profits
and incomes of local exporters. Their purchasing power and the
overall aggregate demand of the economy increase which leads
to inflation.
(ii) Thirdly if a country’s exports are attractive and have good
reputation then devaluation can make country’s balance of
payment favorable. The export earnings will outweigh the import

expenses. Hence the final disposable incomes of the people will
increase, they will demand more and inflation will be the final
result.
(iii) Fourthly a psychological factor also works here when people
have in minds that devaluation is likely to occur, they try to hold
stocks of durable and imported goods. This pushes the short run
aggregate demand upwards and the price level increases
causing inflation.
4.4 THE MARSHAL LERNER CONDITION  J. CURVE
A depreciation of Pak rupee results
(i) in a short-run deterioration in the BOP because of
(1) an immediate rise in the price of imports but a

constant quantity of imports bought;
(2) a fall in the price of exports but a constant quantity

of exports sold (sold by exporting countries).
(ii) in a long-run improvement in the BOP because
(1) eventually Pakistan consumers buy fewer imports;
(2) eventually foreign consumers buy more exports.
It is essential to realize that the overall long-run effect of a

depreciation of sterling depends on the Marshall Lerner
Condition, which states that a devaluation improves the
current account balance if the combined price elasticities
of demand for exports and imports. The J. Effect in Figure
1 shows that a devaluation initially causes a deterioration
in the current account balance (A to B) before demand
and supply adjust to the new prices of exports and
imports (B to C).

Current account
balance (£ million)
C
O
A Months
The J effect
5. Barriers To Free International Trade (Protectionist

measures)
1. Import Tariffs or Custom Duties
Import Tariffs or custom duties are taxes on imported goods to raise

the price for imports while price paid to foreign producers the same.
Therefore revenue of the government increases while quantity of
import may fall.
2. Import Quotas
These are restrictions on the quantity of a product’ that is allowed to

be imported into the country. Imports quotas have different effects as
(i) Both domestic and foreign producer enjoy a higher price,
(ii) Domestic producers supply higher quantity,
(iii) Volume of imports decreases,
(iv) No revenue for the state.
3. Embargo
An embargo is a total ban on imports from a particular country.
4. Hidden Subsidies to exporters

5. Depreciation and devaluation of currency.
6. Domestic deflation.
7. Quality controls and standards on imports by the importing country on

exporting country.
8. Delinking of domestic currency from the major country’s currency.
6. PURCHASING POWER PARITY THEORY
According to theory, the exchange rate between two countries is determined

at a point which expresses the equality between the respective purchasing
powers of the two currencies. This is the purchasing power parity which is a
moving par and not a fixed par as under the gold standard. Thus with every
change in the price level, the exchange rate also changes. To calculate the
new equilibrium exchange rate, the following formula is used:
DemesticPriceIndex
R = Domestic Price of a Foreign Currency x
ForeignPriceIndex
According to Cassel, the purchasing power parity is “determined by the

quotients of the purchasing power of the different currencies”. To explain it in
terms of our above example. Before the change in the price level, the
exchange rate was Rs 60 = Pounds 1. Suppose the domestic (Pakistani)
price index rises to 300 and the foreign (England) price index rises to 200.
Thus the new equilibrium exchange rate will be:
Pound1x 300
R = = Pounds 1.5
200
Rs. 60 = Pound 1.5

This will be the purchasing power parity between the two countries.
7. International Institutions
7.1 The International Monetary Fund (IMF)
The International Monetary Fund (IMF) was set up by the Bretton
Woods Agreement and started operating in 1947. The Bretton Woods
conference was held in 1944 in the US, with the aim of solving the
international monetary problems arising from the Second World War.
The aims of the IMF are to:
 encourage international monetary co-operation, facilitating
international trade and international payments.
 provide a stable exchange rate system, with facilities to help
member countries to protect the exchange rates of their currencies.
 remove foreign exchange restrictions.
The principal function of the IMF is to support countries with balance of

payments problems.
The IMF maintains a fund that is available to member countries with
balance of payments difficulties. The fund is made up from quotas paid
in by member countries. The USA contributes about 20% of the fund.
Loans from the fund are available only on a short-term basis (generally
between three and five years), and under certain conditions. The
conditions laid down are designed to ensure that the country seeking
the loan takes stringent measures to cut its balance of payments deficit
by contracting its economy, reducing demand and, if necessary,
suffering unemployment.
7.2 The International Bank for Reconstruction and Development
(IBRD)
The International Bank of Reconstruction and Development (IBRD) is
more widely known as the World Bank. This was also set up by the
Bretton Woods conference in 1944 and came into operation in 1946. Its
aim is to encourage capital investment designed to reconstruct and
develop member countries.
As with the IMF, it maintains a fund drawn from member countries’

subscriptions and will either make loans from the fund or will channel
private capital to those areas which need it. These loans are generally
long-term. It also raises money by selling bonds on the world markets.
Its loans are made on commercial terms directly to governments or
government agencies, or perhaps with a government as guarantor. Its
subsidiary, the International Development Association (IDA), operates
along similar lines, but provides loans on easy terms and for even
longer periods to developing countries.
Practice questions
Question 1
Which of the following might cause a country’s exports to decrease?
A A fall in the exchange rate for that country’s currency
B A reduction in other countries’ tariff barriers
C A decrease in the marginal propensity to import in other
countries
D A rise in that country’s imports
Question 2
Which one of the following is a characteristic of floating (flexible) exchange
rates?
A They provide automatic correction for balance of payments
deficits and surpluses
B They reduce uncertainty for businesses
C Transaction costs involved in exchanging currencies are
eliminated
D They limit the ability of governments to adopt expansionary
policies
Question 3
Which one of the following is not a benefit from countries forming a monetary
union and adopting a single currency?
A International transactions costs are reduced
B Exchange rate uncertainty is removed
C It economics on foreign exchange reserves
D It allows each country to adopt an independent monetary policy

Question 4
The main advantage of a system of flexible (floating) exchange rates is that it:
A provides certainty for international traders
B provides automatic correction of balance of payments deficits
C reduces international transaction costs
D provides policy discipline for governments
the book.

Contents
1 National Income
2 Concepts of National Income
3 Who Create Economic Wealth
4 The Government and the National Income
5 Approaches / Methods of Measuring Gross Domestic Product
6 Difficulties in the Measurement of National Income
7 Importance of National Income
8 Circular Flow of National Income
9 Numerical Illustration of Different Concepts of National Income
10 Real and Money National Income
11 Business Cycle
12 Interpretation of National Income
13 GDF Deflator

1. NATIONAL INCOME
National Income is an uncertain term which is used interchangeably with

National dividend, National output and national expenditure. On this basis
National Income has been defined in a number of ways. The definitions of
National Income can be grouped into two classes. One the traditional
definitions and second the modem definitions.
1. The Marshallian Definition

According to Marshall, “the labor and capital of country acting on its
natural resources produce annually a certain net aggregate of
commodities, material and non-material including services of all kinds.
This is the true net annual income or revenue of the country or national
dividend”.
2. Modern Definition
From the modern point of view, Simon Kuznets has defined national
income as "The net output of commodities and services following
during the year from the country's productive system in the hands of
ultimate consumers, whereas in one of the report of United Nations,
national income has been defined on the basis of the systems of
estimating national income, as net national product, as addition to the
shares of different factors, and as net national expenditure in a country
in a year's time.
(OR)
National Income can be defined as equal to Gross nation Product (–)
Depreciation allowances (–) Indirect Taxes (+) subsidies or National
Income is equal to Net National Product (–) Indirect taxes (+) subsidies
or National Income = Gross National Product – Depreciation
allowances – Indirect taxes + subsidies.
(OR)
National Income = Net National Product – Indirect Taxes + Subsidies.

2. CONCEPTS OF NATIONAL INCOME
There are a number of concepts pertaining to national income. For instance,

Gross national Product, Net National Product, Net National Income at Factor
Cost, Net Domestic Product at Factor Cost, Personal Income, Disposable
Income, and Real Income. One by one, these concepts are discussed below
2.1 Gross National Product (GNP)
GNP is the total measure of the flow of goods and services at market
value resulting from current production during a year in a country,
including net income from abroad. GNP includes four types of final
goods and services
1. Consumers' goods and services to satisfy the immediate wants

of the people.
2. Gross private domestic investment in capital goods consisting of

fixed capital formation, residential construction and inventories
of finished and unfinished goods.
3. Goods and services produced by the government.
4. Net exports of goods and services, i.e. the difference between

value of exports and imports of goods and services. Net
property income from abroad is added in GNP only and
excluded from gross domestic product (GDP).
2.2 Net National Product (NNP)

The process of production uses up a certain amount of fixed capital.
Some fixed equipment wears out. In order to arrive at NNP, we deduct
depreciation from GNP. The word 'net' refers to the exclusion So NNP
= GNP – Depreciation (Capital Consumption).
NNP at Market Prices

Net national Product at market prices is the net value of final goods
and services valuated at market prices the course of one year in a
country on NNP at market prices = GNP at Market Prices–
Depreciation.

NNP at Factor Cost
Net National product at factor cost is the net output evaluated at factor
prices. It includes income earned by factors of production through
participation in the production process such as wages and salaries,
rents, profits, etc. It is also called national Income. Indirect taxes are
subtracted and subsidies are added to NNP at market prices in order to
arrive at NNP at factor cost.
Thus NNP at Factor Cost = NNP at Market Prices – Indirect taxes +

Subsidies
2.3 Domestic Income or Product (GDP – Gross Domestic Product)

Income generated (or earned) by the factors of production within the
country from its own resources is called domestic income or domestic
product. Domestic income includes
(i) Wages and salaries
(ii) Rents, including inputted house rents
(iii) Interest
(iv) Dividends
(v) Undistributed corporate profits, including surpluses of public
sector undertakings
(vi) Mixed incomes consisting of profit of unincorporated firms, self–
employed persons, partnerships etc.
(vii) Direct taxes
Since domestic income does not include income earned from abroad, it
can also be shown as Domestic Income = National Income – Net
Income earned from abroad.
2.4 Personal Income (P.I.)

Personal income is the total income received by the individuals of a
country from all sources before direct taxes in one year. Personal
Income = Nation Income – Undistributed Corporate Profit – Profit

Taxes – Social Security Contributions + Transfer Payments + Interest
on Public Debt.
Personal income differs from private income in that it is less than the
later because it excludes undistributed corporate profits.
Thus, Personal Income = Private Income – Undistributed Corporate profits
– Profit Taxes.
2.5 Disposable Income (DPI) = PI (-) Direct taxes + previous savings

Disposable income or personal disposable income means the actual
income which can be spent on consumption by individuals and families.
The whole of the personal income cannot be spent on consumption,
because it is the income that accrues before direct taxes have actually
been paid. Therefore, in order to obtain the disposable income, direct
taxes are deducted from personal income. Thus, Disposable Income =
Personal Income – Direct Taxes. + Savings
2.6 Real National Income
Real income is national income expressed in terms of a general level of

prices of a particular year taken as base.
In order to find out the real income of a country, a particular year is
taken as base year when the general price level is neither too high nor
too low and the price level for that year is assumed to be 100. Now the
general level of the prices for the given year for which the national
income (real) is to be determined is assessed in accordance with the
prices of the base year. For this purpose the following formula is
employed
Base year Index (= 100)

Real NNP = NNP for the current year Current year Index
2.7 Per Capita Income

The average income of the people of a country in a particular year is
called Per Capita Income for that year. In order to find out the per
capita income, at current price, the national income of a country is
divided by the population of the country in that year.

National Income
Per Capital Income =
Populationin
3. WHO CREATE ECONOMIC WEALTH
Economic wealth also known as national income is created by:

(a) The people who buy goods and entrepreneur who hire services of
factors of production (Spending). These people are either (i)
households (ii) the government or foreign buyers (Importers) who are
making payments against our exports.
(b) The factor services who are receiving rewards for their services
(Incomes).
(c) The firms or production units may be in the private sector or in the
public sector, which produce goods and services in the national
economy.
4. THE GOVERNMENT AND THE NATIONAL INCOME
Governments are not only having political and administration function but also
has several economic function within the national economy, and so plays
important role in the flows of incomes.
(a) Acts as producer: Along with the private sectors firms government acts
as the producer of certain and specific goods and services (especially
in the developing economies) and therefore, involved in the production
in different sectors like agriculture, industry, minerals, trade,
transportation, education, health, power nervures water resources,
services etc. and pays rewards salary or wages employees.
(b) Acts as buyers: Government also acts as a buyer of final goods and
services, therefore add to spending in the national economy. For
consumption expenditures government collection revenue in the forms
of taxes, duties, fees, polices etc.
(c) Public Investment: Government is also involved in investment activities

(where either private sector is not inclined because of long term risks or
lack of huge financial resources for the large scale production

processes) e.g. construction of hospitals, educational institutions
(Universities) Motorways, Railways, Dams, Ports, Dry ports, Airports
and national-wide IT Services.
(d) Transfer Payments: Government makes transfer payments for example

payments of pensions, unemployment allowances, farm aid programs
and social security benefits to employees.
5. APPROACHES / METHODS OF MEASURING GROSS

DOMESTIC PRODUCT
There are four methods of measuring national income. Which method is to be
employed depends on the availability of data in a country and the purpose in
hand.
5.1 Product Approach / Output Approach

According to this approach, the total value of final goods and Services
produced in a country during a year is calculated at market prices. To
find out the GDP, the data of all productive activities, such as
agricultural products, wood received from forests, mineral received
from mines, commodities produced by industries, the contributions to
production made by transport, communications, insurance companies’
lawyers, and doctors, teachers etc. are collected and assessed at
market prices. Only the final goods and services are included and the
intermediary goods and services are left out.
PRECAUTIONS
1. In estimating National Income the market prices of only final
products should be taken into account.
2. Goods and services rendered free of charge are not included.
3. The transactions which do not arise from the produce of the
current year or which do not contribute in any way to production
are not included.
4. The profits earned or losses incurred on account of changes in
capital assets as a result of changes in market prices, are not
included.

5. Income earned or goods produced through illegal activities are
not included.
5.2 Income Approach
According to this method, the net income payments reserved by all
citizens of a country in a particular year are added up, i.e., net incomes
that occurred to all factors of production by way of net rents, net
wages, net interest and net profits are all added together but incomes
received in the form of transfer payments are not included in it.
The income approach to GDP consists of the remuneration paid in term

of money to the factors of production annually in a country. Thus, GDP
is the sum of the following items.
(i) Wages and Salaries

Under this head fall all forms of wages and salaries earned
through productive activities by workers and entrepreneurs.
(ii) Rent
Total rent includes the rents of land, shop, house, factory, etc.
and the estimated rents of all such assets as are used by the
owners themselves.
(iii) Interest
Under interest comes the income by way of interest received by
the individual of a country from different sources. To this is
added the estimated interest on that private capital which is
invested and not borrowed by the businessman in his personal
business.
(iv) Dividends
Dividends earned by the shareholders from companies are
Included in the GDP.
(v) Undistributed Corporate Profits

Profits which are not distributed by companies and are retained
by them are included in the GDP.
(vi) Mixed Incomes

These include profits of unincorporated businesses, self–
employed persons and partnerships. They form part of GDP.
(vii) Direct Taxes

Taxes levied on individuals, corporations and other businesses
are included in the GDP.
5.3 Expenditure Approach

According to this approach, the total expenditure incurred by the
society in a particular year are added together and includes personal
consumption expenditure, net domestic investment, government
expenditure on goods and services and net exports. This concept is
based on the assumption that national income equals national
expenditure.
(i) Private Consumption Expenditure

It includes all types of expenditures on personal consumption by
the individual of a country.
(ii) Gross Domestic Private Investment (Fixed capital

formation)
Under this comes the expenditure incurred by private
enterprises on new investment and on replacement of old
capital.
(iii) Net Exports

It means the difference between exports and imports or exports
surplus.
(iv) Government Expenditure on Goods and Services
The expenditure incurred by the government on goods and

services is a part of GDP. GDP according to Expenditure
Method = Private Consumption Expenditure (C)+ Gross Domestic
Private Investment (I) + Net Exports (x - m) + Government
Expenditure on Goods and Services (G) or GDP = C + I +G + (x -
m)

5.4 Value Added Approach
Another method of measuring national income is the value added by

industries. The difference between the value of material outputs and
inputs at each stage of production is the value added. If all such
differences are added up for all industries in the economy, we arrive at
the gross domestic product. This is one of the ways to avoid double
counting.
ESTIMATION OF NATIONAL INCOME WITH THE HELP OF VALUE

ADDED APPROACH
The increase in the value or worth of a commodity or a good at each

stage of production process is called "value-added". To understand
value-added approach, consider the making of garments. Suppose a
cotton producer produces and sells cotton for Rs.50,000. The value
added by the grower is Rs.50,000. Now after ginning of cotton the
value becomes Rs.70,000. The value added by the ginning factory is
Rs.20,000 i.e. (Rs.70,000 – Rs.50,000). The value added by the
spindle unit of a textile mill is Rs.30,000, the value added by a textile
mill is Rs.50,000 by a garment factory Rs.70,000, and by the cloth
merchants Rs.40,000. If we add all the values added at these stages
we will get the market price of a garment.
If we add the 'net value added' by different sectors of the economy, we

will get GNP at market price. The 'net value added' of every sector is
equal to the market value of production by the sector minus purchases
from other sectors.

VALUE ADDED APPROACH
Stage of Seller Buyer Sale Price Value
Production added
1 Cotton Producer Ginning Factory Rs.50,000 Rs.50,000
2 Ginning Factory Spindle Factory Rs.70,000 Rs.20,000
3 Spindle Factory Textile Mill Rs.100,000 Rs.30,000
4 Textile Mill Garment Rs.150,000 Rs.50,000
Factory
5. Garment Garments Rs.190,000 Rs.40,000
Factory sellers
Total Rs.190,000
6. DIFFICULTIES IN THE MEASUREMENT OF NATIONAL

INCOME
To calculate the national income of a country is a complicated problem

because of following difficulties
1. Measured in Money
National income is always measured in money, but there are
number of goods and services which are difficult to "be
assessed in terms of money", e.g. painting as a hobby by an
individual, the bringing up of children by a mother.
2. Double Counting
The greatest difficulty in calculating the national income is
double counting, which arises from the failure to distinguish
properly between a final and an intermediate product.
3. Illegal Activities
Income earned through illegal activities such as gambling, or

sale of intoxicants etc. is not included in national income.

4. Transfer Payments
Then there arises the difficulty of including transfer payments in

the national income. Individuals get pension, unemployment
allowance and interest on public loans, but whether these should
be included in national income is a difficult problem. On the one
hand, these earnings are a part of individual income and on the
other, they are government expenditure. To avoid this difficulty,
these are deducted from national income.
5. Capital Gains or Losses

Capital gains or losses which occur to property owners by
increase or decrease in the market value of their capital assets
or changes in demand are excluded from the GNP.
6. All Inventory Changes

All inventory changes whether negative or positive are included
in the GNP.
7. Capital Depreciation (Capital Consumption)

Capital depreciations are deducted from National Income.
8. Price Changes
Another difficulty in calculating national income is that of price
changes which fail to keep stable the measuring rod of money
for national income.
9. Under Estimation of Real National Income

Moreover the calculation of national income in terms of money is
under estimation of real national income. It does not include the
leisure foregone in the process of production of a commodity.
10. Public Services

In calculating national income, a good number of public services
are also taken which cannot be estimated correctly. How should
the police and military services be estimated? In the days of
war, when the forces are active, but during peace they rest in
cantonments.

11. Non-Monetized Sector
There is a large non-monetized sector in a developing economy.
A large portion of production is partly exchange for the other
goods and is partly kept for personal consumption. Such
production and consumption cannot be calculated in national
income.
12. Lack of Occupational Specialization

There is the lack of occupational specialization in such a country
which makes the calculation for national income by product
method difficult.
13. Non–Marketed Transaction

People living in rural areas in a developing country are able to
avoid expenses by building their own huts, tools, implements,
garments and other essential commodities. All such productive
activities do not enter the market transactions and hence are not
include in national income.
14. Illiteracy
The majority of people in such a country are illiterate and they
do not keep any accounts about the production and sales of
their products. Under the circumstances, the estimates of
production and earned incomes are simply guessed.
15. Non–Availability of Data

Adequate and correct production and cost data are not available
in a developing country. Such data relate crops, forestry,
fisheries, animal husbandry and the activities of petty
shopkeepers, small enterprises, construction workers, etc.
7. IMPORTANCE OF NATIONAL INCOME

The study of Natural income is very much important as explained
below:

1. Solution of Economic Problems
Study of National income is important to understand and
analyse the economic problems and economic inequalities and
to solve the economic problems.
2. Analysis of Economic Conditions

The economic status of country is analysed on the basic of
national income, higher the level of National Income, higher the
living standard and vice versa.
3. Study of Rate of Economic Development

Persistent rise in national income of a country over a long period
of time depicts the rate of economic development, economic
welfare and economic prosperity.
4. Study of Different Sectors of the Economy

Study of national income reveals the contribution made by
different sectors of the economy e.g. agriculture, industry,
minerals, bade, transportation etc.
5. Consumption, Saving and Investment

Study of national income provides information about the share of
consumption expenditure, savings of the people and investment
expenditures.
6. Economic Policies and Planning
Study of national income helps in formulation of economic
policies because natural income figures depicts which sectors
are developing and which sectors are backward therefore to
make plans for industrial, agricultural, trade, transport,
communication, water power resources, forestry, minerals etc.
study of National Income provide the base.

All may conclude that the concept of national income is indispensable
proportion for tackling the great issues of unemployment inflation
inequitable distribution of incomes, poverty and economic growth.
8. CIRCULAR FLOW OF NATIONAL INCOME
The circular flow of income and expenditure refers to the process, whereby the
national income and expenditure of an economy flow in circular manner
continuously through times. The various components of national income and
expenditure such as saving investment, private consumption expenditure, etc. are
shown in diagrams in the form of currents and cross currents in such a manner that
national income equals national expenditure.
The circular flow of income and expenditure in such an economy is shown in

figure, where the product market is shown in the upper portion and the factor
market in the lower portion. In the product market, the household sector
purchases goods and services from the business sector while in the factor
market the household sector receives income from the former for providing
services. Thus the household sector purchases all goods and services provided
by the business sector and makes payments to the latter in lieu of these.
The business sector, in turn, makes payments to the households for the services
rendered by the latter to the business, wage payments for labor services, profits
for organisation, rent to land owners and interest for capital supplied, etc.
Thus payments go around in a circular manner from the business sector to the
household sector, and from the household sector to the business sector, as
shown by arrows in the outer portion of the figure. There are also flows of goods
and services in the opposite direction to the money payments flows. Goods flow
from the business sector to the household sector in the factor market, as shown
in the inner portion of the figure.

(Expenditures)
Payment for Goods and Services
Supply of Goods Services

(Output/Product)
Business/ House Holds/
Firm Consumers
Injections to the Withdrawls

flow of N.I funds Services of FOP (i) Saving  S
(i) Investments  I (ii) Taxes  T
(ii) Government spending's  G (iii) Imports  M
(iii) Exports  X
Rewards Paid to FOP
(Incomes)
Figure 9
8.1 Withdrawals and Injections into the Circular
Flow of National Income – Short Term and Long Term

In a national economy there are three withdrawals from and three
injections into the circular flow of national income. Withdrawals from
the national income flows are savings (A), Taxes (T) and Imports (M)
and Injections into the circular flow of national income are Investment
expenditures by firms (I), Government expenditures (G) and Exports
(X).
Leakages and injections
Leakages from the circular flow
It is now necessary to modify some of the earlier simplified
assumptions. People do not spend all they earn within the same short
time period; there is trade between different countries, and the
government has a considerable effect on the total flow of activity.
Savings
For the purposes of national income analysis the part of income that is
not consumed within the same short time period is defined as savings.

Imports
Part of the money paid for the consumption of goods and services goes
to producers outside the country. Payments for imported goods and
services represent a further leak from the circular flow.
Taxation
A distinction must be made between gross and net income. A
substantial share of total income passes to the government in the form
of taxation. Some of the tax is deducted directly from gross income
paid by firms as income tax (and really in much the same way by
national insurance contributions). Some is paid to the government
instead of firms through indirect taxation when buying goods and
services (e.g. value added tax). Whatever the form of tax, it has the
effect of causing a leakage of income out of the circular flow of activity.
Injections into the circular flow

Each of the three leaks, however, has a corresponding injection −
although there is no guarantee that each always has the same value as
its ‘partner’.
Investment
Much of what is saved is placed with various kinds of financial
institution; banks, building societies, insurance companies, pension
funds and trusts. These institutions in turn provide funds for investment
by firms in new capital and stocks. This may be in the form of loan
finance, or investment by insurance companies, pension funds and
trusts in the capital of firms. Therefore much of what is saved finds its
way back into the circular flow via the investing activities of the financial
institutions.
Exports
Some income is spent on imports but, at the same time, some
production is sold to foreign buyers and increases the flow of income
within the domestic economy In addition to this there will be inflows and
outflows of money as a result of international investment activity.

Government spending
Clearly, not all incomes earned by households or revenues earned by
firms come from one another. Some result from the spending activities
of central and local government. This may be spending on things like
housing, education, health or roads, grants or subsidies to firms, and
payment of various types of benefit, such as pensions or
unemployment benefit.
Figure 11.3 Circular flow of income in an open economy
National income equilibrium is reached not only by the equality of

aggregate demand and aggregate supply but also the planned
withdrawals from the flows of national income must also be equal to
planned injections into the circular flow of national income i.e.
withdrawals = Injections or S + T + M = I + G + X.
(a) Any difference in the balance of payments deficit or surplus is

equal to the long values of import payments (M) and export
receipts (X) of goods and services long. In the short run this
difference is filled by borrowings or lending from or to abroad.

(b) The difference between public expenditure and public revenue
can be filled by public sector borrowing requirements (PSBR)
and public sector debt repayments (PSDR).
(c) Although people who save and invest are different even then in
the long run savings are made equal to investment through
capital market.
Lord Keynes explained the difference between planned withdrawals and
planned injections in terms of trade cycles.
9. NUMERICAL ILLUSTRATION OF DIFFERENT CONCEPTS OF

NATIONAL INCOME
Example
Given the following data of a firm in an economy during a certain period
of time. Calculate GDP according to
(a) Income approach

(b) Expenditure approach
(c) Value added approach Rupees
(i) Raw material imports 400,000
(ii) Wages and salaries paid 900,000
(iii) Output sold 2,000,000
(iv) Profits 700,000
(v) Pays its post-tax profits to Shareholders as dividend 400,000
(vi) Taxes on labor are 200,000 and on the company 300,000
(vii) Domestic consumer's expenditure 1,100,000
(1,100,000 = 700,000 wages + 400,000 (profits) dividends)
(viii) Govt expenditures
(500,000 = 200,000 tax on labor + 300,000 tax
on company) 500,000
(ix) Exports 400,000

SOLUTION
(a) The expenditure approach.

(i) Consumer expenditures Rs. 11,00,000
(ii) Govt expenditures Rs. 5,00,000
Total expenditure Rs. 16,00,000
(iii) Exports Rs. 4,00,000
20,00,000
(iv) Imports (–) 4,00,000
GDP Expenditure approach 16,00,000
(b) Income Approach

Income received by the labor force (Pretax) = Rs. 900,000
Gross profits of the firms (Pretax) = Rs. 700,000
GDP Income approach Rs. 16,00,000
(c) Value added approach/output approach.

Total output produced & sold = Rs. 2,000,000
Imports of raw material Rs. (–) 4,00,000
GDP Value added approach Rs. 16,00,000
EXERCISE
The following data relates to the economy of a country over one year period.
Rs. in million
Consumers expenditures 20,000
Federal government expenditures 4,500
Capital formation 5,100
Physical decrease in stocks (100)
Exports receipts 7000
Imports payments 6500
Taxes on expenditures 6000
Subsidy 500
Net property income from abroad 500

Depreciation (Capital consumption Expenditures) 2,000
Required
(i) GDP at market prices
(ii) GDP at factor cost
(iii) GNP at market prices
(iv) GNP at factor cost
(v) National income at factor cost
(vi) NNP at Market price
SOLUTION
Rs. million
Consumption expenditure 20,000
Federal Govt. Consumption expenditures 4,500
Capital formation 5,100
Value of physical decrease on stocks (100)
______
Total domestic expenditures 29,500
Exports 7,000
Imports (6500)
I GDP at market prices 30,000

GNP at market prices 30,500
II GDP at market prices 30,000

Taxes on expenditure (6000)
Subsidy 500
III GDP at factor cost 24,500

______
IV GNP at factor cost 25,000
_____

Depreciation (Capital Consumption) (2000)
V National Income at factor cost 23,000
VI GNP Pat market price 30,500

( - ) Capital consumption (2,000)
NNP at market prices 28,000
Note NO. 1
GDP at market prices = Consumption expenditures + Federal Govt.

expenditures + Capital formation – physical decrees in stocks +
Exports–Imports
NOTE NO. 2
GNP at market prices = GDP at market prices (+) Net property income
earned from abroad.
NOTE NO. 3
GDP at factor cost = GDP at market prices – Taxes on expenditures

+ subsidies
NOTE NO. 4
GNP at factor cost = GDP at factor cost + Net property income earned
from abroad.
NOTE NO. 5
National income at factor cost = GNP at factor cost – Depreciation i.e.,

capital
(NNP at factor Cost) consumption.
Example
The Economic Survey of the government of Pakistan discloses the
following

Rupees
in millions
Government expenditure 7,500
Sales value of output of firms 30,000
Imports 6,000
Profit before tax of firms 10,500
Consumers’ expenditure 16,500
Wages etc. received by employees 12,000
Tax deducted out of wages 1,500
Exports 6,000
Cost of goods and services purchased from outside country firms 6,000
You are required to compute Gross Domestic Product (GDP) by using:
(i) expenditure approach
(ii) income approach
(iii) value added approach
Solution
(i) Computation of G.D.P. by expenditure approach
Rupees
in million
(a) Consumer’s expenditures 16,500
(b) Government expenditure 7,500
(c) Total exports 6,000
(d) Total imports (6,000)
Total expenditures 24,000
(ii) Computation of G.D.P. by income approach

(a) Profit before tax of firms 10,500
(b) Wages etc. received by employees 12,000
(c) Tax deducted out of wages 1,500
Total income 24,000
(iii) Computation of G.D.P. by value added approach

(a) Sale value of output of firms 30,000

(b) Cost of goods and services purchased
from outside firms ( 6,000)
Total value 24,000
Exercise
Following data relates to the economy of a country over a year period.
Capital consumption 2,625
Subsidies 450
Exports 9,675
Imports (9,360)
Consumers’ expenditure 27,600
Taxes on expenditure (4,140)
Value of physical decrease in stocks (30)
Gross domestic fixed capital formation 7,380
General government final consumption 6,810
Required:
You are required to compute the following, showing necessary workings
a. Gross Domestic Product (GDP) at market prices and at factor cost
b. Gross National Product (GNP) at market prices and at factor cost
c. National Income at factor cost and at Market price
Solution
(a) GDP at market prices = Consumption expenditure +
Federal Government expenditure + capital
formation  physical decrease in stocks +
exports  imports.
(i) Consumers expenditure Rs. 27,600 million
(ii) Gross domestic fixed capital formation Rs. 7,380 million
(iii) General Govt. final consumption Rs. 6,810 million
(iv) Physical decrease Rs. (30) million
(v) Exports Rs. 9,675 million
(vi) Imports Rs. (9,360) million

GDP at market prices Rs. 42075
(b) GDP at factor costs GDP at market prices  Taxes

on expenditure + subsidies.
(i) GDP at market prices Rs. 42,075million

(ii) Subsidies Rs. 450 million
(iii) Taxes on expenditure Rs. (4,140) million
GDP at factor cost ________
Rs. 38,385
(c) GNP at market prices GDP at market prices + Net

property income earned from
abroad.
(i) GDP at market prices Rs. 42,075 million
(ii) Net property income from abroad Rs. 315 million
GNP at market prices __________
Rs. 42,390
(d) GNP at factors cost GDP at factor cost + net

property income from abroad.
(i) GDP at factor prices Rs. 38,385 million
(ii) Net property income from abroad Rs. 315 million
GNP at factor cost ________
Rs. 38,700
(e) National income at factor cost GNP at factor cost ()

Capital Consumption
(i) GNP at factor cost Rs. 38,700 million
(ii) Capital consumption Rs. 2,625 million
National Income at factor cost ________
Rs. 36,075

(f) NNP at Market prices
(i) GNP at market prices Rs. 42,390

(ii) Capital consumption Rs.(2,625)
NNP at Market prices Rs. 39,765
10. REAL AND MONEY NATIONAL INCOME
 Money (or nominal) national income (M.N.Y.) is the value of this year’s
output at current prices.
 A price deflator is an index used to eliminate the effect of inflation.

There are two main price indices in the UK
(i) the Retail Price Index (RPI), covering only consumer goods and
services;
(ii) the GDP deflator, covering both consumer and capital goods.
 Real national income (R.N.Y.) is the value of this year’s output at

constant prices and is calculated by using either of the following
equations
M.N.Y.
R.N.Y. = GDP deflator  100
price index of base year

R.N.Y. = M.N.Y.  price index of current year
11. BUSINESS CYCLE

Definition
According to J.M. Keynes
“A trade cycle is composed of period of good trade characterized by rising

prices and low unemployment percentages alternating with periods of bad
trade characterized by falling prices and high unemployment percentages.”
11.1 Depression
Meaning

Depression means slump. It is used to explain such a time when
economy is under crises and difficulties. In words of Keynes
depression can be called a bad period. There is very low economic
activity
Characteristics of Depression
Following are the characteristics of depression phase.
1. Very low economic activity
2. Low prices of goods and services
3. General disappointment among investors and businessmen.
4. Due to fall in revenues and income, investor and businessmen

become pessimistic.
5. Due to falling revenues, the old capital equipment is not

replaced.
6. Many firms and companies shut down their business.
7. The demand from the consumer side declines.
8. Heavy stocks of goods pile up in stores and warehouses.
9. The production of capital goods is reduced. This situation could

be alarming because capital goods are necessary to maintain
steady rate of growth so that the country is pulled out of
depression
10. The factories fail to operate at normal capacity level.
11. The capital market and stock exchanges are also the major
victim of depression. The stocks business face a sharp fall in
trading and investors try to transfer their capital abroad.
12. It also affects the imports and exports of the country. Due to low
production the exports may fall leading towards trade deficits
and disequilibrium in balance of payments.

Four Phases of Business Cycle
Boom
Boom
Economic Activity
Re
y
very
over
ce
ss
ion
Reco
Rec
Depression
Time
O
11.2 Revival
Meaning
The second phase of trade cycle is called recovery or revival. Just like
a sick person recovers from illness over a time so a sick economy
recovers from financial ills. But the recovery of the economy is very
slow and time consuming.
Following are the characteristics of this stage.
Characteristics
1. At this stage the stock of goods that have piled up in the
depression comes to an end.
2. The demand of consumer goods grows.
3. The increase in demand is a signal to producer to accelerate the
production process.
4. The government also plays a role in initiating revival. During
depression it takes different expansionary measures and incurs
capital expenditures. Results of such activities start appearing in
the revival phase.
5. Economy takes a move after a nap of depression.
6. Prices start increasing and profit margin that have disappeared
in the previous phase, reappears.
7. Due to start of production and manufacturing processes
unemployment starts to decline.
8. The savings begin to show signs of improvement. This helps in
increasing the credit supply to the sick economy.
9. Various mega projects are initiated by the government in order
to induce growth in the sluggish economy.
10. Privatization can be a distinctive feature of this phase.
Governments normally try to hand over state owned units to
private sector. This also leads to liberalization of the economy.
11. The entrepreneurs start chalking out new plans and policies.
They also decide to take risks in the hope of better returns.
11.3 Boom
Meaning
Boom means a period of very rapid economic activities and high
revenues. It means the state of overall bliss and happiness.
Characteristics
Following are the characteristics of this phase:
1. There is a rapid rise in production in response to a rise in

consumer demand.
2. Demand for factors of production increases, unemployment falls

and wages increase.
3. Investors earn a very healthy return over their investments.
4. Capital equipment is quickly replaced as it wears out or become

obsolete due to new inventions or discoveries or innovations.
5. There is a wide spread prosperity and improvement in living

standard.
6. As profit rate exceed cost of borrowing so borrowing increases

and supply of credit rises.
7. The credit and money supply grow rapidly. The easy availability
of loans induce investors to start new projects.
8. People find themselves free from financial worries.
9. The governments and other institutions also pay attention

towards socio-economic activities.
10. Boom also helps in payment of internal and external debts.

11. During boom the foreign capital and expertise fly in the country
to take benefit of higher return.
12. More and more resources are explored and brought to

production.
13. Due to higher production there may be environmental problems

such as pollution and loss of wild life etc. however when the
economy is expanding rapidly such problems will lead to further
research and innovations resulting in the establishment of
environment friendly processes of production.
14. The boom stage also leads to structural changes in all the
industries of the economy. New capital will be installed and firms
will be more competitive.
15. The capital market also flourishes rapidly. New companies are
incorporated and capital base strengthens.
11.4 Recession
Meaning
As we say that after every rise, there is a fall and once you reach a
mountain peak you have nowhere to go but to come down from the
other side. So after an economy has reached a boom it gradually
moves towards recession. The recession period starts because of the
following reasons:
1. Decreasing to Scale
2. Diseconomies of Scale
3. Incompatible Combination of Resources

Characteristics
1. Due to increased, demand in boom periods, demand for factors of
production also increases but as the resources are scarce, so
increase in demand leads to increase in prices of these resources.
This increases the cost of production and hence the prices also
rise.
2. To check the rise in prices, the credit controls are exercised. This

increases cost of borrowing and investment fall. The fall in
investments act as breaks on business activity. Prices begin to fall
and profit margin decrease.
3. On the other hand due to increased interest rates people prefer to
save than to consume. This result in the fall in consumer demand.
Stocks of unsold-goods start piling up again.
4. Signals are sent to producers to stop or decrease production. The
decrease in production compelled the producers to lay off workers
that have been hired at high cost in boom periods. Due to this
unemployment increases.
5. The government also reduces its capital expenditures. The result
is that the economy contracts.
6. Due to higher savings, Withdrawals from the economy increase.
On the other ‘hand due to high cost of borrowing the investments
fall. All this leads to contraction of the economy.
The recession is a slow and gradual process that finally ends in depression
and in this way, a cycle comes to an end.
EXERCISE
GDP: Income approach
Rs million
Operating surplus of non-financial corporation’s 234,704
Profits of financial corporation’s 37,995
Adjustment for financial services (51,719)
Operating surplus of general Government 12,605
Operating surplus of households and NPOs serving households 78,441
Total operating surplus 312,026
Compensation of employees 684,618
Mixed income 76,112
Statistical discrepancy (917)
GDP at factor cost 1,071,839
Taxes on products 162,267

Subsidies (9,391)
GDP at market prices 1,224,715
Notes:
(a) Three types of factor income are included clearly above – wages
(‘compensation of employees’), profits (the first five figures) and rent
(within ‘mixed income’). The fourth, interest, is actually included in
these figures also, within the profits figures.
(b) Note that no transfer payments are included, as explained above.
12. Interpretation of national income

It is extremely difficult to measure all the necessary figures accurately. This is
a very significant problem in the less developed countries, where productive
activities are carried out on a small scale and in a fragmented way. It is
unlikely that accurate records of transactions will be kept. In a ‘black
economy’ transactions are made in cash and not recorded, so that tax can be
avoided. Such transactions distort the national income statistics.
The standard of living of a population is a rather nebulous concept. Most

people know what it means, but defining it is difficult. Let us define it loosely
as ‘how well off people are’. The size of the national income must be
connected to this: it assigns a monetary value to the goods and services that
people can buy. The national income also measures how productive the
economy is (recall that income equals output), which must be connected to
the standard of living of the population. We therefore need a measure of
national income that reflects the flow of goods and services generated within
the economy. This is where problems arise.
One difficulty was mentioned above – many services are provided free of
charge. This is seen in many areas as the voluntary sector – people caring for
a sick relative and do-it-yourself carpentry being other examples.

Another problem arises in the valuation of durable goods. For example, a car
purchased by a family is recorded as a consumer purchase at the point at
which the purchase is made; on the other hand, cars owned by car hire
companies give rise to income each time they are used. There is no such
parallel charge made when a private car is used. This is an example of how
the statistics generally reflect not the use of a durable good, but the method of
paying for that good.
KEY POINT
The national income figures should be taken as giving a general picture of the
state of the economy, but the inaccuracies and definitional problems should
not be ignored.
Inflation also distorts the picture presented by national income statistics, as it

will cause apparent rises in national income, when the real value of the
underlying flows has not changed. Although it should be possible to make
adjustments to strip out the effects of inflation, these adjustments will be very
complex, as the constituents of the accounts all inflate at different rates. The
calculation of stock appreciation (income method) is an example of such an
adjustment.
All these difficulties mean that the national income figures should be taken as
giving a general picture of the state of the economy, but the inaccuracies and
definitional problems should not be ignored.
Differentiate the GDP deflator and consumer price index (CPI)
13. GDP Deflator

GDP deflator is the most comprehensive available index of the price level
because it covers all the goods and services that are produced by an entire
economy.
GDP base - period prices (Real)

GDP deflator = x 100
GDP at current prices (Nominal)
Consumer Price Index - CPI

CPI measures the average cost of the goods and services that are
bought by the average consumer. The CPI expresses the price level at

any time in relation to what a given bundle of commodities consumed
by the average consumer.
Summary
• The methods of measuring the national income are complex,

and the detailed formats of the different approaches to the
calculations need not be learned.
• An understanding of the connection between income, output and

expenditure is vital if you are to understand the Keynesian
theories covered in the next chapter.
Practice questions
Question 1
Which of the following represent withdrawals from the circular flow of national
income?
(i) Distributed profits
(ii) Interest paid on bank loans
(iii) Income tax payments
(iv) Imports
A (i) and (ii) only
B (ii) and (iii) only
D (iii) and (iv) only
Question 2
GNP (Gross National Product) at factor cost may be best defined as:
A the total of goods and services produced within an economy
over a given period of time
B the total expenditure of consumers on domestically produced
goods and services
C all incomes received by residents in a country in return for factor
services provided domestically and abroad

D the value of total output produced domestically plus net property
income from abroad, minus capital consumption
Question 3
Which one of the following is a transfer payment in national income
accounting?
A Educational scholarships
B Salaries of lecturers
C Payments for textbooks
D Payments of examination entry fees
Additional question
National income
The following passage is concerned with national income.
National income can be calculated in a number of ways but, however it is
calculated, the figures are not a reliable guide to use in comparing changes in
standard of living over a period of time.
Required:
Using both your knowledge of economic theory and the passage above:
(a) Explain the three methods of calculating national income
(b) Examine the following two problems associated with calculating
national income:
(i) the ‘black economy’
(ii) unpaid work
(c) Explain how the following may affect the standard of living but
not national income:
(i) quality of goods and services
(ii) pollution
(iii) distribution of income
(d) Explain for what other purposes might national income figures
be used?
For the answer to this question, see the ‘Answers’ section at the end of the book.

Contents
1 Fiscal Policy
2 Public Finance
3 Government Fiscal Policy
4 Inflationary and Deflationary Gaps
5 Taxation and Expenditure Measures
6 The Principles of Taxation
7 Direct and Indirect Taxation
8 The Incidence of Indirect Taxation
9 Subsidies
10 The Quantity Theory of Money
11 Monetarism
12 Monetary Policy − The Keynesian And Monetarist Views
13 The Demand for Money − Keynesian View
14 The Supply of Money
15 Interest Rates and Liquidity Preference
16 The Classical View of Interest Rates
17 The Pattern of Interest Rates
18 Government Macroeconomic Policy
19 Unemployment
20 Causes of Unemployment
21 Remedies for Unemployment
22 Inflation
23 Sources of Inflation
24 Inflation and Unemployment
25 Economic Growth
26 Causes of Growth
27 The Balance of Payments − Overview

1. Fiscal Policy
Fiscal policy means the process of shaping government taxation and
government spending so as to achieve certain objectives. In the words of prof.
Lindholm, fiscal policy means the development of the type, the time and the
procedure to be followed in making government expenditures and in obtaining
government revenue. According to Paul a. Samuelson "by a positive fiscal
policy we mean the proceeds of shaping public taxation and public
expenditure".
Professor Lipsey defines thus, "government's revenue raising and its
spending activities are called fiscal policy".
In short, fiscal policy refers to the taxing, spending and borrowing policy of the
government. It is mainly concerned with the process of shaping government
revenue and govt. Expenditure so as to achieve certain important, specific
and main objectives.
1.1 Objectives of Fiscal Policy/Public Finance

1. Economic Growth And Economic Development
The basic objective of a fiscal policy is to promote economic
growth in the economy. In all countries, whether developed or
under developed, the state gives top priority to economic
development i.e. rising if national income, per capita income and
standard of living.
Govt. adopts certain measures to stimulate the rate of growth in
the economy. The fiscal measures like deficit financing, deficit
budget and borrowings are very helpful in promoting economic
growth.
2. Fair Distribution Of Income

In a free enterprise economy, economic development is always
accompanied by inequalities in the distribution of wealth. A small
group of population becomes richer and richer and majority of
the population becomes poorer and poorer.
A prominent objective of fiscal policy is to minimize the disparity

in the distribution of wealth. Disparities of income can be
minimized by taxing high income groups at a progressive rate
and by subsidizing the cost of living of the poor people.
3. Full Employment/Reducing Unemployment

The achievement of full employment is another objective of
fiscal policy. Employment level can be increased by giving
incentives to investors and govt., though fiscal policy can induce
by lowering down the tax rate or by increasing slabs. Income tax
holiday and reduction in other taxes may bring larger
investment.
4. Economic Stability
Economic fluctuations are very frequent in a free enterprise
economy. This injects the element of instability in the economy.
Sometimes the economy has to suffer from the undesirable
situation of depression and sometimes there is a problem of
inflation.
In order to obtain stability, the govt. Adopts the policy of deficit
budget in depression and surplus budget in inflation.
5. To Discourage The Production Of Unnecessary Goods

Production of intoxicant and other injurious to health goods can
be stopped through heavy taxation. Production of cigarettes may
be in the individual interest but not in the interest of the nation.
The govt. Imposes heavy taxes on such commodities so as to
discourage their production.
6. To Correct The Disequilibrium In The Balance Of Payments

Disequilibrium in the balance of payments arises when the
import payments of a country exceeds its exports. To correct
this disequilibrium the govt. May adopt certain fiscal measures.

On the one hand a heavy custom duty and tariffs are imposed in
order to discourage the volume of imports and on the other
hand, the govt. May provide subsidies to those industries which
are producing exportable goods. When imports are discouraged
and payments are stimulated, the disequilibrium in the balance
of payments is corrected.
7. Value Of Money
Changes in the value of money cause instability in the economy.
Therefore, govt. Action is necessary to stabilize the value of
money. During inflation govt. Reduces private expenditure. In
case of deflation government increases its own expenditure and
encourages private expenditures by a cut in taxes. That is, govt.
Gives relief to taxpayers and they are induced for investment.
8. Suitable Consumption Level

It is also necessary that through fiscal policy a suitable and desirable
level of consumption should prevail in the country.
1.2 The Long Run Objectives Of Fiscal Policy Are As Follows:

(i) High Level Of Employment
The economic system may operate below or above the high
level of employment. Modern economists, therefore, advocate
that long-run basic aim of the fiscal policy should maintain
growing high level of employment without inflation in the country.
(ii) Stabilization Of Price Level

Stabilization of price level is another long run objective of the
fiscal policy. When prices begin to rise, the government should
adopt contracting fiscal policy and when they begin to fall, the
expansionary fiscal policy should be adopted.
(iii) Reduction In Inequality Of Income

The modern economists are of the view that reduction in the inequality
of income should be one of the aims of fiscal policy. The government
should tax the rich people at a progressive rate and spend the income
for the benefits of the poor.
1.3 Tools Of Fiscal Policy

Public Expenditure
An increase in public expenditure during depression adds to the
aggregate demand for goods or services and leads to an increase in
income and during inflation reduction in public expenditure reduces
aggregate demand, national income, employment and prices. Thus
inflationary and deflationary pressures can be controlled in this way.
Government Expenditure
Two types of government expenditure
a. Non development
b. Development expenditure
A. Non Development Expenditure

I. General Service expenses incurred by the various
departments and ministries.
II. Expenditure on public servicing of internal and external
debt i.e. interest payments and capital repayment.
III. Defense, justice and police cost of maintaining police and
armed forces and law courts.
IV. Social and community services expenditure on education,
health social welfare and public works.
V. Economic services promotion of productivity and
economic growth in various sectors e.g. manufacturing,
transport, construction, communication and public
utilities.

B. Development Expenditure
Expenditure incurred for purpose of economic & social development
e.g. building of schools, hospitals, roads and express ways, drainage
and sewerage systems, development of residential estates.
Public Revenue
A reduction in taxes affects in raising the disposable income of
the people which in turn increases consumption and investment
expenditures of the people, on the other hand an increase in
taxes tends to reduce disposable income and as a result there is
reduction in consumption and investment expenditure.
Public Debt
To control inflationary and deflationary pressures government
changes its fiscal policy. During depression government by
public lending increases the income, consumption and
investment while during inflationary pressures government
borrows from the financial institutes to decrease the disposable
income, consumption and investment expenditures.
Public Debt
Public debt refers to borrowing by a government from within the

country or from abroad from private individuals or association of
individuals or from banking and non-banking financial
institutions
Purpose Of Public Debit:
The following are the principal purpose for raising public loan.
(a) Bridging gap between revenue and expenditure.
(b) Financing public works program.
(c) Financing economic development.
(d) Curbing inflation.
(e) Financing the public sector.
(f) War finance.

1.4 The Built-In-Stabilizers
The automatic or built-in-stabilizers are as follows:
1. Progressive Taxation
Our present taxation system automatically operates to eliminate
the cyclical fluctuations in the economy. When there is a rise in
prices, rise in profits and the need is to contract the inflationary
pressure, the progressive tax system comes to rescue and
contracts the surplus purchasing power from the economy, and
vice versa.
2. Unemployment Allowance And Employment Tax
In advanced countries of the world, people receive
unemployment allowance and other welfare payments when
they are out of job. As soon as they get employment, these
payments are stopped. When national income is increasing, the
unemployment fund grows due to two main reasons
(i) The government receives greater amount of payroll taxes
from the employees, and
(ii) The unemployment allowance decreases. During
depression unemployment allowance and other welfare
payments augment the income stream and they prove a
powerful factor increasing income, output and
employment in the country.
3. Farm Aid Programs

Farm aid programs also stabilize against cyclical fluctuation.
When the prices of the agricultural products are falling and the
economy is faced with depression, government purchases the
surplus products of the farmers. The income and total spending
of the agriculturists remains stabilized.
When the economy is expanding, the government sells these
stocks and absorbs the surplus purchasing power. It reduces
inflationary potential by increasing the supply of goods and
contracting the pressure.

4. Corporate Savings And Family Savings
The corporations and companies and wise family members too
play an important part to contract cyclical fluctuations. For
instance, the corporations withhold part of the dividends of the
boom years to pay in the depression years. Similarly, wise
persons also try to save during the prosperous days in order to
spend the savings in the difficult time.
2. Public Finance
In public finance we study the collection of revenue and expenditure by the

state. Public finance can be divided into four branches (elements of public
finance)
(a) Public Expenditure i.e. allocation of public funds to different

uses and their effects on the economy.
(b) Public Revenue in public revenue we study the nature,

classification and burden of taxes.
(c) Public Debt we study public borrowings and lending’.
(d) The study of budget as a whole.
2.1 Objectives Of Public Finance

(i) Control the important sectors.
(ii) Provision of basic services to citizens e.g. defense, law & order
peace & security etc.
(iii) To arrange for maximum social services to people.
(iv) To bring economic and price stability in the country to attain
accelerated rate of growth and development.
(v) To set priorities of private and public investment in different
sectors of the economy.
(vi) To provide full employment, correction of balance of payments,
to control inflation and deflation, economic planning breaking up
monopolies and inequalities of income.

The management of personal and private income to make certain and
specified expenditures is known as private finance while state
management of its revenue and expenditure is public finance.
2.2 Private And Public Finance

There are some similarities and dissimilarities in private and public
finance.
Similarities
Balance Income Expenditure
(i) Both private and public finance have utmost try to balance their
income and expenditures.
(ii) Private finance and public finance both works for maximum
benefits out of scarce resources at their disposal. Individuals try
to maximize satisfaction and state has the objective of maximum
welfare of the society.
(iii) In both the cases the gap between current income and
expenditure is filled through borrowings.
(iv) Both can increase their incomes by making more investment.
Dissimilarities
Adjustment Of Income & Expenditure
(i) Individuals adjust their expenditure to their income while

government adjusts their incomes according to the
expenditures.
(ii) Individuals do not have specific budget period. This period may
be a week, a month may be 3 months, 6 months or year while
government prepares its budget for one year.
(iii) Private sector may or may not keep the record of its income and
expenditures while government keeps permanent record of its
income and expenditure.

Borrowings
(iv) Individuals borrow from other persons, e.g. friends, relatives,
shopkeepers, traders or from financial institutions. While
government arrange for loan not only from domestic financial
institution but also from international financial institutions and
other countries.
(v) Government can increase the supply of money through the
process of deficit financing while it is not possible for individuals.
Different Objectives
(vi) Individuals have the objective of maximum personal satisfaction
while government has the objective of social welfare of the
people.
(vii) Individuals during the times of difficulty and adversity cannot
bring about big and deliberate changes in income and
expenditure while it is fairly easy for the government to bring big
and deliberate changes in income and expenditure.
(viii) A surplus budget for the individuals is a dream and they are
known as prudent consumers while the budget surplus for the
government is treated as inefficiency of the government.
(ix) Individuals keep secrecy of their income and expenditures while
government gives publicity to its fiscal policy i.e. revenue and
expenditures.
3. Government Fiscal Policy
3.1 The Theory Of Fiscal Policy
The term, fiscal policy, refers to the manipulation of government

spending and taxation levels in the budget for the achievement of
macroeconomic aims. The classical approach to macroeconomic policy
(now revised in the form of monetarism) was that there was a self-
balancing process that ensured a full employment level in the long run.
The role of government should therefore be to remain neutral by
ensuring a ‘balanced budget’ (i.e. net expenditure = taxes raised). This
view was reinforced with analogies to personal households.
Definition
Fiscal policy refers to the government’s decisions and actions
regarding taxation and expenditure. Monetary policy refers to the
government’s decisions and actions regarding the level of interest rates
or the money supply.
3.2 Definition Of Terms
• Government income > government expenditure = budget

surplus.
• Government income < government expenditure = budget deficit.
• Government income = government expenditure = balanced

budget.
• The policies that control the government’s income and

expenditure decisions are called fiscal policies.
• Increased government expenditure financed by increased

taxation is a balanced budget increase in expenditure.
• Increased government expenditure not financed by increased

taxation is deficit-financed expenditure.
3.3 The Objective Of Fiscal Policy

The objective of fiscal policy will be to choose to operate either:
• A budget deficit to deal with a deflationary gap
or
 A budget surplus to deal with an inflationary gap
In either case, the government can alter the budget by some

combination of changes in taxation and expenditure decisions.
4. Inflationary And Deflationary Gaps

the inflationary or deflationary gap may be defined as follows:
• A deflationary gap occurs when level of aggregate demand is

lower than the level needed to generate that level of output that will
employ all resources in the economy.
• An inflationary gap occurs when the level of aggregate demand
rises to a level greater than that which will bring about the output
level at which all resources are employed.
The concept of full employment is not as clear as it first appears.

Because of the factors discussed earlier, there will always be some
unemployment e.g. structural or frictional. However, for the moment,
full employment may be taken to mean the highest practicable level of
employment.
The gaps can be demonstrated graphically:
Expenditure
Rs.m E=1
Fe Deflationary gap
Ee C + I +G + (X - M)
45
0 Equilibrium Full National income £m
employment

figure 14.1 deflationary gap
Expenditure
Rs.m E=1
e
C + I +G + (X - M)
Inflationary
gap
e
4
0 5 Full Equilibriu National income £m
employmentm
figure 14.2 inflationary gap
1.5 Closure Of The Gap

What happens if government spending is increased and taxation cut?
The answer depends on whether the economy is in the situation
depicted by either figure 14.1 or figure 14.2 above. Consider, by way of
example, a spontaneous increase in government expenditure from g to
g1, on the two situations portrayed in figures 14.1 and 14.2
a = deflationary gap with

G
b = deflationary gap with
G1+ I + G + (X-
C
3 M)
b C + I +G1 + (X -
2
M)1
+ (X –
a
1 M)
4
0 5Full Equilibriu National income
Effect: deflationary gap reduced
employme m £m
output increase no inflation
ntEquilibrium
with G1
with
G
figure 14.3 effect of increasing government expenditure (deflationary gap)

C + I + G1 + (X-M)
3
b C + I +G + (X - M)
2
a
1
a = inflationary gap with G
b = inflationary gap with G1
45
0 Full Equilibrium National income £m
employment with G1
Equilibrium with G
Effect: deflationary gap widened no
output increase no inflation
figure 14.4 effect of increasing government expenditure (inflationary

gap)
There is a sharp contrast between the two effects because, where

there is a deflationary gap, the shift from g to g1 is reflected by an
increase in output, using the multiplier process described earlier.
However, in the second situation, since output is already at the full

employment level, the shift must increase the inflationary gap and
hence the rate of price inflation, without increasing output.
4.2 Policy Implications Of The Keynesian Model

The Keynesian model suggests that it is possible to achieve both full
employment and nil inflation. If there is unemployment, the government
increases its net expenditure (the budget deficit) to close the
deflationary gap. If, on the other hand, there is inflation, then net
government expenditure is reduced and the inflationary gap closed.
This is because aggregate demand is reduced − in terms of the above
diagrams the c + i+ g + (x − m) curves move down instead of up.

This concept lay behind the fine-tuning approach to government fiscal
policy in the 1950s and 1960s. The evidence suggests that the
procedure does not work in the way the simple model above indicates:
this will be studied in more detail later.
At this stage, you should appreciate that the Keynesian model of the
economy developed above remains the only complete model. The
great controversy that does exist is about additional factors and their
relative importance, not the basic model.
5. Taxation And Expenditure Measures

5.1 Taxation Measures
Changes In Income Or Personal Taxes
Two elements are important in determining how much income tax an
individual has to pay. These are:
• The total allowances (tax-free income) the person can claim.
• The percentage or rate of tax levied on the remaining taxable
income.
if the government raises the level of allowances or widens the lowest

bands of tax-free income or the lowest rated band, then all taxpayers
benefit, but the lower income groups benefit most of all and some will
be relieved of tax altogether. Such changes − if they are reductions −
will be costly to the government because there are far more people
with low incomes than with high incomes, and a high proportion of the
total tax collected is paid by those who pay only the lower rates of tax.
From a social point of view there may be objections to this type of relief
because the very low income groups who pay no tax at all will not
benefit in any way.
If the government changes the rates of tax only, the effect on the total
tax collected may be considerable but the amount of relief given to the

majority of taxpayers may be very small. There is thus a temptation on
the part of governments to increase taxes by changes in standard and
higher rates but to reduce them by increasing allowances and
broadening the lower tax bands.
Over a long period this tendency can have severe effects on the
effective taxes levied on middle and higher income groups.
Changes In Taxes Paid By Business Organizations

Sole owners and partners pay taxes as individuals on their net income
from business activities, but the government can alter the rules for what
can legitimately be claimed as business expenses. Important items
include the cost of running a motor vehicle and other travel and
communication expenses. These can have a significant effect on
taxable income and the amount of tax paid.
Limited companies are treated as separate entities and pay corporation

tax. Again, the government can alter the rules concerning business,
especially capital or investment allowances, and so change the
proportion of a company’s revenue likely to become net, taxable profit.
It can also change the rate of tax. Company profits are the main source
of finance for business investment, so that changes in business taxes
influence the level of investment rather than that of consumer
spending. It can be argued, however, that high rates of business tax
force firms of all kinds to pay owners and employees in material
benefits that can often escape tax or at least be taxed at relatively low
levels.
Changes In Indirect Taxes

A change in an indirect tax affects the real pressure of consumer
demand because it alters the prices of goods as they appear to the
final consumer. Thus, suppose a consumer has Rs. 1,2000 available

for spending and indirect taxes average 20%. This means that,
although the consumer spends Rs. 12,000, in practice Rs. 2,000 of this
spending goes to the government in tax and Rs. 10,000 to business
firms. If the government raises the indirect tax level to 25%, then Rs.
2,400 of the consumer’s spending goes to the government and only
Rs. 9600 to firms. The consumer will get less for their money in goods
and services and the demand pressure on firms will, it is thought, be
relaxed. The most important indirect tax for most European countries
today is value added tax (vat). The operation of this is discussed
further on.
5.2 Practical Constraints On Taxation Changes

Chancellors of the exchequer at one time used to explain their
economic policies in terms of driving cars. In seeking to maintain a
correct relationship between the pressure of demand and the capacity
of the economy to meet that demand (i.e. keep in balance full
employment and equilibrium levels of national income), they would
refer to brakes and accelerators. To keep the economy going steadily
in spite of changes in the external environment the government was
supposed to touch the accelerator (reduce taxes) or touch the brake
(increase taxes) if demand were running too fast.
Unfortunately, constant adjustments through taxation can be damaging
and even self-defeating for the following reasons.
(a) Changes In Direct Taxes Are Expensive And Troublesome
To Administer
They cause a great deal of work and expense not only for the
revenue but also for business organisations that have to deduct
taxes from dividends, interest and incomes. If there is more than
one change in a year the cost is much increased.
(b) Changes Take Time To Appear In Pay Packets And May Not
Be Understood By The People Concerned
Several months can pass between the announcement of a
change and its appearance as an alteration in net pay. The time

gap can be lengthened further if the change is accompanied by
other changes, such as alterations in building society interest
rates. By no means everybody understands the income tax
system and changes can be exaggerated in the popular mind or
misunderstood completely.
(c) Changes Desirable From An Economic Policy Point Of View
May Conflict With Social Objectives
This is one of the main problems in applying fiscal measures to
reduce an inflationary gap. The biggest effect on spending
would be obtained by a tax increase on those with the highest
propensity to consume, i.e. the lower income groups. The
government is likely to be under considerable pressure not to
harm these groups so that it may be forced to make good tax
increases by additional spending on social welfare or it may
raise additional tax on the higher income groups. This may
reduce saving rather than spending and damage business
investment.
(d) Changes In Indirect Taxes Can Disrupt And Weaken
Industry
Business investment requires forward planning. Firms have to
make estimates of future demand and these can be badly
disrupted by changes in government fiscal policies, especially by
increases in indirect taxes. On the other hand, industry may be
reluctant to respond to a reduction in taxation if this is thought to
be subject to change in the future. No firm wishes to commit
itself to expensive investment programs if it cannot be sure of
selling the extra production in the future.
5.3 Expenditure Measures

The alternative to changes in the level of taxation is changes in
the level of expenditure. This could involve, for example,
changes in road-building policy, education policy and so on.

There are attractions in this, particularly when the desire is to
remove a deflationary gap.
• The amount of extra investment needed is less than the
tax reduction. This is because not all of a tax reduction is
spent. Some is saved, some goes to imported goods.
• Government expenditure tends either to create capital
assets (e.g. roads, schools, etc.) or to achieve socially
desirable ends (e.g. higher pensions).
Of course, exactly the converse applies when expenditure is being cut

to remove an inflationary gap. On the other hand, expenditure
decisions have disadvantages:
• There are usually long time-lags before they take effect.
• It could be argued that government expenditure is
inherently less efficient (or more efficient, depending on
political leanings) than private expenditure. However, it is
most appropriate to consider the proportion of
government spending upon ‘marketable’ and ‘non-
marketable’ goods and services.
5.4 Weaknesses Of Fiscal Policy

After two decades of economic planning through fiscal measures linked
to adjustments in the government’s own spending, it has become clear
that these are subject to some serious doubts. They have certainly
proved less effective than had been hoped. At one time, many
economists were claiming Keynesian economic management provided
an effective cure for the old industrial problems of inflation and
unemployment. The appearance of both together in the 1970s was a
bitter disappointment to these hopes and it is impossible to be certain
that the weaknesses of demand management policies are yet fully
understood. However, the following suggestions can be made.

(a) People Adjust Their Own Spending To Changes In The Light Of Experience
There is some evidence that current demand depends now not only on
current income and prices but also in anticipated future incomes and
future prices. If increases in direct tax are associated with inflation, they
may actually increase demand because people wish to buy now before
prices rise even more in the future. They have learned that borrowing
can pay during inflation so that hire-purchase contracts may be taken
out in the belief that the cost will be saved by purchasing articles before
prices rise further.
(b) People React To Increases In Income Tax By Increased Pressure
To Secure Higher Wages
An increase in direct tax, imposed in an attempt to reduce disposable
income and check excess demand, may lead to pressure on wage
inflation and industrial costs. The result is to increase prices.
(c) Inflation Can Lead To Fiscal Drag which In Turn Leads To Further
Inflationary Pressures
Fiscal drag refers to the tendency for actual taxation to increase
because wage inflation brings increased numbers of incomes into
higher tax bands. It has been common for chancellors to say that they
are relieving so many thousand workers from tax when they know that
wage rises will bring those workers back into taxable bands and that
total tax collected will increase rather than fall. Governments have
been a major beneficiary from inflation because of the increased tax
yields produced by fiscal drag.
(d) Steady Growth In Public Spending
If deflationary and reflationary measures were to balance over a period
of time, there should be no proportionate increase in public spending.
Tax reductions to reflate (increase demand) should, over a period,
balance tax increases to deflate (reduce demand). In practice this has
not happened and there was a steady increase in the government’s
share of current expenditure until the late 1970s. A number of reasons
have been advanced for this.

(i) Deflationary measures (tax increases) have led to
unemployment and industrial problems that have been met by
government spending on social welfare, unemployment benefit
and aid to industry.
(ii) Reflationary measures have tended to operate first and most
powerfully by expanding public sector services.
(iii) Demographic factors (changes in the population pattern) and
social changes have increased the demand for public sector
services. These changes include such elements as the growing
numbers of people over retirement age; the growth of higher
education and the tendency to remain longer in full-time
education; improvements in health technology raising
opportunities and costs in the health service;
Changes in transport and communications technology leading to
increased spending on roads and other transport and
communication services; and public pressure to provide a higher
standard of social welfare.
(iv) Political pressures to increase public spending. Although taxes
are unpopular, political reputations have been made more by
spending public money than by saving it.
(e) The Public Sector Has Become So Large That
Comparatively Small Adjustments Make A Major Impact On
The Economy
Keynes appeared to see the government as a balancing force to
counter the movements of the main business cycle.
Paradoxically, government spending has now become so
important that it is part of the business cycle itself. Any change
in tax or government spending sets off economic forces that
more difficult to control. The government’s own freedom to act is
severely constrained by the importance of its spending and the
long-term implications of changes.

The effect of public-spending projects can clearly be seen (e.g. rail
electrification, channel tunnel project, etc.)
(f) Uncertainties In Home Demand Can Led To Undue

Dependence On Imports And Foreign Investment
A number of basic industries have come to rely increasingly on
imported machines; while home-based multinational companies
have tended to increase foreign investment. The high propensity
to import in Britain has already been noted and it has been
shown how this substantially reduces the value of the effective
multiplier. This high propensity to import, combined with a high
level of overseas investment, reduces total employment
opportunities in Britain and ensures that changes in taxation and
government spending tend to operate more on the balance of
payments than on home inflation and unemployment.
6. The Principles Of Taxation
6.1 Introduction
The creation of a tax system requires an underlying set of principles to
guide the types of taxes levied and the methods used to collect them.
Adam Smith, in wealth of nations, described the four ‘canons’ or
principles of taxation. They were:
1 Equity
Taxes should be levied according to the ability to pay of the
taxpayer. This can be extended to the argument that people in
similar circumstances should pay similar amounts of tax.
2 Certainty
The taxpayer should know when the tax should be paid, how
much should be paid and which transactions give rise to a tax
liability. The tax should be unavoidable.

3 Convenience
The tax should be convenient to pay, not involving the taxpayer
in time consuming activities.
4 Economy
The tax should be cheap to collect, otherwise much of the
revenue collected will be wasted.
Although economic systems have changed considerably in the
200 years or so since wealth of nations was written, these basic
principles still apply today.
6.2 Modern Tax Systems

Adam smith’s principles can be developed and applied to modern tax
systems. The main differences between the tax system in his day and
those seen nowadays are the complexity of the different taxes levied,
the amount of taxes paid, and the use of the tax system to further
social and economic policies – as opposed simply to collecting
revenues with which to fund defense and law enforcement.
The fact that there are so many different taxes, and a complex body of
legislation involving their imposition, means that a lot of money and
effort is expended these days in arranging taxpayers’ affairs to
minimize their tax burden. This means that the principle of certainty is
often violated. There are regular calls for simplification of the tax
system so that resources are not wasted on the unproductive activity of
trying to find loopholes in the system.
Another reason for simplifying the tax system is that people often do
not pay the correct tax, simply because they cannot understand the
legislation. Again, resources are wasted in that accountants are
employed to explain an unnecessarily complicated system to their
clients. Not only are the clients spending money on the transaction, but
also good brains could be employed in ways that are more useful to
society.

The complexity of the legislation probably leads to the violation of the
principle of equity as well. Those taxpayers who are wealthy can afford
to employ accountants to minimize their tax liability, while those who
are not, pay the maximum.
The principle of economy still applies and various methods are used to
reduce collection costs. The most efficient method, as far as the
government is concerned, is to make taxpayers collect the tax
themselves. Pay as you earn (payee), the system of deducting tax from
employees’ pay before their salaries are paid, is operated by
employers. They deduct the tax and are responsible for paying it to the
revenue. Similarly, vat is collected by traders and paid to hm revenue
and customs. However, although these systems are very cheap for the
government, they are not cheap for society as a whole. Small
businesses often complain about the burden of accounting for payee
and vat, objecting to the unfairness of having to do the government’s
job for it.
Using taxation to fulfil social and economic policies creates problems

that were not addressed by Adam smith. For example, it is generally
accepted that there should be some redistribution of wealth from the
better-off to the less well-off. The extent to which this should be done is
a matter of social policy. Redistribution of wealth involves taxing higher
levels of income and wealth proportionately more than lower levels.
However, this introduces distortions into the markets: an example is the
possible discouragement of working harder. There is therefore a
conflict between a social principle that weaker members of society
should be helped, and an economic one, that markets should not be
distorted by government intervention.
Economic policies that are based on using fiscal policy to increase or

decrease demand, and that might involve raising or lowering taxes, will

also distort markets. Encouraging certain types of expenditure, such as
particular categories of investment, by giving tax incentives runs the
risk that investment decisions are made for tax reasons, rather than
because the investments are worthwhile in themselves.
Changes in fiscal policy may also cause uncertainty, violating one of

Adam smith’s principles. For example, in the run-up to a general
election, many transactions are either done prematurely, or are put off,
depending on the expected results of the election.
Key Point
Principles of taxation that may be added to those of Adam smith
include simplicity, equity in the sense of wealth redistribution, and
neutrality in that markets are not distorted. The principles may conflict
with each other, as the last two often do. In that case, the government
must prioritize on the basis of its social and political views.
Principles of taxation that may be added to those of Adam Smith

include simplicity, equity in the sense of wealth redistribution, and
neutrality in that markets are not distorted. The principles may conflict
with each other, as the last two often do. In that case, the government
must prioritize on the basis of its social and political views.
7. Direct and Indirect Taxation

7.1 Definitions
• An indirect tax is one that is levied on expenditure, such as vat.
• A direct tax is one that is levied on wealth or income, such as
income tax.
• An ad valorem indirect tax is levied as a percentage of
expenditure. For example, vat is charged at 17.5% of sales
value.

• A specific indirect tax is levied as a fixed amount per unit. For
example, duty is levied at a certain number of pence per gallon
of petrol.
• A regressive tax is one where the proportion of tax paid
decreases as income, wealth or expenditure increases.
• A progressive tax is one where the proportion of tax paid
increases as income, wealth or expenditure increases.
• A proportional tax is one where the proportion of tax paid is the
same, regardless of the level of income, wealth or expenditure.
7.2 Advantages And Disadvantages Of Direct And Indirect Taxes

Some of the relative advantages and disadvantages have already been
mentioned, but it is worth summarizing them.
Highly progressive, direct taxes have been argued to discourage hard
work and innovation, as the more the taxpayer earns, the more is taken
away in tax. However, note that there is no evidence that moderately
progressive tax systems do discourage effort. Also, if the government
wishes to redistribute wealth, the only effective way to do it is by
progressive, direct taxes, besides it is argued that it is fairer to collect
more from those who can afford to pay more.
The higher the direct tax rate, the more incentive there is for taxpayers
to pay advisors to rearrange their affairs to minimize the tax burden.
This is less likely to happen with indirect taxes, partly because they are
less ‘obvious’ (taxpayers are often more or less unaware that they are
paying them) but mainly because the only way to avoid paying them is
by not making the relevant purchase. Therefore consumers can, in a
sense, elect whether to pay them or not by abstaining from certain
purchases, but cannot avoid paying the tax on a taxable transaction
which they have decided to make. Vat, in particular, is difficult to avoid,
since most goods and services, other than basic essentials such as
staple foods and children’s clothing, are liable to vat at 17.5%

Indirect taxes tend to be cheaper to collect as the amount of tax due on
a purchase is clear and is collected by the vendor. Although most
income tax is collected at source by employers, as described above,
many people are self-employed and pay their tax by dealing directly
with the revenue (although the self-assessment scheme, by which the
self-employed effectively assess and ‘collect’ their own tax, has been
introduced).
Indirect taxes cause practical problems if the government tries to use

them as part of a social policy. For example, it may decide, as with vat,
to exempt certain vital goods from the tax. Once exceptions are made,
arguments arise as to the definitions of the exceptions and which
goods are eligible for them. Vat has produced a wealth of ludicrous
wrangling, such as whether lukewarm takeaway food can be classed
as ‘hot’ and how a chocolate biscuit should be defined.
There is sometimes a conflict between collecting revenue and social

aims of indirect taxation. The staple goods that are generally exempt
from expenditure taxes are those for which demand is most inelastic
(being necessities). From the point of view of collecting high revenue,
these would be good items to tax, as the higher price will not have a
significant dampening effect on the quantity demanded, hence the
introduction of vat on domestic fuel. On the other hand, luxuries, which,
from a social point of view, should be taxed, have elastic demand, so
imposing a tax on them will lower demand, reducing the tax take. Note
that certain items, such as tobacco and alcohol have inelastic demand
and are probably seen as legitimate targets for expenditure taxes, as
they are ‘social evils’.
Indirect taxes can be seen as inflationary. An increase in oil prices, for

example, due to an increase in indirect taxes, will push up input prices
and may cause cost-push inflation.

Key Point
Direct taxes may discourage effort if they are highly progressive, but
are the only effective way to redistribute wealth. They may result in
resources being wasted in trying to find methods of avoidance. Indirect
taxes are generally cheaper to collect although, once certain items are
exempted, costly definitional arguments arise. Items with inelastic
demand yield the most revenue, but are generally the items that should
be exempted from tax, as they are often necessities. Increasing
expenditure taxes may cause cost-push inflation.
Direct taxes may discourage effort if they are highly progressive, but
are the only effective way to redistribute wealth. They may result in
resources being wasted in trying to find methods of avoidance. Indirect
taxes are generally cheaper to collect although, once certain items are
exempted, costly definitional arguments arise. Items with inelastic
demand yield the most revenue, but are generally the items that should
be exempted from tax, as they are often necessities. Increasing
expenditure taxes may cause cost-push inflation.
8. The Incidence Of Indirect Taxation

8.1 Introduction
If an indirect tax is imposed on a good or service, producers do not
have to pass on the tax by raising their prices; they could decide to
accept a reduction in profits instead. The final eventual effect of a tax
being imposed will probably be somewhere between these two
extremes. Part of the tax will be recovered through a higher price, while
part of it will be suffered (‘borne’) by the supplier in a fall in profit. The
decision will depend to a great extent on the elasticity of demand for
the product. If demand is inelastic, the price can be raised without
significantly reducing sales volumes, so it is likely that a large
proportion of the tax will be passed on to the consumer. The reverse
will apply if demand is elastic. The proportion of a tax that is suffered

by the consumer and the supplier respectively can be analysed using
standard supply and demand analysis.
8.2 Supply And Demand Analysis

When a tax is imposed, it is equivalent to increasing the unit cost of
output. For example, suppose a specific tax of 15 pence is imposed on
every bottle of alcohol sold by a producer. The producer has to pay the
usual production costs and then an extra 15 pence per bottle is paid to
the government. Figure 14.5 shows the effect of the increased costs,
assuming that the tax is a specific one.
Rs
S2
Tax S1
Quantity
0
figure 14.5 imposing a specific tax
The tax causes the supply curve to rise from s1 to s2. This is because
the supply curve is the marginal cost curve and marginal cost has risen
by the amount of the tax, as described above. Note that the tax has no
effect on the demand curve; it does not change the amount which
consumers are willing and able to buy at any given price. It might (in
fact, it will) affect the quantity purchased, but this will be because of a
move along the demand curve, rather than a shift of the demand curve.
Using the diagram in figure 14.5, it is possible to analyse the incidence
of an indirect tax. A demand curve needs to be added, as in figure
14.6.
Rs S2
P2 Tax S1
P1 Text)
Business Economics (Study 465
D
Quantity
figure 14.6 demand and an indirect tax
Before the tax is imposed, the supply curve, s1, and the demand curve,
d, interact to set equilibrium price and quantity 0p1 and 0q1
respectively. When the tax is imposed, the supply curve shifts upwards
as before. The new price and quantity are 0p2 and 0q2 respectively.
The price has risen from 0p1 to 0p2, so consumers must pay (0p2 −
0p1) extra per unit. The consumers bear (0p2 − 0p1) of the tax.
The amount of the tax borne by the supplier can be found by using the
fact that the vertical distance between the two supply curves equals the
total tax (see figure 14.7).
Rs S2
P2 Tax S1
P1
P3
D
Quantity
0 Q2 Q1
Figure 14.7 supplier’s share of tax
Since the tax equals the distance between the two supply curves, it
must equal (0p2 − 0p3) in figure14.7 (shown by the unbroken line). The
supplier receives revenue of 0p2 per unit from the consumer and then
pays (0p2 − 0p3) to the government. The supplier was originally

receiving 0p1 per unit, so has lost (0p1 − 0p3) per unit. The supplier
bears (0p1 − 0p3) of the tax.
8.3 Total Tax Revenue
The diagram in figure 14.7 can be used to determine the total amount
of revenue received by the government when the tax is imposed.
€
S2
A S1
Tax
P2
P1 B
P3
C
D
Quantity
0 Q2 Q1
Figure 14.8 tax take
The total quantity sold is 0q2, the intersection between the demand
curve, d, and the new supply curve, s2. The tax per unit is given by the
distance ac. Therefore the total tax paid to the government is 0q2 × ac,
the shaded area [p3,p2,a,c]. Of this, consumers bear [p1,p2,a,b] of the
tax, while producers bear [p3,p1,b,c].
8.4 Elasticity Of Demand

The introduction mentioned that, if demand were inelastic, the
consumer would bear proportionately more of the tax than the
producer. This can also be demonstrated using the type of diagram
shown in figure 16.8.
£ £
S2 S2
P2 Tax P2 Tax
S1 S1
P1 P1
P3 P3
D D
Q Q
0 Q2 Q1 0 Q2 Q1
(a) Elastic demand (b) Inelastic demand

figure 14.9 elastic and inelastic demand
The two diagrams are identical except for the elasticity of demand. The
initial equilibrium (0p1 and 0q1) is the same in (a) and (b), as is the
amount of the tax and therefore the vertical shift in the supply curve.
The fact that demand is relatively inelastic in (b) means that the price
paid by the consumer after the tax is imposed (p2), is higher than when
demand is relatively elastic. The tax borne by the consumer is (0p2 −
0p1) per unit in both diagrams, but in (b) this represents a much higher
proportion of the tax. Similarly, the proportion borne by the supplier,
(0p1 − 0p3), is smaller when demand is inelastic.
This is reasonable on an intuitive level, as pointed out above. The

inelasticity of demand means that much of the tax can be passed on to
the consumer without sales quantities suffering unduly.
One would expect the total tax take to be higher with inelastic demand.
This prediction is borne out by the analysis.
£ £
S2 S2
A Tax P2 A Tax
P2 S1 S1
P1 P1
P3 P3
B B
D D
Q Q
0 Q2 Q1 0 Q2 Q1
figure 14.10 tax take with elastic and inelastic demand

As before, the total tax take is the shaded area [p3,p2,a,b] in both
diagrams, with the upper portion being borne by the consumers and
the lower portion by the suppliers. The area of the rectangle in figure
14.10 (b) is greater than the one in figure 14.10 (a), as the height of the
rectangles is the same, but the one in figure 14.10 (b) is wider. This
indicates that the tax take is higher when demand is inelastic. The price
rise resulting from the tax has a smaller effect on sales quantities when
demand is inelastic.
Key Point
The more inelastic the demand, the greater the proportion of the tax borne by
the consumer and the higher the tax take.
The more inelastic the demand, the greater the proportion of the tax borne by
the consumer and the higher the tax take.
8.5 Elasticity Of Supply

A similar analysis can be carried out to show the effect of imposing a
tax on a good with elastic and inelastic supply.
£ S2 £
S2
A Tax
P2 A Tax
S1 P2 S1
P1 P1
P3 P3
B
D B
D
0 Q2 Q1 Q 0 Q2 Q1 Q
(a) Elastic supply (b) Inelastic supply
Figure 14.11 elastic and inelastic supply

Using the same reasoning as before, in each diagram the consumer
bears (0p2 – 0p1) of the tax per unit, and in figure 14.11 (a) this
represents a higher proportion. Similarly, the proportion borne by the
supplier, (0p1 − 0p3), is smaller when supply is elastic.
This is not as easy to understand as the comparative proportions borne

with different demand elasticities, but it does make sense. If supply is
inelastic, it does not adjust responsively to price changes; an example
might be the supply of fresh fruit, which depends primarily on the
harvest rather than on the price. This means that, with inelastic supply,
suppliers are less able to respond to the reduction in the quantity
demanded which will result from passing on a tax in a price rise, by
cutting back on production. Conversely, with elastic supply, the
suppliers can reduce the supply easily to match the fall in demand,
preventing too great a fall in price.
As with inelastic demand, the diagrams show that the tax take
[p3,p2,a,b] is higher with inelastic supply, since quantities produced are
less affected by the price change.
The more inelastic the supply, the greater the proportion of the tax
which is borne by the supplier, and the higher the tax take.
Key Point
The more inelastic the supply, the greater the proportion of the tax is
borne by the supplier and the higher the tax take.
9. Subsidies
9.1 Introduction
A subsidy is the opposite of a tax, in that it is money paid by the
government to a supplier to encourage production of a good or service,
or perhaps to ensure that the market price is low enough to make the
good or service accessible to those on low incomes. It is therefore

useful to carry out an analysis similar to that of the incidence of a tax,
to see how much of a subsidy will actually be passed on to the
consumer and the extent to which it will increase production.
9.2 Effect Of A Subsidy

Using the same reasoning as before, whereas a tax makes the supply
curve shift upwards by the amount of the tax, a subsidy will make it
shift downwards by the amount of the subsidy. Again elastic and
inelastic demand curves can be compared.
£ £ S1
S1
A A
P3 S2 P3 S2
P1 P1
P2 P2 B
B
Subsidy
D D
0 Q1 Q2 Q 0 Q1 Q2 Q
Figure 14.12 a subsidy with elastic and inelastic demand

The initial supply curve is s1, with demand curve d. The initial
equilibrium price and quantity are 0p1and 0q1 respectively. When the
subsidy is given, the supply curve shifts downwards to s2, as costs are
lowered. The new point of intersection with the demand curve gives the
new price and quantity, 0p2 and 0q2 respectively. This means that the
consumer benefits from a price reduction of (0p1 − 0p2) per unit.
The supplier receives 0p2 from the consumer and this is topped up by
the government to 0p3 (established by the vertical distance between
the two supply curves). The supplier therefore benefits from an
increase in revenue of (0p3 − 0p1) per unit.

The total subsidy paid by the government is, as with the taxes, the
shaded area [p2,p3,a,b].
The diagrams show that the proportion of the subsidy passed on to the
consumer is lower, the more elastic the demand. This is because only
a small reduction in price will increase sales considerably, so the
supplier can keep most of the subsidy. The increase in quantity sold is
greater when demand is elastic, which means that the total subsidy
paid is higher.
Key Point
The more elastic the demand, the lower the benefit received by the
consumer and the higher the total subsidy paid.
The more elastic the demand, the lower the benefit received by the
S1
£
£ S1 A S2
A P3
P3 S2
P1
P1
P2 B
P2 B
Subsidy Subsidy
D
D
0 Q1 Q2 Q
0 Q1 Q2 Q
(a) Elastic supply (b) Inelastic supply
Figure 14.13 a subsidy with elastic and inelastic supply
The explanation of the diagrams is exactly the same as for figure

14.12. With elastic supply, more of the subsidy is passed on to the

consumer, since supply can easily adjust to the extra demand created
by the price fall. The subsidy paid by the government is also higher,
since the increase in quantity is greater than with inelastic supply.
Key Point
The more elastic the supply, the greater the benefit received by the
The more elastic the supply, the greater the benefit received by the
10. The Quantity Theory Of Money

10.1 Introduction
The monetarists believe that money is primarily held to fund
transactions of a daily or unforeseen nature, as shown by the
transactions and precautionary motives. They do not agree that people
might hold money for speculative purposes, waiting until interest rates
rise and the price of bonds falls before buying bonds.
If the monetarist view is correct, then demand for money is mainly

governed by factors such as the level of income, and an increase in the
money supply will not have a significant effect on interest rates. In fact,
if you inject more money into the economy, people will simply spend it,
probably encouraging price rises and inflation. The theory behind this
argument is the quantity theory of money.
10.2 The Quantity Theory Of Money

The quantity theory of money is expressed as follows:
Mv= pt
Where:
M = the money supply (money stock)

V = the velocity of circulation (frequency with which the money
stock is spent)
P = the average price of a transaction in a period
T = the number of transactions that takes place in a period
10.3 The Relationships Between The Variables

As it stands, the quantity theory of money is simply a fact: total
expenditure equals total receipts. It becomes a theory when the
relationships between the variables are examined.
The monetarists argue that the velocity of circulation, v, is fairly stable,
governed by payment patterns established in the economy. They also
say that t, the number of
Transactions that take place, essentially depends on the number of

and only changes very slowly over time. Finally, they believe that the
money supply is determined by the government and that the price level
is dependent on the values of the other three variables.
Looking at the equation mv = pt, you can see that if v is stable and t
grows in line with the growth rate of the underlying economy then, if the
government allows the money supply to grow faster than this
underlying growth rate, prices will rise and the economy will suffer from
inflation.
Key Point
Excessive growth in the money supply will cause inflation.
Note that the assumption that t depends on the productive capacity of
the economy essentially means that the economy is at, or near, full
employment. In other words, that the productive capacity of the
economy is indeed being fully utilized and that it would not be possible
to produce more goods without an expansion in that capacity. If the
economy were significantly under-employed, it would be possible to

increase production and hence the number of transactions (as people
buy the extra output) without changing the underlying productive
capacity of the economy.
11. Monetarism
11.1 Introduction
The basis of the monetarist prescription to government is the belief that
market forces are best at governing markets and therefore the whole
economy. Wherever possible, the government should allow market
forces to act freely. However, it should prevent inflation from distorting
price signals by constraining the money supply to grow in line with the
underlying rate of growth of the economy.
Unlike the Keynesian demand-pull inflation and the post-Keynesian

cost-push inflation, monetarist inflation is due to money supply growth.
Nevertheless, there is a connection between demand-pull inflation and
the monetarist view. If the money supply expands and all the extra
money is spent, then the growth in the money supply is translated into
additional demand. If the economy is at, or around full employment,
both the Keynesians and the monetarists agree that there will be
inflation. However, the Keynesians would argue that extra money going
into the system will not necessarily be spent. If interest rates are low
and expected to rise, the speculative demand for money means that
the extra money will be held in the form of cash, as part of people’s
savings. They will simply change the form of their savings from bonds
into money. The amount that they spend is determined by the level of
income, via the consumption function, not by the amount of cash in the
system.
Another point of disagreement is on the meaning of full employment.

We have seen that the Keynesian 45° diagram is unable to explain the
coexistence of inflation and unemployment. One might imagine that
this is also true of the monetarist theory, as the quantity theory of

money assumes that the economy is around the full employment level.
However, the monetarist definition of ‘full employment’ is a very precise
one, which actually allows for the existence of a certain type of
unemployment, called natural unemployment.
Definition
Natural Unemployment is the unemployment that exists due to
frictions in the labor market that prevent it from clearing.
11.2 Natural Unemployment

Natural unemployment arises from imperfections in the labor market.
Wage
S1
S2
X Y
We
D
0 Number
Nx Ny Employed
figure 14.14 natural unemployment
The demand for labor is labelled d. The supply of workers available to

take jobs at different wages is s1. S2 shows the supply of workers who
would be capable of taking jobs. At any given wage there are more
potential workers than shown by s1. This is because a number of them
are prevented from being available to take up employment by frictions
such as lack of information and immobility.
This means that there is one labor supply curve perceived by

employers, s1. The true curve, s2, lies further to the right than s1. The
wage is set where demand equals perceived supply, at point x. Here
the wage is 0we and the number employed is 0nx. However, at that
wage there are actually 0ny workers who could take jobs, as shown by

the true supply curve, s2. There is ‘natural unemployment’ equal to 0ny
− 0nx.
Natural unemployment is therefore caused by labor market distortions.

These include lack of information, inadequate training facilities, barriers
to geographical mobility (such as extensive owner occupation) and
barriers to occupational mobility (such as trade union closed shops).
The unemployment will be made worse if the wage is raised above the
equilibrium wage by, for example, wage councils. In the classical
analysis this resulted in workers pricing themselves out of jobs (revise
the chapter on types of unemployment).
In fact, natural unemployment includes all the different types of

unemployment mentioned before, except for cyclical/demand-deficient
unemployment. They are all caused by various frictions in the labor
market. Another characteristic that they share is that none of them can
be cured simply by expanding demand, which is the remedy for
demand deficient unemployment. The remedies for frictional, seasonal
and structural (i.e. classical) unemployment all involve removing the
frictions that cause them. In effect, the remedies are designed to close
the gap between the two supply curves in figure 14.15. They are known
as ‘supply-side’ policies, in contrast with the demand-side policies of
Keynesianism.
Supply-side policies are the economic policies advocated by

monetarists which are intended to free up the supply of goods and
services in all markets, eliminating frictions which distort market
signals. In the context of the labor market, they are designed to allow
the labor supply to move more freely between jobs, industries and
locations.
Definition

Supply-side policies are the economic policies advocated by
monetarists that are intended to free up the supply of goods and
services in all markets, eliminating frictions that distort market signals.
In the context of the labor market, they are designed to allow the labor
supply to move more freely between jobs, occupations, industries and
locations.
We can identify a number of supply-side policies for reducing the

natural rate of unemployment. Many supply-side policies were
mentioned in the chapter on unemployment. They include:
• setting up job centers to help disseminate information about
vacancies
• giving relocation allowances or persuading employers to give
them
• abolishing tax relief on mortgage interest payments to facilitate
moving around to find jobs
• providing funds for training and retraining workers to give them
suitable skills and prevent them from becoming unemployable
when technology and demand patterns change
• removing the power of bodies such as trade unions and wages
councils to set a minimum wage above the equilibrium level
• encouraging occupational mobility by removing restrictive
agreements imposed by unions and other employee
organisations
• lowering state benefits to make it less attractive to live off
unemployment benefit rather than working.
To the extent that demand-deficient unemployment might exist, it is

seen by monetarists as a temporary phenomenon that disappears as
markets move towards equilibrium. It is therefore not a matter for
concern.
Since natural unemployment is nothing to do with demand or the

money supply, there is no reason why it cannot exist in conjunction

with inflation. Excessive growth in the money supply can feed into
higher prices rather than higher production because the labor market is
such that, despite the existence of unemployment, producers are
unable to tap the unused labor force in order to expand output. The
economy appears to be working at full capacity, even though it is not.
Key Point
The monetarist definition of a fully employed economy is one in which
only natural unemployment exists. The level of natural unemployment
can be reduced by taking measures to remove labor market frictions.
The monetarist definition of a fully employed economy is one in which

only natural unemployment exists. The level of natural unemployment
can be reduced by taking measures to remove labor market frictions.
Finally, note that the natural level of unemployment is not a fixed figure
or percentage; it is whatever proportion of the labor force is out of work
because of labor market distortions.
12. Monetary Policy − The Keynesian And Monetarist Views

12.1 The Keynesian View
Unfortunately, monetary policy means different things to Keynesians

and monetarists. To Keynesians it means manipulating the money
supply with the intention of affecting interest rates. In other words, it
means interest rate policy. To monetarists, it means controlling the
money supply with the intention of controlling inflation.
Return to aggregate demand. Two components in it are private sector

consumption and investment expenditure. The government might wish
to act on these rather than on the other components.
Taking consumption expenditure first, the effect of interest rates on

consumer spending has already been discussed. The availability of
credit and the cost of mortgages are important. By raising interest
rates, the government can reduce consumption and vice versa.

Moving on to investment, the rate of interest is one factor in the
investment decision. The government, for example, might lower
interest rates in the hope that this would stimulate investment
expenditure. However, in the Keynesian model, ‘animal spirits’ are far
more important, and lowering interest rates may not have the intended
effect. This is what happened in 1992. Successive lowering of interest
rates had no effect on investment, as business morale was very low.
Not only that, there was no effect on consumer expenditure either,
because the uncertainty arising from the recession and the threat of
being made.
Redundant made people reluctant to spend.
Using interest rates to manage demand is therefore too indirect and

uncertain a method. Keynesians would advocate the more direct
method of fiscal policy.
There is another reason why Keynesians would be against trying to

use interest rates as part of a demand management policy. It is that
control over interest rates is also difficult to achieve. The control rests
on the interaction between the money supply and the liquidity
preference schedule.
Keynesians argue that it is doubtful whether the government can

actually control the money supply. Remember that a large component
of the money supply is bank deposits, which can be created by the
banks. Historically, when the government has tried to control credit
creation too stringently, the financial markets have found ways to get
round the controls.
Not only might the money supply be out of government control, but the
liquidity preference schedule also presents a very volatile relationship
between the demand for money and interest rates. The relationship
depends on the speculative demand for money, which itself depends
on speculators’ expectations. For example, demand for money will be
high if speculators feel that interest rates are low and expect them to
rise. There is nothing to say that these expectations are stable and, in

much the same way as entrepreneurs’ animal spirits can destabilize
the relationship between investment and interest rates, speculators’
expectations can destabilize the relationship between interest rates
and the demand for money.
All this means that, if a government, for example, buys treasury bills on
the open markets in the hope that the cash introduced into the system
will drive down interest rates and encourage private sector
consumption and investment expenditure then, somewhere along the
way, the hoped-for chain of events may well break down.
Keynesians would steer clear of monetary (interest rate) policy as a

tool of demand management, as the government’s control over
interest rates is too uncertain and the relationship between interest
rates and private sector expenditure is also uncertain.
12.2 The Monetarist View
The monetarists advocate measures to control the growth of the money

supply. Their views come from the quantity theory of money, which
suggests a link between money supply growth and inflation. The
government should ensure that it limits the growth of the money supply
to that of the underlying economy.
Controlling the money supply in practice is not easy; as stated above,

Keynesians are doubtful whether the government really can control it.
Various targets have been established in the past, aimed at various
definitions of the money supply. Some of those definitions were given
earlier in the book.
Current policy is to set a target for inflation and to set, in parallel,

monitoring ranges for m0 and m4. The argument for m0 is that it is m0
which gives the banks a base on which to create credit so that, if this is
controlled, credit creation will also be controlled. Equally, m4 must be
controlled as this is the broad monetary measure. Other ways of

controlling credit creation were covered in the chapter on the banking
system. They involve more overt interference than a truly monetarist
government would be willing to undertake.
Key Point
Keynesians would steer clear of monetary (interest rate) policy as a
tool of demand management, as the government’s control over interest
rates is too uncertain and the relationship between interest rates and
private sector expenditure is also uncertain.
Since 1980, government has abandoned direct monetary controls such

as the asset ratios. The bank of England has used both measures
designed to reduce the size of the public sector borrowing requirement
(psbr), and interest rate manipulation to try to restrain the growth of the
money supply.
Key Point
Monetarists would advocate the use of monetary policy to contain
inflation by controlling the growth of the money supply.
Monetarists would advocate the use of monetary policy to contain

inflation by controlling the growth of the money supply.
Summary
This section has dealt with the two main types of policy – fiscal and monetary.
As always, there is conflict between the two schools. The Keynesians advise
demand management through a fiscal policy of running a budget deficit;
whereas the monetarists advise a minimum of government intervention, but
using a monetary policy of controlling the money supply to control inflation.
Self-Test Questions
Government Fiscal Policy

1 what is the objective of fiscal policy? (1.3)
Public Sector Net Cash Requirement (Psncr)

2 how may the government finance a deficit? (2.2)
The Principles Of Taxation
3 what are Adam smith’s four canons of taxation? (5.1)
Direct And Indirect Taxation
4 distinguish between a direct and an indirect tax. (6.1)
The Incidence Of Indirect Taxation
5 draw a diagram showing the amount of an indirect tax borne by
the supplier and the amount passed on to the consumer. (7.2)
The Quantity Theory Of Money
6 explain the quantity theory of money. (10.2)
Monetarism
7 how do monetarists define the natural rate of unemployment?
(11.1)
Practice Questions
Question 1
According to advocates of supply-side economics, which of the
following measures is most likely to reduce unemployment in an
economy?
A increasing labor retraining schemes
B increasing public sector investment
C increasing unemployment benefit
D decreasing the money supply
Question 2
Policy of fiscal expansion is most likely to reduce unemployment when:
A there is a high marginal propensity to consume
B there is a high marginal propensity to save
C unemployment is mainly of a structural kind
D there is a fixed exchange rate
Question 3

Which one of the following can be used by governments to finance a
public sector borrowing requirement (psbr)?
A a rise in direct taxation
B the sale of public assets
C an increase in interest rates
D an issue of government savings certificates
Question 4
The public sector borrowing requirement is best defined as:
A the total borrowing by the general public over the period of a
year
B the amount of borrowing needed to finance the difference
between a country’s exports and imports
C the amount of taxation and borrowing needed to finance public
expenditure
D the difference between government expenditure and its revenue
from taxation
Question 5
If a government wished to reduce the rate of inflation, which of the
following policies would be appropriate?
(i) a rise in the level of taxation
(ii) a reduction in the level of public expenditure
(iii) restrictions on the level of imports
(iv) reductions in the growth of the money supply
A (i), (ii) and (iii) only
B (ii), (iii) and (iv) only
C (ii) and (iv) only
D (i), (ii) and (iv) only
Question 6
A progressive tax is one where the tax payment:
A rises as income increases

B falls as income increases
C is a constant proportion of income
D rises at a faster rate than income increases
For the answers to these questions, see the ‘answers’ section at the end of
the book.
13 The Demand For Money − Keynesian View

13.1 Liquidity Preference Theory
Liquidity preference theory is the Keynesian view of the reasons why
people want to hold liquid funds.
Definition
Liquid funds are cash, or funds that can easily and quickly be
converted into cash, without significant capital loss, such as current
accounts with banks or building societies. The more liquid an asset is,
the more like cash it is.
The theory is stated in terms of a simple choice between cash and non-
cash assets; cash is seen as earning no interest for its owner, whereas
the illiquid, non-cash assets do pay interest. In the real world,
particularly in the modern financial markets, the choice is not so clear-
cut; an individual has a spectrum of assets available, varying in liquidity
and returns. Nevertheless, as liquidity increases (in other words, as the
financial asset becomes more like cash), the interest paid on the asset
decreases, which is similar to the situation envisaged in the theory.
Returning to the liquidity preference theory, as mentioned above,
Keynes simplified the choices open to an investor: spare funds could
either be held in the form of non-interest bearing cash or in the form of
an illiquid asset, in fact a bond, which did yield interest. He then
analysed why people might prefer liquid, but unprofitable assets (cash)
to illiquid, profitable ones (bonds). This is where the term ‘liquidity

preference’ comes from. Keynes argued that there were three main
reasons why people might prefer cash to bonds:
• the ‘transactions’ motive
• the ‘precautionary’ motive
• the ‘speculative’ motive
The Transactions Motive
One reason for holding cash is for convenience in carrying out daily
transactions. It is not really practicable to sell some bonds (or, in
modern terms, withdraw funds from, say, a medium-term deposit
account) every time a small purchase is made.
The amount of cash held by individuals to meet the transactions motive
depends on the level of their income, how frequently they are paid and
the average value of the purchases they make.
The Precautionary Motive

Once some funds have been set aside for day-to-day transactions
then, if there is any money left, some will be earmarked for unforeseen,
less frequent expenditure, such as unexpected repairs to the car or the
house. Here again, it is more convenient to keep such funds in the form
of cash. The amount of cash held for precautionary reasons will partly
depend on the nature of the individual but will also depend to a great
extent on the individual’s income, as this will affect whether there are
spare funds available after the transactions motive has been met.
Another, but less important, factor will be the level of interest rates. If
interest rates are low, the opportunity cost of holding cash as opposed
to bonds will be low, so people will be more disposed to holding high
precautionary balances. On the other hand, if interest rates are high,
precautionary balances will lose their owner a lot of money, so people
will try to minimize them.
The Speculative Motive

The final reason for holding cash rather than bonds is strongly
connected to the level of interest rates and their relationship with bond
prices. Keynes suggested that investors would hold any surplus wealth
over and above their transactions and precautionary needs in the form
of money, if this was likely to be more profitable than the alternative
options of investment in bonds or shares. As we see below, this
decision depends largely upon the level of interest rates and the
expectations investors hold about the future path of interest rates.
Definition
Speculators are people who deal on the financial markets in order to
make profits.
13.2 Bonds
A bond is a certificate issued by a company or government in order to
borrow money. Usually a bond will be issued with a specified rate of
interest payable to the bondholder. Bonds come in many different
forms, but here we will be interested primarily in irredeemable bonds.
An irredeemable bond is one where the loan is never repaid. Bonds
may be redeemable, in which case the company will repay the initial
loan at some specified future date; or irredeemable, in which case the
loan remains in place throughout the life of the company. The following
discussion applies to both types of bond, but concentrates on
irredeemable bonds, for the sake of simplicity.
Definition
A bond is issued by a company (or the government) as a means of
borrowing. It is like an iou: the purchaser lends the company money, in
exchange for which the company agrees to pay interest.
a bond has a nominal value and a market value. There is no
connection between the nominal and the market values.
The interest payable on a bond is the ‘coupon’ rate, or simply ‘coupon’.

13.3 The Relationship Between Bond Prices And The General Rate Of
Interest
Bond prices are inversely related to the general rate of interest in the
economy. If interest rates rise, bond prices will fall, and vice versa. (in
fact this relationship also applies to other assets, such as shares.)
Do the following activity to see why.
13.4 Speculation
Suppose interest rates are high. The higher they go, it is likely that
more speculators will expect them to start falling soon. This is because
interest rates tend to follow a cyclical pattern. Recall that interest rates
and bond prices are inversely related. This means that when interest
rates are high and expected to fall, bond prices are low and expected
to rise. Bonds will therefore be a good investment, as they can be
bought now at a low price and sold later at a high price; demand for
cash is therefore low.
Key Point
The price of bonds is inversely related to changes in the general level
of interest rates.
The reverse will apply when interest rates are low and expected to rise.
Bond prices will be high and expected to fall, so they will not be a good
investment. Speculators will not want to buy them at a high price,
risking a loss when prices fall; demand for cash is therefore high.
When interest rates are high (and bond prices are low), speculators will
probably have a high demand for bonds and therefore a low demand
for cash. When interest rates are low (and bond prices are high),
speculators will probably have a low demand for bonds and therefore a
high demand for cash.
Key Point
When interest rates are high (and bond prices are low), speculators will
probably have a high demand for bonds and therefore a low demand
for cash. When interest rates are low (and bond prices are high),

speculators will probably have a low demand for bonds and therefore a
high demand for cash.
Note that the relationship between the speculative demand for money
and the rate of interest depends on speculators’ expectations, which
are likely to be fairly volatile, changing rapidly from one day to the next.
This point will be mentioned again later in the book.
13.5 The Total Demand For Money
The demand for money is often seen as governed by its price, the
interest rate. The three motives for holding money outlined above can
be brought together to determine the relationship between liquidity
preference and interest rates.
We saw that the transactions motive for holding money is unconnected
with the level of interest rates. The precautionary motive mainly
depends on income levels, but may be slightly influenced by interest
rates: when they are high, less cash and more bonds will be held. The
speculative motive is highly associated with the interest rate, via its
relationship with bond prices. When the interest rate is high, and is
expected to fall, demand for bonds will tend to rise and the demand for
cash balances will fall to a lower level and vice versa.
13.6 Graphing The Three Motives

The interest rate can be plotted against the vertical axis and the
amount of money held against the horizontal axis. The graphs show
how the quantity of money demanded for each motive is affected by
changes in interest rates.
r r r
D D D
0 0 0
M M M
(a) Transactions motive (b) Precautionary motive (c) Speculative motive

figure 18.1 demands for money

In figure 18.1, ‘r’ represents the interest rate and ‘m’ represents the
amount of money held by the population. Figure 18.1 (a) shows the
amount of money held to satisfy the transactions motive; it is entirely
unrelated to the level of interest rates in the economy, so remains the
same whatever the rate of interest.
figure 18.1 (b) shows the amount of money held to satisfy the
precautionary motive; if interest rates rise a lot, people will reduce their
precautionary balances, as the opportunity cost of the lost interest will
be high. However, precautionary balances are more affected by the
level of income than by the interest rate, so any reduction in demand
requires a very big rise in interest rates.
Figure 18.1 (c) shows the amount of money held to satisfy the
speculative motive. This is highly interest elastic (highly sensitive to
changes in the interest rate), as interest rate changes affect bond
prices. When interest rates are high, and expected to fall, demand for
bonds will be high and the demand for money will be low. If interest
rates fall to low levels, investors will expect them eventually to rise,
following the expected cyclical pattern. In these circumstances, the
demand for bonds will begin to fall, and the demand to hold money
balances will begin to rise.
13.7 The Liquidity Preference Curve
We can now illustrate the total demand for money, incorporating all
these motives; this is called the ‘liquidity preference curve’.
r
Liquidity
preference
curve
c MD
b
a
0 M
figure 18.2 (not to scale) the liquidity preference curve

The lines a, b and c represent the three motives for holding cash, as in
figure 18.1. The total cash held at each level of interest will be the sum
of the amounts held to satisfy each motive. This is shown graphically
by adding the three lines horizontally. Since the shapes of the curves
representing the transactions and the precautionary motives are only
slightly affected by the interest rate, the shape of the liquidity
preference curve is influenced most by curve ‘c’, the speculative
motive.
14 The Supply Of Money

14.1 Introduction
The definition of money given earlier stated that money is anything
which is generally acceptable as a medium of exchange. Far more
precision is needed when the government uses the money supply as a
target within its economic policy.
Before continuing, it is worth clarifying what exactly is meant by the
money supply. When talking about supply of a good, one implicitly
refers to the flow of the good arising within a given period.
Key Point
The money supply means the stock of money in the economy.
14.2 Defining The Money Supply − Narrow Money And Broad Money
The definitions of the money supply are quite detailed and complex.
They range from a very narrow definition to one that encompasses
many types of financial security that could act as money. The examiner
has stated that candidates will not be required to reproduce the details
of different monetary aggregates.
However, they may be required to display:
• an understanding of the difference between narrow and broad
money

• an ability to discuss monetary aggregates sensibly when the
details of these are given (e.g. as in a data response question).
We give the four aggregates currently in use below, but the most
important point to grasp is the difference between narrow money and
broad money and so these are defined first.
Definition
Narrow money has a high degree of liquidity so is available to finance
current spending.
Narrow money is money that has a high degree of liquidity; it is money
that is available to finance current spending, i.e. balances held for
transactions purposes. Since 1992 it is principally measured by m0 and
m2 (see below).
Definition
Broad money is narrow money plus balances held as savings that can
easily be converted into cash for transaction purposes.
Broad money is narrow money plus balances held as savings but

which could easily be converted into cash for transactions purposes. It
is usually measured by m4 (see below). In fact the government
publishes two versions of m4 and therefore has two definitions of broad
money. One definition includes only ‘retail’ deposits, i.e. small deposits
typically from individuals. The broader definition of m4 includes
‘wholesale’ deposits, typically from companies and other institutions.
14.3 Measures Of The Money Supply
There is some debate as to which items to include in the money

supply. The Pak monetary aggregates include
(i) narrow measures, which concentrate on money which is used

mainly as a medium of exchange and bears no interest rate.

(1) m0, which consists of notes, coins and commercial banks’
balances at the SBP;
(2) m1, which includes m0items + sight (current) bank

accounts;
(3) m2, which consists of notes, coins, sight bank accounts,

retail deposit accounts, building society accounts and
national savings bank accounts.
(ii) broad measures concentrate on money kept as a store of value

and on which interest is paid.
(1) m2, which consists of m1items + time (deposit) accounts

and certificates of deposit;
(2) m3, which includes m2measures + foreign currency bank

deposits;
(3) m4, which is essentially m3+ building society shares and

deposits and certificates of deposit;
(4) m5, which includes m4items + private sector holdings of

money market instruments (e.g. treasury bills), certificates
of tax deposits and national savings instruments.
(a) Changes In The Money Supply

the Pak money supply may increase as a result of
(i) credit creation by the banking sector;
(ii) note issue by the SBP;
(iii) a net inflow of rupee from abroad;
(iv) an increase in the public-sector borrowing requirement
(psbr)
(b) The Importance Of The Money Supply

Monetarists believe that changes in the money supply have a
direct and significant impact on the economy. Keynesians
believe that the effects are more complex and difficult to predict.
 the transmission mechanism shows the stages and ways

in which a change in the money supply affects national

income, prices and/or employment. There is still much
controversy between Keynesians and monetarists over
the exact working of the transmission mechanism.
(i) Keynesian Transmission Mechanism

increase in money supply  increase in people’s
money balances  increase in demand for bonds 
increase in the price of bonds  fall in the rate of
interest  increase in investment  multiplier effect
 increase in n.y. increase in output  increase in
employment.
(ii) Monetarist Transmission Mechanism

increase in money supply  increase in people’s
money balances  people using ‘surplus’ money to
demand more goods and services  increase in
prices.
15. Interest Rates And Liquidity Preference

15.1 The Relationship Between The Money Supply And Interest
Rates
Assume that the government can decide on the size of the money
stock in the economy. As in other markets, the interest rate will be set
where the demand for money equals the supply of money.
Figure 18.3 shows how the government might increase or decrease the
money supply to affect the level of interest rates.
r
MS1 MS2
r1
r2 MD
figure 18.3 controlling the interest rate

In figure 18.3 the liquidity preference curve, total demand for money, is
the curve md. The money supply is initially ms1. This is shown by a
straight line, which indicates that changes in the interest rate do not
affect the stock of money in the economy. The interest rate is r1, set by
the intersection of md and ms1. The government wants to lower
interest rates. It does this by increasing the money supply to ms2,
pushing down the interest rate to r2. Similarly, if it wanted to raise
interest rates it could decrease the money supply.
It is not enough to show the process diagrammatically; it is important to

understand the mechanism behind it.
Consider a rise in interest rates, induced by a decrease in the money

supply. The way in which the government decreases the money supply
is to sell government securities, such as government bonds, to the
public. The public pays the government money, in exchange for which
they receive a bond. This has the effect of reducing the amount of
money in the economy, i.e. decreasing the money supply. However, in
order to persuade the public to change their holdings of money into
bonds, the government must offer the bonds at a low price; and this
means that interest rates will rise. The result is that a decrease in the
money supply is accompanied by a rise in interest rates.
The reverse would apply if the government increased the money

supply by paying money to the public in exchange for their bonds. The
price paid for the bonds would have to be sufficiently high to persuade
the public to give them up, causing interest rates to fall.
The purchase and sale of government securities on the open markets

in order to change the money supply and interest rates, is called open
market operations (OMO), as was seen in the previous chapter.

Key Point
In the Keynesian model, an increase in the money supply is associated
with a fall in interest rates, and vice versa.
In the Keynesian model, an increase in the money supply is associated
with a fall in interest rates, and vice versa.
16. The Classical View Of Interest Rates
16.1 Introduction
As explained earlier in the chapter, the classical approach to interest
rate determination is to analyse them in terms of the supply and
demand of loanable funds.
16.2 The Loanable Funds Theory
Supply
The term ‘loanable’ refers to funds available for borrowing. The supply
of loanable funds is generated by people’s savings.
The classical theorists argue that savings are interest-elastic, i.e. that
the volume of savings depends to a large extent on interest rates. As
interest rates rise, the reward for saving increases, so people will save
more. This means that a diagram of the volume of savings against
interest rates will be upward sloping.
Definition
Loanable funds are funds available for borrowing.
Interest rate
r2 S
r1
0 Savings
S1 S2
Figure 18.4 supply of loanable funds

In figure 18.4, savings are interest elastic. The supply of loanable funds
(s) rises as the interest rate rises, so that at interest rate 0r1, the

volume of savings is 0s1, while at interest rate 0r2, the volume of
savings is 0s2.
Demand
The demand for loanable funds mainly comes from firms wishing to
invest, although some comes from households for property purchases
and so on. The classicals argue that interest rates are the most
important determinant of investment. As interest rates fall, demand for
investment funds rises, and vice versa. This can be depicted
graphically as a downward-sloping demand curve.
Interest rate
r1
r2
D
0 Investment
I1 I2
Figure 18.5 demand for loanable funds

In figure 18.5, investment is interest-elastic. The demand for loanable
funds (d) falls as the interest rate rises, so that at interest rate 0r1, the
volume of investment is 0i1, while at interest rate 0r2, the volume of
investment is 0i2.
Equilibrium
Bringing together supply and demand, the ‘price’ of loanable funds, the
interest rate, is set:
Interest rate
S
r
e
D
0 Loanable
LFe funds
figure 18.6 the equilibrium rate of interest

Figure 18.6 shows the equilibrium rate of interest, 0re, and the
equilibrium quantity of funds borrowed and lent in the economy, 0lfe.
Changes in supply of, and demand for, loanable funds induce changes
in the equilibrium interest rate, as with any other good and its price.
The theory of loanable funds predicts that the interest rate is set by the
interaction of supply of, and demand for, loanable funds. The levels of
savings and investment are strongly dependent on interest rates.
Key Point
The theory of loanable funds predicts that the interest rate is set by the
interaction of supply of, and demand for, loanable funds. The levels of
savings and investment are strongly dependent on interest rates.
Contrast the theory of loanable funds with the Keynesian view, which is
far more complicated. In the Keynesian model, interest rates are set by
the interaction of the stock of money in the economy and people’s
liquidity preference, that is, whether they prefer to hold their savings in
the form of money or bonds. The level of savings depends far more on
income levels.
17. The Pattern Of Interest Rates

17.1 introduction
The pattern of interest rates refers to the variety of interest rates on
different financial assets. It is thus different from the general level of
interest rates. How can the pattern of interest rates be explained? The
answer lies in several factors:
• the duration of the loan
• risk
• the need to make a profit on re-lending
• the size of the loan or deposit
• different types of financial asset
• international factors

The Duration Of The Loan
Though they usually move up and down together, short-term
interest rates (i.e. those for loans up to three months) are
normally lower than longer-term rates of interest. The simple
reason for this is that the longer the period of a loan the more
the risk for the lender. Lenders will want a higher rate of return
to compensate them for this enhanced degree of risk on a
longer-term loan. However, it is possible for short-term interest
rates to be temporarily higher than longer-term rates, e.g. as the
result of a foreign exchange crisis. It is also possible for even
overnight money to become extremely expensive when
expressed as an annual rate: this phenomenon can occur as a
consequence of the need for banks and other institutions in the
money markets to balance their books at the end of each day.
Risk
There is a trade-off between risk and return. Higher risk
borrowers will have to pay higher yields on their borrowing, to
compensate lenders for the greater risk involved.
For this reason, a bank will charge a higher rate of interest on
loans to borrowers from a high-risk category than to a low-risk
category borrower. Banks will assess the creditworthiness of the
borrower, and set a rate of interest on its loan at a certain mark-
up above its base rate or its KIBOR (Karachi inter-bank offering
rate). In general, larger companies are charged at a lower rate
of interest than smaller companies.
The Need To Make A Profit On Re-Lending

Financial intermediaries make their profits from re-lending at a
higher rate of interest than the cost of their borrowing.
Intermediaries must pay various costs out of the differences,
including bad debts and administration charges. What is left will
be profit; for example:

• The interest rate charged on bank loans exceeds the rate paid
on deposits.
• The mortgage rate charged by building societies exceeds the
interest rate paid on deposits.
The Size Of The Loan Or Deposit

The yield on assets might vary with the size of the loan or
deposit.
Time deposits above a certain amount will probably attract
higher rates of interest than smaller-sized time deposits. The
intermediary might be prepared to pay extra for the benefit of
holding the liability as a single deposit (greater convenience of
administration).
The administrative convenience of handling wholesale loans
rather than a large number of small retail loans partially explains
the lower rates of interest charged by banks on larger loans. (the
greater security in lending to a low-risk borrower could also be a
factor)
17.2 Different Types Of Financial Asset
Different types of financial asset attract different rates of interest. This
is partly because different types of asset attract different sorts of
lender/investor. For example, bank deposits attract individuals and
companies, whereas long-dated government securities are particularly
attractive to various institutional investors.
International Factors
International interest rates will differ from country to country because of
the different risks involved. The main risk is that the exchange rate may
move against the investor, reducing the capital value of the investment.
17.3 Benchmark Interest Rates
Benchmark interest rates are rates that are indicative of the rates that
are available in different countries and for different maturities.

They provide the investor with a quick reference guide to the typical
rates that are available without having to examine the rates on all the
different available financial instruments (which run into thousands).
Having chosen a country and maturity that suits their purpose;
investors can then focus on those investments and choose a particular
one for their investment.
17.4 The Term Structure Of Interest Rates − Yield Curves
Normal Yield Curve

a graph can be drawn of the yield for each gilt against the number of
years to maturity; the best curve through this set of points is called the
yield curve.
Gross
redemption 8
yield (%)
7
0
5 10 15 20 25
Years to maturity
Figure 18.7 a typical yield curve

The redemption yield on shorts is less than the redemption yield of
mediums and longs, and there is a ‘wiggle’ on the curve between 5 and
10 years. When the yield curve is ‘normal’ interest rates are higher for
larger maturities.
Explanations For The Shape Of The Yield Curve
The shape of the yield curve at any particular point in time is generally
believed to be a combination of three theories acting together:
• expectations theory

• liquidity preference theory
• market segmentation theory
Expectations Theory
This theory states that the shape of the yield curve varies according to
investors’ expectations of future interest rates. A curve that rises
steeply from left to right indicates that rates of interest are expected to
rise in future. There is more demand for short-term securities than
long-term securities since the investors’ expectation is that they will be
able to secure higher interest rates in the future so there is no point in
buying long-term assets now. The price of short-term assets will be bid
up, the price of long-term assets will fall, so the yields on short-term
and long-term assets will respectively fall and rise.
A falling yield curve (also called an inverted or inverse curve, since

it represents the opposite of the usual situation) implies that interest
rates are expected to fall. For much of the period of sterling’s
membership of the erm, high short-term rates were maintained to
support sterling and the yield curve was often inverted since the market
believed that the long-term trend in interest rates should be lower than
the high short-term rates.
the yields shown in section 7.1 also exhibit this pattern. These followed
a period of several increases in the bank base rate in a very short
period long term expectations were that it would start to fall again by
the end of the year.
A flat yield curve indicates that interest rates are not expected to
change materially in the future.
Liquidity Preference Theory

Investors have a natural preference for holding cash rather than
other investments, even low-risk ones such as government securities.
They therefore need to be compensated with a higher yield for being
deprived of their cash for a longer period of time. The normal shape of
the curve as being upward-sloping can be explained by liquidity
preference theory.
Market Segmentation Theory

This theory states that there are different categories of investor who
are interested in different segments of the curve. Typically, banks and
building societies invest at the short end of the market while pension
funds and insurance companies buy and sell long-term gilts. The two
ends of the curve therefore have ‘lives of their own’, since they might
react differently to the same set of new economic statistics.
market segmentation theory explains the ‘wiggle’ seen in the middle of

the curve where the short end of the curve meets the long end − it is a
natural disturbance where two different curves are joining and the
influence of both the short-term factors and the long-term factors is
weakest.
17.5 Significance Of Yield Curves To Financial Managers
Financial managers should inspect the current shape of the yield curve
when deciding on the term of borrowings or deposits, since the curve
encapsulates the market’s expectations of future movements in interest
rates.
For example, a yield curve sloping steeply upwards suggests that
interest rates will rise in the future. The manager may therefore wish to
avoid borrowing long-term on variable rates, since the interest charge
may increase considerably over the term of the loan. Short-term
variable rate borrowing or long-term fixed rate borrowing may be more
appropriate instead.

17.6 Yield on Financial instruments and Global Financial Crises
Present global financial crisis are deeply connected with the Political
crisis and Economic crisis over the world. The yield on the financial
instrument varies from rich countries which are politically and
economically strong as compared to developing countries which are
facing Political crisis even social and cultural crisis along with the
economic crisis. Developing countries faced with the severe problem of
inflation and unemployment. The capital market and money market are
always under the pressure of speculation because of political and
economic crisis, these are facing financial crisis as compared to
advance countries where the money markets and capital markets are
strong enough. Therefore, financial crisis on the financial instruments
are ignorable although there is sometimes greater fluctuation in the
capital markets because of international crisis.
Financial instruments commonly worldwide are bond, debentures,

shares and gifts the financial instruments or either interest based or
equity based. Bonds which are of many varieties the yield on the bonds
which is fixed is called Coupon the bonds may be zero Coupon or may
be revolving Coupon the Coupon on bond is generally fixed but the
Coupon may be changed with the time while other debt instruments are
rewarded with interest. Government long dated securities (Gifts) are
interest based while shares are equity based. Bonds price and interest
rates are inversely related. The interest rate fluctuates with the maturity
time generally short term interest rates are low and long term interest
rates are high because in the long run there are more risks, for
example inflation rates are generally expected high in the long run
there are more risks of bad debts and political instability etc.
If there are more risks in short term and interest rates is high then the
short run interest rate can be high in the short run in then the long run.

The return on the share is the dividend paid to the shareholders, these
may be medium term or long dated issued by the government while
debentures are issued by the public limited company which increases
liability of the company.
Globalization
The term ‘globalization’ does not have a universally agreed definition.
The International Monetary Fund defines globalization as ‘the growing
economic interdependence of countries worldwide through increasing
volume and variety of cross-border transactions in goods and services,
free international capital flows, and more rapid and widespread
diffusion of technology’.
It is useful here to make a distinction between globalization and

internationalization.
Internationalization
Internationalization refers to the increasing spread of economic
activities across geographical boundaries, for example:
• many firms are taking advantage of the internet to sell to new
countries overseas.
• setting up production facilities overseas.
Globalization
Globalization, however, refers to a more complex form of
internationalization where much greater integration is seen, for
example:
• the erosion of trade barriers is creating a single global market,
rather than many different international markets.
• the homogenizing of tastes across geographies. Food, once
highly local in style, has become more global in many respects.

• firms selling the same product in every world market rather than
tailoring products to local preferences.
• greater harmonization of laws in different countries.
• the dilution of traditional cultures in some third world countries
as they are replaced by Western value systems.
The factors driving globalization
When considering the driving forces of globalization it can be difficult to

distinguish between cause and effect. For example, does the existence
of global firms drive globalization or are they the consequence of it?
Both viewpoints have validity. However, the main drivers of
globalization are as follows.
Improved communications
• The advent of the internet over the past ten years has paralleled
the emergence of globalization as a concept.
• Many within developing countries see the internet as an
opportunity to gain access to knowledge and services from
around the world in a way that would have been unimaginable
previously.
• The internet and technologies such as mobile telephony allow
developing countries to leapfrog steps in their development of
infrastructure. A poor land line telephone system in the
Philippines, for example, is being rapidly bypassed by mobile
phones with internet access.
• The wider access to Hollywood and Bollywood movies has also
given rise to greater multiculturalism.
Growth of global industries and institutions

• The growth of global firms has been a key driver of globalization.

• Some would argue that the rapid growth of corporations such as
McDonalds and Coca Cola has resulted in pressure on local
cultures to accept Western tastes and values.
• Global firms can influence governments to open up markets for
free trade.
• Global firms can encourage political links between countries. For
example, the entry of Japanese car manufacturers into the
United Kingdom fostered a stronger political dialogue between
the Japanese and British governments.
The impacts of globalization
 Industrial relocation
 Emergence of growth markets
 Enhanced competition
 Cross-national business alliances and mergers
 Widening economic divisions between countries
Globally is not possible to determine the uniform interest rates over the
countries because of changing economic conditions the risk over the
world are fluctuating because of low risk and high risk investment are
level of lead debts varies over the world the inflation rate which is
dominating factor for determining the yield on financial instruments
varies from country to country even when the bonds are floated
internationally the return on bond may be fluctuating. The yield on long
dated bonds and medium term bonds differs similarly the interest rates
differ. Speculations are playing pivotal role in stock markets, bond
markets and financial instruments. Main financial crises globally
prevailing are because of the intense roll of speculations. The
speculators globally influencing the yield on financial instruments.
18 Government Macroeconomic Policy

18.1 The Macroeconomic Objectives

In the post-war period, governments have adopted four central
objectives of macroeconomic policy:
• low inflation
• full employment
• rising economic growth
• balanced balance of payments
Obviously these have been pursued with varying degrees of
enthusiasm and success depending upon political objectives and
unforeseen internal and external events. Also at times a trade-off
appears to have existed between objectives – for example, falling
inflation has often been at the expense of higher unemployment.
18.2 Macroeconomic Policy Formulation

Government should adopt a particular methodology for matching
policies to problems.
(a) The Problem-Solving Process:
• identify problem
• obtain, review and analyse data
• consider alternative solutions
• consult affected parties
• decide upon policy
• legislate
• implement
• review data and forecasts
• review policy
(b) The Problems Of Formulating Policy And Carrying Out The
Above Process:
• reliability of data and forecasts
• slow consultation process
• lack of co-operation
• political and economic constraints
• external factors
• social, institutional and legal constraints
• time lags
In order to make the process work, government must identify the main
objectives (e.g. inflation and growth) and ensure that they are
compatible with each other and any longer term plans. The targets
must then be linked with the ‘instrumental variables’ as indicated
below.
Government is able to alter the instrumental variables as these

represent measures at its disposal (although note that now that the
government has given responsibility for setting interest rates to the
bank of England, its range of controls is somewhat curtailed).
Instrumental variables in turn will affect intermediate variables such as
those shown above which will have an influence over the policy
objectives. Clearly, the link between the government ‘levers’ and the
final objectives can be somewhat tenuous, particularly when problems
of the policy formulation process are also considered.
19 Unemployment
19.1 Introduction − Unemployment And The Business Cycle
There is a tendency for national income to experience cycles of growth

and contractions, i.e. boom and depression. These cause severe social
problems as a declining level of economic activity throws people out of
work and causes business firms to fail (as in the early 1990s). A period
of severe depression struck almost all industrialized nations in the
period between the two world wars. In Britain the worst years were
from about 1928 to 1934. In some areas unemployment levels were
between 20% and 30% for long periods, and many skilled workers
were out of work for several years.

19.2 The Classical View
Early economists thought that the equilibrium level of national income

would stabilize around the full employment level, that is the level where
all factors available for, and desiring, employment would be employed
in productive activity. The existence of unemployment was seen as
evidence of structural failure in the working of the economy. If the
structural weakness could be removed, the normal economic forces
would be restored and all would be well. They argued that, as the level
of activity fell, prices would fall. Because the prices of production
factors (including wages) were ‘derived’ from the demand and supply of
finished products, these factor prices would also fall until they reached
a level where it would be worthwhile for entrepreneurs to employ them.
Thus, the classical economists argued that the labor market would
reach a state of equilibrium via adjustments in the level of wages.
However, according to their analysis, unemployment could still exist
due to the unwillingness of some workers to offer their services at the
going level of wages. This could be because they are not prepared to
accept the wage, or due to frictional factors such as the mismatch of
the unemployed and the vacancies available as a result of location and
skills required.
This type of unemployment was referred to as equilibrium

unemployment. Sometimes it has been referred to as voluntary
unemployment. More recently, the monetarists have described this as
the natural rate of unemployment.
To illustrate that this is a reasonable theory, consider a group of

agricultural workers who are made redundant. They earn Rs. 100 per
hour and, with the price of wheat at Rs. 1250 per 40 kg, their employer
cannot produce wheat at sufficiently low cost so therefore makes the
workers redundant. If the employer could reduce some or all of the
costs, including the labor costs, the wheat could be sold at Rs. 1250

per ton, thus making a normal profit. Thus, if the workers accepted a
wage of Rs. 50 per hour, they would all be re-employed.
The classical economists blamed unions for resisting wage reductions

and preventing the necessary drop in labor costs required to re-
establish full employment and a return to a rising level of economic
activity. They referred to unemployment caused by excessive wage
levels as involuntary unemployment.
This classical view was summarized in ‘say’s law’ that stated that
‘supply creates its own demand’. We have already looked at the
circular flow of funds in the economy whereby the act of production
(supply) creates an exactly equal amount of income that can purchase
that supply. If prices are flexible downwards, that supply will always be
the level which generates full employment.
This thinking dominated official economic policies and it was the

miners’ resistance to a wage cut in the mines that led to the so-called
‘general strike’ of 1926. Indeed this free market analysis underlies the
more recent approaches to monetary policy that rely upon flexibility
within markets to allow changes in policy to take effect. The
monetarists would argue that government intervention distorts markets,
preventing them from reaching equilibrium levels − through, for
example, the imposition of a minimum wage.
19.3 Keynes
Keynes argued against the whole basis of this thinking. He accepted

that the market mechanism was logical and would no doubt operate ‘in
the long-term’. However, people had to accept the world as it was and
not as it might be in theory. Long before the natural economic forces
brought about a recovery, there would be an extremely damaging
social and political upheaval: to avoid this, ways should be found to
intervene to restore economic activity. His whole argument was based,
therefore, on the belief that in the modern world there was no reason
why the full employment and the equilibrium levels of national
income should be the same. The full employment level might be

above or below the equilibrium level, and it was the gap between the
two that caused the economic problems of inflation and unemployment.
It is however, important to remember today that Keynes was chiefly
concerned with unemployment as the major economic and social
problem and his remedies were developed accordingly.
20 Causes Of Unemployment
20.1 Introduction
Unemployment is a complex problem with many contributory causes.

Some of the more important ones are discussed below.
20.2 Cyclical Unemployment
At the beginning of this section the nature of cyclical unemployment

was discussed. Generally this occurs due to a deficiency of demand,
often referred to as the deflationary gap. The concept of this is shown
in figure 13.2. This shows the equilibrium level of income, but at this
point all resources including workers are not fully employed.
Y
QF C + I +G +(X-M)
QI
0
E F
Equilibrium Full National income
level employment (1000, 000)
figure 13.2 the deflationary gap
To reach full employment would involve pushing national income up to

0f. However, this level cannot be reached, because planned or desired
spending is only 0q1 whereas it is possible to spend up to the level of
0qf. The difference between these is known as a deflationary gap.
Because there is inadequate or deficient demand, the level of income
and output at which all workers would be employed is not achieved.

A deflationary gap, therefore, is characterised by unemployed
production factors, chiefly people, but also land and equipment. The
depression years were characterised not only by the terrible dole
queues but also by agricultural land returning to scrub, by factories
standing empty and machinery rusting in the shipyards. More recently
the recessions of the early 1980s and the early 1990s give instances of
demand-deficient unemployment. The term ‘deflationary gap’ refers to
the fact that, in such circumstances, it is possible that prices will
actually fall.
20.3 Frictional Unemployment

This is caused by the normal friction of business life. At any time there
will always be some people leaving jobs they do not like or with which
they cannot cope. Some firms will be closing for a variety of reasons
and some workers will be dismissed. There will always, therefore, be
some people unemployed. Even in the boom years of when
unemployment is very low, there were many unfilled vacancies. The
people who are unemployed and the jobs available rarely match
perfectly, leading to an inevitable degree of unemployment.
20.4 Structural And Technological Unemployment

This refers to the loss of jobs caused by economic structural change,
i.e. the decline of some areas of productive activity. This, in turn, is
caused partly by changes in consumer demand, such as the relative
decline in the demand for coal as fuel.
One consequence of this type of change is that it often tends to hit

particular regions of the country where the stricken industry was highly
concentrated.
20.5 Technological Unemployment
Technological unemployment can occur when industry is expanding
and moving towards more efficient capital intensive methods of
operation. The development of mechanized and then computerized

accounting and the decline of certain types of clerical office work, and
the introduction of automatic telling machines in banking are examples.
20.6 Seasonal Unemployment
This is predictable and relates to fluctuations in demand for labor
directly related to cycles in demand for the final product. Tourism and
leisure industries provide the best examples, particularly as these can
contribute to regional problems as they are concentrated in particular
areas.
21 Remedies For Unemployment

21.1 Introduction
The choice of an effective remedy for unemployment must depend to a
large extent on the dominant cause. At any particular time several
causes may be operating so that it is more likely that the government
will be adopting a package of remedies rather than relying entirely on a
single policy. However, if each main cause is examined separately, it is
possible to identify relevant measures and to comment on their
effectiveness.
21.2 Deficiency Of Demand

The traditional Keynesian remedy has been to inject additional demand
through government measures. The problems facing the government
are:
• Estimating the extent of the deflationary gap which government
action is seeking to fill.
• Estimating the strength of the multiplier so that the amount of
injection can be calculated, given the estimated size of the gap.
• Taking into account any social, political or other economic
consequences likely to follow from the measures adopted to
inject the necessary demand into the economy.

These problems can be illustrated by making use of one of the simple
models outlined earlier.
Y
AD2
deflationary gap
AD1
QF
0
E F National income
figure 13.3
The government must know the size of the gap between the
equilibrium and full employment level needed to close the deflationary
gap, i.e. the distance between ad1 and ad2 in figure 13.3.
The multiplier might be increased by reducing taxation but this could
have consequences for government borrowing and for areas of
government spending; and, of course, any tendency for imports to rise
faster than exports will cause difficulties in the balancing of trade
accounts. Later it is shown how the government’s freedom to act to
cure one problem is frequently constrained by implications for other
areas of social and economic policy.
Nevertheless, taking into account these problems, the main methods
available to a government to raise the level of general demand are as
follows.
(a) Direct Increase In Government Spending − e.g. on roads,
schools, hospitals and other areas of direct government
responsibility. This increases the g element in the total injections
flow.
(b) Encouragement Of Business Investment − the government
may encourage business investment by its use of cash grants,
loans at low rates of interest, taxation allowances, encouraging

the banks to lend and relaxing controls over bank lending. This
increases the i element in the total injections flow.
(c) Encouragement Of Consumer Spending − by increasing
spendable or disposable incomes through reductions in direct
taxes on income. The government can make market prices
lower by reductions in indirect tax levied on spending, especially
value added tax. It can also stimulate spending on durable
goods such as cars, through reducing money interest rates,
which make hire-purchase contracts cheaper, and by generally
stimulating consumer borrowing through removing restrictions
on bank lending or relaxing the controls on instalment credit
schemes, e.g. allowing lending over longer periods or reducing
the amount of minimum deposit.
(d) Encouragement Of Exports − the government will seek to

encourage those industries that are able to export goods or
services. The British government has been criticised for thinking
only in terms of manufactured goods, and neglecting services,
when organising help for exporters.
21.3 Structural Change
Here, the government may be under considerable political and social
pressure. There will be forces seeking to protect established but
declining industries and to defend traditional employment patterns. The
government will be asked to subsidize firms in financial trouble,
guarantee jobs for workers facing redundancy and to restrict imports of
competing foreign goods. If the government yields to this pressure it
may save some jobs in the short term, but at the expense of taxing and
reducing the profitability of successful firms and industries. It may also
reduce the pressure for modernization and change needed to restore
national ability to compete in world markets.

More positive measures to overcome the problem are to hasten any
necessary restructuring of threatened industries, to help them invest in
modern equipment and retrain workers.
21.4 Improve Operation Of Markets

This is concerned with the flow of information in labor markets and the
more rapid transfer of people between jobs. Particular measures have
been concerned with the rationalization of job centers to obtain
economies of scale and the application of modern technology to link
centers.
22 Inflation
22.1 The Problem Of Inflation
Inflation can be a serious economic problem, and society must
endeavor to keep the rate at which prices are rising under control.
Business Confidence Is Undermined. Businesses fear the higher

interest rates which accompany times of high inflation. Higher rates
raise borrowing costs and lower profits. This will make businesses
hesitant about new investment projects.
Erosion Of Living Standards. Wage demands follow a rise in inflation,

as workers try to protect living standards. This can actually cause
further inflation, as we will see below.
Inflation Discourages Saving. When inflation exceeds the rate of

return on savings, as happened in the 1970s, savers are actually losing
money by saving. Inflation benefits those who borrow at the expense of
those who lend, as the repayments of capital and interest diminish in
value over time as the value of money falls.

It Damages Export Performance And Leads To Import Penetration.
As goods become more expensive, it becomes harder to sell them
abroad, and the population becomes more likely to buy imported
goods. So, high inflation may cause unemployment.
Loss Of Faith In The Currency. If inflation gets out of hand, people

may lose confidence in the value of money and stop using it to
exchange goods and services. Then, the consequences are likely to be
that production and exchange slow down dramatically, and
unemployment rises to high levels. This was one of the economic
problems experienced by Germany in the 1920s.
23 Sources Of Inflation
23.1 Introduction
It is impossible for government to control inflation unless it is able to
identify the source and implement appropriate policies. There are
significant problems related to macroeconomic policy design that will
be compounded if inappropriate measures are used to solve particular
problems. This section is concerned with the various sources of
inflation, some of which overlap.
23.2 Demand-Pull Inflation

This is the traditional explanation. The best example of this relates to
the 1950s and 1960s when the stop-go cycle gave rise to several
periods when economic growth caused demand and purchasing power
to outstrip the rate of output. Thus, as supply and demand analysis
indicates, prices began to rise for final goods and services and factors
of production. The cure for this type of inflation is to deflate the
economy that reduces the pressure of demand and thus slows the rate
of rise of prices. The chapter on fiscal policy will show precisely how
this is achieved.

23.3 Cost-Push Inflation
This is also a traditional explanation and relates to business costs.
Clearly such costs can rise at a time of excess demand because of
shortages for certain factors of production. However, costs can also
rise when demand is weaker due to increased import prices, trade
union ‘pushfulness’ or specific actions of government (e.g. on interest
rates) or producers of raw materials (e.g. the OPEC nations and oil).
The particular source of the cost increase will determine government
policy, although in certain cases the degree of control is limited. If costs
are rising as part of a general economic boom, then deflationary
measures will probably be sufficient. However, if the increase relates to
wages, then a prices and incomes policy might be necessary; while if
cost increases originate from abroad, there may be little that can be
done.
23.4 Imported Inflation
This is a type of cost inflation caused by rising import prices resulting
from a fall in the value of the pound, i.e. a fall in the exchange rate.
However, there is another means by which import prices can rise and
that is through the exchange rate. Movements in exchange rates will be
discussed in detail in a later chapter; here it is sufficient to recognize
that a fall in the value of sterling on the foreign exchange market will
lead to a rise of import prices within the Pakistan. Basically this is
because a greater number of rupees will be required to pay for a given
foreign product.
In these circumstances government can try to use measures to

manipulate the exchange rate upwards. However, there are benefits of
a lower exchange rate; export prices, for example, will be lower. Thus
there is a need to counterbalance the disadvantages of increased
inflation with the potential improvement of the balance of payments.
These problems will be returned to.

23.5 Monetary Inflation
The monetarists would claim that, under certain circumstances,
inflation could result through ‘over-expansion of the money supply’. The
detail of this will be discussed elsewhere but the effect of an increase
in money supply is to expand purchasing power through the enhanced
availability of cheaper credit. Effectively this increases demand and
causes inflation as explained above. However, the analysis is broader
than this because it is claimed that monetary expansion sets the right
conditions for all types of inflation to emerge. In summary, it creates
conditions which are conducive to price increases for both final goods
and services and factors of production. The main monetarist solution to
inflation is to raise interest rates.
23.6 Expectations Effect

The underlying reason relates to the rate of anticipated inflation being
included within current wage bargains and price adjustments. Thus, if a
company expects prices to rise by x% over the next year and builds
this into its pricing policy, then the expectation will be fulfilled. The
same applies to wage bargains that will contribute to the anticipated
inflation rate if the expected inflation is built into the wage agreement.
Therefore the expectations are revised downward by new forecasts or
the introduction of anti-inflation measures that are perceived to be
potentially effective. This influence upon inflation is likely to be far more
serious when inflation is high and expected to rise further.
24 Inflation And Unemployment

24.1 The Phillips Curve
The explanation of the relationship between inflation and
unemployment begins with the Phillips curve. This emerged as a result
of research by Professor A.W. Phillips on data for the period
1862−1958. Phillips observed that the rate of change in money wages
was inversely related to the level of unemployment. Rising money
wages were identified as a source of inflation. Thus, the curve was

fitted to inflation and unemployment data and had remarkably good
predictive powers during the 1950s and 1960s.
Effectively, it summarized the stop-go cycle and the Keynesian trade-

off between inflation and cyclical, or demand-deficient, unemployment.
Inflation appeared to be inversely related to the level of unemployment.
9
Unemployment rate (U) Rate
8 of change of money wages
Inflation7 (W)
% 6 U W
5 1.0 8.7
4 1.5 4.6
3 2.0 2.8
2 2.5 1.8
1 3.0 1.2
1 2 3 4 5
Unemployment rate (%)
figure 13.4 Phillips curve

If this relationship is correct, then any attempt to achieve full employment is
likely to be unsuccessful. It appears that price stability is only possible at a
level of unemployment over 5%. In practice, if the economy grows at an
average rate of about 3% pa, this reduces unemployment to about 2%. Such
a rate appears to be associated with money wage rate changes of about
1.8%.
The Phillips curve worked effectively up to the end of the 1960s since when it
has only provided a general indication of the trade-off. This is because higher
inflation rates became associated with given rates of unemployment, causing
the curve to move upwards and to the right.

24.2 The Long-Term Phillips Curve
A further application of the Phillips analysis accommodates the notion
of long term natural rates of unemployment and the expectations effect.
Inflation
(%) Long-term
Philips curve
W2
W1
N1 N PC3 Unemployment rate (%)

PC1 PC2
figure 13.5 long-term Phillips curve
the explanation for this analysis is as follows:
(a) The natural rate of unemployment (n) is determined by the
underlying structure and competitiveness of the economy. It is
the rate of unemployment to which the economy always returns.
(b) Attempts to reduce unemployment below n will raise inflation.
Thus on pc1 there is no inflation at n. Reflationary measures will
cut unemployment to n1 but raise inflation to w1.
(c) W1 becomes the new ‘base’ for inflation because of the
expectations effect related to the higher level costs of
government spending associated with the expansionary
measures.
(d) Unemployment gradually moves back towards n, particularly as
the higher rate of inflation will further reduce competitiveness
and cause firms to shed labor.
(e) W1 and n are both points on a higher Phillips curve pc2. Further
attempts to achieve n1 will cause higher rates of inflation and
movement to higher curves.
The implication of this analysis is that a long-term Phillips curve can be
constructed at n that indicates that any rate of inflation is possible at n,
depending upon the degree of inflation and attendant expectations.
Alternatively, it can be stated that any attempt to permanently cut

unemployment below its natural rate by using reflationary measures
will fail and that the result will simply increase inflation. If this analysis
is accepted then unemployment can only be reduced by using
microeconomic measures which are likely to be far less inflationary.
This explanation lies at the center of monetary strategy that identifies

the need to make markets and industry operate more efficiently as a
means of reducing inflation. Certainly extensive reflation and monetary
growth are ruled out for the reasons outlined above.
24.3 Non-Accelerating Inflation Rate Of Unemployment (NAIRU)

The non-accelerating inflation rate of unemployment (NAIRU) relates to
the long-run Phillips curve. It relates to a situation where the rate of
inflation has stabilized and changes in unemployment have no further
effect on the rate of inflation. It is thus the rate of unemployment at
which inflation does not change. In the short run it is not stable but, in
the long run, it will tend to be fixed. In the diagram in figure 13.5 it will
be at n.
25 Economic Growth
25.1 Economic Growth And The National Income
Economic growth usually reflects itself in an expansion in a country’s
national income in relation to the size of its population. The concept of
economic growth is closely related to that of an improvement in living
standards. National income does not necessarily reflect accurately the
standard of living.
26 Causes Of Growth
26.1 Introduction
In order to achieve the ability to create more wealth from a given labor
force, it is generally recognized that the level of technology must be
raised. This means that there must be capital investment in machines

and also investment in training and the development of managerial
methods capable of producing more from available machines and
workers.
Economic growth does not always mean working harder. The actual
physical effort involved in work and the hours spent at work may well,
and should both be less. Economic growth is the result of working more
effectively. The following elements are likely to be important:
• capital investment
• innovation or technical progress
• efficient management and educational workforce
• favorable attitudes to business
• appropriate economic policy
26.2 Capital Investment

Certainly more machines are needed and growth cannot be achieved
without more investment. Nevertheless, investment in itself is no
guarantee of growth. British investment rates have risen in the past
without any dramatic effect on growth. Investment itself is not always
easy to calculate: tax regulations can influence figures and business
spending may appear as investment when in reality the true nature of
the spending, e.g. on motorcars, may be closer to consumption.
Government-induced or subsidized investment may not be as
productive as investment that comes genuinely from business profit.
Firms do not advertise their investment failures, but anyone with
knowledge of particular firms and industries can quote examples.
Government-sponsored investment is more public and there are
notable cases of massive sums spent with little return to the public.
26.3 Innovation
A number of economists now suggest that innovation is the most
important requirement. Whilst fairly easy to recognize and to explain, it

is exceptionally difficult to measure. The simplest way is to total
business expenditure on research and development, but this may not
be reliable as spending does not guarantee successful innovation.
Much business research may be trivial in nature and concerned more
with design or marketing techniques rather than directed towards major
production improvements. There is also an important distinction
between research and commercial development.
There are a number of growth theories that place technological change

at the center of their explanation. As explained in chapter 12, the
marginal efficiency of investment or capital can be represented as a
downward sloping curve as shown below.
Rate of
Return
MEC
0
Capital stock
figure 13.6 marginal efficiency of capital

If you look carefully at the diagram you can work out what is happening
as the stock of capital increases. The marginal efficiency of capital is
defined as the rate of return derived from the last £’s worth of capital
stock. It will decline as the capital stock increases as the most effective
projects will be undertaken first. In this case rate of return implies
financial criteria, but there is no reason why a social rate of return
should not be applied instead.
If there is no technological change, eventually all potential projects will

be exploited and the rate of growth falls to zero. This is entirely
compatible with the law of diminishing marginal returns and provides a

situation which can only be avoided by further technological
developments on a major scale. The effect of this can be shown in the
diagram below in figure 13.7.
Rate of
Return
P1,2
MEC2
MEC1
0
K1 K2 Capital stock
Figure 13.7 the effect of technological change
Figure 13.7 shows that technological improvements will increase the

return achieved from investment, since investment will be in superior
machines and equipment which yield higher rates of return. The
diagram shows that, at any given level of average return in the
economy, more investment in capital takes place or, at any given level
of employment of capital (e.g. k1 or k2), higher returns are achieved.
Thus, there will be more investment, leading to a higher growth rate.
26.4 Efficient Management And Educated Workers

The best machines in the world cannot in themselves create successful
economic growth. They have to be employed in creating goods or
services that are in profitable demand. They also have to be kept
productively employed without hold-ups caused by industrial disputes
or poor production and marketing organisation. At the same time,
managers have to be rewarded adequately, not only in salary but also
in social prestige and public recognition and appropriate training must
be made available to management and workers alike.

26.5 Favorable Attitudes To Business
If there is a general climate of opinion hostile to profit and to the
creation of wealth through business activity, then it is hardly surprising
that economic growth rates are low. There must be encouragement for
people to innovate, to take investment risks and to work to secure labor
co-operation. Business must also attract the best brains from those
leaving school and university, and business success must enjoy
comparable social prestige with success in the professions, the
academic world and the public services.
26.6 Appropriate Economic Policy
it is difficult to define precisely what the ideal policy should be, although
it is generally accepted that some degree of intervention is reasonable
in order to:
• Encourage collaborative projects between firms, and between
firms and higher education.
• Encourage the transfer of information technology.
• Encourage innovation on the part of small firms.
Government finance can be important in all three areas.
27 The Balance Of Payments − Overview

The trade, capital and currency flows that occur between nations are
recorded on the balance of payments. This is concerned with all
transactions between nations and is recorded monthly and presented
on both a monthly and annual basis. Effectively the data is recorded
using the same approach as a business balance sheet and thus it is
required to balance.
The most important aspect of balance of payments analysis is

concerned with the flows recorded and the trend over time. The
balance of payments account is split into three parts – the current
account, the capital account and the financial account. As might be
expected, the trends over time reflect the relative strengths and

weaknesses of the economy with difficulties for visible trade in
manufacture being offset by surplus the invisible account related to
services.
Summary
Interest rates have been the subject of this chapter because they are
an unifying factor that touches on many aspects of economics.
Illustrative of this is that interest rates have relevance for, and impact
on, the individual, government and business – not least, of course,
financial institutions and, among these, especially the banks. For the
individual the rate of interest is important because it affects savings
and mortgage and loan payments. For the government it is a key policy
instrument with a major influence on such economic variables as credit
creation and the money supply, inflation and the foreign exchange
value of the pound sterling − and, politically, the chances of re-election.
For business it is of great significance because it affects the cost of
borrowing, earnings from financial assets, the level of and returns from
capital investment in equipment and buildings, and the profitability of
export sales as a consequence of fluctuations in foreign exchange
values. For the banks, the rate of interest is crucial since it forms the
largest part of their income and costs, and net interest income
constitutes the largest part of their profits. Changes in the rate of
interest also affect the capital value of fixed interest assets such as
bills, certificates of deposit and gilts and, via the foreign exchanges, the
profitability in sterling of operations in foreign currencies, whether at
home or abroad.
Interest rates thus have meaning for almost every person and
organisation in society and are at the very epicenter of the monetary
and financial system − the fulcrum on which it turns.
Further, we have examined some core macroeconomic ideas. The

objectives of government macroeconomic and the way in which
policies are set were explored. The chapter then focused on the four

main objectives and examined the underlying factors influencing
inflation, employment and growth.
Self-Test Questions
The Demand For Money − Keynesian View
1 what three motives did Keynes argue might lead people to want to hold
cash rather than bonds? (1.1)
2 what is the connection between a bond’s nominal value and its market
value? (1.2)
3 what is meant by a bond’s coupon? (1.2)
4 if interest rates rise, will bond prices rise or fall? (1.3)
5 sketch a liquidity preference schedule. (1.7)
The Supply Of Money
6 what is the meaning of the money supply? (2.1)
7 distinguish between narrow money and broad money. (2.2)
The Classical View Of Interest Rates
8 what does the loanable funds theory predict for the level of interest rates?
(4.2)
Benchmark Interest Rates
9 what is a benchmark interest rate? (6)
The Term Structure Of Interest Rates − Yield Curves
10 explain the expectations theory for explaining the shape of a yield curve.
(7.4)
Causes Of Unemployment
11 what do you understand by frictional unemployment? (3.3)
12 define structural unemployment. (3.4)
Remedies For Unemployment
13 how could a government act to reduce structural unemployment? (4.3)
Sources Of Inflation
14 what are the causes of inflation? (6)

Inflation And Unemployment
15 draw the Phillips curve. (8.1)
Causes Of Growth
16 what are the causes of economic growth? (9)
Practice Questions
Question 1
Which is the best description of the supply of money in an economy?
A notes and coins issued by the central bank
B money created by the commercial banks
C coins, notes and bank deposits
D all items of legal tender
Question 2
According to Keynesian liquidity preference theory, an increase in the money
supply will:
(i) raise the price of financial assets
(ii) reduce the price of financial assets
(iii) lower the rate of interest
(iv) eventually increase the quantity of money people are willing to
hold
Which of the above are correct?
A (i), (iii) and (iv) only
D (ii) and (iii) only
Question 3
Which of the following are the likely consequences of a fall in interest rates?
(i) a rise in the demand for consumer credit
(ii) a fall in investment
(iii) a fall in government expenditure

(iv) a rise in the demand for housing
A (i) and (ii) only
B (i), (ii) and (iii) only
C (i), (iii) and (iv) only
D (ii), (iii) and (iv) only
Question 4
A yield curve shows how:
A the rate of return on financial assets varies with their maturity
dates
B the productivity of capital goods falls with increasing age of those
goods
C company profits rise or fall over time
D the total amount of tax collected rises as tax rates are raised
Question 5
In the theory of the demand for money, the transactions demand for money is
determined by the:
A level of consumers’ incomes
B expected changes in interest rates
C expected changes in bond prices
D level of notes and coins in circulation
Question 6
Which of the following would lead to a rise in the demand for money?
(i) a rise in disposable income
(ii) a fall in interest rates
(iii) an expectation of falling share prices
(iv) a decrease in the money supply
A (i) and (ii) only
B (ii) and (iii) only
C (ii), (iii) and (iv) only
D (i), (ii) and (iii) only

Question 7
Assuming that the economy is operating at full employment, which of the

following would be most likely to lead to inflation?
A a fall in the level of private investment
B a rise in the productivity of labor
C a rise in the volume of imports
D a reduction in direct taxation
Question 8
Which of the following would, other things being equal, contribute to the
reduction of inflationary pressure in an economy?
(i) a fall in the volume of exports
(ii) a rise in the volume of imports
(iii) a decrease in the level of direct taxation
(iv) an increase in the level of public expenditure
A (i) and (ii) only
C (iii) and (iv) only
D (iii) only
______________________________________________________________
For the answers to these questions, see the ‘answers’ section at the end of
the book.

Contents
1 The value of international trade and services
2 Attributes of the international business environment
3 Reasons for international trading
4 Entry into foreign market
5 Problems associated with international activities
6 Summary of the benefits of trade
7 The law of comparative advantage
8 Protectionism
9 Globalization

1 The value of international trade and services
2 Attributes of the international business environment
2.1 Definitions
• International trading occurs where one company located in its
‘home’ country trades with other non-associated people and
companies in other countries.
• A multinational company (MNC) is defined as one that
generates at least 25% of its sales from activities in countries
other than its own. It generally operates through overseas
subsidiaries and divisions and will have a ‘head office’ located in
one country with which it will probably have strong cultural or
national links.
2.2 The role of MNCs

The activities of MNCs are of major importance because of their size
and the increasingly preponderant part they play in the world economy.
The very largest have revenues greater than the GNP of all except the
top 14 or so national economies. Their significance is increasing all the
time since they are growing (looking at the totality) at a rate some three
or four times the rate of the world economy. The size of the largest
MNCs tends to put them in the limelight, but there are many small
MNCs − about 10,000 in total.
The functions of MNCs in the lesser-developed countries (LDCs) have

received particular scrutiny. Their activities in these countries are often,
though not exclusively, directed towards the extractive industries, oil
and minerals, and agriculture, plantations, rubber and forestry.
3 Reasons for international trading

3.1 National expansion
Much thought has been given to the reason why a company operating
successfully in its own country should seek to extend its activities to
other countries. It is an option that carries considerable risk and is far
from uniformly successful. There is usually the alternative of exporting
which, after all, has traditionally been and still is a principal way of
increasing revenues.
Analysis has focused on those factors that need to be present if the

transformation of a national company into an MNC is to be successful,
and these will be looked at in some depth later. But by themselves they
still leave the basic question unanswered − why?
Of course, from one point of view it could be said that the MNC results
from a natural progression − expansion from town to area, from area to
country and from country to the world. The process is immensely
facilitated by the concurrent advances in communications, both physical
and electronic, and by the international mobility of capital. This sounds
plausible but it should be noted that much of MNC expansion predated
the current avionic and electronic marvels and it is far from clear that
expanding from Birmingham to Frankfurt is of the same order of
naturalness as expanding from Birmingham to Leeds.
3.2 The nature of marketing and competition

Perhaps we can get nearer to the answer if we consider more closely
the nature of trade and competition. Although competition is an ever-
present factor in commercial activities, the pattern of trade when it
began to get under way in a significant sense in the eighteenth century
was largely complementary in nature. Cotton goods would be exported
in return for tea, for example, or later rails and locomotives would be
sent abroad and wheat and cotton imported. At a later stage the
makers of locomotives and rails would compete with one another as
would the makers of machinery, electrical goods, chemicals and the

whole plethora of modern industrial products. The age of competitive
trade was born. Even so, there was considerable demarcation of
markets.
3.3 Internal factors that encourage multinational trading
The factors that play a part in an MNC’s operations and may affect its
success can be conveniently divided into two classes: those that are
internal to the firm and may be described as ownership-specific and
those that are external to the firm.
(a) Process specialization. This is of two kinds. In the first place
the move to standardization of products both in terms of
adhering to internationally accepted standards and in methods
of production has made it possible and often desirable to locate
stages of production in different countries − perhaps labor-
intensive activities in low wage areas and final assembly in the
ultimate market. Secondly, it refers to the particular features of
the firm that make it distinctive and confer on it a measure of
competitive advantage – often referred to as ‘know how’ – and
embracing patents, trademarks and managerial skills.
(b) Product specialization. In spite of a move to standardization,
the vagaries of human taste are such that most markets exhibit
different characteristics. Identifying these and matching products
to them can be a potent factor in success; equally the failure to
do so can be disastrous. In the simplest case consumers
occasionally gain the impression (sometimes justified) that
goods made for export are of a higher quality than those foisted
onto the home market. But the process goes much further than
that. For example, one well-known beverage sold internationally
is called the same everywhere and looks the same but is in fact
produced in 40 different varieties.
(c) Research and development. The larger the part R&D plays in
a company’s activities the more sense it makes to spread the
cost by operating internationally. Drug companies are a good
example. The largest have annual R&D budgets of more than

half a billion pounds. Few, if any, national markets can support
outlays of that kind. Logically there is no reason why R&D
should not be regarded in the same light as process
specialization and after a hesitant start this is gradually
becoming the case. It is becoming quite usual for R&D to be
located wherever there is a natural affinity in terms of expertise,
educational skills and university liaison to the desired activities.
(d) Vertical and horizontal integration. Due to the large size of

many MNCs, the scope to integrate their activities often exists.
Vertical integration occurs when a company gains control of its
suppliers or raw materials (backward vertical integration) and/or
its distribution networks (forward vertical integration). The
classic example is an oil company that finds and controls the
producing wells, refines the product and organizes the
distribution through its own outlets. A tobacco company, on the
other hand, tends to buy in its supplies, perhaps because of the
complexity of blending, and cannot control the distribution
because of the proliferation of brands. It therefore expands
horizontally by setting up factories wherever deemed suitable.
(e) Transfer pricing. This is an important technique that can offer
major financial advantages to an MNC (although not always to
any particular host country). It permits an MNC to minimize its
tax liabilities by maximizing profits as far as possible in the
country with the most favorable tax regime. Essentially this is
achieved by selling products between component parts of the
group at artificial prices so that higher costs are incurred where
taxes are high and lower costs where taxes are lower. In the US
the State of California has attempted to deal with this problem
by taxing MNCs in its jurisdiction on their worldwide income in
proportion to the ratio that the Californian activities have to the
whole. We shall examine transfer pricing in more detail a little
later.

However, before coming to these factors there are some points worth
mentioning. There has been a swing away from expansion into LDCs
and more emphasis placed on expansion into developed countries. At
first sight, this is surprising for two reasons: political risk, which is a
strong deterrent, has markedly lessened in recent years; secondly,
economic theory postulates that capital will flow to regions where it is
scarce, as indeed it did on a large scale from Britain to the US in the
nineteenth century and as it has done from the US to Latin America in
the twentieth century.
International trade has greatly expanded in the last half century and
with it the rise of adversarial competition that has been described at
length previously. There is therefore an incentive for a company in the
light of this new threat to meet its competitors head on in their own
market place. Next, the fast pace of technological change has created
opportunities for new products to be introduced continually even in
developed nations. Further, the development of international capital
markets has made it easier for MNCs to mobilize funds for their
expansion. Finally, some projects are now of such enormous cost that
they are best undertaken by international co-operation and they are
generally of such a nature that they can only be undertaken in the
developed nations.
3.4 Regulation
Nothing so far has been said about control and regulation of MNCs.
The fact is that they are largely unregulated, at least insofar as their
operations as a whole are concerned. The UN has formulated a ‘Code
of Conduct of Transnational Corporations’ but it is only that − a code of
conduct. Individual countries have imposed restrictions from time to
time by reserving certain shareholdings for their own nationals or by
limiting the transfer of profits or royalties, for example. But even
governments have to tread carefully lest the subject of their attentions
abandons the market altogether.

4 Entry into foreign market
4.1 Strategic objectives
In drawing up its strategic plan, a company may identify direct foreign
investment as a means of fulfilling its strategic objectives. Possible
reasons may be:
• financial – a financial analysis might suggest a positive net
present value for such an investment, increasing the wealth of
the parent company shareholders; however, the selection of an
appropriate discount rate may be difficult.
• production efficiency – raw materials or labor might be cheaper
in the overseas market than at home.
• demand-led – a manufacturing base could be established to
satisfy the overseas market’s demand for the company’s
products.
• to avoid tariffs – if tariff barriers have been established by an
overseas country to frustrate imports into that market, a base set
up in the country will not be subject to the tariffs.
A company wishing to sell its products beyond its domestic market is
faced with the choice of legal entity by which its expansion is
structured. The discussion of multinational companies has assumed
that the structure is one of separate companies operating in each
country. This section examines whether that structure is always the
best possibility and appraises other legal forms.
4.2 Export from the home country

A company may decide not to establish any permanent set-up in the
foreign country, but instead to export its goods directly from the home
country. Such a policy is cheap and low risk; no significant capital
expenditure need be incurred in the foreign country. But the policy has
serious limitations.

• The sales force will find it hard to gain a detailed feel for the
market since they will only visit from time to time. Their travelling
expenses will also be high.
• It is difficult for customers to contact the company.
• Sales could be frustrated by the imposition of tariff barriers on
imports by the overseas country. One key way of avoiding tariff
barriers is to set up a manufacturing plant in the overseas
market (e.g. Japanese car manufacturers setting up in the UK).
4.3 Overseas branches

The quickest way to establish an overseas presence is to set up a
branch in the overseas country. This can be as simple as one person
with an office and a telephone, but normally includes a distribution
warehouse from where the country’s demand is met. A branch is cheap
to run and solves some of the limitations identified above. However, the
company might be accused of lack of commitment to the foreign
economy if the branch is just a skeleton operation. There are also tax
consequences of running a branch; it is likely that the profits of the
branch would be treated as profits of the parent company, which might
be inconvenient.
4.4 Overseas subsidiaries
This demonstrates a longer-term commitment to operations in the foreign
country. There may be tax advantages since home country taxation will
not be incurred until profits are remitted home, and there may be
opportunities to set transfer prices to reduce worldwide tax liabilities.
However, there will be legal costs associated with setting up the company
and ongoing costs in resourcing it.
4.5 Joint venture

The Companies Act 1989 introduced the term ‘joint venture’ into
company law for the first time and lays down how such ventures should
be consolidated into group accounts. A common example of a joint
venture is where a UK company wishing to expand into the former

Soviet Union identifies a local company and agrees to undertake a
project jointly while carrying on with their other main activities at the
same time.
DEFINITION
A joint venture is an undertaking by which its participants expect to
achieve some common purpose or benefit. It is controlled jointly by two
or more venturers.
The advantages of joint ventures are that the existing management

should have a detailed knowledge of the overseas market. In addition,
the overseas government should treat the venture more favorably than
if it were all overseas owned and so grants or other incentives may be
available. Joint ventures also enable venturers to pool their expertise
and are less risky than starting operations from scratch.
The disadvantages of joint ventures are mainly practical. They can take
up large amounts of management time with few profits to show from
the effort, disagreements can break out between the venturers as to
the future course of action to take and they are difficult to value in
annual accounts.
4.6 Licensing agreements

A licensing agreement permits a foreign firm to manufacture the
company’s product in return for royalty payments. Such agreements
are a cheap low-risk way of rapidly expanding into foreign markets.
However the quality of goods produced may not be as good as are
produced at home, potentially damaging the value of brand names.
Once the licensing period is over, there is also the possibility that the
foreign company will use the knowledge it has learnt to compete
against the home company.

DEFINITION
A licensing agreement
Permits a foreign firm to manufacture the company’s products in return
for royalty payments.
5. Problems associated with international activities

5.1 Evaluating the performance of international companies
Certain specific problems arise in evaluating the performance of
international groups of companies. These are considered below.
Which currency?
Should analysis be carried out in the group reporting currency or the
individual company’s own domestic currency? Since the objective of
the whole group is assumed to be to increase the wealth of the holding
company’s shareholders, and these people receive their dividends in
the parent company’s currency, it is normally considered best to carry
out all analysis in the parent currency. This begs the next question.
Which exchange rate?
Should a subsidiary’s results be translated at the budgeted rate, the
year-end rate or at an average for the year? Accounting standards lay
down how historical accounts should be drawn up, but there is no
guarantee that this method is also appropriate for evaluation purposes.
This is a complex discussion area, but one possible answer is to
assess the degree to which the subsidiary’s managers are able to
manage the exchange risk arising from their company. If they have no
expertise or training in this area, then they cannot be held responsible
for exchange rate differences that arise, i.e. their results should be
translated at the rate used when their budget was drawn up at the start
of the year. However, if the subsidiary’s managers are trained to
manage their exchange risk, closing actual rates can be applied to their
results and the exchange gain or loss highlighted in the financial report
from the company.

5.2 International treasurer ship
The managing of cash and other liquid assets involves a number of
problems for companies trading internationally:
• size and internationalization of companies – these add to both
the scale and the complexity of the treasury functions.
• size and internationalization of currency, debt and security
markets – these make the operations of raising finance,
handling transactions in multiple currencies and investing much
more complex, but they also present opportunities for greater
gains.
• sophistication of business practice – this process has been
aided by modern communications, and as a result the treasurer
is expected to take advantage of opportunities for making profits
or minimizing costs which did not exist a few years ago.
For these reasons, most large international corporations have moved

towards setting up a separate treasurer ship department.
5.3 Political risk

A further issue involved in overseas investment is that of political risk.
This is examined here under the headings:
• confiscation political risk
• commercial political risk
• financial political risk
Confiscation political risk

A subsidiary in a stable industrialized country may seem free from the
risk of confiscation. However, a parent company reviews the list
beginning with countries vulnerable to changes of regime or invasion
by powerful neighbors passing on to countries in which a transition to

local ownership is already law then to countries in which confiscation is
a very real possibility.
Commercial political risk

This is a large area of risk. The Portuguese revolution of 1974 was
followed by several years of left-wing military rule in which wages were
compulsorily raised and prices controlled at unrealistic falling real
levels. Subsidiaries of foreign parents found their margins squeezed
and little sympathy from the authorities. Those that happened to be
suppliers to the government were hit hardest and also had to face
serious attempts by the unions to take control of the management.
Many such subsidiaries were either abandoned by their shareholders
or sold at knockdown prices to local interests. What drove their parents
out was not confiscation but interference with the commercial
processes of supply and demand.
Financial political risk

This risk takes many forms.
• Restricted access to local borrowings is sometimes
discriminatory against foreign-owned enterprises. Access is
often barred or restricted particularly to the cheapest forms of
finance from local banks and development funds. Some
countries ration all access for foreign investments to local
sources of funds, so as to force the company to import foreign
exchange into the country.
• Restrictions on repatriating capital, dividends or other
remittances can take the form of prohibition or penal taxation.
• Financial penalties on imports from the rest of the group can
exist, such as heavy interest-free import deposits.
5.4 Exchange control risk
This risk is not necessarily different from the others above and some
specific exchange controls have already been referred to in the above

forms of risk. The purest form of exchange control risk is that the group
may accumulate surplus cash in the country where the subsidiary
operates, either as profits or as amounts owed for imports to the
subsidiary, which cannot be remitted out of the country.
However, in financing investments in such countries, it may well pay to

have as much local debt as possible, which can often be repaid from
such blocked funds if they arise. A low equity also makes it easier to
accept restrictions on remittances of capital or profits.
5.5 Foreign exchange risk

Firms dealing with more than one currency are exposed to risks due to
exchange rate movements. There are three main aspects of this.
Economic risk
Long-term movements in exchange rates can undermine a firm’s
competitive advantage. For example, a strengthening currency will
make an exporter’s products more expensive to overseas customers.
Transaction risk
In the time period between an order being agreed and payment being
received the exchange rate can move, thus causing the final value of
the transaction to be more or less than originally envisaged.
Transaction risk can be hedged by fixing the exchange rate with a bank
in advance. Such an arrangement is known as a forward contract.
Translation risk
If a company has foreign assets (e.g. a factory) denoted in another
currency, then their value in its home currency will depend on the
exchange rate at the time. If its domestic currency strengthens, for
example, then foreign assets will appear to fall in value.

This risk however, is not realized unless the asset is sold, so is of less
commercial importance.
5.6 Credit risk
Firms experience problems collecting debts from local firms, but these
difficulties are worse if the customer is in another country, possibly with
different time zones and a different language.
Credit risk can be managed by a mixture of the following:
Advances
The exporter’s (seller’s) bank may agree to advance cash against the
instrument by which the payment is to be made by the customer. The
instrument might be a cheque payment or a bill of exchange.
Letters of credit
Provided all conditions are fulfilled within the time specified, letters of
credit (LC) guarantee payment to the exporter and formally establish
the payment period, which ranges from immediately upon presentation
to the designated paying bank, to an unlimited period.
However, a letter of credit is not simply a means of boosting the rights
of the exporter: it also protects the customer against being pressed for
payment before being presented with documentation, which conforms
with the conditions originally set out with the exporter.
Export credit guarantees

Export credit guarantees are a form of insurance for exporters.
Export factoring
Export factoring is, in essence, no different from the factoring of
domestic trade debts. The service provided by the factor is effectively
one of underwriting the client’s debt; if the client’s debtors fail to meet
their debt obligations, the factor rather than the client bears the
financial loss.

6. Summary of the benefits of trade
(a) Choice
As already pointed out, domestic populations would lose much
of the choice they are used to if countries were to stop trading.
Taking the UK as an example, many brands of goods that we
consume are imported, cars being an obvious example. In
addition to extending the variety available, many goods that we
import could not be produced here.
(b) Competition
International trade opens up domestic markets to more
competition. We saw earlier that competition is often argued to
be beneficial; domestic industries that are large relative to the
home market and may be in monopolistic or oligopolistic
positions will have less power in international markets.
(c) Efficiency and lower costs

As a result of the increased competition, resources are more
likely to be used efficiently and costs can be cut. This will result
in lower consumer prices and enable all the trading nations to
increase their standard of living.
(d) Economies of scale
Economies of scale may become available when overseas

markets are opened up. For example, advertising will become
more cost effective and access to cheaper funds may be
possible.
(e) Specialization
Intuitively, it is clear that, if countries specialize in producing
those goods and services in which they are most efficient, total

output should be increased and everyone will be better off.
However, without trade between different countries,
specialization would be difficult, as countries must ensure that
their populations have an adequate variety of goods and
services. International trade allows such specialization as it
enables countries to exchange their surplus goods with one
another, giving their populations all the goods and services they
need.
In fact, the theory of comparative advantage, discussed in the
next section, shows how specialization can improve the
standard of living of all countries.
7 The law of comparative advantage

7.1 Introduction
The law of comparative advantage dictates that countries should
produce those goods in the production of which they are relatively
most efficient.
DEFINITION
The law of comparative advantage states that countries should
produce those goods in whose production they are relatively most
efficient.
We have already seen the operation of the theory of comparative

advantage when considering specialization earlier in the book. We
repeat the theory here to emphasize that it is the same theory whether
we are considering specialization in the domestic or international
economy.
Specialization has been mentioned above as one of the benefits of free
trade. The theory of comparative advantage analyses how
specialization operates to increase worldwide output. It relies on
relative rather than absolute efficiency.

For example, a qualified accountant may be able to carry out basic
calculations more rapidly than a newly recruited trainee accountant The
qualified accountant has an absolute advantage in doing the
calculations. However, it is more efficient for the trainee to do those
calculations while the qualified accountant does another task. This is
because the qualified accountant can do more complicated tasks than
the trainee. It is wasteful for their employer to use the accountant to do
something basic.
The key lies in considering opportunity costs. The opportunity cost of

qualified accountants doing basic calculations is represented by the
more difficult tasks that they are prevented from doing. The opportunity
cost of trainees doing the calculations is represented by other basic
tasks that they are prevented from doing. This opportunity cost is
clearly the lower of the two.
We say that the trainee has relative, or comparative, advantage in

doing the calculations, as this results in less lost production overall.
7.2 Numerical example
We now extend the idea of absolute and relative efficiency to world
trade. For simplicity, suppose that only two countries exist, A and B.
Also assume that there are only two products, X and Y.
The quantities of each good that can be made in each country are
given by the following table:
Quantity of X per day Quantity of Y per day
Units Units
Country A 1,200 720
Country B 960 240
Total daily production 2,160 960
As you can see, Country A has absolute advantage in the production of
both X and Y. However, it has comparative advantage in the production
of one of the goods only. There are a number of ways to identify which

country has comparative advantage in which good. This section will
give one method, based on direct calculation of opportunity costs. The
next section will give an alternative. Choose whichever you prefer as
they are equally valid.
Method 1 for identifying comparative advantage

If Country A were to concentrate on producing X rather than Y,
then for every 720 units of Y it gives up, it will gain 1,200 units of
X. Therefore the opportunity cost of producing 1,200 units of X is
the lost output of 720 units of Y. Calculating the opportunity cost
on a per unit basis, producing one unit of X must cost 720/1,200
= 0.6 units of lost Y.
Method 2 for identifying comparative advantage

Suppose Country A only made good X, while Country B only
made good Y. Each country could double its daily production
levels of the good in which it specializes. Total output would be
as follows:
Quantity of X per day Qua
Units Units
Country A 2,400 Nil
Country B Nil 480
Total daily production 2,400 480
Total output is 2,400 + 480 = 2,880 units.
However, if Country A specialized in making good Y, while Country B

specialized in X, the output totals would be:
Units Units
Country A Nil 1,440
Country B 1,920 Nil
Total daily production 1,920 1,440

Total output is 1,920 + 1,440 = 3,360 units. This pattern of
specialization is therefore preferable to the previous one, where total
output was only 2,880 units. Therefore Country A should specialize in
producing Y, in which it must have comparative advantage, while
Country B should specialize in making X, in which it must have
comparative advantage. This is the same outcome as derived from
Method 1 in Activity 3.
7.3 Output levels with specialization
Having established what the pattern of specialization should be,
suppose Country A does begin to specialize in making Y. Assume it
makes one more unit of Y, losing 1.67 units of X. To see what happens
to ‘world production’ of X, let us assume that Country B makes one unit
less of Y, counterbalancing Country A’s extra output. If Country B
diverts factors away from producing one unit of Y, it will be able to
produce 4 more units of X.
KEY POINT
Specialization increases world output.
The total change in production will be:

Units Units
Country A − 1.67 +1
Country B +4.00 −1
Net change + 2.33 0
The result is an increase in production of X, with no loss in output of Y.
7.4 The limit to specialization
Specialization cannot continue indefinitely. If Country A were to move
more and more factors of production into the sector that manufactures
good Y, diminishing returns would start to set in. This means that the
opportunity cost of producing each unit of Y in terms of lost production

of X would rise: each unit of Y produced would take successively
greater amounts of input.
Similarly, as Country B moved more factors into the X-producing
sector, the opportunity cost of producing each unit of X would rise.
The countries should stop specializing when the opportunity costs of
producing X and Y are the same in both countries. At this point there
are no efficiency gains to be made from specialization.
7.5 Implications of the theory

The theory or concept of comparative advantage is often used to justify
the case for free trade on the grounds that the world will benefit if as
many countries as possible specialize their production on the basis of
comparative advantage.
However, there are some warnings to be given before this contention
can be accepted. There are some important assumptions that have
been made that might not apply in practice.
KEY POINT
The countries should stop specializing when the opportunity costs of
producing X and Y are the same in both countries. At this point there
are no efficiency gains to be made from specialization.
(a) The assumption that all production factors are in use

If there are unemployed production factors, then their
opportunity cost is nil. It may even pay a country to keep them
employed in relatively inefficient forms of production as
otherwise they are a burden on other factors (through welfare
benefits).
(b) The assumption that production factors are transferable

Remember that the term production factor includes workers.
People cannot always be moved easily from one form of
production to another. This may mean changing a whole style of
life, moving from one district to another, losing status or the

chance to use a hard-earned skill. Workers and their equipment
are often highly specialized and not available for moving from
one industry or form of production to another.
(c) The assumption that all production factors within a country

and industry are equally efficient
No allowance is made for diminishing marginal productivity or
increasing returns to scale. In practice, either of these would be
more probable than constant productivity per factor. Some
people argue that specialization is more likely to increase total
efficiency because more vigorous or enterprising people and
firms would move and those left behind would have to become
more efficient to survive. It is possible that the gains from
specialization and trade might be greater than suggested by
simple calculations of the type used in this chapter.
(d) The assumption that productivity does not change over
time
The theory, set out in a simple form, ignores the effect of time. In
practice, it has to be recognized that countries are in different
stages of development. At any one time there will be some
industries not producing at the levels of efficiency that can be
attained in the future. If specialization takes place, these
potential achievements may be prevented from taking place.
Some countries may wish to protect some of their industries,
especially young and growing industries, from foreign
competition, so that they can develop higher standards of
efficiency and thus improve their productivity. It has to be
pointed out, however, that rotation can also remove the spur to
become more efficient: protected industries may become less,
not more, productive.
The fundamental case in favor of free trade (that specialization

usually tends towards the increase of total production) remains
unchallenged. If all countries in the world seek to limit imports,

then total trade and total production decline and there is less
total wealth available for sharing among the peoples of the
world.
8. Protectionism
8.1 Introduction
In practice, most countries operate some form of protectionism that
discourages other countries from selling their goods in the domestic
market. They use tariffs, quotas, exchange controls and bureaucratic
procedures to limit imports.
The following sections will discuss the main forms of protectionism and
then analyse why so many countries do not allow free trade.
8.2 Tariffs
DEFINITION
A tariff is a tax imposed on imported goods.
Figure 15.1 shows the equilibrium position of a market for an imported good.
Rs
Pe
D
0 Quantity
Qe
Figure 15.1 Equilibrium

The effect of imposing a tariff is exactly the same as that of imposing a tax on
any good: the supply curve shifts upwards by the amount of the tariff (see
Figure 15.2).

Rs
S2
Tariff
S1
Pt
Pe
D
0 Quantity
Qt Qe
Figure 15.2 Imposition of a tariff
The market is initially in equilibrium, with supply curve S1 and demand

curve D. The equilibrium price and quantity are 0Pe and 0Qe
respectively. When the tariff is imposed, the marginal cost of
production rises by the amount of the tariff, causing the supply curve to
shift upwards to S2.
The result is that the price rises to 0Pt and the quantity purchased falls
to 0Qt.
The amount of revenue collected by the government can be analysed
in exactly the same way as the tax take was identified in the chapter on
taxation, as can the incidence of the tariff on the consumer and the
supplier.
KEY POINT
Imposing a tariff on an imported good causes the price paid by
consumers to rise and the quantity purchased of the good to fall.
Imposing a tariff on an imported good causes the price paid by

consumers to rise and the quantity purchased of the good to fall.

8.3 Quotas
A quota limits the quantity of a good which can be imported. The basic
diagram of a market initially in equilibrium Figure 15.1 can also be used
to analyse the effect of a quota as shown by Figure 15.3.
DEFINITION
A quota limits the quantity of a good that may be imported into a
country.
Rs
S1
P1
Pe X
D
0 Quantity
Quota Qe
Figure 15.3 Imposition of a quota

The initial equilibrium position is the same as in Figures 15.1 and 15.2.
A quota is imposed, limiting the amount that can be imported to a level
below the equilibrium quantity. Clearly there would be no point in
imposing a quota above the equilibrium quantity, since nobody would
want to import even as much as the quota.
Although suppliers would like to import more than the quota, they are
not able to do so, so the supply curve essentially becomes the kinked
line SXS1.
The amount that consumers will be willing to pay for the total amount of
goods imported is given by reading upwards to where the new supply
curve intersects the demand curve. This gives a price P1.
Again the price has risen and the quantity bought has fallen, but a
major difference between a quota and a tariff is that, with a quota the

suppliers will receive any benefit from the price rise, while the
consumers suffer any cost. The government receives no revenue.
8.4 Exchange controls
A company wishing to buy foreign goods will generally have to pay for
them in the foreign company’s currency. In order to do that it must first
buy the currency. If the government has limited the amount of foreign
currency available to importers, this will limit imports.
In fact, the main reason for using exchange controls is as part of a

wider macro-economic policy that requires control of the value of the
domestic currency on the foreign exchange markets. This aspect is
covered later in the chapter.
DEFINITION
Exchange controls limit the amount of foreign currency bought and sold by
the domestic population.
8.5 Bureaucratic controls

A more covert way of discouraging imports from entering the country is
to subject them to an inordinate amount of ‘red tape’, making importers
go through lengthy customs procedures and so on. This will clearly not
be as effective as more direct methods and will also not earn the
government any revenue, but the fact that it is a covert method may
reduce the risk of overseas countries retaliating with their own import
restrictions.
8.6 Arguments in favor of protectionism

There are many reasons put forward as to why protectionism should be
used, some more valid than others. They are presented below.
(a) Strategic arguments

A country whose economy is dependent on one or two exports is very
vulnerable to changes in demand or supply patterns which cause a fall
in commodity prices. For example, demand is affected by cyclical
changes, the discovery of new resources or changes in taste, such as
the recent emphasis on healthier diets. Supply may be reduced by
natural disasters, such as drought. Developing countries, in particular,
have suffered when the prices of their main exports fell. Examples are
Brazil and coffee, Ghana and cocoa, Malaysia and tin and rubber.
On the other side of the coin, a country can also be vulnerable if it

relies too heavily on certain imports, particularly essential ones such as
oil. The foreign countries that supply those imports can exert political
pressure, as is seen when there are trade embargoes on countries
operating policies that are seen to be undesirable. In the event of a
war, the importing country is particularly vulnerable.
(b) Infant industries
A country may wish to protect newly emerging industries, which
are not yet able to compete on the international markets. This
argument will apply particularly to developing countries.
(c) Old industries
Conversely, a country might want to protect old, now inefficient
industries. This may be for strategic reasons, as mentioned
above, or for domestic political reasons, such as an attempt to
prevent structural unemployment from blighting certain areas of
the country.
(d) Aggregate demand
The Keynesian equation for aggregate monetary demand
emphasizes that net exports, i.e. exports minus imports, are an
injection into the circular flow of funds. One way to increase
aggregate demand and consequently the national income is to
limit imports. Protectionism therefore combats unemployment.
(e) Balance of payments problems

The sections below on balance of payments discuss how import
restrictions can be used to try to solve balance of payments
problems.
8.7 Arguments against protectionism
One of the main arguments against protectionism has already been quoted,
which is the theory of comparative advantage. Protectionism reduces the
amount of specialization that can take place, thus reducing world output. We
have also mentioned the increased choice provided by free trade, the
encouragement to competition and efficiency, and the potential reduction in
consumer prices, leading to higher standards of living. All these factors
militate against the use of protectionist policies.
Other arguments against protectionism include the following.
(a) Retaliation
If a country imposes restrictions against other countries’ exports, it is
likely that retaliatory restrictions will be imposed.
(b) Cost
The cost of operating all the administrative and bureaucratic
procedures necessary to ensure that import controls are adhered to
can be enormous.
8.8 The General Agreement on Tariffs and Trade (GATT)
GATT came into being as an international organisation in 1948 with the
aim of reducing barriers to free international trade. It grew to having
some 100 member countries that participated in regular rounds of talks
designed to remove or reduce protectionist policies around the world.
Each set of negotiations could take several years before the final terms
were agreed.
The Uruguay round was successfully concluded and signed at the
beginning of 1994 after seven tortuous years of talks with various
accusations between Europe and the USA of discriminatory or unfair
policies. It was the most ambitious by far of the eight GATT
liberalization rounds owing to the attempt to bring some entirely new
areas − trade in services, the trade-related aspects of intellectual

property rights and trade-related investment measures – within GATT’s
sphere, as well as the need to incorporate some old but very
contentious elements such as agriculture and textiles into the system.
The past years have demonstrated an international desire for a more
comprehensive multilateral trading system with nations recognizing the
obvious benefits to world trade.
The treaty at the end of the Uruguay round created the World Trade
Organisation (WTO) as a new international body to take up GATT’s
work in the future, and GATT went formally out of existence in April
1994.
8.9 The World Trade Organisation (WTO)

The WTO started operations on 1 January 1995 with 104 countries as
its founding members. The WTO exists to monitor member countries’
adherence to all the prior GATT agreements that they had signed up to
(including the Uruguay round), and to negotiate new trade liberalization
agreements in the future. It is based in Geneva in Switzerland.
In early 1999, the US complained to the WTO that European countries

were unfairly favoring banana imports from the Caribbean, while the
EU complained that the US was exporting genetically modified crops
that had been certified as GM-free. The WTO’s role as a stronger
organisation than GATT which monitors and resolves trade disputes
(rather than just establishing agreements) is being continually tested.
9. Globalization
9.1 Introduction
The term ‘globalization’ does not have a universally agreed definition.
The International Monetary Fund defines globalization as ‘the growing
economic interdependence of countries worldwide through increasing
volume and variety of cross-border transactions in goods and services,

free international capital flows, and more rapid and widespread
diffusion of technology’.
It is useful here to make a distinction between globalization and
internationalization.
Internationalization
Internationalization refers to the increasing spread of economic
activities across geographical boundaries, for example:
• many firms are taking advantage of the internet to sell to new
countries overseas.
• setting up production facilities overseas.
Globalization
Globalization, however, refers to a more complex form of
internationalization where much greater integration is seen, for
example:
• the erosion of trade barriers is creating a single global market,
rather than many different international markets
• the homogenizing of tastes across geographies. Food, once
highly local in style, has become more global in many respects
• firms selling the same product in every world market rather than
tailoring products to local preferences
• greater harmonization of laws in different countries
• the dilution of traditional cultures in some third world countries
as they are replaced by Western value systems
9.2 The factors driving globalization
When considering the driving forces of globalization it can be difficult to

distinguish between cause and effect. For example, does the existence
of global firms drive globalization or are they the consequence of it?

Both viewpoints have validity. However, the main drivers of
globalization are as follows.
Improved communications
• The advent of the internet over the past ten years has paralleled
the emergence of globalization as a concept.
• Many within developing countries see the internet as an
opportunity to gain access to knowledge and services from
around the world in a way that would have been unimaginable
previously.
• The internet and technologies such as mobile telephony allow
developing countries to leapfrog steps in their development of
infrastructure. A poor land line telephone system in the
Philippines, for example, is being rapidly bypassed by mobile
phones with internet access.
• The wider access to Hollywood and Bollywood movies has also
given rise to greater multiculturalism.
Political realignments
• The growth of trade agreements, free trade areas and economic
unions, described above, all contribute towards the idea of
single markets replacing separate ones.
• In addition, political realignments have opened the huge markets
of China and the old Soviet Union, both of which used to be
closed to Western firms.
• The collapse of communism in the USSR in 1989 (the date of
the fall of the Berlin Wall) marked the beginning of new trade
opportunities in the Soviet Union.
• Political change in China led to the signing of a bilateral trade
agreement with the USA in 1979. This has been further
reinforced by China joining the WTO.

Growth of global industries and institutions
• The growth of global firms has been a key driver of globalization.
• Some would argue that the rapid growth of corporations such as
McDonalds and Coca Cola has resulted in pressure on local
cultures to accept Western tastes and values.
• Global firms can influence governments to open up markets for
free trade.
• Global firms can encourage political links between countries. For
example, the entry of Japanese car manufacturers into the
United Kingdom fostered a stronger political dialogue between
the Japanese and British governments.
Cost differentials
• Viewed simplistically, most firms’ competitive strategy is based
on cost and/or quality advantages. Many firms have found that
they can manufacture their products at a much lower cost in
‘third world’ countries than in their home markets. This is usually
due to much lower labor costs. For example, most clothing sold
in the UK is manufactured in factories in China, Sri Lanka and
India.
9.3 The impact of globalization

Industrial relocation
As mentioned above, many firms have relocated their
manufacturing base to countries with lower labor costs.
However, this can give the impression that the only form of
expansion is from ‘First world’ to ‘Third world’. This is not always
the case as illustrated by Nissan building a car factory in
Sunderland in the UK to avoid EU import quotas and tariffs.

Emergence of growth markets
As mentioned above, many previously closed markets, such as
China, are opening up to Western firms.
In addition, if tastes are becoming more homogeneous, then this
presents new opportunities for firms to sell their products in
countries previously discounted.
Enhanced competition
The combination of firms’ global expansion plans and the
relaxation of trade barriers have resulted in increased
competition in many markets. This can be seen in:
• greater pressure on firms’ cost bases with factories being
relocated to even cheaper areas.
• greater calls for protectionism.
Cross-national business alliances and mergers

To exploit the opportunities global markets offer, many firms
have sought to obtain expertise and greater economies of scale
through cross-national mergers and acquisitions. For example:
• In 2004 American brewer Anheuser-Busch Limited
purchased the Chinese company Harbin Brewery
Company Ltd.
• The merger of Hoechst (a German company) and Rhone
Poulenc (French) to create Aventis in 1999 created the
second largest drugs manufacturer in the world at the
time.
Widening economic divisions between countries
Many opponents of globalization argue that it is creating new
gaps between the rich and the poor. For example:
• Rich countries have much greater access to the internet
and communications services. In the current information
age wealth is created by the development of information

goods and services, ranging from media, to education
and software. Poor countries are not taking part in this
information revolution and are falling further behind.
• The relentless drive to liberalize trade i.e. to remove trade

barriers, promote privatization, and reduce regulation
(including legal protection for workers), has had a
negative impact on the lives of millions of people around
the world.
• Many poor countries have been pressured to orientate
their economies towards producing exports and to reduce
already inadequate spending on public services such as
health and education so that they can repay their foreign
debt. This has forced even more people into a life of
poverty and uncertainty.
Summary
The chapter has demonstrated the value of international trade for all involved.
Inevitably, trade has led to the development and increasing dominance of
large and growing multinational companies, which may possess powers to
influence the policy – making process in the countries in which they operate.
Nevertheless, the benefits of trade outweigh the drawbacks, and
organisations like the WTO exist to foster trade and prevent a retreat into
protectionism which, more than anything else, will stifle world economic
growth.
Self-test questions
Attributes of the international business environment

1 Explain what is meant by ‘a multinational company’. (2.1)
Reasons for international trading
2 Explain what is meant by ‘process specialization’ and ‘product
specialization’. (3.3)

Alternative methods of foreign market entry
3 What might be an advantage of setting up an overseas
subsidiary rather than an overseas branch? (4.3, 4.4)
Problems associated with international activities
4 Give three examples of the problems a firm might face when
selling in overseas markets. (5)
Summary of the benefits of trade
5 Give four examples of the benefits of international trade to an
economy. (6)
The law of comparative advantage
6 Explain the law of comparative advantage. (7.1)
Protectionism
7 Give two examples of how imports may be restricted. (8)
8 Explain the arguments in favor of protectionism. (8.6)
9 Explain the arguments against protectionism. (8.7)
10 Explain the role of the World Trade Organisation. (8.9)
Practice questions
Question 1
The following table shows the output possibilities, in tons per day, for two
goods in two different countries:
Country X Country Y
Beef 10 1
Steel 2 1
Which of the following statements is true?
A No trade is possible as X is better at producing both goods
B X will tend to export steel to Y
C Y will tend to import beef from X
D X has a comparative advantage in the production of both goods

Question 2
A country is said to have a comparative advantage in the production of a good
when:
A it can produce more of it than any other country
B it has captured a larger share of the world market than any other
country
C it can produce it at a lower opportunity cost than its trading
partners
D its costs of production for the good are lower than in other
countries
Question 3
The existence of international trade is best explained by the fact that
countries:
A use different currencies
B have different economic systems
C have different endowments of factors of production
D have specialized in different goods and services
Question 4
The imposition of which one of the following would not act as a barrier to
international trade?
A A value added tax
B Tariffs
C Import quotas
D Exchange controls
Question 5
A multinational company is best described as one which:
A engages extensively in international trade

B sells its output in more than one country
C produces goods or services in more than one country
D is owned by shareholders in more than one country
Question 6
Which one of the following is not an economic advantage of international
trade?
A It encourages international specialization
B Consumer choice is widened
C It enables industries to secure economies of large-scale
production
D Trade surpluses can be used to finance the budget deficit
Question 7
The theory of comparative advantage suggests that countries should:
A diversify their production as much as possible
B engage in trade if the opportunity costs of production differ
between countries
C engage in trade only if each country has an absolute advantage
in at least one good or service
D aim to make their economies self-sufficient
Question 8
The comparative cost model of international trade shows that trade arises
because of differences between countries in:
A the absolute costs of production
B patterns of consumer demand
C the opportunity costs of production
D the structure of production

Question 9
A restriction imposed on the flow of imports into a country would be expected
to lead to all of the following except which one?
A An improvement in the trade balance
B A reduction in unemployment
C Reduced competition for domestic producers
D A fall in the rate of inflation
the book.
1. Trade and the balance of payments

1.1 Definition
The balance of payments is a record of all the transactions that occur during a
year between the residents of a country and overseas residents. All inflows
from abroad are recorded as positive in the balance of payments, while all
outflows are recorded as negative. For example, if a UK resident buys a
Japanese car, the transaction is recorded as a negative outflow.
1.3 Format of the balance of payments accounts

In September 1998 the format of the balance of payments accounts was
significantly changed to become consistent with International Monetary Fund
formats. The balance of payments is now analysed into three separate
accounts and a balancing figure:
• The current account contains trade in goods and services,
income and current transfers.
• The capital account contains capital transfers, for example to
or from EU
institutions.
• The financial account contains investments in external assets
and liabilities (confusingly, this used to be called the capital
account).

• Net errors and omissions is the required balancing figure.
The current and capital accounts combined should balance with
the financial account. The difference required to make this so is
now called ‘net errors and omissions’. Previously, it was called
the ‘balancing item’.
We look at each of the accounts below and explain why the balance of
payments account must balance.
1.4 The current account
The current account is a record of income and expenses, much like a
profit and loss account, but constructed on a cash rather than accruals
basis. Given below is a hypothetical example of a current account:
Current account
Rs. million
Visible
Exports 10,000
Imports (15,000)
_____
(5,000)
Invisible
Services 1,000
Interest, profit and dividends 2,000
_____
Balance (2,000)
_____
Some of the items above need explanations.
Visible
As the name implies, these are visible or tangible items traded between
Pakistan residents and overseas residents. They include all goods imported
and exported such as cars, food, machinery and so on. Notice that exports
are positive as they result in funds coming into the country, while imports are
negative as they require payments to flow out of the country. In the example
above there was a net outflow of Rs. 5 billion on visible trade.

The net inflow or outflow on visible is known as the balance of trade,
which for the Pakistan is normally negative, or ‘in deficit’. As a general
rule, the Pakistan spends more money on imports than it receives from
exports.
Invisible
These are payments for services, such as financial advice, and other
intangible earnings and payments, such as interest earned on assets
held abroad, or dividends paid by Pakistan companies to overseas
shareholders. In addition, there are ‘one-way’ current transfers.
The Pakistan invisibles balance is usually negative, and in the past it

was often high enough to outweigh the deficit on the balance of trade.
As the Pakistan’s net earnings on visible exports have fallen, the need
for a positive invisibles balance has increased. The Stock Exchange,
together with the foreign currency and commodity exchanges, are also
major contributors to invisible earnings, being amongst the largest
exchanges in the world.
Tourism also features strongly in the invisibles balance, although there
is often a net deficit in this area, with money spent by Pakistan tourists
abroad exceeding money received from foreign tourists.
Balance
In the example above, a total of Rs. 2 billion left the country during the
year, being net expenditure on goods and services received from
abroad, together with investment income received.
1.5 Capital account

The capital account includes capital transfers as well as the acquisition
or disposal of non-financial non-produced assets. Under the previous
system, all these items were included in the current account.

1.6 Financial account
The financial account shows the balance of investments made
overseas by Pakistan entities, investments made in the Pakistan by
overseas entities, and the movements on assets held as reserves by
the Pakistan government.
The whole balance of payments presentation can therefore be thought

of as a standard double-entry account through which all transactions
between residents and non-residents pass. Typically, one entry of each
transaction will relate to resources and the other entry to the financing,
so that the double entry can be maintained, and the total debits equals
the total credits. It is this maintenance of the double entry that implies
that the figures in the balance of payments account must balance
(subject to any errors in gathering the figures).
To continue the hypothetical example, the financial account might look

as follows:
Financial account
Rs. million
Pakistan investment overseas (30,000)
Overseas investment in the Pakistan 23,000
Reserve assets 9,000
_____
Balance 2,000
_____
As one would expect, Pakistan investments overseas are an outflow,
while investments by foreigners in the UK are an inflow.
1.7 Summary
If we bring all the accounts together, we have an overview of the net
situation for the year.

Current account
Rs. million
Visible
Exports 10,000
Imports (15,000)
_____
(5,000)
Invisible
Services 1,000
Interest, profit and dividends 2,000
____
Balance (2,000)
____
Financial account
Pakistan investment overseas (30,000)
Overseas investment in the Pakistan 23,000

Reserve assets 9,000
_____
Balance 2,000
_____
1.8 The balancing item
Unfortunately, in practice, it is very difficult to measure accurately all
the figures that make up the balance of payments. When the total of
the current account balance and the capital account balance is worked
out, it never precisely equals the balance on the financial account.
There is always an error in the calculations, which is called the ‘net
errors and omissions’, a problem with which you are probably all too
familiar.

The balance of payments might therefore be represented by the
following figures, presented beneath the current and capital accounts:
Rs. million
Financial account balance 1,500
Net errors and omissions 500
_____
Balance 2,000
_____
You can now see how the balance of payments earns its name: it
always balances, since one half of it is a record of the net outflows from
the country, while the other half shows where the funds came from.
Of course, there may be net inflows in a year, in which case the

balance on capital and current accounts taken together would be
positive. The second part of the balance of payments would show how
the net inflow had been used; for example, the State Bank of Pakistan
could have used it to pay off some borrowings or simply to replenish its
foreign currency reserves.
1.9 Summary so far
The work covered to this point has established that the balance of
payments records total flows of funds into and out of a country. It is
subdivided into two parts, which should balance. Since there are
always inaccuracies in the figures, a balancing item is also inserted,
which does not form part of the main balance of payments.
Since the balance of payments essentially records net outflows and the
source of those outflows, or net inflows and the use to which those
inflows have been put, it must balance.

2 The terms of trade
2.1 Introduction
The terms of trade measure the relative change of the price of
domestic goods sold abroad and the price of overseas goods sold in
the home market.
DEFINITION
The terms of trade are the ratio of an index of (visible) export prices to
an index of (visible) import prices. They measure the relative change of
the price of domestic goods sold abroad and the price of overseas
goods sold in the home market.
A base year is chosen, at which point the average price of exports is

assigned an index value of 100, as is the average price of imports. Any
difference in subsequent price changes is then measured by the index.
Suppose that, in 20X5, the base year, the average price of a basket of
visible Pakistan exports was Rs. 450, while the average price of a
basket of imports was Rs. 500. Each of these prices would be assigned
an index number of 100, and the terms of trade would be:
(100/100) = 1
In fact, this ratio is multiplied by 100 when the terms of trade are
calculated. So the terms of trade for 20X5 are 100.
Now, suppose that next year the average price of exports rose by 5%,
to Rs. 472.5, while the average price of imports rose by 2%. The index
for exports would rise to 100 × 1.05 = 105, and the index for imports
would rise to 102. The terms of trade for 20X6 would be:
(105/102) × 100 ≈ 103
The rise in the terms of trade reflects the fact that export prices have
risen more than import prices.
An increase in the terms of trade is called an improvement in the terms
of trade, although it may not actually be desirable.

Summary
The balance of payments is of great significance to the economic well-
being of the community, particularly in regard to the level of economic
activity and thus the level of employment. Its status depends on both
current account flows and movements of capital. The exchange rate
system in operation in the economy will affect the policies required to
maintain a stable or acceptable balance. Fixed and floating approaches
both enjoy merits and demerits. The development of the single market
and monetary union hold out considerable promise for the development
of the economies of the European union.
Self-test questions
Trade and the balance of payments
1 What do you understand by the current account of a country’s

balance of payments? (1.4)
2 What do you understand by the financial account of a country’s

balance of payments? (1.6)
The terms of trade
3 Under what circumstances will an improvement in the terms of

trade be advantageous to a country? (2.2)
Practice questions
Question 1
Which of the following best describes the terms of trade?
A The difference between the volume of imports and exports
B The difference between the value of imports and exports
C The rate at which imports and exports exchange for each other
D The rate at which currencies exchange for each other

Question 2
A devaluation of the exchange rate for a country’s currency will normally result
in:
(i) a reduction in the current account deficit
(ii) an improvement in the country’s terms of trade
(iii) a reduction in the domestic cost of living
(iv) an increased level of domestic economic activity
Which of the above are correct?
A (i) and (ii) only
B (i) and (iv) only
C (ii) and (iii) only
D (ii) and (iv) only
Question 3
Which of the following might cause a country’s exports to decrease?
A A fall in the exchange rate for that country’s currency
B A reduction in other countries’ tariff barriers
C A decrease in the marginal propensity to import in other

countries
D A rise in that country’s imports
Question 4
Which one of the following cannot be used to finance a deficit on the current
account of a country’s balance of payments?
A Running down foreign exchange reserves
B Increased taxation
C Borrowing from foreign and central banks
D Attracting inflows of short-term capital

Question 5
A favorable movement in the terms of trade for a country means that:
A the balance of trade has improved
B the volume of exports has risen relative to the volume of imports
C the prices of exports have risen relative to the prices of imports
D the revenue from exports has risen relative to the revenue from
imports
Question 6
Which of the following is most likely to cause a country’s balance of payments

to move towards a deficit?
A A devaluation of that country’s currency
B An expansionary fiscal policy
C A contractionary fiscal policy
D A rise in the rate of domestic saving
Question 7
The current account of the balance of payments includes all the following
items except which one?
A The inflow of capital investment by multinational companies
B Exports of manufactured goods
C Interest payments on overseas debts
D Expenditure in the country by overseas visitors
the book.

3. Exchange rate systems
3.1 Exchange rates
The exchange rate of a currency is a price. It is the external value of a
currency expressed in another currency, for example.
£ 1 = $ 1.60
The exchange of currencies is vital for trade in goods and services.
British firms selling abroad will require foreign buyers to exchange their
currency into sterling to facilitate payment. Similarly, British importers
will need to pay out in foreign currencies. Also, when funds are
transferred between people in different countries, foreign exchange is
required.
3.2 Exchange rate systems - floating exchange rates

Exchange rates that float are flexible and free to fluctuate in the light of
changes which take place in demand and supply. Such exchange rates
are examples of nearly perfect markets.
Demand
Demand for a currency, sterling say, comes from a number of sources:
 It is required to pay for UK exports – for example, a French
supermarket buying English food will need to pay its suppliers in
sterling.
 Overseas investors making investments in the UK will need
sterling – for example, an American property company buying a
factory building in the UK will have to pay in sterling.
 Speculators may buy sterling if they feel it is about to increase
(appreciate) in value relative to other currencies.
 The government (strictly the central bank) may wish to buy
sterling to manipulate the exchange rate.
 For some currencies there may be a demand for it to be held as
an international medium of exchange as is the case with the US
dollar.

Supply
Supply of sterling is also derived from number of sources:
 UK residents wishing to buy imports will need to sell sterling and buy
foreign currency.
 UK residents making overseas investments will need to sell sterling and
buy foreign currency.
 Speculators may sell sterling if they feel its value is about to decrease
(depreciate) relative to other currencies.
 The UK government may sell currency on the international markets to
weaken the currency to improve export performance.
Today, the sale and purchase of currencies for trading purposes is dwarfed by
the lending and borrowing of funds.
Impact of different factors on the exchange rate

Putting these issues together, we can comment on how various economic
factors affect exchange rates as follows:
 High inflation will weaken a currency as it makes goods more
expensive thus dampening export demand and reducing the demand
for the currency.
 An increase in interest rates will have a two-fold effect.
In the short run “hot money” will be attracted to UK deposits, increasing
demand for sterling and a corresponding rise in the exchange rate.
In the long run, high interest rates will erode the competitiveness of UK
businesses reducing the supply of a demand for UK goods. This will
reduce the demand for sterling, reducing the exchange rate.
 A trade deficit will result in the demand for sterling to buy exports being
lower than the supply of sterling to buy imports. This will result in
downward pressure on the exchange rate.
 Speculation can influence the exchange rate up or down. This is
usually a short-term factor.

Example using a diagram of supply and demand
Price of £ in dollars S
P
P1
D
D1
Qd Qs
Quantity of £
In the diagram, suppose we have a factor that causes British goods to

become less competitive on world markets.
 This will result in a fall in the demand for British exports and
hence a causes a shift the demand curve for sterling to D 1.
 This shift causes a fall in the exchange rate to P 1, assuming that
the demand for British imports (and hence the supply curve)
remains unchanged.
 P1 Q1 would be a new equilibrium position at which the demand
for pounds and the supply of pounds are equal.
3.3 Exchange rate systems – dirty floating
Governments often intervene in the foreign exchange markets (either

by creating demand or supply of their currency as required) in order to
maintain or achieve an exchange rate target. The purpose of this
normally is to make a country’s exports more competitive, by lowering
the exchange rate, or to assist in the control of inflation.
The central bank will be instructed to:
 Buy or sell the currency to raise or lower the exchange rate.

 Alter interest rates to encourage the buying or selling of the
currency. For example, a raising of interest rates should
encourage speculators to deposit more funds in that country.
The subsequent rise in demand for the currency should cause a
rise in the exchange rate.
For example, China operates a managed floating exchange rate

system for the Yuan and international leaders have criticized the
Chinese government for keeping the value of the Yuan artificially low,
to boost exports.
3.4 Exchange rate systems – fixed exchange rates

The world economy has experienced different exchange rate
mechanisms. In the nineteenth and twentieth centuries, the gold
standard was used, where exchange rates were fixed in terms of gold.
A managed exchange rate system was established at Bretton Woods

(United States) in 1944 to encourage stability and redevelopment after
the second would war. This established exchange rates between
economies but allowed a 1% band either side of its parity. The rate was
determined by supply and demand but governments had to manage
policy to ensure that the actual rate stayed within its band. If this
proved too difficult Governments were allowed to devalue their
currency and more to a new but lower “peg”.
For Example, on 12 March 1947 the exchange rate between the

Japanese yen and the US dollar was $1 = ¥ 50 but on the 5 July 1948
this was changed to $1 = ¥ 270.
In 1979 the European exchange Rate Mechanism (ERM) was set up,
party to reduce exchange rate variability but also as a step towards
monetary union and the creation of the euro in 1999. The ERM was
similar to the Bretton Woods system in as much that currencies were
allowed a degree of fluctuation (here 2.25%) as a result of normal
supply and demand changes but governments were again expected to
intervene to ensure these limits were not breached.

The pound crashed out of ERM on 16 September 1992 (“Black Wednesday”)
due mainly to the efforts of speculators, notably George Soros. On that date,
the UK Chancellor Norman Lamont raised interest rates from 10% to 12%
then to 15%, and authorized the spending of billions of pounds to buy sterling
order to support the value of the pound. However, the measures failed to
prevent the pound falling lower than its minimum allowed level in the ERM
and the decision was taken to leave the ERM.
Price of £
P fixed
Qd Qs
Quantity of £
In the above diagram the exchange rate has been fixed at a level higher than
would be the case if the currency were floating. As with any minimum price
this results in a surplus of supply (Qs) over demand (Qd). Here the
government would have to make up the gap in demand (Qs – Qd).
3.5 Arguments for floating rates

Balance of payment
In theory, the floating rate automatically adjustments a balance of payments
disequilibrium.
 Suppose a country has a balance of payments deficit due to imports
being greater than exports.
 This will result in supply of the currency (to buy imports) exceeding
demand (to buy exports) resulting in a fall in the value of the currency.

 The lower value of the currency will make exports seem cheaper to
foreign buyers (so exports should increase) but imported goods will
appear more expensive (so imports will decrease).
 The net result is that the balance of payments deficit will be reduced.
This will continue until the deficit is eliminated.
The self-correcting mechanism means that policies, such as deflation, to

rectify a balance of payments deficit will not need to be implemented. This
gives a government greater freedom to pursue domestic policies.
Speculation reduced
Less speculation will occur because a currency can appreciate or

depreciate whereas under fixed rate regime currency changes were
nearly always devaluations. This meant that speculators, who sold a
currency which had been devalued, could not lose and could only gain.
For instance, someone holding £ 1,000 at £ 1 = $ 1.8 moves into

dollars, securing $ 1,800 (assuming no transaction costs). If sterling is
devalued to £ 1 = $ 1.4 the dollar holding is now worth £ 1,280 the
switch back into sterling is made in order to secure a capital gain.
Conversely, if sterling is not devalued, the switch back into sterling is
still worth £ 1,000 with no loss made.
Resource allocation
A more efficient allocation of resources is secured if exchange rates

reflect changed economic conditions. It is argued that floating rates will
reflect changes in demand and supply and that they are more sensitive
and respond quickly to underlying economic trends. This might enable
the theory of comparative advantage to be operative.
As floating rates change daily, they are more subtle but probably at the
cost of greater volatility. Fluctuations in exchange rates can cause

uncertainty. This could deter trade, as contracts with fixed prices
become more risky as exchange rate appreciation will cut profit
margins. However, to some extent this problem can be offset by buying
a currency in the forward market.
Reserves
A large supply of reserves is unnecessary in a floating system because

the automatic adjustment of a balance of payments deficit (or surplus)
is achieved by an exchange rate depreciation (or appreciation). In
theory, reserves will be automatically maintained and so domestic
policy changes such as interest rate increases will not be needed to
keep the exchange rate up.

ANSWERS TO END OF CHAPTER QUESTIONS
Chapter 1
PRACTICE QUESTIONS
Question 1
The central economic problem stems from the fact of relative scarcity,
i.e. that human wants will always outstrip the resources available to
satisfy those wants. The correct response is therefore D.
C is wrong because, although it refers to the allocation of resources, it

stresses the optimum allocation. The fact that resources are not
allocated in an optimum way is an economic problem but it is not the
central one of the need for this allocation in the first place, i.e. scarcity.
A is incorrect because it refers to money and not to real resources; and

B again concentrates on an issue which, while an important economic
problem, is not the central one.
Question 2
Each statement should be considered separately to test its validity. B is
the correct response since it is the only one which is not true − profit
will not be the same in absolute terms in all firms, even if they are
equally efficient. The most we can say is that all firms will earn normal
profit, but this is not the same thing. Each firm’s normal profit will be a
different amount and will depend on subjective factors such as the size
of the firm, its expectations etc.
All the other statements are true by definition.
Question 3
The correct answer is B.

Question 4
The market mechanism operates automatically through prices to
provide information for producer and consumer decisions and
producers’ concern with profit promotes technical efficiency, hence a
reduction in costs.
Question 5
The correct answer is C.
The opportunity cost of producing a commodity or service is the
alternatives sacrificed given that resources are limited.
Question 6
It can be argued that the free market mechanism does allocate income
in the form of wages, rent and profit; however, it is not based on need,
which is obviously subjective.
Question 7
The answer is C.
Consumer demand will mainly determine which goods are produced. In
a market economy, supplying goods that consumers do not want will
result in business failures and resources being switched into producing
goods that are in demand.
Question 8
Opportunity cost is the alternative forgone, therefore B – the value of
goods and services that could otherwise have been produced with the
resource used to build the road – is correct.
ADDITIONAL QUESTION
Allocation of resources

(a) People want more of almost everything, but the resources available to
meet these wants are limited. Society must decide what to produce and
who gets the final product – the state, individuals, businesses or future
generations. This decision is the central problem that economics tries
to solve – how to allocate the limited resources, or factors of
production, which are land, capital, enterprise and labor, to meet
unlimited wants. The allocation of resources is important, because only
if the right decisions are made will economic welfare be maximized.
(b) A mixed economy is one in which the free market economy operates
with some degree of state intervention. Britain is an example of a
mixed economy. There is a lot of free enterprise and many decisions
are driven by the market mechanism. Businesses make their own
production and pricing decisions (largely free of government
intervention), and consumers decide what they will buy with their
income (mostly without government intervention). But government does
intervene in the working of the market mechanism to:
(i) promote competition and limit the growth of monopoly power;
(ii) ensure the production of merit and public goods;
(iii) make some goods illegal or discourage their consumption;
(iv) ensure that externalities are reflected in producer's costs and
thus in prices.
Within a competitive market, consumers decide what they want to buy

at the prevailing market prices and signal their decisions to producers
by the way they spend their income. If this causes surpluses or
shortages at current prices, the prices change. A shortage causes price
rises and a surplus causes price falls. These price changes signal to
businesses whether it is profitable to increase production or not. In
search of profits, firms will increase production of a good in short
supply and thus increase their demand for resources used in the
production of such goods. This will result in a rise in the price of these
resources. In the same way, businesses cutting back on the production
of goods where there are surpluses, reduce their demand for the

resources they employ, their price falls and fewer resources are
supplied to those lines of production. Thus it is consumer choice that
determines the allocation of resources.
The extent of government intervention in the mixed economy varies

according to political persuasion. But it typically includes the following:
(i) To promote competition and thus ensure that consumer demand
results ultimately in higher production and not just higher prices,
governments act to restrict monopoly power. Examples from the
UK are the Competition Commission, the 'Watchdogs' created to
oversee the privatized industries, and the legislation restricting
the power of the trade unions.
(ii) Merit goods are goods which are generally believed to be
beneficial and which the State may supply to ensure that they
are available to all consumers regardless of income. Examples
are education or health care.
(iii) Public goods are goods which must be provided communally
because their consumption is non excludable. Examples are
roads and street lighting.
(iv) Uneconomic goods are goods that the government wishes to
see produced, which would not be produced in a pure market
economy. Examples are foodstuffs and armaments.
(v) The government may believe that some goods are bad and will
intervene in the market economy to prevent them being
produced, or levy taxes on them to discourage their
consumption. Examples are drugs and cigarettes.
(vi) Finally, prices established in the free market do not take into
account any external costs or benefits owing to externalities.
The government may intervene with, for example, taxes to curb
pollution from factories or subsidies to encourage the
continuation of a social benefit such as bus services for rural
communities.

Thus in the mixed economy, resources are allocated by both the price
mechanism reflecting consumer preferences and by decisions made by the
State.
Chapter 2
ADDITIONAL QUESTION
Private v public sector objectives

Tutorial note: This is a fairly wide-ranging question and you need to
apply a general knowledge of business operations as well as specific
knowledge of financial management. A wide variety of answers would
be acceptable. The major points are covered in the following essay
plan.
(a) Financial objectives
(i) State-owned enterprise
• Overall objective is commonly to fulfil a social need.
• Owing to problems of measuring attainment of social
needs the government usually sets specific targets in
accounting terms.
• Examples include target returns on capital employed,
requirement to be self-financing, cash or budget limits.
(ii) Private sector
• Firm has more freedom to determine its own objectives.
• Stock market quotation will mean that return to
shareholders becomes an important objective.
• Traditionally financial management sees firms as
attempting to maximize shareholder wealth. Note that
other objectives may exist, e.g. social responsibilities,
and the concept of satisficing various parties is important.
(b) Strategic and operational decisions

The major change in emphasis will be that decisions will now have to
be made on a largely commercial basis. Profit and share price
considerations will become paramount. Examples of where significant
changes might occur include:
(i) Financing decisions – The firm will have to compete for a wide
range of sources of finance. Choices between various types of
finance will now have to be made, e.g. debt versus equity.
(ii) Dividend decision – The firm will now have to consider its
policy on dividend payout to shareholders.
(iii) Investment decision – Commercial rather than social
considerations will become of major importance. Diversification
into other products and markets will now be possible. Expansion
by merger and takeover can also be considered.
(iii) Threat of takeover – If the government completely relinquishes
its ownership it is possible that the firm could be subject to
takeover bids.
(iv) Other areas – Pricing, marketing, staffing etc., will now be
largely free of government constraints.
Chapter 3
PRACTICE QUESTIONS
Question 1
The demand curve will shift to the right when consumers are buying
more of the good for some reason other than a reaction to a change in
the price − B is therefore incorrect. The correct answer is D because, if
a close substitute becomes more expensive, people will buy more of
the first product even though its price has not changed.
C is wrong because the normal reaction to an increase in the price of a
complement is to buy less of both products − the demand curve for the
first product would therefore shift to the left.

A is wrong because a decrease in production costs will cause the
supply curve to shift and not the demand curve.
Question 2
Indirect taxes such as VAT shift a producer’s supply curve to the left. At
each price the producers supply less because part of sales income
goes in tax to the government.
Question 3
A is concerned with the supply curve not the demand curve. B would
lead to a movement along the demand curve not of the whole curve. D
would lead to the demand curve moving to the left.
Question 4
When the price of a good is held above the equilibrium price, supply
will exceed demand which will cause a surplus of the good, therefore C
is correct.
Chapter 4
PRACTICE QUESTIONS
Question 1
A, B and D are all true statements about the elasticity of supply. C is to
do with productivity.
Question 2
The correct answer is A.

If a good is price inelastic, then the ratio of the percentage change in
quantity demanded to the percentage change in price is less than one.
In other words the proportionate change in quantity demanded is less
than the proportionate change in price, so an increase in price will
increase total revenue and a fall in price will reduce total revenue.
Hence only A is correct.
Question 3
Question 4
The correct answer is D.
A consumer will not change the amount normally demanded of a good
even if its price changes provided that it does not affect significantly his
or her overall spending pattern.
Question 5
If a good is price elastic it means that the demand for it is price
sensitive, hence a rise in price will lead to a greater proportional fall in
demand so that overall expenditure on the good falls.
Question 6
Elasticity of demand measures how responsive consumers are to
changes in price. Demand is elastic when a fall in price brings about an
increase in total expenditure. If expenditure fell by the same amount as
the price fall then demand must be perfectly inelastic to A.
Chapter 5
PRACTICE QUESTIONS
Question 1

Each of the options should be considered carefully to see which one
follows logically from the original statement. A is the correct answer
because if wages form a large proportion of costs, then an employer
will resist or avoid raising wages so as not to escalate total cost.
B is incorrect because if the demand for the product is price inelastic,

the producer could raise the wages of the workers, raise the price of
the product to preserve the profit margin and increase the revenue,
since consumers would not respond by buying a lot less.
C is incorrect because if it is not easy to substitute capital for labor,

then a demand for higher wages by the union could be successful in
that the employer has no alternative factor of production to use, and
would have to keep the workforce happy.
D is wrong because, if the demand for the product is expanding, then
the producer could afford to pay higher wages and raise the price of
the product without losing sales.
Question 2
B is the correct answer.
Any payment to a factor of production that is greater than its supply
price is a kind of surplus that is known as economic rent. Considering
the diagram, the economic rent is the shaded area, PP1R.
Price
S
R
P
P1 D
Q Quantity

As the supply curve for labor becomes more inelastic, so the shaded area
above the curve increases, as shown below.
Price
S
R
P
P1 D
Q Quantity
A is therefore incorrect as it assumes the opposite. C and D are incorrect as

they are dealing with the demand curve for labor, when economic rent
concerns the supply curve for labor.
Question 3
If the minimum wage is below the market wage, there will be no effect
on unemployment. If the demand for labor is inelastic, then the
imposition of a minimum wage will not significantly affect demand or
the level of unemployment. But the more elastic the demand the bigger
the fall in demand in response to the minimum wage and thus the
greater the resulting unemployment.
Question 5
The elasticity of the supply of labor is primarily determined by the
response of workers to a change in the wage and this in turn is
dependent on the mobility of labor between occupations. If there are
barriers of entry into a job or profession owing to, say a long training
period, then the supply curve will be more inelastic. Hence A and B are

incorrect. D is also incorrect as elasticity has nothing to do with the
actual wage level.
Question 6
The correct answer is A
Wages are a factor of production. If they are a high proportion of total
costs, firms will be sensitive to wage increases; if demand for the
industry’s product is price elastic, so too will be consumers. If labor and
capital are easily substituted, labor will be replaced by capital. So, by
process of elimination, A is correct.
ADDITIONAL QUESTION
Determination of wages
(a) The demand for labor is a derived demand in that it comes from
demand for the final product or service.
Factors that affect the demand for labor include:

• the productivity of workers and the sales value of the end
product or service as shown by the Marginal Revenue Product
of Labor (MRPL)
• the cost of labor as shown by the Marginal Cost of Labor (MCL).
Another worker will be employed until MRPL = MCL, as shown
in the diagram below.
Wages
MRPL MCL
D
0
L Quantity of labor

The demand for labor
A quantity of 0L workers will be employed at a wage rate of £0W. According to
the classical theory, if MRPL were to increase, by means of increased
productivity or an increase in the final selling price of the good or service, it
would shift to the right and result in a higher equilibrium wage and a possible
increase in the number of workers employed.
(b) The supply of labor is the result of the number of workers willing to
work for a particular wage. The supply of labor can be reduced by
cultural and legal considerations which may make some groups of
people ineligible for work, for example, under/over certain ages,
academic or other requirements, physical attributes, etc.
Factors affecting the supply of labor include:
• non-monetary rewards which may encourage workers to enter
low paid work, for example housing, travel, job satisfaction, etc.
• the length of training periods
• the requirement of specific skills or talents, for example agility,
physical strength, typing skills, sporting ability, etc. – some may
be taught but some may be talents common to very few in the
population
• workers may find difficulty in moving between occupations or
geographical areas because of language skills, work permit
requirements, housing availability and cost, social and family
ties, qualifications and experience, etc.
(c) The classical theory of wage determination is based on market forces
of supply and demand as shown by Marginal Revenue Product of
Labor (MRPL) and Marginal Cost of Labor (MCL). The more skilled the
worker, the higher the price that can be commended for the finished
product or service and the higher is MRPL, as shown in the diagram
below.
Wages
Business Economics (StudyMRPL

Text) 599
1
Ws
w
Increased MRPL and the effect on wage rates
The effect of shifting MRPL to the right is a wage rate increase from 0W to
0Ws.
The existence of non-monetary rewards in some occupations may keep
monetary wages lower and, in the opposite case, the existence of dangerous
or difficult working conditions may increase wage rates. In practice, MRPL
may be difficult to calculate. In cases where there is no identifiable final
product (service industries), or where workers work in teams or where
machinery is part of the process, MRPL per worker cannot be calculated.
In the last resort, wages must reflect cost and benefit to the community and
must be seen as ‘fair’.
(d) A minimum wage represents an attempt to ensure that workers are not
exploited and the state does not support exploitative employers by
paying ‘top up’ amounts to their employees.
Regulations for a national minimum wage in all industries, will affect
industries that for whatever reason pay low wages, and the effects may
be both positive and negative.
The positive effects may include:

• increased spending by a section of the population leading to an
increase in output to meet the demand and, as a result,
economic growth.
• preventing the worst exploitation of groups such as part-time
workers, workers with disabilities, immigrant workers and non-
unionized workers.
• a reduction in state benefits paid to low paid workers.

• an increase in taxation revenue as more people take up
employment and existing workers earn more and pay more tax.
The negative effects may include:
• an increase in unemployment due to the creation of a surplus in
the labor market.
• an increase in the rate of inflation as workers demand wage
increases to maintain the differential between skilled and
unskilled rates of pay.
• an increase in state benefit payments as more workers are
unemployed.
• a reduction in training and other benefits that employers may
have been prepared to offer.
Chapter 5 and 6
PRACTICE QUESTIONS
Question 1
Note: we are talking about the short-run situation, obviously in the long
run all costs must be covered.
Question 2
Question 3
Neither A, C nor D vary directly with the level of production whereas
the cost of raw materials used does.
Question 4

The traditional theory of the firm is based on the premise that the
objective of a firm is to maximize profits and will thus strive to achieve
this situation by producing at the equilibrium position where marginal
cost equals marginal revenue.
Question 5
Question 6
A is not true as any firm can benefit from economies of scale providing
it is of sufficient size to obtain such economies. C is not true by
definition. D is not true as management can generally be inefficient and
still make some good decisions.
Question 7
Unlimited expansion of scale of output may not result in ever-
decreasing costs per unit as average costs may begin to rise as the
size of the business becomes uneconomic. However, this will only
happen in the long run.
Question 8
As firms become very big the effects of economies of large-scale
production are outweighed by other opposing factors such as complex
management structures which become relatively more costly, labor
relations become more unwieldy and staff become less motivated.
Question 9
Question 10
An economy of scale takes place when unit costs are reduced as a
result of expanding output. Cost savings resulting from new production

techniques reduce costs at every level of output, therefore D is the
answer.
Chapter 6
PRACTICE QUESTIONS
Question 1
A perfectly competitive industry must have many producers, none of
which can have any dominance in the market. They are all price takers.
Industries A, C and D do not have this organisational set up.
Question 2
If fixed costs are high in comparison with variable costs, there is less
opportunity for a producer to gain a competitive edge by being more
efficient and reducing unit costs.
Question 3
One condition of a perfectly competitive market is a homogeneous
product. Due to this fact alone, if a producer charged a different price, it
would go out of business, either because of lack of demand if the price
were higher than all the other producers or because it was not making
normal profit if the price were lower.
Question 4

This was a straightforward question testing the properties of perfect
competition. Differentiated goods are a feature of imperfect
competition. Alternatives (i), (iii) and (iv) are all features of perfect
competition so, by process of elimination, B is the answer.
ADDITIONAL QUESTION

Revenue and costs
(a) The completed table looks like this:
Output Total Marginal Total Marginal cost
revenue revenue
0 - - 110 -
1 50 50 140 30
2 100 50 162 22
3 150 50 175 13
4 200 50 180 5
5 250 50 185 5
6 300 50 194 9
7 350 50 219 25
8 400 50 269 50
9 450 50 325 56
10 500 50 425 100
Marginal revenue is defined as the addition to total revenue from

producing one more unit. The marginal revenue is the same at all
levels of output, i.e. total revenue increases by Rs 50 each time an
extra unit is produced. Marginal revenue is therefore constant
throughout and must be the same as average revenue or price.
Graphically, average revenue is thus a horizontal straight line, i.e. the
demand curve is perfectly elastic. This can happen only under
conditions of perfect competition and this firm is operating in a perfect
market.
(b) The fixed costs of a firm are those that, in the short run at least, do not
vary with output. Fixed costs have to be paid even when output is zero
and they are the only ones paid when no production is taking place,
since variable costs are incurred only when output is being produced.
The firm’s fixed costs are therefore the total cost of zero output, i.e. Rs.
110.

The marginal costs are the additions to total cost of producing extra
units, and are shown in the table above.
(c) The firm aims to maximize profits and it will do this where the marginal
revenue gained from selling the last unit is just equal to the marginal
cost of producing that unit. The only output level where marginal
revenue equals marginal cost is 8 units, where both MR and MC are
Rs. 50. The firm will thus produce 8 units.
Profit equals total revenue minus total cost. At 8 units this is Rs. 400 –
Rs. 269 = Rs. 131.
(d) There are no barriers to entry in a perfect market and so new
producers can come in. They will do so, however, only if there is
enough profit to attract them in, i.e. only if the existing firm (or firms) is
making a supernormal profit. The industry will be in equilibrium, i.e.
new firms will stop entering when all firms are making a normal profit.
Normal profit is that amount of profit which will just keep a firm in
business and it is earned when the firm covers all its costs, including
the opportunity cost of giving up the next best alternative employment.
The entry of new producers will reduce the supernormal profit being
earned by the existing firm and will also cause its output to fall. This
can be illustrated graphically.
Price AT D S1
M
P1 AR1 = MR1 P1 S2
P2 AR2 = MR2P2
Output Output
0 Q1 Q2 0
When new firms enter the market, the industry supply curve increases
i.e. shifts to the right. The new supply curve S2 interacts with the
original demand curve and causes market price to fall from P1 to P2.
Each firm therefore receives a lower price and average and marginal
revenue curves fall from AR1 to AR2 and from MR1 to MR2. The firm’s

output is reduced from Q1 to Q2. Output and price will continue to fall
as new firms continue to enter until all firms are earning just normal
profit − there is now no further incentive for any more firms to join the
industry.
In conclusion, the firm’s output and profits will both fall as new
producers enter the market.
Chapter 7
PRACTICE QUESTIONS
Question 1
This question tests knowledge of the assumptions underlying
monopolistic competition. The only one which is not found in such a
market is a homogenous product − one of the essential features of
monopolistic competition is producer differentiation. B is thus the
correct response. All the others − a large number of firms, no barriers
to entry or exit and product differentiation − are found in this type of
market.
Question 2
The correct answer is D. A, B and C are standard characteristics of an
oligopolistic market.
Question 3
In oligopoly there is product differentiation and barriers to entry are
created. Firms realize that a price war will not be in their best interests
and they tend to collude to prevent them.
Question 4
One of the characteristics of monopolistic competition is product
differentiation, hence the correct answer is D. Although firms are free to
set their own price, another characteristic of monopolistic competition is
freedom of entry into the market, hence in the long-term other firms
would enter the market place and prices would be forced down.

Answers A and B are therefore not true in the long term. C is also not
true owing to, for example, the influence of advertising campaigns on
people’s perception of products.
Chapter 7
PRACTICE QUESTIONS
Question 1
D is the right answer since pure public goods are those that must be
provided communally, e.g. defense or public transport.
C is incorrect since the consumption of a public good by one person
must not, by definition, reduce the amount available for another person.
A and B are incorrect since in both cases the goods are not produced
according to the conditions stated in D and C above.
Question 2
The tax means that true cost of production will be reflected in prices,
which improves resource allocation.
Question 3

Public goods, merit goods and goods for which there is a natural
monopoly in production need to be produced in the public sector if they
are to be produced in sufficient quantity to ensure the public good.
Question 4
Alternatives A and B are fairly obvious reasons why firms in an industry
would choose to locate close together. External economies of scale
arise from having some local advantage, e.g. supply of labor, so the
odd one out is D.
Chapter 09
PRACTICE QUESTIONS

Question 1
The correct answer is B. This is rather an ambiguous question; the
wording has to be read with care.
Question 2
The Stock Exchange provides a market for existing securities and for
the flotation of existing companies and government securities.
Question 3

Question 4
According to the liquidity preference theory, a rise in interest rates is inversely

related to the price of bonds which will therefore fall, hence the exception is A.
Chapter 10
PRACTICE QUESTIONS
Question 1
The correct response is C.
Only C takes money out of the economy since balances have to be
drawn down to pay for the securities. A reduced quantity of money,
other things remaining equal, will lead to a reduction in the money
supply. It should be noted that a sale of government securities will only
have this effect if they are sold to the non-bank public and the question
should perhaps have made this clear, although it would have also
made the answer more obvious.
Question 2

This is simply a question of knowing the definition. The correct answer
is C.
Question 3
The correct answer is C. Customer’s deposits are a liability of a
commercial bank.
Question 4
The correct answer is B, since (iii) is not correct. A central bank may
carry out monetary policy on behalf of the government but not fiscal
policy.
Question 5
Question 6
Monetary policy is the function of a central bank, Fiscal policy is the function
of the Treasury, so A is the answer.
Chapter 11
PRACTICE QUESTIONS
Question 1
A fall in the exchange rate for a country’s currency will encourage

exports as they will become relatively cheaper to the foreign importer,
hence A is incorrect. B is also wrong since reducing tariff barriers will
open up export markets giving exporting countries more opportunities.
A rise in a country’s imports could indicate that that country has a
buoyant and growing economy and, in order to meet increased
aggregate demand firms may switch sales to the home market at the
expense of exports. However, the more likely explanation is C, i.e. a
decrease in the marginal propensity to import in other countries.
Question 2

B is not correct as a floating rate means that exchange rates are never
certain. C is incorrect as transaction costs will still exist when one
currency is exchanged for another, regardless of whether a fixed or
floating system is in operation. To keep a currency at a fixed rate limits
a government’s ability to adopt policies which may put pressure on that
rate, hence D is not correct.
Question 3
Chapter 12
PRACTICE QUESTIONS
Question 1
Withdrawals from the circular flow of income are those amounts not
passed on from firms to households or vice versa. There are three
categories of withdrawals − savings, taxation and imports. The correct
response is D because it includes tax payments and imports −
distributed profits and interest paid on bank loans are both types of
income which are passed on from firms to households and are thus not
withdrawals.
Question 2
The correct answer is C. A and B are measures of Gross Domestic Product
(GDP). D measures national income (net).
Question 3
Transfer payments are payments made for which there were no
productive services in exchange. The receiver of an educational
scholarship is not contributing anything back. The answer is A.
ADDITIONAL QUESTION
National income
(a) National income calculations are based on the circular flow of
income model which assumes that all output is sold, all income
is spent and all resources are fully employed. It should be

possible to look at total output, total income or total expenditure
in an economy and arrive at the same figure, whichever route is
chosen. This total represents the economic activity or national
income of the economy for a specified period of time.
The three methods are therefore:
• Output – the total value of production for all industries in the
economy
• Income – the rewards for the use of the factors of production
which are paid in the form of rent, wages, interest and profit
• Expenditure – the spending by both households and firms on
the final products and services of the production process. The
prices paid must be adjusted by deducting taxes (added to
price) and adding back subsidies (deducted from price).
(b) (i) The ‘black economy’ is the name given to the value of goods
and services produced in the economy but never officially
recorded and are therefore excluded from national income
figures. When paid work is done illegally by those workers
officially classed as unemployed, or income is under-declared
on official forms such as income tax returns, the national income
figures will not reflect the actual activity of the economy. In some
countries without a tradition of centrally collected written data,
the output of the black economy may exceed that of the official
economy. In such economies national income figures have little
meaning.
(ii) Unpaid work occurs when goods and services are not traded
through the market and do not become part of official figures.
Examples of unpaid work include DIY, housework, childcare and
gardening. Differences between cultures may reflect the amount
of unpaid work and therefore reported national income; care
should be taken when making comparisons.
(c) National income is the monetary value of the output of an economy,

adjusted for inflation, for a specified period of time. Standard of living

reflects national income to some extent, but is also dependent on other
factors such as climate, environmental issues and health issues.
(i) The quality of goods and services is not always reflected in their
price. As the price of goods and services increases, so does the
value of national income. An inflation index such as the Retail
Price Index (RPI) is based on average price increases. Using
the RPI to remove inflation from national income figures will not
remove price increases that are higher than the average inflation
rate. Although the price of such goods and services has risen,
there is no guarantee that the quality has improved or even
stayed the same. If the quality has not risen with price then the
standard of living cannot be said to have increased.
(ii) National income figures are a reflection of market prices
adjusted for taxation, subsidy and inflation. Pollution is an
externality in that it is a social cost not reflected in market price.
Market price is concerned with private cost and private benefit
and not social cost or social benefit. Industrialization, processes
to remove waste materials and transport all create pollution
which reduces the quality of life and has a detrimental effect on
the standard of living, none of which is reflected in national
income figures.
(iii) National income figures such as Gross Domestic Product (GDP)
may be shown as a total figure for the economy or may be
divided by the population total to show national income per head
of population (per capita). GDP per capita represents a fictitious
amount that everyone in the economy is assumed to receive as
income. In practice, the distribution of national income is more
likely to be uneven, with a few people receiving considerably
more than the per capita figure and many receiving much less.
The standard of living for most people is therefore unlikely to
reflect GDP per capita.
(d) Apart from being used to compare the standard of living in other
economies, national income figures may also be used to:
• loan future government spending so as to achieve economic growth.
• determine whether past plans have achieved economic growth by
comparing current national income in real terms with the figures for
last year.
• determine economic trends, such as booms and slumps, and so
enable specific government strategies to be prepared and put into
action.
• give confidence to producers and investors in the economy that
government actions have achieved targets and are therefore likely
to achieve future targets.
• persuade voters to re-elect the government.
Chapter 13
PRACTICE QUESTIONS
Question 1
The correct response is D.
In the conditions stipulated, a reduction in direct taxation would
immediately feed through into increased demand and increase
inflationary pressures. So would a fall in private investment in the
longer run given unchanged conditions. But the question carefully asks
what factor would be most likely to lead to inflation.
Question 2
The correct answer is A. Both C and D are likely to fuel inflation rather
than reduce it since both will contribute towards an increase in
aggregate demand in the economy.
Chapter 13
PRACTICE QUESTIONS
Question 1

Supply-side policies are microeconomic in nature, i.e. they focus on
individual firms and workers rather than on aggregate demand, etc.
and they aim to reduce frictions in the labor market, e.g. immobility. A
is the correct answer because it is the only microeconomic measure
that is likely to reduce unemployment − retraining workers makes them
more occupationally mobile.
B is incorrect because, although it is an anti-unemployment measure, it
is macroeconomic in nature.
C is wrong since, even though it is microeconomic, it might encourage
marginal workers to remain unemployed.
D is incorrect because decreasing the money supply is a contractionary
measure and would increase unemployment.
Question 2
A is the correct answer. If the government pursues a policy of fiscal
expansion this means it is reducing taxation, increasing disposable
income which, if the population has a high propensity to consume, will
in turn increase aggregate demand, stimulate industry and hence
create jobs.
B is incorrect as a high propensity to save will have the opposite effect

to that described above. Fiscal expansion is unlikely to have any effect
on structural unemployment. Such unemployment is caused by a
complete change in the demand or supply conditions for particular
industries, hence C is not correct.
Whether a country has a fixed or flexible exchange rate will not directly
affect the way fiscal expansion works to reduce unemployment, hence
D is incorrect.
Question 3
The correct answer is D. A, B and C are methods of reducing a PSBR
not financing it.
Question 4

The PSBR has nothing to do with borrowing by the general public or a
deficit on the balance of payments. Taxation is not part of the PSBR.
Question 5
Restrictions on the level of imports will help the balance of payments,
not the level of inflation. Increasing taxation and reducing the level of
public expenditure will deflate the economy, and reducing the growth of
the money supply will reduce price rises.
Question 6
A and C are proportional taxes. B is a regressive tax.
Chapter 14
PRACTICE QUESTIONS
Question 1
The correct response is C. X has the comparative advantage in the
production of beef (1 ton of beef costs 1 5 ton of steel) compared to Y
(1 ton of beef costs
1 ton of steel).
A is incorrect as the different opportunity cost ratios mean that both
countries can benefit from specialization and trade.
B is wrong as it represents the opposite pattern of trade to that dictated
by comparative advantage.
D is incorrect − X has an absolute but not a comparative advantage in
the production of both goods.
Question 2
C is the correct response because it defines comparative advantage,
which means that the country’s opportunity cost of producing a good is
lower than in other countries.

D is incorrect because it refers to absolute advantage.
Both A and B are incorrect because comparative advantage is not
concerned with how much the country produces in total, neither with
the share of the world market secured by the country, although it is
possible that, if a country had a comparative advantage, it would
produce more of the product.
Question 3
A and B are largely irrelevant to the causes of trade. D may have been
your choice but specialization is caused by the different factor
endowments (i.e. C). Thus C is the best explanation because, for
example, if a country has a plentiful supply of labor it will choose
production processes that are labor-intensive and specialize in and
trade with the output of those processes.
Question 4
The correct answer is A because VAT is applied to all commodities,
both imported and home-produced.
B, C and D act as barriers to international trade because they apply to
imported goods only.
Question 5
Question 6
Question 7
The theory of comparative advantage says nothing directly about
diversity of production and purports the opposite to economic self-
sufficiency. It does state, however, that countries should trade if they
have a relative advantage not an absolute advantage in the production
of a good or service.
Question 8
Question 9

Chapter 13
PRACTICE QUESTIONS
Question 1
C is the correct answer because, in simple terms, the money supply
comprises notes, coins and bank deposits. Both A and B are therefore
incomplete, as is D since legal tender refers only to notes and coins up
to a certain limit.
Question 2
B is the correct answer. According to Keynesian liquidity preference
theory, if the government wishes to increase the money supply it must
purchase bonds and hence their price rises (not falls as in (ii)) and,
because of the inverse relationship with the rate of interest, the rate of
interest falls. In such circumstances, the theory suggests, people will
eventually become less willing to hold bonds and prefer to hold cash.
Question 3
The correct answer is C. (ii) is more likely to happen following a rise in
interest rates that makes investment projects less profitable.
a fall in interest rates − borrowing money thus becomes cheaper. (iii) is
likely as governments become wary of fueling inflation.
Question 4
Question 5

B, C and D have no bearing on the holding of cash for convenience in
carrying out daily transactions.
Question 6
Chapter 14
PRACTICE QUESTIONS
Question 1
The correct response is C.
A and B can be eliminated immediately because they are simply
arithmetical summing up and say nothing about the ratio which the
index of export prices has to the index of import prices that defines the
terms of trade. In the case of D it is true that currency changes will
affect the ratio but they do not constitute it. Currency changes can
occur for reasons apart from the question of imports and exports. The
best description, therefore, is C, the rate at which imports and exports
exchange for each other.
Question 2
B is the correct answer.
(iii) is incorrect since the terms of trade measure the relative change
of the price of domestic goods sold abroad (exports) and the price of
overseas goods sold in the home market (imports); if there is a
devaluation in the home currency this ratio will worsen not improve.
(iii) is also incorrect as prices of imports will rise, thus the domestic
cost of living will increase. Following from this, as imports become
more expensive and exports cheaper, demand for imports will fall and
demand for exports should rise, helping to eradicate a current account
deficit and stimulate domestic economic activity. Hence (i) and (iv) are
correct.
Question 3

A fall in the exchange rate for a country’s currency will encourage
exports as they will become relatively cheaper to the foreign importer,
hence A is incorrect. B is also wrong since reducing tariff barriers will
open up export markets giving exporting countries more opportunities.
A rise in a country’s imports could indicate that that country has a
buoyant and growing economy and, in order to meet increased
aggregate demand, firms may switch sales to the home market at the
expense of exports. However, the more likely explanation is C, i.e. a
decrease in the marginal propensity to import in other countries.
Question 4
A current account deficit must be financed by net overseas borrowing
(from foreign and central banks or of short-term capital) or by a
decrease in official reserves. Increased taxation finances the PSBR not
the current account deficit.
Question 5
The rate at which one country’s goods exchange against those of other
countries is referred to as the terms of trade and is measured as:
Index of import prices
Index of export prices × 100
Question 6
A balance of payments deficit occurs when there is a net outflow of
funds. With an expansionary fiscal policy consumers will have more
money to spend on imports, thus increasing the outflow of funds
without a corresponding inflow since industry is unlikely to export more
due to inflationary pressures and high domestic demand.
Question 7
The correct answer is A. The current account of the balance of
payments is the visible balance plus the invisible balance. The inflow of

capital investment by multinational companies would go in the capital
account, so A is correct.


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Business Economics (Study Text)

Business Economics (Study Text)

This book and material including write-up, tables, graphs, figures,

Institute of Cost and Management Accountants of Pakistan

First Edition 2014

Business Economics (Study Text)

DEMAND AND SUPPLY ANALYSIS

PRICE ELASTICITY OF DEMAND

6 COST BEHAVIOUR 187

7 PROFIT MAXIMIZATION 214

Business Economics (Study Text)

9 FUNCTIONS OF THE FINANCIAL SYSTEMS 284

10 DOMESTIC INSTITUTIONS AND MARKETS 340

11 FOREIGN EXCHANGE MARKETS 428

12 MACRO ECONOMIC TRADE CYCLES 400

13 MACRO ECONOMIC: THE ROLE OF GOVERNMENT 436

14 INTERNATIONAL CONTEXT 533

15 ANSWERS TO END OF CHAPTER QUESTIONS 587

Business Economics (Study Text)

 Detailed learning outcomes. You should assimilate these before beginning

 Step-by-step topic coverage. This is the heart of each chapter, containing

 Examples. Most chapters are illustrated by more practical elements, such as

 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

Business Economics (Study Text)

Prepare a written schedule summarizing the above and stick to it.

Tips for effective studying

Business Economics (Study Text)

Business Economics (Study Text)

2. Understanding the definition

4. The nature of profit

5. Rational economic behavior

6. Three basic economic problems

7. Alternative economic systems

Business Economics (Study Text) 2

Alfred Marshall, a famous economist, defined economics as ‘the study of man

2. Understanding the definition

2.2 Wealth and welfare

In many poor countries much of resource allocation is purely concerned with

Business Economics (Study Text) 3

So, we use resources to produce wealth to consume in order to satisfy wants.

2.3 Types of resources

Rent Reward Capital

Pre-determined Wage Reward Entrepreneur

No risk Pre-determined Interest Reward

No risk Pre-determined Profit

No risk Not predetermined

Business Economics (Study Text) 4

The entrepreneur – a fourth resource?

An entrepreneur or enterprise is a person or group who will organize

Business Economics (Study Text) 5

Organisation, managing and risk-bearing are the entrepreneurial functions. In

2.4 Factors of production and their rewards

As resources or factors of production are used in the process of wealth

Business Economics (Study Text) 6

2.5 What about ‘money’?

2.6 The fundamental economic problem

Business Economics (Study Text) 7

Psychologists have attempted to explain the unlimited nature of human wants

Furthermore, innovation brings new products on to the market and consumers

Business Economics (Study Text) 8

MICROECONOMICS AND MACROECONOMICS

There are two branches of economics (a) microeconomics and (b)

Business Economics (Study Text) 9

An economy’s macroeconomic health can be defined by a number of goals: