-

Tey 1--fwei Choo

Nabila Ahmad
Zulkhairi Nisa
lrlisuhayu Mohd Ramli
Rosmaiza Abd Ghani
OXFORD
VNIVERSITY PRESS

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,:, Dr Azhar Harun

... Associate Professor

School of Government
ca College of La,-v, Government and International Studies
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0 Kedah, Malaysia

ca Low Mei Peng

Senior Lecturer
>­
...
Department of Economics
Faculty of Accountancy and Management
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Ul
■a I Marina Mustapha
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Taylor's Business School
Taylor's University Lakeside Campus
Subang Jaya, Selangor, Malaysia

<( Dr Mohd Nizam Barom

,:, Assistant Professor

... Department of Economics

Kulliyyah of Economics and Management Sciences
0 International Islamic University Malaysia (IIUM)
Jalan Gon1bak, Kuala Lumpur, Malaysia

><
II I
Dr Nor Yasmin Mhd Bani

0 Senior Lecturer
Department of Economics
Faculty of Economics and Management
Universiti Putra Malaysia (UPM)
Serdang, Selangor, Malaysia

Professor Dr Wong Koi Nyen

Associate Dean (Undergraduate)
Head, Department of Econon1ics and Management
Sunway University Business School
Sunway University
Bandar Sun-..vay, Selangor, Malaysia
(I)
t) The contents and layout of this textbook are in accordance with the syllabus of
basic economic courses. Hence, this textbook serves as a useful reference for
students v,ho are undertaking Economics at sixth for1n level, diploma level and
II I the first year of university.
(I) Many students find Economics difficult to comprehend, especially ,vhen they
1--1 encounter the subject for the first time. This textbook thus aims to make the
learning of economics interesting, easy and applicable to daily life. It presents the
contents in a simpler way to enlighten students. It introduces the concepts and
theories of economics to the reader using engaging examples of varying degrees of
complexity, ranging from the most simple to the most difficult. We have presented
the general fundamentals both carefully and precisely, con1pleting then1 with
some case studies for better understanding.
The coverage of this textbook is comprehensive and complete. We are
confident that it will benefit students in1mensely. Besides the texts, case studies,
ample exercises at the end of each chapter and complete ans"vers at the end of
this textbook, ,ve have also provided a host of complementary online animations,
teaching PowerPoint slides and online quizzes. Additionally, an economics
textbook will not be complete without discussing the Islamic economic theory
and banking systems, as many countries are practising Islamic economics and
banking. Hence, this textbook includes introductory discussions on the topic to
fulfil this need.
Furthermore, this textbook is self-contained. The examples provided should
help students to absorb the concepts and theories of microeconomics and
macroeconomics. In studying economics, we truly believe in the importance of
understanding and applying the concepts acquired rather than memorizing and
regurgitating facts. Secondly, it is imperative to comprehend the application of
figures, graphs and formulas in economics. Thirdly, students are encouraged to
prepare their own short notes, atten1pt the exercises after each chapter, refer to
our online resources and discuss with their peers by forn1ing group discussions.
We trust that students "vho work through this textbook conscientiously will gain
a thorough understanding of the basic principles of economics.

Tey Hwei Choo

Nabila Ahmad
Zulkhairi Nisa
Irlisuhayu Mohd Ramli
Rosmaiza Abd Ghani
Ul
Ir
First and foren1ost, we ,vould like to express our utmost gratitude to the
C: Almighty God. He specializes in the impossible, enabling ordinary people like
us to accomplish better things. He strengthens us, enabling us to soar like eagles
(I) and reach greater heights. It is ,-vith His guidance that we have published this
comprehensive, yet easy to understand, economics textbook.
We ,-vould like to thank Mr Tanweer Ahmad at Oxford Fajar for giving us
the opportunity to ,-vrite this economics textbook. Mr Tanweer and his skilled
team, especially Mr Terence Chiew, have nurtured the textbook at every stage.
Without their support, encouragement and dedication, this textbook and its
complementary online resources would not be a reality.
The successful conception of this textbook ,-vas also n1ade possible by the
expertise of Professor Dr Wong Koi Nyen and all the technical reviewers who
helped us to shape this textbook further. We are grateful for all their constructive
comments, suggestions and additions to the contents.
In addition, ,ve are also thankful that the chosen tea1n of authors is a perfect
blend of expertise, experience, skills and knowledge, ,vho have devoted their
undivided attention, time and effort to,-va!fds the successful completion of this
textbook. We are indebted to our beloved spouses, children and family members
for their unfailing love, understanding, support and encouragement. They are
ah-vays by our side to inspire and motivate us throughout our careers and the
process of writing this textbook.
Last but not least, ,-ve ,-vould like to thank our superiors, the academic staff and
the students at Universiti Teknologi MARA (UiTM), as well as the academicians
and students of other colleges and universities, who have constantly challenged
and tested us in the journey towards n1aking this textbook the best version that
it can be.

Tey Hwei Choo

Nabila Ahmad
Zulkhairi Nisa
Irlisuhayu Mohd Ramli
Rosmaiza Abd Gha11i
 Oxford Advisory Board
Ul Preface
V
..
Ir Acknowledgements
.
Vil

C
IX

Chapter l Introduction to Economics 1

G) Introduction 2
Ir 1.1 Definition of Economics 2

C 1.2 Basic Economics Concepts

1.3 Production Possibilities Curve
5
7

0 1.4 Basic Econo1nic Problems

Conclusion
Summary
15
28
29
Key Concepts 30
Exercises 30

Chapter 2 Demand and Supply 37

Introduction 38
2.1 Classification of Goods 38
2.2 Demand, Law of Demand, Individual Demand, and Market Demand 40
2.3 Movement Along a Demand Curve versus Shift of a Demand Curve 44
2.4 Determinants of Demand 45
2.5 Exceptional De1nand 49
2.6 Supply, Law of Supply, Individual Supply, and Market Supply 51
2.7 Change in Quantity Supplied and Change i11 Supply 55
2.8 Determinants of Supply 56
2.9 Exceptional Supply (Labour Market) 58
2.10 Supply of Goods and Services from an Islamic Perspective 60
Conclusion 61
Summary 61
Key Concepts 62
Exercises 63

Chapter 3 Elasticity 67
Introduction 68
3.1 Elasticity of Demand 68
Case Study 3.1 81
Conclusion 83
Summary 83
Key Concepts 84
Exercises 85

Chapter 4 Market Equilibrium 89

Introduction 90
4.1 Definition of Market Equilibrium 90
4.2 Determination of Equilibrium Price and Equilibrium Quantity 91
4.3 Changes i n Demand and Supply, and the Effects on Market Equilibrium 93
4.4 Government Intervention in the Market 99
Case Study 4.1 103
4.5 Price Control from an Islamic Perspective 114
Conclusion 115
 117 n
-
Summary
Key Concepts 118 0
:s
Exercises

Chapter 5 Theory of Consumer Behaviour

118

125
-
:s
rn
Introduction 126
5.1 Utility Analysis 126
5.2 Ordinal Approach 129
Conclusion 136
Summary 137
Key Concepts 137
Exercises 138

Chapter 6 Production, Cost and Revenue Theory 143

Introduction 144
6.1 Short-run Production 144
6.2 Short-run Costs 152
6.3 Relationship Between Short-run Production and Short-run Costs 160
6.4 Long-run Production 162
6.5 Long-run Costs 166
6.6 Relationship Between Long-run Production and Long-run Costs 168
Case Study 6.1 170
6.7 Revenue in Economics: Meaning and Concept 171
Conclusion 173
Summary 173
Key Concepts 174
Exercises 174

Chapter 7 Theory of the Firm and Market Structure 179

Introduction 180
7.1 Theory of the Firn1 180
7.2 Market Structure 185
7.3 Perfect Competition 186
7.4 Monopoly 197
7.5 Monopolistic Competition 209
7.6 Oligopoly 216
Conclusion 223
Summary 225
Key Concepts 227
&en�a n7
Chapter 8 Theory of Distribution 235
Introduction 236
8.1 Theory of Marginal Productivity 236
8.2 Rewards for Factors of Production 238
Case Study 8.1 257
Conclusion 260
Summary 262
Key Concepts 263
Exercises 264
 Chapter 9 Introduction to Macroeconomics 269
Introduction 270
9.1 Introduction to Macroeconomics 270
0
u 9.2 Objectives of Macroeconomics 271
Conclusion 276
Summary 276
Key Concepts 277
Exercises 277

Chapter 10 Measuring National Income and Output 281

Introduction 282
10.1 Components of Macroeconomics 282
10.2 Circular Flow of Income in Two-, Three- and Four-sector Economies 283
10.3 Concepts of National Income 286
10.4 Methods of Measuring National Incon1e 290
10.5 Nominal Incon1e versus Real Income, Per Capita Income and Growth Rate 301
Case Study 10.1 304
10.6 Uses of National Income Statistics 305
10.7 Problems of Measuring National Income 306
Conclusion 307
Summary 308
Key Concepts 309
Exercises 309

Chapter 11 Determination of National Income Equilibrium 317

Introduction 318
11. l Approaches in Determining National Income Equilibrium 318
11.2 Autonomous and Induced Consumption 319
11.3 Islamic Consumption Theory According to Fahim Khan
Islamic Consumption 327
11.4 Autonomous and Induced Investment 329
11.5 Income Equilibrium in Two-, Three- and Four-sector Economies 332
11.6 Definition and Calculations of the Expenditure Multiplier 341
11.7 Inflationary Gap and Deflationary Gap 346
Conclusion 347
Summary 347
Key Concepts 348
Exercises 349

Chapter 12 Money, Banking and the Financial System 355

Introduction 356
12.1 Money 356
12.2 Keynesian Demand for Money 362
12.3 Supply of Money 366
12.4 Money Market Equilibrium 370
12.5 The Central Bank and Its Monetary Policy 371
Case Study 12.1 377
12.6 Commercial Banks and Credit Creation 378
12.7 Islamic Banking Products 386
Conclusion 391
Summary 391
Key Concepts 394
Exercises 394
 -
Chapter 13 Public Finance 399 n
Introduction 400
0
:s
13.1 Concepts of Public Finance
13.2 Conventional Government Revenues
13.3 Types of Government Expenditures
400
401
403
-
:s

13.4 Types of Tax Structures 404

13.5 Types of Govern1nent Budgets 406
13.6 Fiscal Policy 407
13.7 Public Finance in Islam 409
13.8 Islamic Government Revenues 409
13.9 Islamic Government Expenditures 410
Conclusion 412
Summary 413
Key Concepts 413
Exercises 414

Chapter 14 Macroeconomic Problems 419

Introduction 420
14. l Inflation 420
Case Study 14.1 440
14.2 Une1nployment 442
Case Study 14.2 451
14.3 Relationship Between Inflation and Unemployment 452
Conclusion 453
Summary 454
Key Concepts 455
Exercises 456

Chapter 15 International Economics 461

Introduction 462
15.1 International Trade 462
15.2 Protectionism 472
15.3 Balance of Payments 474
Case Study 15.1 482
15.4 Exchange Rate 483
Conclusion 489
Summary 490
Key Concepts 491
Exercises 491
Answers 497
References 549
Index 552
Introduction
to Economics
U2 At the end of this chapter, you should be able to:
� • Interpret the definition of economics and distinguish between
0 microeconomics and macroeconomics.
...,:so • Describe the three economic concepts: scarcity, choice and
0 opportunity cost.

·e
g> • Discuss and illustrate the production possibilities curve (PPC).
• Describe the three economic problems.
CO • Differentiate the four types of economic systems.
�

Econom ics is defined as a
social sci ence that studies
how society allocates scarce
resources to fulfil their
unlimited wants.
Factors of production-
land, labour, capital and
entrepreneur-are the
resources used by firms to
produce goods and servi ces
during the production process.
E conomics is one of the most important aspects to be explored
and understood by people. The nature of human beings is to
have unlimited wants or desires, such as clothes, gadgets, houses or
properties, cars, entertainment, convenience and so on.They will strive
to fulfil their unlimited wants, in order to gain maximum satisfaction in
Iife.
However, economics is an entity that faces the obstacle of limited
resources or limited factors of production. Even though society is blessed
with the different functions and benefits of resources, such as land, labour,
capital, entrepreneur and natural resources, society will still encounter
the problem of scarce resources.Therefore, economics is a social science
which is concerned with the efficient allocation of scarce resources to
achieve the maximum satisfaction of humans' unlimited wants.
1.1 DEFINITION OF ECONOMICS
The word 'economy' comes from a Greek word which means 'one who
n1anages a household'. Here are some quotations from three famous
economists:
Adam Smith (1776): Economics or political economy is an enquiry
into the nature and cause of the wealth of nations.
Milton Friedman (1962): Economics is the science of ho"" a
particular society solves its economic problems.
Richard Lipsey (1990): Economics is the study of scarce resources
to satisfy unlimited hlllman wants.
Generally, economics is a study of how people and society organize
scarce and limited resources to produce goods and services to satisfy
unlimited human wants. Society is divided into four main groups,
nan1ely households, firms, governments andforeign sectors. Resources
are also known as factors of production. They are inputs that are used
to produce goods and services in the economy. There are four factors of
production used in the production process:
1 Land
Land includes all natural resources, which are derived from the
earth and land itself. The return to land is 'rent'.
2 Labour
Labour or workers are defined as people who contribute their
energy mentally and physically in the production of goods and
 services. They are classified into skilled labour, semi-skilled labour
and unskilled labour. 'Wages' and 'salaries' are the ret1trns to labour.
-
::3
"'1

--·
0
3 Capital C.
s::
Capital is the most important factor of production. It is defined as 0
wealth used for production. It refers to the stock of goods created 0
::3
by society to be used in the production of goods and services; for
example, machinery, tools and equipment, building, factories and
0
tr:I
so on. Interest is the return to capital. 0
0
4 Entrepreneur ::3
-·
0
Entrepreneur refers to a person who organizes the other factors
of production, i.e. land, labour and capital, to produce goods and 0
services. An entrepreneur has the ability to plan, organize, direct
and control. The difference between an entrepreneur and labour is
that the former (entrepreneur) is able to take risks i11 dealing with
his or her business, whereas the latter (labour) do not take any
risks and work for an entrepreneur.
These four factors of production are scarce, and society should try
to use them efficiently in the process of fulfilling their unlimited wants.
Unlimited human wants consists of goods and services; these are
explained as follows:
(a) Goods
Goods refer to tangible things, such as electrical appliances;
books, newspapers and other reading materials; calculators,
computers, furniture, gardening tools, camping equipment and
so on. Goods are the things that can be seen and touched.
(b) Services
Services are known as intangible things, such as education,
transportation, communication, banking, medical care, postal,
insurance, massage therapy, veterinary care, gym membership
and so on. Services are the things that cannot be seen and touched,
but we can use and enjoy the benefits provided by these services.

1.1.1 Branches of Economics

Economic models fall into two categories: microeconomics and
macroeconomics.

Microeconomics
Microeconomics is a branch of economics which studies the
/l.1icroeconomics deal with
individual and specific units
behaviour and decisions of individual entities, such as households, of economics.
firms and markets. Microeconomics studies the way in which
individual markets work, the detailed way in which regulations
and taxes affect the allocation of labour, and goods and services.
- Macroeconomics
Macroeconomics deal with Macroeconon1ics is concerned with the overall perforn1ance of
.c: economics as a whole .
the economy. It seeks to present the 'bigger picture' rather than
u the detailed individual choices. Macroeconomics examines the
determination of the overall levels of economic activity, such as
unemployment, aggregate inco1ne, average prices, inflation and
international trade.

Some differences between the two branches, microeconomics and

n1acroeconon1ics, are explained in Table 1.1.

Table 1.1
Differences between
microeconomics and
macroeconomics Studies individual and specific Studies economics as a whole
economic units
Analyzes the economic entity in Analyzes the economic unit in general
detail
Looks at the individual unit Looks at the entire or aggregate aspects
Examples: Examples:
(a) Production (a) Production
Individual, firm and industry Gross Domestic Product (GDP), Gross
National Product (GNP), aggregate
demand and aggregate supply
(b) Prices (b) Prices
Individual goods and s•ervices Average prices, Consumer Price Index
(CPI) or inflation
(c) Income (c) Income
Distribution among factors of Total wages and salaries, total profit
production
(d) Employment (d) Employment
Household supply of labour Total employment and
unemployment

SAMPLE QUESTION 1.1

1 Define microeconomics and macroeconomics, with appropriate examples.

Solution:
• Microeconomics is concerned with the individual and specific units of the economy,
whereas macroeconomics studies the entire economy as a whole.
• Examples of microeconomics are the price of a pen, the production of Honda cars and
the income of a tailor.
• Examples of macroeconomics are the Gross Domestic Product (GDP) of Malaysia in a
year, the unemployment rate in Indonesia and the total palm oil exported to China.
•••
�...;.
 Besides discussing the differences between the two branches of -::3-
economics, in some Islamic countries, Islamic economics and banking "'1

--·
0
are being practiced. The differences ben-veen conventional economics C.
and Islamic economics are as follows:
s::
0
I Conventional perspectives
Conventional econo1nics is a study of how societies organize
scarce resources to fulfil their unlimited ,-vants.
0
-
::3
0
tr:I
2 Islamic perspectives 0
0
Islamic economics is a social science which studies the economic ::3
-·
0
problems faced by people. Islamic econo1nics is imbued with
Islamic values that are based on the principles of Shari'ah. 0

1.2 BASIC ECONOMICS CONCEPTS

In economics, society is faced with scarce factors of production, that
is the problem of scarcity. Therefore, society must make choices when
trying to satisfy their unlimited wants or desires. They must use the
scarce resources "visely and efficiently "vithout wastage. There are three
basic economic concepts: scarcity, choice and opportunity cost.

1.2.1 Scarcity
People have unlimited "vants, but the resources available to satisfy those
wants are lin1ited. Thus, when goods are limited relative to hun1an
Scarcity arises due to limited
resources and unlimited
wants, the situation of scarcity arises. Human wants are unlimited, so human wants.
much so that there are simply not enough goods and services to satisfy
even a small fraction of humans' consumptions.

1.2.2 Choice
People must make choices due to scarcity. Society must make the best
choice possible after considering the available alternatives. Society
must choose what to produce and who gets the final product. For
example, the more food you choose to buy, the less n1oney you will
have left to spend on other goods. At the level of a whole society, if the
government wants to build more roads, it then has to sacrifice other
things such as fuel subsidies.
Choices involve a rational decision after considering several
alternatives. Individuals and the society make choices to maxin1ize their
Society must make the
best choice possible due to
satisfaction, while firms make the best choices to maximize their profits. scarcity.
Governments, on the other hand, make choices to maxin1ize social
welfare in the country that they govern.

1.2.3 Opportunity Cost

Opportunity cost is defined as the number of a good forgone, or the Opportunity cost can be
second best alternative and its benefits that is given up, to make
exemplified as the quantity
of Good A given up for a unit
the best choice. For instance, you want to purchase both an iPhone 7 of Good B that is consumed
and a laptop, but have to choose either one due to limited funds. If or produced.
- you choose to buy the iPhone 7, your opportunity cost of buying that
iPhone 7 is the laptop that is forgone.
Other examples of opportunity cost are:
.c: (a) An individual needs to choose between going for a football game
u
and attending a swiinming class. If the individual chooses the
latter (swin1ming class), the opportunity cost of going for that
swimming class is the football game that is forgone.
(b) The government is considering ,,vhether to build more hospitals
or more schools. If the government decides to build more of
the former (hospitals), the opportunity cost of building more
hospitals is the number of schools forgone. In other words,
society will have more options of healthcare at the expense of
having more options of schools for their schoolgoing children.
Figure 1.1 illustrates the connection between these three basic
economics concepts.
--------------------------­'
,
Figure 1 .1 : Unlimited wants : : Limited or scarce resources :
How scarcity, choice and
opportunity cost are
interrelated '·················'��� '#,___________________________,
Scarcity
(the problem)

1.2

1 Explain briefly the three basic economic concepts.

Solution:
Scarcity exists due to unlimited human wants which cannot be fulfilled by available
resources that are limited. Therefore, society must make the best choices possible to
maximize their satisfaction. Choice will be associated with opportunity cost, where the
second best alternatives are forgone. For example, if the government has to decide
between building a school and a hospital in a certain area, and the government cannot
build both simultaneously due to scarcity, then a choice has to be made. If society prefers
a school t o a hospital in that area, then the government will build a school and maximize
social welfare. Thus, the opportunity cost of building the school is forgoing the hospital,
__._• • • assuming that the construction of both buildings would have cost the same amount.
1.3 PRODUCTION POSSIBILITIES CURVE -
::3
""1

--·
The concepts of scarcity, choice and opportunity cost can be illustrated
0
C.
through a production possibilities curve (PPC). A production
Production Possibilities s::
Curve 0
possibilities curve shows the alternative combinations of two goods The alternative combinations
0
which can be produced with the existing resources and the current ::3
of two goods which can be
produced with the existing
level of technology. Drawing a production possibilities curve is based resources and the curre nt 0
on four main assumptions: level of technology.
tr:I
0
0
::3
-·
Assumptions: 0
1 The econon1y is producing only two goods; for exa1nple,
televisions and radios.
0

2 The resources available are fixed in both quantity and quality.

3 The current technology level is fixed.
4 The economy is operating at full e1nployment.

A numerical example can be shown as follows:

Table 1.2
Production Alternative Television (Unit) I Radio (Unit) Alternative combinations o f
production possibilities
A 20 0
B 18 1
C 15 2
D 11 3
E 6 4
F 0 5

Television (Unit)
Figure 1.2
Concave-shaped production
21 A
possibilities curve
• Z (Scarcity)
8
18

15 C
�-- --__,. Choice

12
D
•y
9

6
(Unemployed input)
\ E
• Opportunity cost

3
�
F
2
Radio (Unit)
3 s
0
1 4
- The curve formed by joining points A to F represents the production
.c:
u and efficient combinations. The PPC also indicates that the economy is
Points inside the PPC represent
attainable but inefficient
production, due to waste of
resources.
Points outside the PPC
represent unattainable
production, due to lack of
resources (known as scarcity).
Points along the PPC represent
the most efficient and
attainable product ion, known
as choice.
Movement from one point
to another point on the PPC
represents opportunity cost.
possibilities curve (hereafter PPC). The PPC sho,-vs the various
combinations of television and radio that a society can produce by using
its limited resources. All the points on the curve sho,-v the attainable
operating at full en1ploy1nent, which n1eans that all resources are fully
utilized. For exan1ple, at point A, the economy uses all its resources
to produce 20 units of televisions and O unit of radio. At point B, the
economy produces 18 units of televisions and 1 unit of radio. At point F,
all its resources are allocated to produce the 1naxin1um number of radios
(5 units) without producing any televisions.
Point Y, ,-vhich is located inside the PPC, indicates that there are
unemployed resources in the economy. This reflects unemployed,
wasted and inefficient allocation of resources. Points found inside
the curve provide society with fewer units of both goods. Society
would thus prefer the points on the PPC rather than any other points
inside the PPC.
Point Z, ,-vhich is situated outside the PPC, sho,-vs unattainable
production. This situation is caused by the lack of resources to produce
at that point. This point is known as scarcity due to lin1ited resources.
Points found outside the curve could be achieved, however, if there were
more resources available in the economy.
The PPC illustrates three concepts:
(a) Scarcity
Scarcity is implied by unattainable combinations beyond the
boundary, such as point Z. There are not enough resources to
produce point Z. Therefore, it reflects the concept of scarcity.
(b) Choice
Points on the PPC imply the concept of choice, as we have to
choose among the attainable points on the boundary (i.e. between
points A to F) which reflect efficient combinations of production.
Movi11g from points A to B, for exa1nple, indicates that the choice
is to produce 1nore radios and fewer televisions.
(c) Opportunity cost
Opportunity cost is implied by the negative slope of the boundary,
which shows that obtaining more of one type of output requires
having fe,ver of the other type of output. For exa1nple, at point A,
the economy produces 20 units of televisions and O unit of radio.
As we s,-vitch from point A to any other points on the PPC, this
movement involves an opportunity cost. If we move from point A
to B, the economy now produces 18 units of televisions and 1 unit
of radio. As such, we can observe that in order to obtain 1 extra
unit of radio, 2 units of televisions must be given up or sacrificed.
In sum, the opportunity cost of getting more units of radios is less
production of televisions, ru1d vice versa.
 Table 1.3 shows the opportunity cost of obtaining extra units of
televisions:
-
::3
"'1

--·
0
C.
s::
Table 1.3 Opportunity cost of obtaining extra units of radio 0
0
Production · Television Radio Movement Opportunity I Opportunity Cost ::3
Alternative I (Unit) (Unit) from Point Cost (Total) (per Unit) 0
'
tr:I
A 20 0 -/- -/- -/- 0
0
2 2 ::3
A to 8/A to B 2TV/2TV -=2TV/-=2TV
-·
B 18 1 0
1 1
3 5 0
C 15 2 B to CIA to C 3TV/STV -= 3 TV/-= 2.5 TV
1 2
4 9
D 11 3 Cto D/A to D 4TV/9TV -=4TV/-=3TV
1 3
5 14
E 6 4 Oto E/A to E STV/14TV -=STV/-=3.STV
1 4
6 20
F 0 5 EtoF/Atof 6TV/20TV -=6TV/-=4TV
1 5

In Table 1.3, we can see that the PPC has a negative slope because,
in a fully employed econo1ny, 1nore of one good can only be produced
if available resources are fixed by producing less of other goods. The
calculation of the opportunity cost is as follows:
(a) The (total) opportunity cost
The opportunity cost by total can be deter1nined by calculating
the nun1ber of goods sacrificed. In Table 1.3, the opportunity
cost to increase the production of radios from O to 1 unit is to let
go of 2 units of televisions (20 units - 18 units). When v,re move
from C to D, the total opportunity cost to increase the production
of radios from 2 to 3 units is to let go of 4 units of televisions
(15 units - 11 units). Likewise, if we move from A to E, the total
opportunity cost to obtain 4 units of radios is to let go of 14 units
of televisions (20 units - 6 units).
(b) Toe opportunity cost (per unit)
The opportunity cost per unit can be measured by dividing the
number of goods forgone by the number of goods increased.
In Table 1.3, the ,.vay to increase the production of 1 unit of
radio fro1n O unit is to let go of 2 units of televisions (2/1 = 2
units). When we move from C to D, the per unit opportunity
cost of producing radios is 4 units of televisions, where 4 units
of televisions are divided by 1 unit of radio. Likewise, if we move
from A to E, the per unit opportunity cost of producing 4 units
of radios (instead of O unit) is to let go of 3.5 units of televisions
(14/4 = 3.5 units).
- SAMPLE QUESTION 1 .3

.c: The following table shows the production possibilities of mobile phones and laptops
u produced by Country Z with available resources.

A B C D E

0 1 2 3 4

30 28 22 12 0

(a) Sketch the production possibilities curve of Country Z.

(b) What is the opportunity cost if Country Z uses all resources to produce mobile
phones?
(c) Calculate the opportunity cost:
(i) of producing 2 million mobile phones from Point A
(ii) when the production increases from 3 to 4 million mobile phones.
(d) Assuming Country Z intends to produce 2 million mobile phones and 26 million
laptops:
(i) Is this combination achievable?
(ii) If the answer to (d)(i) is 'No; what can Country Z do to make the combination
achievable?
Solution:
(a) Laptop (Million)
Laptop (Million)

E Mobile phone
O ._________._4___,. (Million)

(b) 30 million laptops

(c) (i) 8 million laptops
(ii) 12 million laptops
(d) (i) Not achievable, due to scarcity
••• (ii) The PPC should shift to the right through improvement in technology, an increase
••• in resources and growth in the economy.

1.3.1 Shapes of Production Possibilities

Curves
Production possibilities curves can be represented in three shapes.
The PPC which is concave to the origin (see Figure l.3(a)) shows the
principle of increasing opportunity cost. This means that in order to -::3-
get one more unit of a good, more units of another good would have "'1

--·
0
to be sacrificed. As illustrated in Figure l.3(a), in order to increase the C.
units of Good X, more units of Good Y should be sacrificed.
s::
0

Good Y

1 Yfor lX
Figure 1.3(a)
Increasing opportunity cost
0

0
-
::3

10 i------- - tr:I
0
0
9 -------·--------
' ::3
-·
' 0
8 '
'
'
7 -------�--------
' 0
'
6 '
'
'
5
4 -------�--------r--------r------
' '
'
3
2
1 4Yfor lX
0-
' ---- - - - - -- -L-----.Good X
-4
1 2 3

The PPC can also be convex to the origin (see Figure l.3(b)), which
implies a di1ninishing or decreasing opportunity cost. This shows that
to obtain one more unit ofa good, less units of another good would have
to be sacrificed. As illustrated in Figure l.3(b), in order to increase the
units of Good X, less units of Good Y should be sacrificed.

GoodY Figure 1.3(b)

Decreasing opportunity cost
10
9
8 4Yfor lX
7
6 -------
5 3Yfor1X
4
'
3 _______ ,' ______ _
, 2Yfor1X
2
1 -------�--------�-------
'
'
'
'
1 Yfor lX
o L..._____;
____;_
__ _;__..=____.,. Good X
1 2 3 4

Toe PPC can also be linear or a straight line (see Figure l.3(c)),
implying a constant opport11nity cost. This indicates that as more units
of a good is produced, the same number of units (or constant amount) of
another good would have to be sacrificed. As illustrated in Figure l.3(c),
in order to increase the units of Good X, the amount of Good Y that is
forgone are the same. This means that the society is indifferent towards
- the production of both Good X and Good Y, whereby both goods are
desirable to them.

.c:
u Figure 1.3(c)
Constant opportunity cost
GoodY
10
9

8 3Yfor 1X

7
• • • • • • • •••
6
5
3Yfor 1X
4

3 ----------�-----------
• ••
2 ••
• 3Yfor1X
1
o '----�------'-___...___...,GoodX
1 2 3

1.3.2 Factors that Influence the Shift of the

Production Possibilities Curve
With reference to Figure 1.2, point Z is unattainable as it is beyond
the PPC. However, the following four factors will shift the PPC to
the right or outwards and enable point Z to be reached. This shift
outwards is also illustrated in Figure 1.4.
I Increased inputs and resources
The increase of inputs, such as a capital expansion through
investment, enables an increase in the production of goods and
services in a nation. Labour force can be increased quantitatively
through population growth, migration and an increase in fertility
rate. Labour force can also be increased due to an increase in
labour productivity, as people receive training and seek additional
education. These factors will cause the PPC to shift to the right or
outwards.
2 Improved level of technology
Improvement in the level of technology due to successful research
and development (R&D) enhances efficiency. This in turn shifts
the PPC to the right.
3 Increased economic growth
When a country is experiencing economic growth, this usually
indicates that the country is able to produce more goods and
services. Therefore, the PPC ,.,ill shift out,.,ards.
4 Increased population
If a country is experiencing an increasing population, this would
increase the PPC because the country is able to produce more due
 to an i11crease in the number of people who are willing to work. -::3-
At the same ti1ne, the bigger the population, the higher the de1nand "'1

--·
0
of goods and services in the country. Hence, the PPC will shift to C.
the right.
s::
0

The PPC may also shift to the left or inwards. Figure 1.5 shows a
country that is experiencing inferior technology, resulting in the PPC
shifting to the left. This shift means that the country is producing less
0
-
::3
0
tr:I
goods and services. Four other factors that ,-vill result in a decrease in the 0
0
PPC are as follows: ::3
-·
0
I Reduced inputs and resources
When the amount of inputs or resources reduces in the economy, 0

a nation will not be able to produce more goods and services.

Hence, this causes the PPC to shift to the left or in,-vards.
2 Inferior technology
When a country is facing inferior technology, a nation has less
ability to produce goods and services. This, therefore, causes the
PPC to shift to the left.
3 Economic do,vnturn or recession
A recession reduces a nation's income, and the nation will not
be able to increase the number of inputs to produce more goods
and services. As a result, the nation will produce fewer goods and
services and the PPC will shift inwards.
4 Decrease in population
When the number of population reduces in a country, the nun1ber
of people ,-vho are ,-villing to work will also decrease and reduce
the production of goods and services. Also, as the number of
population reduces, the demand of goods and services will be less,
thus resulting in less production of goods and services and causing
the PPC to shift to the left.

··1···-----...·-
GoodY Figure 1.4
The PPC shifts outwards due to
technological advancement

''
'
'
••
••
••
•
► ·''
•'
._ ___
_,__
_______ -
' --+GoodX
- Figure 1.5
The PPC shifts inwards due to
GoodY

_ J_·--
inferior technology

.c:
u

''
'
''
'
''
''
'•

'---------�---'-----+ GoodX

Additionally, the PPC ,-vill also shift outwards or inwards towards only
one good and the production of the other good remains unchanged. If
the improvement in technology occurs only in the production of Good
Y, then the PPC will shift outwards towards Good Y and Good X will
remain constant (see Figure 1.6). On the other hand, ,-vhen there is a
problem in technology for the production of Good X only, then the PPC
will shift inwards more towards Good X and Good Y remains unchanged
as illustrated in Figure 1. 7.
Figure 1.6 GoodY
The PPC shifts outwards
towards Good Y
-' -
''
''
'
''
''
'
''

'
•'
••
•'
''
''
.__________.._ ___.GoodX

Figure 1.7 GoodY

The PPC shifts inwards
towards Good X
--- --
--
---
''

' ''
' ''
''
'
'
'
'
''
'
''

.__ __.
_________ _
..,___. Good X
1.4 BASIC ECONOMIC PROBLEMS
-::3-
"'1

--·
The problem of scarcity in the economy results in society having to
0
C.
resolve three fundamental economic problems. Figure 1.8 depicts
s::
0
what these economic problems are.

Figure 1.8
0
-
::3
0
tr:I
Three basic economic problems 0
0
What to produce ::3
-·
and how much to 0
produce?
0

1 What to produce and ho,v much?

In the presence of scarcity, producing more of one good means What to produce and how
producing less of another good. A society, therefore, has to choose much to produce refers
wisely among scarce resources to satisfy its ,-vants and address to the types of goods and

the question: what are the types of goods and services to produce
services to be produced,
based on society's demand
for the economy? The answer to this question involves resource and the available resources.
allocation. For exan1ple, producing a large output of food requires
a big amount of resources to be allocated to food production.
In addition, the types of goods to be produced depend on
society's demand. Society has to utilize the scarce resources
efficiently to satisfy its unlimited demand. How n1uch to produce
refers to the quantity to be produced, and this also depends on
society's demand as well as is related to the wise and efficient usage
of scarce resources, without any wastage.
2 How to produce?
This question refers to the methods or techniques of production:
who will be producing the goods and services, using what resources,
How to produce refers to the
methods or techniques of
and combining the resources in what way, using appropriate production.
technology? The producer can choose to use 1nethods which are
either labour intensive (1nore labour as co1npared to capital)
or capital intensive (more capital as con1pared to labour). The
producer \.vill choose the best method of production that minimizes
the cost. For example, agricultural goods can be produced using
either labour intensive or capital intensive 1nethods.
- 3 For whom to produce?
The distribution of goods and services depends on the distribution
For whom to produce is
based on society's income of income in society. People ,.vith higher income are able to
.c: distribution and purchasing
purchase more goods than the lo\.ver income groups, as the former
u power.
have higher demand and purchasing power. Necessity goods are
produced for everyone and luxury goods are produced for those
who have higher income and purchasing power. For example,
people ,.vith higher income will demand expensive or luxury
furniture, whereas people with lower income ,.vill demand cheaper
furniture "vhich incidentally is of lo,..ver quality.
The solutions to the above questions also depend on the economic
system of a country, ,-vhich we will explore next.

SAMPLE QUESTION 1.4

1 How does an economist solve basic economic problems?

Solution:
What to produce and how much to produce?
An economic decision of what to produce and the quantity to produce depends on
society's demand. The efficient use of scarce resources is crucial in order to produce goods
and services in demand by society.
How to produce?
An economist may use either a labour intensive or capital intensive method, depending
on which one is less costly. The producer should be able to utilize the resources efficiently
and use available technology to produce the goods and services.
For whom to produce?
The production of goods and services depend on the distribution of society's income. The
••• rich will get more goods and services, while the poor will get less .
•••

Society can resolve the basic economic problems differently through

alternative economic systems. The real world economies can be divided
into four types of economic systems: command economy, free market
economy, n1ixed econo1111y and the Islainic economy.

1.4.1 Command Economy/Central Planning/

A s ocialist economic system,
known as a centrally planned
economicsystem, involves
the government making all
economic decisions .
Socialist Economic System
The government makes all important decisions about production
and distribution-it decides on what to produce and how much to
produce, how to produce, and for whom to produce. Price mechanism
does not operate in a pure command economy. The government o,.vns
all factors of production and directs the operations of enterprises in
the comn1and economy to produce the desired goods. A decade ago,
one-third of the world's economies, such as North Korea, Cuba, China,
Vietnam and Cambodia, relied heavily o n central planning. Today,
the number of such countries is small, as most countries currently -::3-
depend on the forces of the market to solve the economic problems. "'1

--·
0
C.
s::
Characteristics of the Socialist Economic System 0

-
1 A socialist economic system is also known as a centrally planned 0
economic system, '1-vhere the government makes all economic ::3
decisions ,-vithout the involvement of the private sector. 0
2 The government owns all factors of production in the economy, tr:I
as well as the outputs produced. The factors of production are
0
0
::3
allocated tl1rough the Central Planning Authority and rationed
-·
0
according to society's needs.
3 Society must abide by the government's directives because the 0
government has the absolute power and autocracy; individuals
have no right to make their own economic decisions.
4 There is an equal distribution of income since, regardless of what
,-vork society participates in, the citizens '1-vould earn ahnost the
same or an equal amount of income.

Advantages of the Socialist Economic System

I The government can direct the nation's resources to produce
desirable goods and services.
2 There is a lower level of unemployment compared to other
economic systems, as the state ensures that labour is directed to
industries where labour is needed.
3 Prices of goods and services are controlled by the state. Hence, the
inflation rate is lower than that of a free market economy.
4 Inequalities of income and ,-vealth can be minimized as the
ownership of property is decided by the state. National income is
more evenly distributed. Therefore, there is no discrimination as
everyone is given sufficient incon1e, according to ttheir needs.
5 The government provides public goods for the benefit of society
,-vhich depend on the needs of society. Therefore, all areas are
developed equally for the welfare of society.

Disadvantages of the Socialist Economic System

1 There is no economic freedom in a command economy. Workers
have no choice on where to work and what to work as because
their jobs are assigned by a planning authority. Consumers also
have no choice on ,-vhat to buy and producers cannot choose what
to produce and which method of production to use because all
decisions are made by the government.
2 Workers lack any incentives to work hard and the absence of
competition results in a slower rate of developn11ent in research
and development (R&D). Generally, countries that practice a
command economy are more inferior in terms of technology
compared to those that practice a capitalist system.
3 As there is no price system, it is difficult to estimate tl1e demand of
goods and services. lhe state 1nay produce too 1nuch or too little
of certain goods.
- 4 The government may produce goods that are not required by
.c:
u 5 Command economy is a bureaucratic system that lacks flexibility.
A capitalist economic system,
known as a free market
economy, involves the private
sector making all economic
decisions.
the public. For example, in the Soviet Union, the government
allocates more resources towards military and space equipment
rather than consumer goods. The consumers' welfare is ignored.
Central planning has to estimate the wants of consumers and
allocate resources to produce those goods and/or services. This
causes both a waste of resources and delays in making a decision.
Economic Decisions in the Socialist Economic System
What and How Much to Produce
Decisions on what and how much to produce are made by the
Central Planning Authority. The governn1ent v.rill produce goods
and services that the society needs.
How to Produce
The government or Central Planning Authority will decide on the
methods or techniques of production. They might use a modern
or traditional 1nethod! which will n1ini1nize cost.
For Whom to Produce
The Central Planning Authority will produce basic needs first to
serve social welfare. The government will set a lower or cheaper
price for essential goods and a higher or more expensive price for
luxury goods.
1.4.2 Free Market Economy/Laissez-faire/
Free Enterprise/Capitalist Economic
System
In most democratic countries, such as the United States of America,
Canada, Japan and Germany, the free markets resolve basic economic
problems. In this type of economy, government intervention is kept
at a minimum. Firms and households make all economic decisions.
Firn1s seek to maximize profits fro1n production by producing the
commodities that yield the highest profits ( the what) using techniques
that incur the least cost in production (the how). Consumers seek to
maximize satisfaction from their consumption of goods and services.
Consumption is decided by the decisions made by individuals on how
to spend their wages and property income (the for whom).
Characteristics of the Capitalist Economic System
-::3-
1 Resources are owned by private sectors and there is no government "'1

--·
0
intervention in making any economic decisions. C.
2 Individuals and firms have the liberty to make their own economic
s::
0
decisions and are free to possess property as ,.vell as wealth without
any limitations.
3 Price mechanism is an important indicator in the free economy.
0
-
::3
0
If consumers are willing to pay more for the goods and services, tr:I
0
they will receive more, whereas those who pay less will get less 0
::3
goods and services.
-·
0
4 The ultimate objective of a producer is to maximize profit and
minimize cost, while the consumers' objective is to maximize 0

satisfaction.

Advantages of the Capitalist Economic System

1 There is freedom of choice. Consumers have the freedom to
choose ,-vhat they want to buy, and producers can choose what to
produce and how to produce.
2 People have the right to own properties. Both consun1ers and
producers can buy land and own properties. The government will
not confiscate properties owned by individuals.
3 There is incentive for people to work harder because the allocation
of wealth depends on the society's income. The harder they work,
the more goods and services they ,vill receive.
4 There is mobility of labour. Geographical mobility of labour
is made possible, where workers can move from one place to
another. Occupational mobility of labour is also allowed in which
a worker can switch from one occupation to another or fron1 one
form of employment to another.
5 The presence of competition encourages research and
development (R&D). Invention and innovation are made possible
with science and technology. Hence, this moves the economy
towards efficient use of resources and econon1ies of scale. This in
turn enhances foreign direct investment, thus economic growth
can be achieved.

Disadvantages of the Capitalist Economic System

1 There would be a wide gap between the rich and the poor. As a
result of a non-intervention policy by the government, the rich
or those ,-vith skills and scarce resources are able to exploit more
resources and wealth. They will get richer, while tl1e poor will get
poorer. The wide gap between the rich and the poor results in a
pyramid-shaped income distribution pattern as shown in Figure
1.9, where a minority is rich while the majority is poor.
- Figure 1.9
; Pyramid-shaped income
- distribution pattern

.c:
u

2 There is existence of unemployment. In a capitalist system, an

economy is governed by an invisible hand through the power
of den1and and supply of the market. If the supply of labour is
more or greater than the demand for ,.vorkers, unemployment
will occur. This situation explains the high unemployment rate in
most capitalist states.
3 Misallocation of res.ources occurs. As producers are motivated by
profits, they may devote more economic resources to producing
luxuries for the rich, resulting in overproduction of certain goods
and underproduction of necessity goods for the poor.
4 Human welfare is ignored. Public goods may not be provided by
the private sector. Merit goods such as education and the health
system may not be provided adequately, resulting in higher prices
of the merit goods. As such, the poor cannot afford them.
5 Problems of social cost or external cost arise. As the objective of a
producer is to maximize profit, they may consider only the direct
cost of production and might ignore the external cost caused by
their production. This may pollute the environment, leading to
water and air pollution.
6 Monopoly power is established. Bigger and more efficient firms
will enjoy the advantages of econon1ies of scale. The bigger firn1s
that enjoy economies of scale ,.vill force out smaller firms from
the industry and establish their monopoly power. Prices thus may
increase.

Economic Decisions in the Capitalist Economic System

Consumers sovereignty refers

to the power ofconsumers, not
producers, to determine what
goods and services are to be
produced.
What and How Much to Produce
It depends on the demand controls supply which is known as
consumers sovereignty. Consumers sovereignty refers to the
power of consumers, not producers, to determine what goods
and services are to be produced, as markets depend heavily on
demand. The rising price of a good indicates that there is an
increase in demand for the good, ,.vhere consumers are willing to
pay more for it. This acts as a signal to producers to manufacture
or produce n1ore of this said good.
 -::3-
How to Produce "'1
A profit maximizing firm will switch to cheaper factors of
--·
0
C.
production to minimize costs. The firm also needs to decide s::
0
whether to use a labour intensive or capital intensive production
technique that will give the lowest cost of production. The method
of production relies on the efficacy of resource utilization and the
0
-
::3
0
objective of maximizing profit. tr:I
0
0
::3
-·
0

For Whom to Produce 0

Only those who are able to pay the market price will be allocated
the goods and services. Hence, consumers with greater purchasing
po,-ver ,-vill have more goods and services.

1.4.3 Regulated Market Economy/

Mixed Economic System
Most societies today operate mixed economies; there has never been
a 100% free market economy or 100% command economy. In a mixed
A mixed economic system is
a combination of the public
economy, part of the economy is left to the free n1arket with some and private sectors.
varying degrees of state intervention. For example, although the
United States of America is a capitalist economy, its government still
monitors the functioning of the 1narket and passes laws to regulate
the economy. For China, there are son1e private sectors although
it is a communist economy. Meanwhile, countries such as Iceland,
Sweden, France, the United Kingdom, Malaysia and Singapore
practice a mixed economy.
In a mixed economy, the economic behaviour results from some
n1ixture of government control and free market. The price mechanism
is allowed to operate with some intervention from the government
in certain areas. Price control might be implemented. The private
and public sectors work hand in hand to ensure economic growth is
achieved.

Characteristics of the Mixed Economic System

1 Resources are owned by both the government and the private
sector. Both public and private sectors make economic decisions
to ensure the economic grov.rth of the country.
2 The government intervenes by providing public goods such as
roads and street lighting because these are goods that will not be
provided by the private sector.
3 The govern1nent also provides merit goods such as education and
health services, so as to raise the standard of living for the people
and curb the sale and production of demerit goods such as alcohol
and tobacco.
- 4 Individuals and firms are free to own wealth, but are levied with
tax by the government. In addition, the government i1nposes
progressive taxation to reduce income inequality, where higher
.c: income groups are taxed more than the lo,-ver income groups.
u As such, the income gap between the rich and the poor will be
narrowed.
5 Individuals and firms are free and independent to n1ake
economic decisions, but the government intervenes through la,,v
enforcement whenever necessary. The government will try to
reduce social costs by ensuring the production method used will
cause the least harm to the environment and by regulating laws to
control pollution.
6 In some cases, the government may allow only a single producer to
operate. This prevents unnecessary competition among producers,
which in turn prevents duplication and wastage of resources. For
exan1ple, Tenaga Nasional Berhad is given monopoly po,-ver to
generate and supply electricity to the public in Malaysia.
7 The government reduces or controls monopoly power, as
monopolists will try to reduce outputs to keep prices high. The
govern1nent has to control and regulate the power of monopolies
to take care of consumer welfare.

Advantages of the Mixed Economic System

1 There is a variety of goods and services produced by the private
sector and the government provides public goods at affordable
prices.
2 Economic activities are more stable and organized, and negative
externalities, such as air, environmental and noise pollution as
well as industry wastes, are curbed when the govern1nent controls
the existence of monopolies.
3 The income gap between the rich and the poor is narrowed down
since the government imposes a progressive tax system, where
higher income earners pay more tax than lower income earners.
Society will thus receive more benefits in the econon1y as there is
less price discrimination and monopoly power.
4 The social cost is minimized as the government regulates laws to
ensure the production method used by producers causes the least
harm to the environment.

Disadvantages of the Mixed Economic System

I A mixed economy is run by a social democratic government. One
of the biggest issues is the government gaining too much power
in finding a balance bet"veen wealth equality, market freedo1n and
individual freedom .. This excessive control over business activities
can discourage investment.
2 A mixed economy also allows excessive intervention of the
government, especially that which is influenced by short-term
political factors, "vhich may bring about inefficient outcomes.
3 More government intervention in the economy requires a greater -::3-
investment by the governn1ent ,vhich largely co1nes from tax "'1

--·
revenues. Heavy taxes reduce investment and decrease motivation
0
C.
in work, as most of the earnings and profits go to taxation. s::
0

-
4 In a mixed economy, the government may limit company sizes 0
to reduce monopoly power. Hence, entrepreneurial spirit may be ::3
destroyed. 0
tr:I
0
Economic Decisions in the Mixed Economic System 0
::3
-·
0

What and How Much to Produce 0

Decisions on what and how much to produce is determined by
the market's demand and supply mechanism. Both private goods
and public goods are provided in the country. Society enjoys basic
goods at a cheaper price, and a variety of goods and services are
provided by the private sector.

How to Produce
Producers choose the most efficient and cost-effective method of
production. Meanwhile, the government enforces laws to combat
inefficiencies that arise from negative externalities, such as
pollution and industry wastes. The producers will choose either a
labour intensive or capital intensive method that minimizes cost,
maximizes profit and achieves efficiency.

For Whom to Produce

The production of goods and services depends on the market's
demand and society's needs. It is based on the society's income
distribution. The public sector produces basic goods and public
goods at affordable prices to serve social interests, while the private
sector produces goods and services based on the market's demand
and achieves maximum profit. Ho,-vever, if there is a necessity or if
the social interest is disrupted, the government will intervene and
control the prices of goods and services.

1.4.4 Islamic Economic System

The basis of an Islamic economic systen1 is the principles of Islamic
The Islamic economic
Shari'ah. The principles are in accordance with the Qur'an as well system is based on the
as hadith, which are based on the sayings and actions of Prophet principles of Islamic Shori'ah.
Muhammad S.A.W The production of goods and services in this
economy should be based on these principles, which are to produce
- permissible (halal) goods and services and to avoid the production of
non-permissible (haram) goods and services. The production of goods
and services should also be parallel to the classifications of goods in
.c: Islam, namely:
u (a) Dharuriyyah (necessity goods)
(b) Hajiyyah (comfort goods)
(c) Kamaliyyah/Tahsiniyyah (luxury goods)
The above goods will be discussed further in Chapter 2.
The social interest should be fulfilled first and private interest later.
The only objective of the Isla1nic economic system is to achieve Al-Falah,
which means success in one's life and also the life hereafter. Economic
activities in Islam are not seen only from the materialistic aspect, but also
from the spiritual aspect in this world and the life hereafter.
Here are five basic philosophical foundations in the Islamic economic
system:
I Concept of Tauhid
Tauhid refers to the concept of believing that in Islam there is only
one God, Allah S.WT., to be worshipped. The belief of Tauhid is
divided into two parts:
• The relationship bet,,veen man and Allah S.W.T.
(Habluminallah)
• The relationship among mankind (Habluminannas)
2 Concept of Rububiyyah
Rububiyyah refers to the concept of believing that Allah S.W.T.
alone is the most powerful creator, who organizes and rewards
man's economic activities for genuine interests to achieve A l F - alah
in this world and th,e life hereafter.
3 Concept of Tazkiyyah
Tazkiyyah refers to the concept of purification as Islam believes
that man must have a pure and good soul before he indulges in any
economic activities. Individuals can purify his wealth by giving
out tithe (zakat) and donating (sadaqah) to the poor. Zakat is
mandatory for all Muslims, whose income has reached a certain
stated amount. It is not a charitable contribution, but is considered
as a tax. The amounil: collected is first paid to zakat collectors, then
to poor Muslims. Sadaqah refers to voluntary charity done out of
con1passion, love, friendship, religious duty or generosity.
4 Concept of Khalifa.h
Khalifah refers to the 'steward' or leader of a caliphate. It means
men are the servants of Allah S.WT., who are created as trustees
and are responsible to prosper the land set by the Islamic Law
(Shari'ah).
5 Concept of Ukhuwah -::3-
Ukhuwah means brotherhood, as all men must love, respect and be "'1

--·
0
responsible to each other. Those who are willing to help, reconcile C.
and sacrifice for their brothers sho"v the sign of faitih, as oppression
s::
0
and extortion do not exist in the Islamic economic system.

Economic Decisions in the Islamic Economic System

0
-
::3
0
tr:I
0
0
::3
What and How Much to Produce
-·
0
All economic decisions are determined by the principles of
Shari'ah which are laid out in the Qur'an and Sunnah. There is the 0

production of permissible (halal) goods and services, while non­

permissible (haram) goods and services are not to be produced.
The types of goods to be produced based on the classifications of
goods in Islam include basic goods (Dharuriyyah), ,-vhich should
be produced first, followed by other types of goods and services.

Ho,v to Produce
The techniques used depend on the least costly method. The
concept or philosophy of the Islan1ic economic system, such
as the concept of Tauhid, Rububiyyah, Tazkiyyah, Khalifah and
Ukhuwah, should be applied in economic decision-making.

For Whom to Produce

The rights of the poor is served first by producing basic goods
at cheaper prices and, at the same time, the rights of the rich is
not left out. T11e Islamic aid, such as zakat, sadaqah and waqf,
are important to ensure fair distribution of inco1ne and wealth
bet,-veen the rich and the poor.

1.4.5 Summary of the Four Types of

Economic Systems
Table 1.4 gives an overview summary of the four economic systems
that were discussed.
- Table 1.4 Summary of the four basic economic systems

Socialist Capitalist Mixed Islamic

Item Economic Economic Economic Economic
System System System System

1 Characteristics 1 Production 1 Production 1 Both public and 1 Production of

of goods and of goods and private sectors goods and services
services by services by produce goods and based on Shari'ah
public sector/ private sector. services. principles.
government. 2 No or minimum 2 Price mechanism 2 Individuals and
2 No private government is vital and, at the the private sector
sector/Central intervention. same time, the are free to make
Planning 3 Laissez-faire prices of certain economic decisions
Authority 4 Price mechanism goods are fixed by and gain profit,
involvement. is important. the government. while the public
3 Price 5 Competition i s 3 Production of both sector ensures that
mechanism is highl y practiced. private and public social welfare is the
less important. 6 Freedom of goods. priority.
4 No competition. choice. 4 Public and 3 Production of
5 Less freedom of 7 Production of private sectors permissible (halal)
choice. various goods work together to goods and services,
6 Production of and services. maximize profit but no production
public goods is and social welfare. of non-permissible
top priority. (haram) goods and
services.
4 Production of
goods and services
depends on the
hierarchy of needs.

2 Advantages or 1 SociaI welfare is 1 Society has 1 Society has 1 Production of

Merits served Iirst. economic economic freedom goods and services
2 Production of freedom. and social welfare depends on the
basic needs 2 Various goods is fulfilled. classifications of
(necessities) and and services in 2 Efficient wealth goods in Islam.
public goods for the market. allocation since 2 The poor's interests
social interest. 3 Production public goods and are served first.
3 Equitable of quality private goods are 3 The best allocation
distribution products due to produced at the of wealth and fair
of wealth and competition. same time. distribution of
income. 4 Research and 3 There is income through the
4 Allocation of development competition, concept of zakat,
wealth depends (R&D) takes place. leading to the sadaqah and so on.
on the societ y's 5 Enhanced production of
needs. foreign direct quality products
5 Less monopoly investment. and the production
power in the of basic goods by
country. the government.
4 Both public and
private interests are
served.
 -
::3

--·
0

-
Disadvantages 1 No or less 1 No public goods 1 The government
or Demerits economic are produced. may have excessive 0
::3
freedom and 2 There is a price control over
consumer to be paid business activities, 0
sovereignty. for all goods hence this may 0
Absence of and services discourage 0
competition, produced. investment. ::3
-·
0
leading to the 3 Inequality in 2 Greater
production distribution intervention by 0
of low quality of wealth and the government rn
products. income. may lead to greater
3 Inferior 4 Allocation of investment, hence
technology wealth depends heavier taxes.
since no on purchasing 3 The government
initiatives for power. may limit company
research and 5 Existence of sizes to reduce
development monopoly power. monopoly power,
(R&D). 6 The poor is hence affecting the
4 Waste of discriminated. entrepreneurial
resources. 7 High social cost. spirit.
8 Social welfare is
disrupted.

SAMPLE QUESTION 1.5

1 Briefly explain the advantages of capitalism.

Solution:
• There is economic freedom since a variety of goods and services are produced by the
private sectors.
• There is competition among businesses which leads to the production of quality
goods and services.
• There is innovation of new products and new technology since businesses are
involved in research and development (R&D).

--­•••
• The production of quality products enhances foreign direct investment and leads to
economic growth.
•••
 In this chapter, we have discussed the economics concepts in detail. Economics
can be defined as how people use scarce or li1nited resources to fulfil the
unlimited human wants. Economics can be classified into 1nicroeconomics and
macroeconomics. Microeconomics deals with individuals and specific units of
economics ,-vhich are analyzed in detail, whereas macroeconomics deals with
economics i11 aggregate.
The study of microeconomics begins with the three basic economic concepts.
Firstly, scarcity, which exists due to limited resources and unlimited hun1an
desire. Secondly, choice, which arises due to scarcity and the need for society to
make the best choice, in order to maximize satisfaction. Thirdly, opportunity cost,
which is the second best alternative to be sacrificed. These three basic economic
concepts are best described with the use of a production possibilities curve (PPC).
The PPC is a curve that shows the alternative combinations of two goods which
can be produced with existing resources and the current level of technology. There
are four assumptions before the PPC is drawn, which are (1) there are only two
goods produced in a nation, (2) the factors of production are limited, (3) the
current level of technology is fixed, and (4) the nation's economy is operating at
full employment. The PPC comes in three shapes, depending on the opportunity
cost associated with each PPC. A concave curve represents increasing opportunity
costs, a convex curve reflects decreasing opporttmity costs, and a straight line or
linear curve indicates constant opportunity costs. In addition, the PPC may shift
in two ways, either to the right or to the left parallel to the PPC, or shift outwards
or inwards towards only one good.
The explanation of microeconomics continues with the three basic economic
problems. What and how much to produce refers to the types of goods to be
produced based on consumer den1and and the available resources. How to produce
refers to the method or technique of production, ,-vhere a producer may choose to
apply either a labour intensive or capital iI1tensive method, depending on which
n1ethod is the least costly. For whom to produce refers to the group of people who
,-vill receive the goods and services produced and it depends on the distribution
of income.
The last part of this chapter discusses the four basic economic systems. The
socialist economic system, also known as centrally planned economy, refers to
the economic decisions n1ade solely by the governn1ent without private sector
intervention. The capitalist economic system or free market economy is managed
solely by the private sector and there is no government intervention. The mixed
economic system refers to an economy that is run by the private sector with some
government intervention. The Islamic economic system is an econon1ic system
based on the principles of Shari'ah as laid out in the Qur'an and Sunnah.
• Economics can be defined as a social science which is concerned with the
efficient allocation of scarce resources to achieve the maximum satisfaction
of human unlimited wants.
• Microeconomics analyzes the specific units of economics in detail, such as
individual entities, households, firms and markets..
-
• Macroeconomics analyzes the entire econo1nics in aggregate, such as
unemployment, aggregate income, average prices, inflation, international
trade and so on.
• Scarcity exists due to the situation where unlimited desire cannot be
fulfilled by limited resources.
• Factors of production are known as resources or inputs used in the process
of production, namely land, labour, capital, and entrepreneur, as ,.vell as
natural resources.
• Choice arises because of scarcity and society will make the best choice
possible to maximize satisfaction.
• Opportunity cost is known as the second best alternative forgone and it
arises after society has made the best choice.
• Production possibilities curve (PPC) refers to the alternative combinations
of two goods which can be produced with existing resources and the
current level of technology.
• Points outside the PPC are unattainable points and known as scarcity,
due to lack of resources.
• Points along the PPC are known as choice; they are points which are
attainable and most efficient.
• Movement from one point to another point refers to opportunity cost
,vhich indicates that more goods should be sacrificed to produce more of
another good.
• Points inside the PPC refer to attainable but inefficient points because
the resources are not fully utilized.
• The PPC will shift outwards when there is technological advancement,
economic gro,vth, an increase in resources, an increase in population
and so on.
• The PPC will shift inwards due to inferior technology, a reduction in
economic gro,vth, recession, a decrease in resources, a decrease in
population, natural disaster and so on.
• The three econon1ic problems consist of what and ho,v much to produce,
how to produce and for whom to produce.
• What and how much to produce refers to the types of goods to be produced
and it depends on the demand of society and the limited resources an
economy has.
• How to produce refers to the method or technique of production, that
is ,vhether to apply a labour intensive or capital intensive method; an
economy will choose the best method ,vith the least cost possible.
- • For whom to produce depends on the distribution of society's income and
purchasing po,ver.
• The four basic economic systems are the socialist economic system,
.c:u capitalist economic system, mixed economic system and Islamic
economic system.
• A socialist economy is also known as a planned economic system, where
the economic decision-making is made by a Central Planning Authority
which is the government.
• A capitalist economy is also known as laissez-faire, where there is no
government intervention in economic decision-making and the production
of goods and services is run by the private sector.
• A mixed economy is an economic system consisting of the private sector
and public sector, who are involved in the economic decision-making.
• An Islamic economy is based on the principles of Shari'ah which is laid out
in the Qur'an and Sunnah.

+ Key concepts

• Economics • Production possibilities • Socialist economic system

• Microeconomics curve (PPC) • Capitalist economic
• Macroeconomics • What to produce and system
• how much to produce • Mixed economic system
Scarcity
• How to produce • Islamic economic system
• Choice
• For whom to produce
• Opportunity cost

+ Exercises

Multiple-choice Questions
Answer the following questions.

1 Economics is best described as C the decision of maximizing society's

A how society uses scarce resources to needs.
produce unlimited wants. D human wants should be fulfilled although
B how to allocate wealth from rich to poor. there is a lack of resources.
2 Microeconomics is concerned with
A the study of entire econo1nics.
B the study of specific economic units.
C the study of aggregate demand and
aggregate supply.
D the study of economics generally.
3 Which of the following items reflects the
study of microeconomics?
A Aggregate supply and aggregate demand
B Unemployment and inflation
C General prices of goods and services
D The production of PERODUA cars
4 refers to the types of goods
produced in a country.
A 'What to produce?'
B 'How to produce?'
C 'How much to produce?'
D 'For whom to produce?'
5 An ouh-vard shift of the production
possibilities curve is caused by
A less availability of resources.
B a decrease in population.
C an increase in technology.
D an increase in the cost of production.
6 A movement along the production
possibilities curve reflects
A an unattainable point.
B an attainable but inefficient allocation of
resources.
C an attainable and efficient allocation of
resources.
D an inefficient point.
7 Which location on the production
possibilities curve represents scarcity?
A A point inside the production
possibilities curve.
B A point along the production
possibilities curve.
C The movement on the production
possibilities curve from the Y-axis to
X-axis.
D A point outside the production
possibilities curve.
8 The concave shape of the production -::3-
possibilities curve is a result of
--·
A increasing opportunity cost.
0
C.
B decreasing opportunity cost. s::
0
-
C linear opportunity cost. 0
D inconsistent opportunity cost. ::3
0
9 Which of the following statements is true
about a production possibilities curve?
0
0
A Movement from one point to another
::3
-·
0
point is known as choice.
B Unattainable points represent the 0
problem of scarcity.
C Points inside the production possibilities
curve indicate the lack of resources.
D Any point along the production
possibilities curve is an inefficient point.
10 It is possible to achieve an unattainable
point on the PPC if
A new techniques are invented by the
country.
B the cost of production increases.
C a recession occurs in the country.
D the economic growth of a country
declines.
11 Which of the following elements is a
characteristic of capitalism?
A Central Planning Authority
B Public ownership of resources
C Less competition
D Private ownership of resources
12 In an Islamic economic system, the
economic decisions are
A made by the public and private sectors.
B made based on principles of Shari'ah.
C n1ade due to consun1ers' den1and.
D made based on price mechanism.
13 Which of the following economic systems
does not use price as an indicator?
A Capitalist economic system
B Mixed economic system
C Islamic economic system
D Socialist economic system
- 14 A capitalist economic system is beneficial to
society because
A there is production of permissible goods.
.c: B social welfare would be the priority.
u C there is production of quality products.
D there is production of basic goods.
Questions 15 to 17 are based on the diagram.
GoodY
A .o
C B microeconomics and macroeconomics.
eB
C Point D indicates a waste of resources.
D Point C is in1possible to achieve.
17 The shape of the production possibilities
curve 1s_ _ _ _ and reflects the_ _ _ _
A convex; decreasing opportunity cost
B linear; constant opportunity cost
C concave; increasing opportunity cost
D convex; increasing opportunity cost
18 The basic econo1nics concepts include
A what, how and ho,.v much to produce.
C capitalism and socialism.
D scarcity, choice and opportunity cost.

19 The production possibilities curve of

clothing moved inwards. Which of the
._________..___.Good X

following resulted in this shift?

15 Point A represents
A an inefficient point of production by a
country.
B the allocation of all resources in the
production of Good Y.
C the maximum production of Good X.
D an unachievable point.
16 \,Vhich of the following statements is true?
A Points A and C are attainable and
efficient.
B Point B implies a lack of resources.
A An increase in the nu1nber of workers.
B An increase in the price of cotton.
C An increase in consumer's income.
D An increase in the number of births.
20 Which of the following aspects is a concern
of the Islamic economic system?
A Production of goods according to
classification of goods
B Serving private interests first
C Less government intervention
D Less economic freedom

Short-answer Questions
Answer thefollowing questions.
1 State whether each of the following statements relates to microeconomics or macroeconomics.
(a) The price of bottled mineral ,.vater produced in Malaysia.
(b) Honda's production increased from 10% to 20% in the year 2016.
(c) The inflation rate in Malaysia during the second quarter of 2015 is 2.2%.
(d) The export of rice in Thailand dropped due to a drought.
(e) The salary of public servants increased in 2018 due to an increase in economic growth in
2017.
2 The table shows the production possibilities of Country M.
-
::3
"'1

I I Opportunity Cost
--·
0
Combination Rice (kg) Wheat (kg) C.
s::
0
A 100 0
0
B 92 1 ::3
0
C 80 2
tr:I
D 65 3 0
0
::3
-·
E 40 4 0
F 0 5 0

(a) Plot the production possibilities curve of Country M in a graph paper.

(b) Calculate the opportunity costs of wheat.
(c) If Country M decides to allocate all its resources to the production of wheat, what
is the opportunity cost?
(d) Based on the PPC you have drawn, show whether the combination of 3 kg of
wheat and 75 kg of rice is attainable? Justify your answer.
3 The table shows the production possibilities of fans and air conditioners.

Alternative Fan (Unit) Air Conditioner

Combination (Unit)

A 0 300
B 5 270
C 10 220
D 15 160
E 20 90
F 25 0

(a) Plot the production possibilities curve, where the Y -axis represents units of air
conditioners and the X-axis represents units o f fans.
(b) Calculate the opportunity cost
(i) for the first 10 units of fans.
(ii) if the production increases from 15 to 20 units of fans.
(iii) if the country produces the maximum amount of air conditioners.
(c) On the same PPC in (a), illustrate the effect of an increase in technology on the
production of air conditioners.
(d) On the same PPC, show the combination of 10 units of fans and 150 units of air
conditioners. Label the point obtained as Y. Indicate whether this point is scarcity,
choice or inefficiency.
- 4 Toe diagram shows the production possibilities curve of Country Seri Intan.

Car (Unit)

.c:
u 3,ooo r----
2,soo ················

1,500 ................., ...................

.,L_
, -+
o
_
.__ _ _
_ 2,....:. s_
o_ o _ _ s
__,0�0-0 6
_ o o o_ Motorcycle (Unit)

(a) Is the opportunity cost faced by Country Seri Intan increasing, decreasing or
constant? Give your reason.
(b) Calculate the opportunity cost of
(i) producing 3,000 units of cars.
(ii) increasing the production of motorcycles fron1 2,500 to 5,000 units.
(c) Label the follo,.,ing points on the diagram above:
(i) Point A: Scarcity
(ii) Point B: Choice
(iii) Point C: Attainable but inefficient production
(d) State the four assumptions of the production possibilities curve.
5 Answer the questions based on the information in the table.

A B C D E

5,200 4,800 3,900 2,200 0

0 100 200 300 400

(a) Plot the production possibilities curve in a graph paper.

(b) State whether the follo,.,ing combinations are unattainable, attainable and
efficient, or attainable but inefficient:
(i) 200 kg of mangoes and 4,500 kg of durians
(ii) 2,200 kg of durians and 300 kg of mangoes
(iii) 100 kg of mangoes and 1,800 kg of durians
(c) If any one of the answers above is 'unattainable: provide two factors that would
make the production attainable instead.
Essay Questions -::3-
Answer the following questions.
"'1

--·
0
C.
1 Explain the three basic economic concepts, namely scarcity, choice and opportunity s::
cost, using a production possibilities curve.
0

2 Distinguish ben.veen microeconomics and macroeconomics, and give appropriate

examples.
0
-
::3
0
3 Define production possibilities curve. Discuss the factors that can cause a production tr:I
0
possibilities curve to shift outwards. 0
::3
4 Discuss how a mixed economic system solves the three basic economic problems.
-·
0
:3
5 Differentiate between a capitalist economic system and a socialist economic system. 0
rn
6 Elaborate the advantages of a 1nixed economic systen1 and the disadvantages of a
capitalist economic system.
7 Explain the Islamic economic system in detail.
Demand and
Supply
At the end of this chapter, you should be able to:
gJ
E • Describe all types of goods.
8 • Explain the definition of demand, law of demand, individual
demand, and market demand.
:,
• Differentiate between change in quantity demanded, change in
demand, the determinants of demand, and exceptional de1nand.
·s • Explain the definition of supply, law of supply, individual supply,
and market supply.
• Differentiate between change in quantity supplied, change in
supply, the determinants of supply, and exceptional supply.

Free Goods
Goods that are available
without production and
are usually referred to as
'gifts of nature'.
Economic Goods
Goods that are limited in
supply and man-made. They
require effort to be produced
and involve cost of production.
Thus, consumers have to pay
for the goods.
D emand and supply are the most fundamental concepts in
economics. These basic concepts of supply and demand are
integrated into the daily actions of people from all walks of life. In
this chapter, types of goods in both the conventional and Islamic
perspectives will be introduced. Next, we will discuss the basics
of demand and supply, the law of demand and supply, as well as
the differences between (1) changes in demand and supply, and
(2) changes in quantity demanded and quantity supplied. This chapter
will also explain some of the determinants of demand and supply, and
the violation of the law of demand and supply.
2.1 CLASSIFICATION OF GOODS
There are 1nany types of goods. Therefore, goods can be classified into
different categories based on their distinctive characteristics; from
responsiveness of quantity demanded to price change(s), to income
change, to change of price of other goods, and so forth.
Under economics, goods are categorized into the following three
groups, as surmned up in Figure 2.1.
1 Free goods are available without production. Free goods, such as
sunlight, air, trees, rain water and rivers, are usually referred to
as 'gifts of nature' since they are provided by nature. There is no
element of rivalry with these goods, but this does not mean that
they are unlimited. In fact, free goods are absolutely produced
from limited resources.
2 Economic goods are limited in supply and they are man-made
goods. Econon1ic goods require effort to be produced and involve
cost of production. Therefore, consumers have to pay for the
goods. Economic goods also involve opportunity cost. Some
examples of these goods are notebooks, pencils, skateboards and
cars. Economic goods are divided into t,-vo sub-groups:
(a) Perishable goods that cannot last long, such as fruits, meat
and vegetables.
(b) Non-perishable goods that can last for a longer time, such as
houses, gardening tools, exercise equipment and televisions.
3 Public goods are non-excludable and non-rivalrous goods that
everyone can consume and enjoy.
(a) Non-excludability means that no one can be prevented from
using the good once it is provided.
(b) Non-rivalrot1s consumption, or non-exhaustibility, means
that the consumption of the good by one person will not
reduce the amount available to others. If the good is supplied
to one person, it is made available to all.
 Public goods can be divided into two types, partial public goods and Public Goods 0
pure public goods. The difference beh-veen partial publiic goods and pure
CD
Goods that are
public goods is that it is possible to exclude people from consuming partial non-excludable and
non-rivalrous; everyone :s
public goods if they do not pay for the goods (for example, highway with can consun,e and enjoy Q.
toll fares), whereas it is impossible to exclude people from consun1ing these goods. :s
ll)

pure public goods when these goods are supplied (for example, national Q.
defence and street lights). en
C
'O
'O

Figure 2.1
Economics: Types of Goods Types of goods in

I
economics

I
Free goods Economic goods Public goods
E.g. Air E.g. Books E.g. Public parks
I

SAMPLE QUESTION 2.1

1 The types of goods that cannot last long are _____

2 Name two examples of free goods.
3 List three types of goods under the conventional economics perspectives.

Solution:
1 perishable goods
2 Sunlight and rivers
3 (i) Fr e e goods
(ii) Economic goods
••• (iii) Public goods
•••

Goodsin Islamic
Goods under the Islamic economics perspectives car1 be classified into Perspectives
four categories according to hierarchy of needs, as shown in Figure 2.2. The four types of goods
are Dharuriyyah, Hajiyyah,
Ka,naliyyah and Tarafiyyah.

Figure 2.2
Islamic Economics: Types of Goods Types of goods in Islamic

I I
economics

- •
Dharuriyyah Hajiyyah Kamaliyyah Tarafiyyah
Necessity good Comfort good Luxury good Extravagant
I E.g. Food E.g. Microwave good

Demand is defined as the
ability (purchasing power) and
the willingness of a consumer
to buy goods and services
at a certain price level, place
and time range, ceterisparibus
(other factors remain constant).
Ceterisparibus stands for 'all
other things being unchanged
or constant'.
I Dharuriyyah goods refer to necessity goods that we cannot
live without. Humans cannot survive without these goods, for
example food, shelter, clothes and education.
2 Hajiyyah goods are comfort goods, which provide comfort
to human beings. Without these goods, humans' day-to-day
existence would be less comfortable. Some examples of comfort
goods are refrigerators, air conditioners, washing machines and
vacuum cleaners.
3 Kamaliyyah goods are luxury goods which satisfy the needs of
humans, but without them, humans can still survive and live
comfortably. Some examples of luxury goods are Ferrari cars,
bungalows, Louis Vuitton and Coach leather accessories, and
diamond necklaces.
4 Tarafiyyah goods refer to non-permissible goods that will cause a
negative impact on society. These goods are extravagant, leading
to a waste of resources. Some examples of extravagant goods
include extravagant flights, lavish furniture, luxurious toilets (The
Indian Express, 2016) and jewel-embellished or diamond teeth
(Sunl,Vest Dental, 2015).
2.2
f>N mc,i�kt'f1E'lfA�b�:�g,
E
MARKET DEMAND
2.2.1 Definition of Demand
People demand goods and services in an economy to satisfy all their
desires. In econon1ics, demand is different from 'desire: 'wish: 'want'
and 'like: De1nand refers to effective de1nand. A consumer who wants
or desires to have a product or service must have the ability to buy
(purchasing power) and willingness to pay for the said good or
.
service.
Demand is defined as the different quantities of goods or services
which buyers are willing and able to buy at different possible prices in a
given period of time, ceteris paribus.
Demand Schedule
A demand schedule shows a series of alternative possibilities of
quantities being demanded, ,-vhich can be set do\>vn in a tabular
format as per Table 2.1. Given the various prices of ballpoint pens,
the quantity demanded shows ,-vhat amount of the pens the buyer is
willing and able to buy, ceteris paribus.
 Combinations of Prices of Quantity Demanded Table 2.1 0
Individual demand schedule
Ballpoint Pens Ballpoint Pens of Ballpoint Pens
for ballpoint pens
(Unit) (USO) (Unit)

1 100
B 2 80 Q.
en
C 60

D 4 40 '<

E 5 20

From above Table 2.1, we can see that when the price of the ballpoint
pen increases from USD2 to USD3, the quantity demanded for ballpoint
pens will fall from 80 to 60 units. Conversely, ,-vhen the price of the
ballpoint pen decreases from USD4 to USD3, the quantity demanded for
ballpoint pens will increase from 40 to 60 units.
Figure 2.3 sho,vs the demand curve (D) for ballpoint pens that is
plotted based on the demand schedule in Table 2.1. The most crucial
determinant of demand is the price of the good itself.

P(USD)
Figure 2.3
Down ward sloping demand
E curve for ballpoint pens
5

4 D

3
C

2
B

A
1
D
0 Quantity
20 40 60 80 100

2.2.2 The Law of Demand

The law of demand states that when the price of a good itself increases,
the quantity detnanded for the good will fall and when the price of the
The law of demand states
that when the pr ice of a
good decreases, the quantity demanded will increase, ceteris paribus. good increases, the quantity
In other words, the la,,v of demand shows an inverse relationship demanded for the good will

between the quantity demanded and the price of the good itself.
fall, and vice versa.

However, the law is only true by assuming other factors influencing

demand are held constant, i.e. only the price of the good itself changes.
Therefore, the demand curve will generally be downward sloping,
indicating the negative relationship between the price of a good or
service (P) and the quantity demanded (Q).
 Downward sloping
demand curve
La,v of Demand 11¢ (Negative relationship
between price and
quantity demanded)

2.2.3 Individual Demand and Market

Demand
There are t,-vo types of demand, ,-vhich are:
I Individual demand-this refers to the demand of goods and
services from a single consumer.
2 Market demand-this is a horizontal summation of all the
individual demand in a particular market.
Let us look at an example of market demand using the following
Table 2.2. Assume that there are only two customers in the market, i.e.
Customers A and B. Table 2.2 shows that at the price of USD 10, Customer
A would buy 7 units of Good X, while Customer B would buy 5 units
of Good X. Hence, we can obtain the market demand by horizontal
summation of7 + 5 = 12 units at the price ofUSDlO. However, when the
price increases to USD20, Custo1ner A decreases the quantity den1anded
to 5 units while the quantity being demanded by Customer B is 4 units,
and the accumulated quantities being demanded are 5 + 4 = 9 units at
USD20.
The relationship ben-veen the individual den1and and market demand
is illustrated in the said Table 2.2.

Table2.2
Market demand schedule
Total Quantity Demanded of
Price of Good X Good X (Unit) Market
for Good X
(USD) Demand
CustomerA CustomerB

10 7 5 12
20 5 4 9

30 4 3 7

40 3 2 5

so 2 1 3

With this information, we can now derive the market demand curve,
as shown in Figure 2.4.
Price Price Price Figure 2.4 0
Customer A Customer B Market Demand CD
Individual demand curves and
the market demand curve
20 -- - -- ------ - - - - -- :s
Q.
-------- '.-------
10 -----,-- - - - _ ',_ -
:s
'' ll)
'' '' ''
' '' ' Q.
De en
C
5 7 Quantity 4 5 Quantity 9 12 Quantity 'O
'O

SAMPLE QUESTION 2.2

The table shows the individual demand sche,dule for vanilla ice-cream in a college.

Market
Price (USO) Ali Sara Dave
Demand

5 1 3 2

4 2 4 3

3 3 5 4

2 4 6 5
1 5 7 6

1 Derive the market demand for vanilla ice-cream.

2 Draw the demand curve for vanilla ice-cream in the space given.

Price (USD)

5 ------,-------r------T------,-------r------r--·
l I I I I I
I I I I I I
I I I I I I

------�-------L------•------�-------L------�---
I I t I I

4 I

1
I

I
I

I
I

I I
I

I
I I I I I I
I I I I I
I I I I I

3 ------�-------r·-----1------�-------r··----r--·
I I I I I
I I I I I I

I I I I I I
I I I I I I
I I I I I I
I I I I I I

2 ------�-------�------·------�-------�------�--·
I I I I I I

I I I I
I I
''
I I

'
1 -- - - - - _,_
' - - ---_._'' - -- - -- •••••• J' •••••••'�------�---
'

0
L-- � � -
�- -
�- -
�- -
�- � - _.. Quantity
(Unit)
 Solution:
1
Quantity Demanded in
Price (USO)
the Market

5 6

4 9

3 12
2 15
1 18

2
Market Demancl for Vanilla Ice-cream

-
::, 4
V>

a,
V 2
-
5 10 15 20
••• Quantity (Unit)
•••

2.3 MOVEMENT ALONG A DEMAND

The price of a good itself is
the factor that determines a
change in quantity demanded.
CURVE VERSUS SHIFT OF A DEMAND
CURVE
Change in quantity demanded happens along the same demand curve.
In other ,-vords, there is only movement along the demand curve. The
change in quantity demanded is caused by the change in the price o f
the good itself, whereas other factors influencing den1and remains
unchanged.
On the other hand, a change in demand is caused by relevant factors
other than the price of the product which ,-vill involve the shift of the
demand curve. Remember, the price of the good itself will not be the
cause of a change in demand.
The differences between change in quai1tity demanded (movement
along a demand curve) and change in demand (shift of a demand curve)
are summarized in Tabne 2.3.
Table 2.3 Differences between change in quantity demanded and change in demand 0
CD
Change in Quantity Demanded Change in Demand
:s
Q.
P(USD) P(USD)
:s
ll)

Q.
en
C
'O
'O
Increase in demand

P2 f-- - -
--">- Contraction in demand /'
� Decrease in de nd
✓
P 1 1-----+-___::'I... Expansion in demand
� Po --------- -------
Poi--- - -
---r--t---"I,.
Do
L_
_ _ _..L
_ _ _L_
_ _L_ _
:,._
_ _
► Quantity
0
O L- ----------
➔ Quantity
01 Oo 02

Occurs along the same demand curve. In other words, Causes the entire demand curve to change, i.e. involving
there is only movement along the demand curve. a rightward or a leftward shift of the demand curve.

The change in quantity demanded is caused by the The change in demand is caused by other factors
change in the price of the good itself, ceteris paribus. influencing demand, whereas the price o f the good itself
remains unchanged.

If price increases from P, to P2, the quantity demanded
will fall from Q1 to Q2 units. The decrease in the quantity
demanded is known as contraction in demand.
If price decreases from P, to P0, the quantity demanded
will increase from Q, to Q0 units. The increase in the
quantity demanded is known as expansion in demand.
The rightward shift of the demand curve from D0 to D2
shows increase in demand. With price being constant at
OP0, quantity demanded has increased from OQ0 to OQ2•
The leftward shift of the demand curve from D0 to D,
shows decrease in demand. With price being constant at
OP0, quantity demanded has decreased from OQ0 to OQ1.

2.4 DETERMINANTS OF DEMAND

The demand for a product is influenced by many factors. Here are
some of the determinants of demand. It is crucial to comprehend these
The factors that determine
a change in demand are
factors for better understanding of the demand pattern of a particular preferences or tastes, income,
good or service. market size or population,
price of related goods,
I Price of the good itself (movement along a demand curve) expected future prices,
vVhen price changes, quantity demanded will change and this will and government pol icies

cause a movement along the same demand curve. A change in

and socio and economic
condit ions.
price does not shift the demand curve.
According to the law of den1and, changes in the price of the
good itself will cause a change in the quantity demanded. When
the price of the good increases, assuming other factors influencing
demand are ceteris paribus, the quantity demanded for that
particular good will fall. Conversely, when the price of the good
decreases, the quantity de1nanded ,-vill increase. This negative
relationship is shown in Figure 2.5, as follows.
 Figure 2.5 P(USD)
Change in quantity demanded

t '
P1 ---------�------

Po
t I' '
---------�------,------

O '--------------� Od (Unit)
02-< 01 ► Oo

As shown by F.igure 2.5, if the price of the good increases from

P1 to P2, the quantity demanded will fall from Q 1 to Q2 units. If
the price of the good decreases from P1 to P0, then the quantity
demanded will increase from Q 1 to Q0 units.
Figure 2.6 shows the factors influencing the changes to a
demand curve. The demand curve shifts leftward or righh.vard due
to factors other than price, such as the consumers' preferences or
tastes, the consu1ners' income, a change in population, a change in
the price of related goods, the consumers' expectations of future
prices, as well as government policy and socio and economic
conditions. When there is a change in these non-price factors, the
entire demand curve will shift.

Figure 2.6
Factors influencing the shift of
the demand curve Consumers'
Preferences

Government
Policy and Socio
Consumers'
and Economic
Income
Conditions

Consumers' Number of
Expectations Consumers/
of Future Market Size
Prices
Prices of
Related Goods
(Substitute/
Complement)
2 Consumers' preferences 0
Preferences or tastes is influenced by the types of advertising or
CD

information that the consumer gets, the changes in fashion trends, :s

seasons, and so forth. Changes in tastes will cause a change in Q.
den1and. Favourable change leads to an increase in den1and and :s
ll)

will shift the demand curve to the right. For example, when a Q.
consumer changes his or her beverage preference from soft drinks en
C
to strawberry milkshakes, this consumer v.1ill demand more of the 'O
'O
strawberry milkshake.
3 Consumers' income
With higher individual income, the demand for normal or
superior goods and services will increase. A rise in income ,.,ill
shift the demand curve of normal goods rightward, and vice versa.
A norn1al good is any good that increases in demand when income
increases, such as food or clothing. A superior good is similar
to a normal good, but is relatively expensive and scarce, such as
diamonds or luxury cars.
Conversely, the higher the incon1e, the lo\over the den1and
for inferior goods. An inferior good is any good that decreases in
demand when income rises, such as lo,.,er quality clothes, lo,.,er
quality rice or salted fish.
4 Number of potential consumers/Market size
Generally, a higher number of buyers or a bigger population in the
market will lead to an increase in demand, causing the demand
curve to shift to the right. Hov.1ever, if the size of the market is
small or there are fewer potential buyers, then the demand curve
shifts to the left.
In terms of population structure, the different age groups
in the market also influences demand differently. The younger
population will demand more technology, entertainment, fast
food, books, shoes and so on, whereas the older population ,.,ill
den1and more health services, health food, mobility, comfort and
others.
5 Changes in the prices of related goods and services
Related goods refer to other goods that have a relationship with a
particular good. There are two types of related goods, i.e. substitute
goods and complen1entary goods.
(a) Substitute goods are goods that serve tl1e same purpose
or have the same use, such as ink pens and ballpoint pens,
Substitute Goods
Goods that have the
LED televisions and LCD televisions, as well as butter and same use.
margarine. If the price of margarine increases, assuming that
the price of butter is constant, the demand for butter will rise
as margarine is now relatively more expensive than butter.
This shows that both products are positively related.
=:> The price of one product and the demand for
another product are directly related:
Price of margarine t Demand for butter t
 Figure 2.7 Margarine Butter
,..
('ii
P(USD)
Change in the demand curve o,
for substitute goods DJ'

Po
t -----

J.f.
' o,
+: D D,
Quantity Quantity
0
Q, Qo 0
Qo ➔ Q,

Figure 2.7 indicates that when the price of margarine

increases, the demand for margarine ,-vill decrease because
consumers will S\.vitch to buying more butter than margarine,
which is now relatively more expensive than butter. Hence,
the demand for butter increases, although the price of butter
remains the same.
Complementary Goods
(b) Complementary goods are goods that must be used or
Goods that must be used consumed together. Complementary goods cannot be used
together. without each other. Some examples are printers and ink
cartridges, bread and butter, as well as cars and petrol. When
the price of petrol increases, people will tend to use less of
their cars to conserve petrol. Hence, these two products are
negatively re]ated.
=:> The price of one product and the demand for
another product are inversely related:
Price of petrol t
Demand for cars .j,
Figure 2.8 sho,-vs that ,-vhen the price of petrol i11creases,
the demand for cars will fall because these two goods must
be used together.
Figure 2.8
P(USD) Petrol P(USD) Automobile
Change in the demand curve for
complementary goods D D

P, --- ,
t: p
Po ---�-- ----------------------------
, '
'' ''
' ''
'' ' ' D
:....-.:
' ' D Do :
'
0 Quantity 0 Quantity
O, Oo Oo +-0,

6 Consumers' expectations of future prices

If one speculates that the price of milk powder will iI1crease in
the near future, the person will buy more of and stock up on milk
powder now to avoid paying more later. Hence, the demand for
milk powder will increase and this situation may shift the demand
curve to the right ten1porarily.
7 Socio and economic conditions 0
When the economy is in recession, people are uncertain about their
CD

future income and job. They will tend to have lower income and
A recession refers to a period
of temporary economic :s
to spend less. Hence, less goods would be demanded. However, if decline during which trade Q.
the economy is booming, the purchasing po"ver of the people is and industri al activity are
reduced, accompanied by :s
ll)

higher and the demand of goods would tend to increase. In the a rise in unemployment. Q.
instance of war, the demand for food and ,-veapons will increase A recession is generally en
C
while the demand for goods such as sportswear or leisure items identified by a fall in GDP in
t�vo successive quarters.
'O
'O
will decrease.

2.5 EXCEPTIONAL DEMAND

The law of demand states that when price rises, quantity demanded Definition of Exceptional
will fall. A nor1nal demand curve is al,vays down,vard sloping, showing Demand
that there is an inverse relationship between the price of a good and The law of demand does not
the quantity demanded. However, the law is not always true. There
apply because the higher
the price, the higher the
is the possibility where when price increases, the quantity demanded quantity demanded wi ll be.
also increases, or ,vhere the quantity demanded of a good decreases
together with its price decrease. In this case, the demand curve for
such goods is known as the exceptional demand curve. It has an
upward sloping demand curve as shown in Figure 2.9, which means
the higher the price offered, the more goods would be demanded.

Price Figure 2.9

Exceptional demand curve
D

P1 t--- - - - - - - - -
---,,(

Pt--------?(

o .__
_____
__._ __,_
_ _ _ ___. Quantity Demanded
_ _ _
Q 01

Exceptional demand occurs in the following three cases:

1 Giffen goods
Giffen goods are inferior goods that have few substitutes and are
normally consumed by those in the poor income group. They are
poor quality goods of which the poorer households spend a major
portion of their income on. Examples of giffen goods are low
quality potatoes and broken rice.

2 Veblen goods or luxury goods
Veblen Goods
Goods bought by higher
income groups to sho1,v off
their status.
3 Speculation of a future change in price
As the price of broken rice falls, while holding other factors
constant, the real income of consumers will increase. The monthly
income allocated for buying broken rice will now be larger than
before. Hence, less broken rice (giffen good) is demanded and
the consumers now switch to buying better quality goods, such as
quality rice and meat.
Conversely, if the price of broken rice increases, while holding
other factors constant, the real income of consun1ers will decrease.
The monthly income allocated for buying broken rice will now
be smaller than before. Hence, more broken rice is demanded as
it is considered a necessity to avoid starvation, and less meat is
consumed.
P,owqu.>htync, t Real inconle i Q lowqualityrke t
Veblen goods are goods bought by people in the higher income
group to show off their status, as these goods have snob appeal. For
example, diamonds, world famous paintings or luxury cars which
are purchased as status symbols. When the price of diamonds
increases, more will be bought at a higher price. If the price of
diamonds falls, then diamonds will no longer be considered as
prestige goods. The rich may stop buying diamonds and start
considering them as a cheap product. Therefore, the quantity
demanded of diamonds would fall. There is a direct relationship
between the price and quantity demanded of dian1onds.
P f Q t and P i Q i
If people expect the price of a good to rise in the future, they
will buy more of the product now even if the price has risen. The
increase of the price does not reduce the quantity demanded of
the good, but instead increases the quantity demanded as people
speculate that the price ,.vill continue to rise further. This usually
happens in stock markets. Speculators in the stock exchange will
buy n1ore shares if the price of the shares show a rising trend, and
vice versa. Therefore, this demand is considered as exceptional
demand.
 If consumers expect the future short-tern1 price of a good to 0
increase, they will buy more of the good for storage. For example, if
CD

the price of milk powder is expected to increase, then the quantity :s

demanded increases even though the price of milk po,-vder now C.
has increased. :s
ll)

C.
en
2.5.1 Interrelated Demand C
'O
1 Joint demand/Complementary demand 'O
Joint demand or complementary den1and refers to two products Joint Demand/
that are used together or demanded together. When there is an Complementary Demand
increase in the demand for Good X, then the quantity demanded Two products that are used
for Good Y will also increase. Examples of joint demand are cars together.

and petrol, bread and butter, and calculator and battery.

2 Competitive demand/Substitute goods
Competitive demand or substitute goods are two products that Competitive Demand/
compete for the demand of consumers. Competitive goods are Substitute Goods
goods which can be substituted with one anothe.r. An increase in Two products that compete
den1and for Good X will result in a fall in the quantity demanded for the demand of consumers.

for Good Y. Examples of competitive goods are coffee and tea,

butter and margarine, and spectacles and contact lenses.
3 Derived demand
Derived demand are goods that are demanded to help in the
production process (of something). For example, the demand for
factors of production, such as timber (for the manufacturing of
furniture), bricks (for the development of housing), and wood (for
papermaking). The demand of the comn1odity depends on the
demand for the final good. Thus, if the demand for the final goods
increases, then the demand for the commodity also increases.

2.6 SUPPLY, LAW OF SUPPLY,

INDIVIDUAL SUPPLY, AND
MARKET SUPPLY
2.6.1 Definition of Supply
Supply is defined as the producer's ability and willingness to supply Supply is defined as the
different quantities of goods and services at different possible prices producer's ability and
and time range, ceteris paribus. willingness to supply
different quantities of goods
and services at different
Supply Schedule possible prices and time
A supply schedule shows a series of alternative possibilities of quantities range, ceteris paribus.

being supplied at different prices, as shown in Table 2.4. Given the

various prices of pen drives, the quantity supplied is the amount of
pen drives that the seller is willing and able to produce, ceteris paribus.
52

Table2.4
,..
('ii
Combinations of Pen Prices of Pen Drives Quantity Supplied of
The rel ationship between price
and the quantity supplied of
Drives (Unit) (USO) Pen Drives (Unit)
pen drives
.c: A 20
B 40 2
C 60 3
D 80 4
E 100 5

From above Table 2.4, we can see that when the price of pen drives
increases from USD20 to USD40, the quantity supplied for pen drives
also increases from l to 2 units. Similarly, when the price of pen drives
decreases from USD80 to USD60, the quantity supplied also decreases
from 4 to 3 units. Figure 2.10 shows the supply curve (S) for pen drives
that is plotted based on the supply schedule in Table 2.4.

Figure 2.10 Price

Upward sloping supply curve
for pen drives
s
100 l--- - - - - - - - - - 7r
-

80 1-----------"7(
60 1-----------,,<

20 I-----,<
Quantity
o L_
_ _J_
_
1
__J
2
_
L_ _,_
_
3
__J
_
4
...J_
_
5
_ �
_

2.6.2 The Law of Supply

The law of supply states that
when thepriceof a good
increases, the quantity supplied
for the good will increase, and
vice versa.
The law of supply states that when the price of a good itself increases,
the quantity supplied for the good will increase and \.vhen the price of
the good decreases, the quantity supplied \.vill decrease, ceteris paribus.
In other v.1ords, the law of supply shows a positive relationship between
the quantity supplied and the price of the good itself.
However, the law is only true by assuming other factors influencing
supply are held consta11t, i.e. only the price of the good itself changes.
Therefore, the supply curve will generally be upward sloping, indicating
the positive relationship between the price of a good or service (P) and
the quantity supplied (Q).
Upward sloping supply curve
Lalv of Supply (Positive relationship
between price and quantity
supplied)
2.6.3 Individual Supply and Market Supply 0
CD
There are two types of supply, which are:
1 Individual supply-this refers to the supply of goods and services :s
from a single seller.
Q.

2 Market supply curve-this curve can be derived by horizontal :s

ll)

summation of all individual supply curves, i.e. by adding up all

Q.
en
the quantities supplied by all sellers in the market at each price, C
'O
as shown by Figure 2.11. 'O

Price Price Price Figure 2.11

Market supply curve
Seller A Seller B Market Supply

20 -------- ------------
'
10 -----

S 7 Quantity 34 Quantity 8 11 Quantit

y

The relationship beh-veen the individual supply and market supply is

illustrated in Table 2.5.

Total Quantity Supplied of Table 2.5

Price of Good X Good X (Unit) Market Market supply schedule for
(USO) Supply Good X
Seller A Seller B

10 5 3 8

20 7 4 11
30 11 5 16

40 13 6 19
so 15 7 22

SAMPLE QUESTION 2.3

The table shows the individual suppl y schedule for vanilla ice-cream in a college.

Price (USO) : Shop O I Shop E Shop F I Market Supply

5 5 7 6

4 4 6 5
3 3 5 4

2 2 4 3

1 1 3 2
1 Derive the market supply for vanilla ice-cream.
2 Draw the supply curve for vanilla ice-cream in the space given.

Price (USD)

4 ------J-------�------�------�-------�------�------J------J
' ' '

3 ------�-------r------1------,-------�------r------ ------�
I I I I I I

•••••••
I•••••• ... ••••••♦•••••• ... •••••_.,_••••••�••••••�••••••• I
2

1 - --- -- -,- - - - ---,- --- - - - - - --- --,- --- - - -, -- - - --

I

I
I

I
I

I
I

I
-------.
o L-
- --�- �
� - -�- -
�- -
�-�- -
�� Quantity (Unit)

Solution:
1
Quantity Supplied in
Price (USO)
the Market

5 18
4 15
3 12
2 9
1 6

2
Market Supply forVanilla Ice-cream

-
� 4

-
5 10 15 20
Quantity
2.7 CHANGE IN QUANTITY SUPPLIED 0
CD
AND CHANGE IN SUPPLY
The change in quantity supplied is shown by a movement along the
:s
Q.
same supply curve. It is caused by the change in the price of the good
The factor that determines a
:s
ll)
change in quantity supplied
itself, while other factors i11fluencing supply re1nains unchanged. is the pri ce of the good itself. Q.
On the other hand, a change in supply is caused by relevant factors en
C
other than the price of the product which will involve the shift of the 'O
'O
supply curve. Remember, the price of the good itself will not be the cause
of a change in supply.
The differences between change in quantity supplied (movement
along a supply curve) and change in supply (shift of a supply curve) are
illustrated in Table 2.6.

Table 2.6 Differences between change in quantit y supplied and change in suppl y

Change in Quantity Supplied Change in Supply

P(U5D) P(U5D)
51

'
s Decrease
P2 -------------------
in suppl s0
P o ------------- . P o --- - -- - - -- - --- - - - - - - - 52
-
: ;,r . xpans1 on
E
Pi _________ ,
' ,/
' in supp 1 y �
,
:\ Increase
'
in sup:ply
' '
'' ✓ ''
Contrattion:
'
in sup�ly
ol...----Q�·- Q
1�0�o-�0�2-----...

Change in quantity supplied is shown by a movement Causes the entire supply curve to change, i.e. involving a
along the same supply curve. rightward or a leftward shift of the supply curve.

The change in quantity supplied is caused by the The change in supply is caused by other factors
change in the price of the good itself, ceteris paribus. influencing supply, whereas the price of the good itself
remains unchanged.

If the price of the good increases from PO to P2, the
quantity supplied also increases from Q0 to Q2 units. The
increase in quantity supplied is known as expansion in
supply.
If the price of the good decreases from PO to P 1, the
quantity supplied also decreases from Q0 to Q1 units. The
decrease in quantity supplied is known as contraction
in supply.
There would be an increase in supply if the supply curve
shifts rightward from S0 to S2. Price remains at P0, but
quantity supplied has increased from Q0 to Qr
There would be a decrease in supply if the supply curve
shifts leftward from S0 to S1. Price remains at PO' but
quantity supplied has decreased from Q0 to Q1 •

The factors that determine
a change in supply are the
cost of production, price
of related goods, level of
technology, government o r
econom ic policies, expected
future pri ces, and number of
suppliers.
Pr ice changes cause quantity
supplied to change and
movement along the same
supply curve.
Figure 2.12
Changes in quantity supplied
2.8 DETERMINANTS OF SUPPLY
The supply for a product is influenced by many factors. Here are some
of the determinants o f supply. It is vital to recognize these factors for
better understanding, especially for suppliers to be able to study their
1narket better.
1 Price of the good itself (movement along a supply curve)
When price changes, quantity supplied ,-vill change and this will
cause a movement along the same supply curve. A change in price
does not shift the supply curve.
According to the law of supply, changes in the price of the good
itself will cause a change in the quantity supplied. When the price
of the good increases, assuming other factors influencing supply
are ceteris paribus, the quantity supplied for that particular good
will increase. Conversely, when the price of the good decreases,
the quantity supplied will increase. This positive relationship is
shown in Figure 2.12, as follows.
s
P(USD)
- - - - -- - --- --- - - -- - -- - -- - --- - -- - -
P2
_t_ _ _ _ _ _ _____ _ _ _ _ _ _ _ _ _ _ 1/ : p o,ioo io '"pply
E, a
Vi
P,
Po ................................... Contraction in supply
•
•
►:•
-( ••
s
••
•
0
Os (Unit)
Oo 01 02
The change in quantity supplied is shown by a movement
along the same supply curve. If the price of the good increases
fro1n P0 to P2, the quantity supplied also increases from Q0 to Q2
units, and vice versa.
Figure 2.13 shows the factors influencing change of supply
curve. The supply curve shifts upward or downward due to factors
other than the price of the good, such as the cost of the factors
of production, the price of related goods, the level of technology,
government policy or economic policy, the producer's expectations
of future prices and the number of suppliers. Any changes to these
factors will shift the entire supply curve.
 Figure 2.13 0
Factors influencing the shift of
CD
Cost of
the supply curve
Factors of
Production
:s
Q.

:s
ll)
Prices of
Number of Related Goods Q.
Suppliers (Substitute or en
.......-, Complementary) C
'O
'O

Producers'
Expectations Level of
of Future Technology
Prices
Government
or Economic
Policy

2 Cost and availability of the factors of production

If there is an increase in wages, the cost of product ion ,-vill increase.
Factors other than the price of
goods that influence change
The profit of suppliers will decrease, thus reducing the supply of of the supply curve: the cost
goods and shifting the entire supply curve left"vard. of factors of production,
price of related goods, level
3 Changes in the prices of related goods of technology, government/
(a) Goods in joint supply or complementary goods economic pol icy, producers'

Joint supply goods or complementary goods refer to goods

expectati ons offuture prices,
and number of suppliers.
which are supplied at the sa1ne tin1e. For example, beef
and leather are supplied at the same time when a cow is
slaughtered. When the price of beef increases, the quantity
supplied for beef will increase and the supply of leather ,-vill
also increase since both goods are complen1entary goods.
(b) Goods in competitive supply or substitute goods
The supply of a good will decrease if there is an increase in
the price of a substitute good. Take for example a normal
sports car and a hybrid sports car. A producer who responds
to the higher price of a hybrid sports car by increasing the
quantity supplied of hybrid sports cars that are produced,
results in the supply of normal sports cars declining. This
situation happens because some of the resources no,,v are
being used to produce hybrid sports cars.
4 Level of technology
Higher technology levels allo,-v a smaller quantity of resources to be
used for production, which in turn reduces the cost of production.
This thus increases the supply of a product by shifting the entire
supply curve right,vards.
5 Government or economic policy
Government policies consist of taxation and subsidies. When the
production of goods is taxed, this increases the cost of production
 and reduces the an1ount of profit earned. This will lead to a decrease
in supply. The entire supply curve shifts leftward. Subsidies work
in a different way, ,-vhere ,-vhen the government subsidizes the
production of goods, this encourages the producers to produce
n1ore. This in turn will increase supply. The entire supply curve
shifts right,-vards.
6 Producers' expectations of future prices
If the producers anticipate that the future price of smartphones
will increase, the producers will supply less at that present time.
Hence, this will decrease the supply of smartphones.
7 Number of suppliers
With more suppliers, more outputs can be produced in the market.
Supply will increase and, hence, the supply curve will shift to the
right.

SAMPLE QUESTION 2.4

True or False
1 When the price of a substitute for Good A changes, we would expect a movement
along the supply curve for Good A.
2 A supply curve shifts rightward because of a decrease in the cost of production.
3 The change in quantity supplied is shown by a movement along the same supply
curve.

Solution:
1 False, we would expect a shift of the supply curve.
2 True, a decrease in the cost of production will increase the sellers' profit.
True, a change in quantity supplied will only represent movement along the same supply
----• • •
3
curve.

2.9 EXCEPTIONAL SUPPLY (LABOUR

Exceptional supply states that
the higher the price, the lower
the quantity supplied.
MARKET)
The normal supply curve (SS) fulfils the law of supply which states that
quantity supplied rises when price rises, and vice versa. It is always
upward sloping, showing that there is a direct relationship bet,veen
the quantity supplied and the price of the good.
However, there is an exception to the law of supply, ,-vhereby a supply
curve can bend backwards so that an increase in price will result in a
fall in the quantity supplied. In this case, the supply curve is negatively
sloped. The exceptional supply curve is called the backward bending
supply curve, which is commonly used to study the relationship benveen
wages offered and the number of working hours.
 Wages Figure 2.14 0
Backward bending supply curve CD

Income effect :s
(the exceptional supply
Q.

:s
ll)
curve)
Q.
•
Wo ---- - -- - -- - -- - --- --- - -· •: - - - - - - en
•• C
•• 'O
'O
w, ...... -.................................. -........ -:-..
•
Substitution effect
(the normal supply
curve)

0
Working Hours

Figure 2.14 shows the relationship between wages and working hours.
The labour will spend 24 hours in a day to either ,.vork or have leisure
tin1e, which means that the opportunity cost of working is to forgo the
hours of leisure. At the wage rate of below W 0, an increase in wage rate
will encourage the labour to substitute leisure time for work. For instance,
,.vhen wage rate increases from W 1 to W0, the worker is prepared to
work additional H1 H0 hours. This is called the substitution effect of an
increase in wage rate. The supply curve is a normal supply curve which
slopes up,.vards to the right.
Ho,.vever, there ,.vill come a point where people will choose to relax
more than work, even though the wages offered are high. For example,
after wages W0, workers prefer more leisure than higher wages. \!\Then
the wage rate increases from W0 to W2, the working hours has decreased
from OH0 to OH2-a reduction by the amount of H2H0working hours for
leisure time. This is due to the income effect of an increase in wage rate,
because in the event of a rise in ,.vage rate, the labour can still maintain
the san1e level of income even if he/she decreases the hours of work.
Hence, less time is spent on work and there is a decrease in the quantity
of labour supplied. The normal supply curve will start to bend backward
to form the exceptional supply curve.
Another example of an exceptional supply curve happens in the stock
market when prices are expected to drop further. When the stock prices
are expected to fall, people will sell their shares even though the prices
are falling. Therefore, more shares will be supplied when prices fall,
which voids the law of supply.

Exceptional Supply Curve happens in:

• Supply of labour-when wage rate increases, hours of work
decrease
• Stock market-sell shares even if prices are falling, n1ore shares
will be supplied at a lower price
2.9.1 Interrelated Supply
1 Joint supply
Joint supply refers to two goods which are produced together.
When the quantity supplied of one good rises, the supply of the
other good also increases. For example, when more sheep are
slaughtered, the supply of n1utton rises and the supply of wool rises
as they are all from the same source (the sheep). Another example
is when the quantity supplied of petroleum rises, the supply of
natural gas, which is a by-product of petroleum, also increases.
2 Competitive supply
Competitive supply occurs when the supply of two goods are
competitive in nature. An increase in the supply of one good will
result in the decrease in the supply of the other good, and vice
versa. For instance, a piece of land can be used to grow rice or
corn. If the price o f rice falls, less rice will be grown which results
in an increase in the supply of corn, as the land is limited and the
farmers have to switch to planting more corn to make more profit.

2.10 SUPPLY OF GOODS AND SERVICES

FROM AN ISLAMIC PERSPECTIVE
In Islam, supply is influenced by Islamic values. A Muslim producer
must not produce or sell any goods and services that are forbidden by
Islam.
In Islam, supply is not only meant to satisfy the demand of consumers
or to maximize the producers' profit, but also meant to take care of the
whole society. In other ,.vords, the Muslim producers should supply a
sufficient an1ount of Dharuriyyah goods (basic goods) and Hajiyyah
goods (co1nfort goods), before supplying Kamaliyyah goods (luxury
goods).
Muslim producers must not supply goods and services that are
wasteful and dangerous to society. For example, they must not supply
goods and services such as liquor, drugs and gambling. This basically
1neans they must avoid supplying goods and services that are forbidden
in Islam.
Muslim producers must also not undertake transactions that are
forbidden by Allah $.WT. For example, the Muslim producer should
conduct his/her business transactions in the best possible n1anner while
respecting his/her customers. The actions of cheating and mistreating
customers or conducting business rudely are considered bad in Islam.
In this chapter, we have examined the t,¥0 most important economic elements,
i.e. demand and supply.
Demand is defined as the consumer's ability and willingness to buy different
quantities of goods and services at different possible prices and time range. The
law of demand states that when the price of a product increases, the quantity
demanded for that product ,vill decrease because price and quantity demanded
have an inverse relationship. The factor that influences the change in quantity
demanded is the price of the good itself, while the factors that influence change
in demand are other factors, but not the price. However, in certain circumstances,
the law of demand is void and quantity demanded will be positively related to its
price.
Supply is defined as the producer's ability and willingness to supply different
quantities of goods and services at different possible prices and time range. The law
of supply states that when the price of a product increases, the quantity supplied
for that product will also increase because price and quantity supplied have a
positive relationship. The factor that influences the change in quantity supplied
is the price of the good itself, ,-vhile the factors that influence change in supply are
other factors, but not the price. As for the labour supply curve, ho,vever, the law
of supply is void after a certain level of ,¥age rate and the quantity supplied will be
inversely related to its price. This is known as the backward bending labour supply
curve.

• Economic goods are free goods, economic goods (perishable and non­
perishable) and public goods (partial and pure).
• From an Islamic perspective, goods and services can be categorized into
Dharuriyyah (necessity), Hajiyyah (comfort), Kamaliyyah (luxury) and
Tarafiyyah (extravagant).
• Demand is the ability (purchasing power) and the willingness of a
consumer to buy goods and services at a certain price level, place and time
range, ceteris paribus (other factors remain constant).
• The la,v of demand states that when the price of a good itself increases,
the quantity demanded for the good will fall, and vice versa.
• Individual demand refers to demand of goods and services from a buyer.
• Market demand is a horizontal summation of all the individual demand in
a particular market.
 • Change in quantity demanded happens along the same den1and curve
caused by the change in the price of the good itself.
• Change in demand is caused by relevant factors other than the price of the
product which ,vill involve the shift of the entire demand curve.
• Exceptional demand does not apply the law of demand because as the
price increases, the quantity demanded also increases, and vice versa.
• Supply is the producer's ability and ,villingness to supply different
quantities of goods and services at different possible prices and time range,
ceteris paribus.
• The law of supply states that when the price of a good itself increases,
the quantity supplied for the good will iJ1crease, and vice versa.
• Individual supply refers to supply of goods and services fron1 a seller.
• Market supply is a horizontal summation of all the individual supply in a
particular market.
• Change in quantity supplied happens along the same supply curve caused
by the change in the price of the good itself.
• Change in supply happens at a different supply curve (shift of the supply
curve) caused by other factors influencing supply, ,vhereas the price of the
good remains unchanged.
• Exceptional supply does not apply the law of supply because at some point
when the price increases, the quantity supplied will decrease, and vice
versa.

+ Key concepts

• Economic goods • Change in quantity • Market supply

• Islan1ic economic demanded • Change in supply
goods • Determinants of • Change in quantity
• Demand demand supplied
• Law of demand • Exceptional demand • Determinants of supply
• Market demand • Supply • Exceptional supply
• Change in den1and • Law of supply
+ Exercises
0
CD

:s
Q.
Multiple-choice Questions :s
ll)

Answer the following questions.

Q.
en
C
'O
I Which of the following goods should 6 An upward movement along a demand 'O
not be consumed, according to Islamic curve is due to an increase in- - -
perspectives? A the price of the good
A Kamaliyyah B the number of buyers
B Tarafiyyah C the number of suppliers
C Dharuriyyah D the price of the substitute good
D Hajiyyah
7 If the demand for Good B declines as the
2 As the price of a normal good decreases, the price of Good Cincreases, then Good B and
quantity demanded ,-vill ___ Good Care ---
A decrease A normal goods
B be uncertain B complementary goods
C increase C inferior goods
D be unchanged D substitute goods

3 If the demand for cheesecake decreases when
income increases, this means that cheesecake
IS_ _
_ price of the cupcakes will cause
A a complementary good
B a normal good
C a luxury good
D an inferior good
4 The law of demand states that
A a decrease in the price of a good will
cause the demand curve to shift to the
left.
B an increase in tl1e price of a good
will cause the demand curve to shift
rightwards.
C the price of a good is negatively related to
the quantity demanded of the good.
D the price of a good is positively related to
the quantity demanded of the good.
5 A rightward shift of the demand for silk
scarves might be caused by
A an increase in the cost of production.
B a decrease in the number of buyers.
C the price of silk scarves increasing.
D an increase in the buyers' salary.
8 The demand curve for blueberry cupcakes
is do,-vnward sloping, thus an increase in the
A the demand curve to change.
B a leftward shift of the demand curve.
C a rightward shift of the demand curve.
D an upward movement along the demand
curve.
9 When income increases, the demand for
Good Z decreases. Therefore, Good Z is
A a luxury good
B an inferior good
C a normal good
D a necessity good
10 The order of classification for goods from an
Islamic economic viewpoint is
A Kamaliyyah, Hajiyyah, Tarafiyyah and
Dharuriyyah.
B Kamaliyyah, Tarafiyyah, Dharuriyyah and
Hajiyyah.
C Dharuriyyah, Kamaliyyah, Hajiyyah and
Tarafiyyah.
D Dharuriyyah, Hajiyyah, Kamaliyyah and
Tarafiyyah.
11 An iJ1crease in the price of flour will 17 If the increase in the price of Good W leads
to an increase in the supply of Good Y, this
A increase the quantity supplied of means that Goods W and Y are ---
flour A complementary goods
B increase the den1and for flour B substitute goods
C shift the demand curve to tl1e right C luxury goods
D cause nothing to change D inferior goods

12 If the price of Good F decreases, the supply 18 The law of supply states that
curve for Good F's close substitute will A a decrease in the price of a good will
cause the supply curve to sl1ift to the
A shift to the left right.
B shift to the right B an increase in the price of a good will
C remain constant cause the supply curve to shift to the
D be undecided right.
C the price of a good is not related to the
13 Which of the following factors is not a quantity supplied of the good.
determinant of supply? D the price of a good is positively related to
A Number of sellers the quantity supplied of the good.
B Cost of production
C Number of consumers 19 Suppose that the demand curve for
D Technological advancement skateboards shifts to the right. Which of
the follo,-ving statements best explains this
14 As price decreases, the quantity supplied will incident?
A A decrease ill the dema11d for
A decrease skateboards, due to an increase ill the
B be uncertain price of the skateboards.
.
C increase B A decrease in the demand for
D be unchanged skateboards, due to an increase in the
supply of an imitation.
15 Which of the following pairs are C An illCrease in the demand for
complements? skateboards, due to the brand's popularity
A Tea and coffee and trend of skateboarding.
B Butter and margariJ1e D A decrease ill the dema11d for
C Pen and ink skateboards, due to a decrease in its
D Cotton blouse and silk blouse supply.

16 The upward movement along the supply
_
curve is caused by an increase ill_ _
A the number of population
B the number of suppliers
C the number of substitute goods
D the price of the particular good
20 The term ceteris paribus stands for_ _ _
A 'substitute to each other'
B 'complement to each other'
C 'if price increases, the quantity demanded
will decrease'
D 'all other things are held constant'
Short-answer Questions 0
CD
Answer the following questions.
1 A curve representing the quantities that consumers are willing to buy at various prices :s
Q.
is known as a ------- curve. :s
ll)

2 When the price of petrol increases, people will buy less petrol, ceteris paribus. This
Q.
en
would be described as a change in_ _ _ _ _ _ _ _ _ C
'O
3 A curve representing the quantities that producers are willing to sell at various prices 'O
is known as a curve.
4 Demand curves generally slope because of the
relationship between and
5 Supply curves generally slope because of the
relationship between and

Essay Questions
Answer the following questions.
1 Explain three non-price determinants of demand, with examples.
2 Explain the hierarchy of goods according to Islamic perspectives, with examples.
3 With the aid of a diagram, explain exceptional supply.
4 Differentiate between change in demand and change in quantity demanded.
5 Explain four goods under conventional economics, with examples.
Elasticity
At the end of this chapter, you should be able to:
m
e
0
Calculate price elasticity of demand, and discuss its concept and
determinants.
t)
'S • Calculate and interpret income elasticity of demand.
0 • Calculate and interpret cross-elasticity of demand.
g,·a
• Calculate price elasticity of supply, and discuss its concept and
determinants.

-
�
Cl)

Figure 3.1
Types of elasticity for demand
and supply
Types of Elasticity of
Demand
1 Price elasticity of demand
2 Income elasticity of
demand
3 Cross-elasticity of demand
I n Chapter 2, we have studied about demand and supply. In this
section, we will learn about elasticity.
Elasticity refers to the relative responsiveness of a demand or
supply curve in relation to any of its determinants. In other words, we
can say that elasticity measures the responsiveness of one variable (the
dependent variable) to a change in another variable (the independent
variable). Elasticity can be compared roughly by the slope of the demand
curve, using the steepness or flatness of the demand or supply curve.
Specifically, however, the types of elasticity can be determined by
calculation. The four main types of elasticity that we will discuss are:
1 Price elasticity of demand
2 Income elasticity of demand
3 Cross-elasticity of demand
4 Price elasticity of supply
Both price elasticity of demand and price elasticity of supply
represent the degree of elasticity, whereas income elasticity of
demand represents the types of goods. Meanwhile, cross-elasticity of
demand represents the relationship between two goods. Although
it may seem that all formulas and calculations for the types of elasticity
are similar, they are not identical. Figure 3.1 shows the four main types
of elasticity.
I Elasticity
I
Demand Supply
Price Elasticity Income Cross­ Price
(s.) Elasticity (sy) elasticity (s) Elasticity (s,)
3.1 ELASTICITY OF DEMAND
Elasticity of demand measures the response between the percentage
changes in quantity demanded for a good with respect to the
percentage changes i n any of its determinants, such as price, income
and so forth. There are several kinds of elasticity of den1and. The three
types of elasticity of demand are:
1 Price elasticity of demand (ed)
2 Income elasticity of demand (t )
>
3 Cross-elasticity of de1nand (£) X
3.1.1 Price Elasticity of Demand
Price elasticity of demand measures the degree of responsiveness
of the quantity demanded for a particular good, ,.vith respect to the
Ceteris paribus stands for
·all other things being
-·-·
rn
....
changes in the price. More precisely, it is the percentage change in unchanged or constant'.
quantity demanded relative to a one per cent change in price , ceteris
paribus. The formula for calculating the coefficient of price elasticity
of demand is as follo,.vs.

Price elasticity of demand

Formula to calculate price elasticity of den1and measures the degree of
Percentage change in quantity demanded of Good X (QcLx)
responsiveness of the quantity
demanded for a particular
Percentage change in price of Good X (Px)
I::d =
good, with respect to the
changes in the price.
Qdis -Qdx 1 Px2 - Px 1
I::cl =
QcLxI Px1

Qd� -Qdx 1 Px,

=
Qdx 1 Px2 - Px 1
I:: X
d

Since there is an inverse relationship between price and quantity

demanded (the law of demand) and both change occurs in the opposite
directions, the given formula will always give a negative coefficient; the
coefficient of price elasticity of demand ,.vill always have a negative sign.
However, in practice, the negative sign is excluded.

SAMPLE QUESTION 3. 1

If price of Good X decreases from USD40 to USD30, and quantity demanded increases from 50
to 75 units, what is the price elasticity of demand for Good X?

Solution:
List the details needed.
Qdx 1 = 50, Qdx 2 = 75, Px1 = USD40, Px2 = USD30

Qdx2 - Qdx1 Px 1
I:: =- - - -
- X
- - -
d Qdx 1 Px2 - Px 1
Substitute all details into the formula.
75-50 40
I::d =
so X 30-40
E = 2
-
d

IEd I= 2 +--We use absolute value to exclude the negative sign. In this case, as Ed > 1,
demand is very responsive to the price changes. As price decreases by 1%, the
quantity demanded for Good X will increase by 2%, and vice versa.

Degrees of Price Elasticity
of Demand
1 Perfectly inelastic demand
2 Inelastic demand
3 Unitar y elastic demand
4 Elastic demand
5 Perfectly elastic demand
Degrees of Responsiveness in Price Elasticity of
Demand
The degrees of price elasticity of demand refers to the varying
consumers' reactions (quantity demanded) to a change in price. The
degree of elasticity of demand helps in defining the shape and slope
of a demand curve. Therefore, the price elasticity of demand can be
determined by the slope of the demand curve. The flatter the slope of
the demand curve, the more responsive to price the demand v,rill be.
There are five degrees of responsiveness in price elasticity of demand
as shown in Table 3.1.

Table 3.1 Degrees of responsiveness in price elasticity of demand

*No matter how the A change in the price A change in the price A change in the price *The change in the
price changes, the of a good causes a of a good causes a n of a good causes a price will change the
quantity demanded smaller percentage equal percentage bigger percentage quantity demanded
will stay the same. change in quantity change in quantity change in quantity by an infinite value.
E.g. Medical needs demanded. demanded. demanded.
for patients E.g. Petrol E.g. Chocolate bars

Shapes of Demand Curves

Vertical demand Steeper slope of Rectangular Flatter slope of Horizontal demand
curve demand curve hyperbola demand demand curve curve
curve
p D p p p p
'' ''
D D
\
P2 P2 p2

P1 P1 p P 1t-- - - D
- -

, Qd Qd ' Qd
Q1
Qd ._____➔ Qd
01 0201
r

Consumers will buy The% changes in Consumers respond The% changes in At a certain price,
a good or service price (P, increases to an equivalent % of price (P1 increases the quantity
regardless of the to P) is larger than change in quantity to P2) is smaller than demanded is infinite.
movement of price, the% changes in demanded from Q, the% changes in If a firm increases
even when price quantity demanded to Q2 as the price quantit y demanded price by 1%, it
increases from P, (Q, decreases to Q2). changes from P, to (Q, decreases to Q2). would see all of its
to P2• p2' quantity demanded
evaporate.

Price Elasticity Along Demand Curves

Perfectly Not very responsive One-to-one Relatively responsive Perfectly responsive
unresponsive responsiveness

*Happens only in extreme cases, which are very rare in real life.
 Figure 3.2 depicts price elasticity of demand along a linear demand
curve. Elasticity varies because:
I As the price of a good increases, consumers ,-vill replace relatively
-·-·
rn
....
expensive goods with cheaper goods. Hence, the more related
the substitutes, the more elastic the demand as we travel up the
demand curve.
2 As prices rise, it accounts for a larger proportion of income;
hence, elasticity will tend to increase.

p Figure 3.2
Price elasticity of demand along
Perfectly elastic demand, cd = oo a linear demand curve

Elastic demand, 1 < cd < oo

Unitary elastic demand, Ed = 1

/
Inelastic demand, O <Ed< 1

Perfectly inelastic demand, Ed = 0

/
Qd

Price Elasticity of Demand and Its Effects on Total

Revenue
The relationship between the price elasticity of den1and and a firn1's
total revenue is important since total revenue can b e maximized by
knowing the price elasticity of its demand. This also helps a firm's
management when 1naking pricing decisions for its products.
Total revenue of a firm equals a price charged 1nultiplied by the
quantity sold. Total revenue equals total consumer expenditure, as
whatever received from consumers by firms are equal to the spending
of consumers on goods and services. Therefore, the price elasticity of
demand on total spending is exactly the same as the effects on total
revenue.

'I'otal Revenue ("fR) = Price charged (P) x Quantity sold (Q)

 Table 3.2 depicts total revenue and how it is affected by price elasticity
of demand.

Table 3.2
Effects on Total
Price elasticity of demand and Price Elasticity of
total revenue Price Revenue (Consumer
Demand
Expenditure)

rise fall
Elastic
fall rise

If demand for a good is elastic (1 <Ed < 00), an increase in price reduces total
revenue.

rise unchanged
Unitary
fall unchanged

If demand for a good is unitary (Ed= 1), an increase in price does not change
total revenue.

rise nse
Inelastic
fall fall

If demand for a good is inelastic (0 <Ed < 1 ), an increase in price increases total
revenue.

Elastic Demand and Total

Revenue
A decrease in price will
increase the total revenue
Based on Table 3.2, when demand for a good is elastic, an increase
in price reduces total revenue and a decrease in price increases total
revenue. For example, as shown in Figure 3.3(a), when price is at USD8,
the total revenue is USD800 (8 x 100). v\Then price increases to USDlO,
the total revenue decreases to USD400 (10 x 40). On the other hand,
Figure 3.3(b) shows that when price is at USD8, total revenue is USD800
(8 x 100) and when the price decreases to USD6, total revenue increases
to USD960 (6 x 160).

Figure 3.3 p p
Demand is elastic
D D
10
+8 __,______ 8 - - -- - ---
6 ---------1-------,
''
''
'
'--�-,---� - - -
..-Qd '--- ---'-- - -'-- -
➔ Qd
40 +-100 100 ► 160
(a) (b)
 When demand for a good is inelastic, the demand curve is steeper, an Inelastic Demand and
increase in price increases total revenue and a decrease in price reduces
total revenue. For example, as shown in Figure 3.4(a), v.1hen price is at
Total Revenue
An increase in price will -·-·
rn
....
USD8, the total revenue is USD800 (8 x 100). When price increases to increase the total revenue

USDlO, the total revenue increases to USD900 (10 x 90). On the other
hand, Figure 3.4(b) shows that ,vhen price is at USD8, total revenue
is USD800 (8 x 100) and when the price decreases to USD6, the total
revenue decreases to USD660 (6 x 110).

p p Figure 3.4
Demand is inelastic
D D
10
---·-- 8 ------
8
..,6 .............. J .. ..

- Qd
.__-'-�- - - + - Qd
'----'----'-- - - ►
90+100 100�110
(a) (bl

If the demand curve forms a rectangular hyperbola ,vith unitary

elasticity of demand (see Figure 3.5), the proportionate change in
quantity demanded is exactly equal to the proportionate change in price.
Therefore, total revenue remains constant regardless of price changes.

p
Figure 3.5
Demand is unitary
D

P2 .........• .................

.___....:...,____._________�Qd
o, 02

Factors Influencing Price Elasticity of Demand

Some goods and services are elastic, while some are inelastic. The
types of price elasticity of demand vary for every product. There are
a number of factors which lead to determining price elasticity of
demand (see Table 3.3).
rt> Table 3.3 Factors influencing price elasticity of demand
...
Q)

.c:
u 1 Availability of A good with more close substitutes will have a higher elasticit y. Consumers can respond
substitutes to a rise in price by switching to a substitute, which has not experienced any increment
in price. Demand is usually inelastic when fewer or no subst itutes are available. For
example, tea and coffee are substitutes. If the price of tea rises, the consumer may
change to buying coffee instead.

2 Proportion of If only a small proportion of income is spent on a good, the demand will be inelastic. For
income spent on a example, toothpaste and salt. The consumer may still buy toothpaste, although the price
product has increased by 10%. On the other hand, goods for which a consumer spends a large
proportion of his/her income (e.g. a car and house) will have an elastic demand.

3 Nature of goods The demand for essential goods i s generally less elastic. For example, consumers still
(Necessities vs. have to buy rice, even when there is an increase in its price. On the other hand, the
Luxuries) demand for luxurious goods (e.g. luxur y food, imported cigars, branded accessories such
as watches and shoes) is more elastic because even with a small change in their prices,
there is a large change in the quantity demanded. The consumer can choose to stop
buying the luxury good altogether.

4 Consumer's habits For consumers who are habituated or accustomed to consuming a particular good,
such as cigarettes or a certain brand of coffee, the demand for the good will be inelastic
because it becomes an essential item to them. Thus, smokers will want to smoke no
matter how expensive the cigarettes are.

5 Joint demands For goods that are jointly demanded, such as cars and petrol or bread and jam, etc., the
elasticit y is linked in a similar way. If the demand for cars is less elastic, the demand for
petrol will also become less elastic. If the demand for bread is elastic, the demand for jam
will also become elastic.

6 Time frames In the short term, demand tends to be more inelastic because it may take time for a
price change to become known and for consumers to respond to it. Additionally, in the
short run, the goods that are demanded will have limited substitutes. The longer the
time period after a price change, the more elastic the demand becomes.Wi thin a long
period, consumers will gain more knowledge about the market situation and, thus, more
substitutes can be found.

7 Level of income Those with high incomes generally have an inelastic demand because, being richer,
they are less sensitive to price changes. However, those with lower incomes have an
elastic demand, whereby a slight change in the price of a good will affect their budget
considerably.
3.1.2 Income Elasticity of Demand
Income elasticity of demand measures the degree of responsiveness
of the quantity demanded for a particular good, with respect to the
-·-·
rn
....
changes in income of the consumer. We can also define this concept
as the ratio of the percentage change in the quantity demanded for
a commodity to the percentage change in income. Income elasticity
of demand is calculated to determine the type of the particular good,
whether it is a normal, a luxury or an inferior good. The for1nula for
calculating income elasticity of demand is as follows.

Income elasticity of demand

Formula to calculate incorne elasticity of demand measures the degree of
re�ponsiveness of the
Percentage change in quantity de1nanded of Good X (Qdx) quantity derr1anded for a
£ =
r Percentage change in consun1er incon1e (Y) particular good, with respect
to the changes in income of

Qdx2 - Qdx 1
the consun,er.
= . y2 - Y I
Qdx1
£
y Y,

Qdx2 - Qdx 1 Y,
£y = X
Qdx 1 y2 - Y I

SAMPLE QUESTION 3.2

Daniel's income rises from USDl,000 to USDl,600, and his demand for Good X increases from
30 units to 65 units per month. Determine the type of good for Good X.

Solution:
List the details needed.
Qdx, = 30, Qdx2 = 65, Y1 = USDl ,000,Y2 = USDl,600

Qdx2 - Qdx1 Y,
E = ----- X ---
Qdx, Y2 -Y1
y

Substitute all details into the formula.

65- 30 1,000
Ey =
30 X 1,600 - 1,000

E = 1.94 � Elastic income. Therefore, Good X is a luxury good. A rise of income by 1% will
y
------:.• • • lead to an increase in quantity demanded for Good X by 1.94%.

Degrees of Income Elasticity
of Demand
1 Negat ive income elasticity
of demand
2 Zero income elasticity of
demand
3 Inel astic in come elasticity of
demand
4 Elastic income elasticity of
demand
Table 3.4 Degrees of responsiveness in income elasticity of demand
Negative income
elasticity
E <0
An increase in the
consumer' s income
will cause a decrease in
quantity demanded, and
vice versa.
Inferior good, e.g. broken
nee.
Income (Y)
D
An increase in income from
Y, t o Y2 leads to a decrease
in quantity demanded
from Qd, to Qd2• The
consumer will reduce
the purchase of inferior
goods and switch t o
better quality goods when
.income rises.
.
Degrees of Responsiveness in Income Elasticity of
Demand
The degree of income elasticity of demand refers to the varying
consumers' reactions (quantity demanded) to a change in income.
There are four degrees of responsiveness in incon1e elasticity of demand
(see Table 3.4). Tue incon1e elasticity may be positive or negative, or
even zero, depending on the nature of a good. The income elasticity
is positive if an increase in income leads to an increase in quantity
demanded. A good "vhich has positive income elasticity is either a
normal good or luxury good. On the other hand, incon1e elasticity is
negative ,,v-hen an increase in incon1e causes a decrease in den1and for
a good. Such a good is defined as an inferior good.
Zero income Inelastic income Elastic income
elasticity elasticity elasticity
E =0 O<t:<1 E > 1
No matter how the income A change in the A change in the
changes, the quantity consumer's income causes consumer's income causes
demanded will stay the a smaller percentage a bigger percentage
same. change in quantity change in quantity
demanded. demanded.
Types of Goods
Essential good, e.g. rice, Normal good, e.g. clothing, Luxury good, e.g. sports
bread, etc. sports shoes, etc. cars.
Shapes of Demand Curves
Income (Y) Income (Y) Income (Y)
' D
D
D
L_�-
Q - ➔
-. Q
d
dl
An increase in income An increase in income from An increase in income from
from Y , to Y 2 will have no Y, to Y2 leads to an increase Y 1 to Y 2 leads to an increase
impact on the quantity in the quantity demanded in quantity demanded
demanded. The quantity from Qd, to Qd2, but the from Qd, to Qd2, but the
demanded for an increase in demand is increase in the quantity
essential good will remain less than the increase in demanded is more than
unchanged. income. the increase in income.
3.1.3 Cross-elasticity of Demand trJ

Cross-elasticity of demand measures the degree of responsiveness

of the quantity de1nanded for a particular good (e.g. Good Y), with
-·-·
rn
....
0
respect to the change in the price of another good (e.g. Good X). <
The change in the price of a related good may lead to a change in the
demand of another good.
Cross-elasticit y of demand is calculated to determine the relationship
of both products, whether or not they are complements, substitutes or
not related at all. The formula for calculating cross-elasticity of demand
is as follows.

Cross-elasticity of demand
For,nula to calculate cross-elasticity of de,nand measures the degree of
responsiveness of the
Percentage change in quantity den1anded of Good X (Qdx) quanti ty demanded for
Percentage change in price of Good Y (Py)
£C =
a particular good (e.g.
Good Y), with respect to
Qd)½- Qdx 1 Py2 - Pyl
the change in the price of
= another good (e.g. Good X).
Qdx 1 Px 1
I::
C

Qdx2 - Qdx 1 Pyl

£C =
Qdx 1
X
Py2 - Pyl

SAMPLE QUESTION 3.3

Last month, the quantity demanded for Good A was 300 units when the price for Good B was
USD3.SO. This month, the price for Good B increased to USD5 and the quantity demanded
for Good A decreased to 75 units. Calculate the cross-elasticity of demand and state the
relationship between Goods A and B.

Solution:
List the details needed.
QdA, = 300, QdA2 = 75, PB, = USD3.50, PB2 = USD5

Substitute all details into the formula.

75 - 300 3.50
£C=
300 X 5 -3.50

_,
£, = - 1.75 +--When£,< 0, Good A and Good Bare complements. An increase in the price
•• • of Good Bdecreases the quantity demanded for Good A by 1.75%.
 Degrees of Responsiveness in Cross-elasticity of
Demand
The cross-elasticity of demand between hvo goods indicates the
Degrees of Cross-elasticity
of Demand relationship between the said two goods. There are three degrees of
1 Negative cross-elasticity of responsiveness in cross-elasticity of demand (see Table 3.5). If both
demand
2 Zero cro s s e- lasticity of
goods are substitutes for each other, the cross price elasticity will be
demand positive. If the goods are complementary, then the cross-elasticity will
3 Positive cross -elasticity of be negative. However, if both goods are not interrelated, the cross­
demand
elasticity will be zero.

Table 3.5 Degrees of responsiveness in cross-elasticity of demand

Negative cross-elasticity Zero cross-elasticity Positive cross-elasticity

EX <0 EX =0 E >0

If the coefficient is less than zero, an If the coefficient is zero, an increase If the coefficient is greater than zero,
increase in the price of a good leads in the price of a good wilI give no an increase in the price of a good
to a reduction in quantity demanded impact on quantity demanded for leads to an increase in quantity
for another good. another good. demanded for another good.

Types of Relationship
Complementary goods, e.g. coffee Independent goods, e.g. coffee and Substitute goods, e.g. coffee and tea.
and creamer. socks.

Shapes of Demand Curves

Px Px Px
D
D
D

Px1 i-- -+-<

-

'----,-.L...L-'-
Oy20y1--+Qy '----'- - �Qy
Q yl - -
- ➔

Price of product X increases from Price of product X increases from Price of product X increases from
Px1 to P.2, while quantity demanded Px1 to P.2 but there is no change P,1 to P.2 , while quantity demanded
•
for Y reduced from Q , to QY2 . Then, in quantity demanded for Y.Then, for Y also increased from Q 1 to QY2.
y Y
products X and Y are viewed as products X and Y are viewed as Then, products X and Y are viewed as
being complements. being not related. being substitutes.

3.1.4 Price Elasticity of Supply

Price elasticity of supply measures the degree of responsiveness of the
quantity supplied for a particular good, with respect to a change in the
price. More precisely, it is the per cent change in quantity supplied
relative to a one per cent change in price, ceteris paribus. Tue formula
for calculating the coefficient of price elasticity of supply is as follows.
 79

trJ
Formula to calculate price elasticity of supply
Pr ice elasticity of supply

Percentage change in quantity supplied of Good X (Qsx)

measures the degree of
re�ponsiveness or the
quantitysupplied for a
-·-·
rn
....
0
Percentage change in price of Good X (Px)
I::=
s particul.ir good, with respect <
to a change in the price.
Qsx, - Qsx 1 Px, - Px 1
I::s=
Qsx 1 Px 1

Qs)½ - Qsx1 Px1

Qsx 1 Px2 - Px1
i::= X
s

SAMPLE QUESTION 3.4

If the price for a chocolate bar decreases from USD4 to USD3, and quantity supplied decreases
from 8,500 to 6,000 units, what is the price ela:sticity of supply for the chocolate bar?

Solution:
List the details needed.
Qsx1 = 8,500, Qsx2 = 6,000, Px, = USD4, Px2 = USD3

Qsx - Qsx, Px1

€ =- -2 - - - - - -
X
s Qsx, Px2 - Px,

Substitute all details into the formula.

6,000 - 8,500 4
€s = x -
8,500 3-4
i::, = 1.18 +- Elastic supply. In this case, as i::, > 1, supply is very responsive to the price
changes. If there is a 1% decrease in price, the quantity supplied will decrease
•• • by 1.18%.

Degrees of Responsiveness in Price Elasticity of

Supply
The degrees of price elasticity of supply refer t o the varying suppliers' Degrees of Price Elasticity
reactions (quantity supplied) to a change in price. The degree of of Supply
elasticity of supply helps in defining the shape and slope of a supply 1 Perfectly inelastic supply
curve. Therefore, the price elasticity of supply can be determined by
2 Inelastic supply
3 Unitary elastic supply
the slope of the supply curve. The flatter the slope of the supply curve, 4 Elastic supply
the higher the elasticity of supply. Supply elasticity is usually a positive 5 Perfectly elastic supply
coefficient, siJ1ce price and supply are positively related. There are five
degrees of responsiveness in price elasticity of supply as shown in
Table 3.6.
rt> Table 3.6 Degrees of responsiveness in price elasticity of suppl y

Perfectly inelastic Inelastic Unitary elastic Elastic Perfectly elastic

£ =0 0< £ < 1 £ =1 £ > 1
.c:
£ =oo
s s s s

u *No matter how the A change in the price A change in the A change in the price *The change in price
price changes, the of a good causes a price of a good of a good causes a will change the
quantity supplied smaller percentage causes an equal bigger percentage quantity supplied by
will stay the same. change in the change in its change in the an infinite value.
quantity supplied. quantity supplied. quantit y supplied.

Shapes of Supply Curves

Vertical supply Steeper slope of Rectangular Flatter slope of Horizontal supply

curve supply curve hyperbola supply supply curve curve
curve
p s p p p p
s
s
P2 P2
P1 - / P,

� Os
L----, -
0,
:!:- -.► 0s
- Os o, 02
L----!:----:!:----'
01 02
► Os L---=--
01
-
--' ► Os

Suppliers will sell The% changes in Suppliers respond to The% changes in At a certain price,
a good or service price (P 1 increases an equivalent% of price (P1 increases the quantity
regardless of the to P} i s larger than change in quantity to P} is smaller than supplied is infinite.
movement of price, the% changes in supplied from Q1 the% changes in
even when price quantity supplied to Q2 as the price quantity supplied
increases from P, (Q1 increases to Q}. changes from P, (Q 1 increases to Q2).
to P2• to Pr

*Happens onl y in extreme cases, which are very rare in real life.

Factors Influencing Price Elasticity of Supply

Some goods and services are elastic, while so1ne are inelastic. The
types of price elasticity of supply vary for every product. There are a
number of factors which lead to determining price elasticity of supply
(see Table 3.7).
Table 3.7 Factors influencing price elasticity of supply

-·-·
rn
....
1 Time frames Supply is perfectly inelastic in the momentary period. In the short run, supply will be
inelastic because the quantity supplied is limited to the existing firms. In the long run, a
firm will increase the input of all factors of production and, thus, the quantity supplied
becomes more elastic.

2 Availability of Supply will be more elastic if inventories can be kept without loss of quality and at low
inventory cost because the quantity supplied can be added very quickly in the market, assuming
that variable factors are readily available.

3 Surplus capacity If current production is below full capacity, the quantity supplied can be increased by
making use of surplus capacity. Firms can expand output easily by using labour and raw
materials which are readily available if demand rises.

4 Perishables vs. Perishable goods have a limited shelf life, so any changes in price will not change supply
non-perishables by a lot. Therefore, the quantity supplied i s price inelastic for perishable goods, and vice
versa for non-perishable goods. Examples of perishable goods are fruits and flowers.

s Mobility and If the factors of production are easil y available and can be switched in many ways
availability of towards production of a product, tlhe quantit y supplied is price elastic. However, if a
resources production has scarce resources, then the supply is inelastic.

6 Ease of entry into The easier it is to enter into a market, the greater the number of firms will be (available in
the market the market), and the more price elastic the market supply will be.

7 Level of technology If the latest technology is used for producing goods, then it will result in faster
production. The higher the technology level, the more price elastic the quantity supplied
will be.

Barry Callebaut has reported a drop in its full-year nett profit; a worse than
expected reduction. The Swiss-based con1pany, which is also the world's
biggest industrial chocolate maker, has thus reduced its sales growth targets in
an effort to try and maintain profit margins.
Additionally, the company will cut its production capacity in Port
Klang, Malaysia, with immediate effect and shut down its cocoa factory in
Bangpakong, Thailand, by end January 2016-an indilcation that overcapacity
and falling demand in Asia are hurting profits.
According to the co1npany's full-year 2014/15 results report, "A challenging
market environtnent characterized by a historically low combined cocoa ratio
triggered by grinding overcapacity and low demand for cocoa products had a
negative impact on profitability':
Since early 2014, cocoa grinders globally have faced a dismal combined
ratio-the processing margin for both cocoa butter and powder-while cocoa
bean prices soared to four-year highs. As a consequence, many large chocolate
companies have raised their retail prices, affecting consumers and demand in
the process.
Tl1e cocoa den1and in Asia has been hit particularly hard, despite it being an
e1nerging 1narket for chocolate. Even Hershey Co., for \.vho1n Barry Callebaut
provides chocolates, has noted slowed growth in China for the past five
quarters. This was because cocoa grinding, which separates the beans into
powder and butter, has fallen in Asia.
Asian cocoa bean processing has been relocating from Malaysia, \.vhereby
global companies, such as Olam International Ltd. and Cargill, have opened
their cocoa processing facilities in Indonesia in 2014. Mean,vhile, some
independent and older grinders have reportedly closed down in recent years
as they were unable to compete.

Source: Adapted from The Star Online, 2015.

Case question
Explain how the knowledge of elasticity can help Barry
Callebaut in its decision making.

Solution
The chocolate producer should firstly determine the price elasticity of demand
for its chocolates, before 1naking a decision on an appropriate pricing strategy,
i.e. ,vhether to increase or decrease the price of the chocolates, in view of an
increase in the cost of producing chocolates. This in turn depends on the types
of elasticity of supply. In this case, the chocolates have many substitutes. Thus,
the supply is elastic. If the price of Barry Callebaut's products keep increasing
( due to the increase in the price of the cost of production), it is safe to say that
this producer's profit will not be as much as expected.
In this chapter, we have examined two types of elasticity: elasticity of demand
and elasticity of supply. Elasticity of demand is divided into three kinds; price
elasticity of demand, incon1e elasticity of demand and cross-elasticity of
demand. For elasticity of supply, there is only one type: price elasticity of supply.
Elasticity can be estimated for price, income and prices of related goods. There
are five degrees of responsiveness in price elasticity of demand and supply, four
degrees in income elasticity of demand, and three degrees in cross-elasticity of
demand. Price elasticity has a very important relationship ,.vith total revenue.
When demand is elastic, the supplier should decrease price to increase total
revenue. When demand is inelastic, the supplier should increase price to
increase total revenue, and when de1nand is unitary, the supplier should not
change the price since a given price change will result in the same revenue
change.
On the contrary, income elasticity of demand is calculated to determine the
type of the particular good. A normal good has a positive but inelastic income
elasticity. A luxury good also has a positive income elasticity, but it will be more
elastic. On the other hand, an inferior good has a negative income elasticity,
whereas an essential good has zero income elasticity. Meanwhile, cross-elasticity
of demand is calculated to determine the relationship of two products, whether
or not they are complements, substitutes or not related at all. When t,.vo goods
are substitutes to each other, the cross price elasticity for the two goods will be
positive. When two goods are complements to each other, the cross price elasticity
for the two goods will be negative. When two goods are unrelated to each other,
the cross price elasticity for the two goods will be zero.

• Elasticity refers to the relative responsiveness of a demand or supply curve

in relation to any of its determinants.
• Price elasticity of demand measures the degree of responsiveness of the -
•

quantity demanded for a particular good, with respect to the changes in

the price.
• The price elasticity coefficient, Ed, can be calculated using this formula:

Percentage change in quantity demanded of Good X (Qdx)

Percentage change in price of Good X (Px)
=
Ed

• The coefficient of price elasticity of demand will always have a negative

sign; ho,vever, in practice, the negative sign is excluded.
• Five degrees of price elasticity of demand: elastic demand, inelastic
demand, unitary elastic demand, perfectly elastic demand and perfectly
inelastic demand.
t')
• Income elasticity of demand measures the degree of responsiveness of the
...
Q)

quantity demanded for a particular good, with respect to the changes in

.c: income of the consumer.
u
• The income elasticity coefficient, er' can be calculated using this formula:

Percentage change in quantity demanded of Good X (Qdx)

£ =
y Percentage change in consumer income (Y)

• Four degrees of income elasticity of demand: elastic income, inelastic

income, negative income and zero income elasticity of demand.
• Cross-elasticity of demand measures the degree of responsiveness of the
quantity demanded for a particular good (e.g. Good Y), with respect to the
change in the price of another good (e.g. Good X).
• The cross-elasticity coefficient, ex, can be calculated using this formula:

Percentage change in quantity demanded of Good X (Qdx)

Percentage change in price of Good Y (Py)
£X =

• Three degrees of cross-elasticity of demand: positive cross elasticity,

negative cross elasticity and zero cross elasticity.
• Price elasticity of supply measures the degree of responsiveness of the
quantity supplied for a particular good, with respect to a change in the
price.
• The price elasticity coefficient, e., can be calculated using this formula:

Percentage change in quantity supplied of Good X (Qsx)

Percentage change in price of Good X (Px)
£=
s

• Five degrees of price elasticity of supply: elastic supply, inelastic supply,

unitary elastic supply, perfectly elastic supply and perfectly inelastic supply.

+ Key concepts

• Elasticity • Perfectly elastic • Income elasticity of

• Price elasticity of
demand
• Elastic demand
• Inelastic demand
• Unitary elastic demand
de1nand
• Perfectly inelastic
demand
• Determinants of price
elasticity of demand
• Total revenue
demand
• Cross-elasticity of
demand
• Price elasticity of supply
• Determinants of price
elasticity of supply
+ Exercises
trJ

-·-·
rn
....
0
<
Multiple-choice Questions
Answer the following questions.

1 The coefficient of price elasticity of demand B inferior

for Good ABC is 5.5. Therefore, the demand C luxury
for Good ABC is- - - D essential
A inelastic
B unitary elastic 6 Isabella normally purchases six pieces of
C perfectly elastic doughnuts every month. Recently, Isabella's
D elastic income increased from USDl,800 to
USD2,500. She does not buy doughnuts
2 The price elasticity of demand measures the anymore. For Isabella, the doughnuts are
responsiveness of the
A quantity demanded to changes in price of A normal goods
another good. B inferior goods
B quantity demanded to changes in the C luxury goods
tastes of consumers. D essential goods
C quantity demanded to changes in price.
D quantity supplied to changes in price. 7 When income changes, the quantity
demanded for Good F does not change.
3 A 35% increase in the quantity demanded Therefore, the income elasticity of de1nand
for fried chicken results from a 15% decline for Good Fis- - -
in the price of the food. The price elasticity A less than one
of demand for fried chicken is- - - B more than one
A 1.3 C equal to one
B 2.3 D equal to zero
C 3.3
D 4.3 8 v\Then the income elasticity of demand is less
than one, but more than zero, a good will be
4 The price elasticity of de1nand for beef is 6. considered as a- - -
A 10% increase in the price of beef results in A luxury good
a ___ decrease in the quantity demanded B inferior good
for beef. C normal good
A 60% D essential good
B 61%
C 62% 9 Assume that there are two commodities. A
D 63% positive cross-elasticity of demand indicates
that the rnro commodities are_ _ _
5 Assume that the inco1ne elasticity of A essential goods
demand for flat screen televisions is 2.1. B complementary goods
The coefficient suggests that flat screen C substitute goods
televisions are _ _ _ goods. D inferior goods
A normal
10 The cross-price elasticity of demand 15 Price elasticity of demand is not influenced
measures how the quantity den1anded of a by
good is related to the_ _ _ _ A the consumer's habits.
A cost of production B technology advancement.
B consumer's income C the consumer's income level.
C price of another good D the existence of substitute goods.
D price of ra,-v materials
16 Total revenue is defined as
11 Cross-price elasticity of demand is used to A the change in quantity supplied divided
decide whether by the change in price.
A two co1n1nodities are substitutes or B the change in quantity demanded
complen1ents. divided by the change in price.
B a product is a normal or a luxury good. C price multiplied by quantity.
C the demand is elastic or inelastic. D price multiplied by the change in
D the de1nand is perfectly elastic or quantity.
perfectly inelastic.
17 If a price reduction leads to higher total
12 Which of the following factors is a revenue, this situation sho,-vs that demand
determinant of price elasticity of demand? lS
_ _
_
A Population A elastic
B Future price expectation B inelastic
C Number of buyers C perfectly elastic
D Existence of substitute goods D perfectly inelastic

13 If a 7% decrease in the price of Good Y 18 Price elasticity of supply is not influenced by

results in a decrease of 7% in the quantity A improvement in production technology.
supplied for Good Y, then it can be B time frame.
concluded that the supply is_ _ _ C perishability.
A elastic D the price of other related goods.
B inelastic
C unitary 19 If the price elasticity of supply for a leather
D infinite purse is 0.65 and the price increases by 3%,
then the quantity supplied for the leather
14 As a manager of a bakery, Olivia has been purse will
informed by her staff member that the A increase by 1.95.
price elasticity of demand for one of the B decrease by 1.95.
bestselling cakes in the bakery is less than C increase by 0.217.
one. To increase total revenues, Olivia D decrease by 0.217.
should
A do nothing. 20 Supply is relatively elastic \.\Then_ _
_
B increase the price of the cake. A es =0
C decrease the price of the cake. B es < 0
D improve the production technology. C e <1
D es > 1
Short-answer Questions
Answer the following questions.
I The table gives the demand and supply schedule for Good OPQ.
-·-·
rn
....

Quantity Supplied Quantity Demanded

Price (USO)
for Good OPQ for Good OPQ

8 800 400
7 700 500
6 600 600
5 500 700
4 400 800

Calculate the:
(a) Price elasticity of demand when the price increases from USD4 to USDS.
(b) Price elasticity of demand when the price decreases from USD8 to USD7.
(c) Price elasticity of supply when the price increases from USDS to USD6.
(d) Price elasticity of supply when the price decreases from USD7 to USD6.
2 The table shows the quantity of Goods D, E and F purchased in two different months,
in ,-vhich the prices of the three goods in general did not rise, but Sheraz's income did.

Quantity Quantity Quantity Sheraz's

Month Demanded Demanded Demanded Income
for D forE forF (USO)

January 2016 30 50 100 4,500

February 2016 so 40 110 5,000

What is the income elasticity of demand for Good D, Good E and Good F if income
rises from USD4,500 to USDS,000?
3 Fill in the blanks with either 'decreases: 'increases' or 'is constant'.
(a) When demand for a product is elastic and its price_ _ _ _ _ _, total
revenue increases.
(b) When demand for a product is elastic and its price increases, total revenue

(c) When demand for a product is inelastic and its price increases, total revenue

( d) When demand for a product is inelastic and its price_ _ _ _ _ _, total

revenue decreases.
(e) When demand for a product is unitary elastic and its price changes, total revenue
4 The table shows the quantity de1nanded for Good M and Good K.

Quantity Demanded Quantity Demanded

Price of Good N
for Good M for Good K
(USO)
(Unit) (Unit)

10 1,400 500
12 1,250 800
14 1,000 1,300
16 700 1,850

(a) Assume that the price elasticity of demand for Good N is 0.75. \,Vhat should the
supplier do if he/she wants to increase the total revenue?
(b) Calculate the cross-elasticity of demand for Good M if the price of Good N
i11creases from USD12 to USD14. What is the relationship bet"veen both goods?
(c) Calculate the cross-elasticity of demand for Good K if price of Good N decreases
fron1 USD16 to USD12. What is the relationship between both goods?
5 Based on the table, calculate the income elasticity of demand for ,vatermelons when
Kumar's income increases from USD3,500 to USDS,500. What is this type of good?

Price of Watermelon/kg Kumar's Income/Month

(USO) (USO)

7 5,500
6 4,500
5 3,500
4 2,500

Essay Questions
Answer the following questions.
1 What is cross-elasticity of demand? Explain how economists use cross-elasticity of
demand to distinguish the relationship !between t,vo goods.
2 Define price elasticity of demand. Discuss any four determinants of price elasticity of
demand.
3 With the aid of a diagram, explain all types of price elasticity of demand.
4 What is inco1ne elasticity of demand? Explain how economists use inco1ne elasticity of
demand to determine the types of goods.
5 Define price elasticity of supply. Discuss any four determinants of price elasticity of
supply.
Market
Equilibrium
At the end of this chapter, you should be able to:
ffl
E • Define market equilibrium price and quantity.
8 • Explain market equilibrium and disequilibrium.
-
::s • Explain the changes of market equilibrium price and quantity,
due to changes in dema11d and supply.
�

·e
S:: • Describe price control, i.e. maximum price and minimum price,
and discuss the effects of price control on n1arket equilibrium.
«s • Discuss the effects of non-price control, i.e. indirect tax and
.! subsidy, on market equilibrium.
• Explain price control based on Islamic perspectives.
 I n Chapter 2, we have learned about demand and supply. The
demand curve is downwards sloping due to the law of demand,
whereas the supply curve is upwards sloping due to the law of supply.
Now, we can put the demand and supply curves together to identify
the market equilibrium condition.
In this chapter, we will explore how consumers make decisions
in buying goods and services and how producers make decisions in
selling goods and services. For a better understanding of this chapter,
you should recall the non-price determinants of demand and supply
that were discussed in Chapter 2.

4.1 DEFINITION OF MARKET

Market equilibrium is a
condition whereby quantity
demanded and quantity
supplied are equal.
EQUILIBRIUM
Buyers and sellers meet together to make decisions on the goods and
services to purchase and sell in the market. Therefore, the market is
a place, whereby both buyers and sellers interact to determine the
equilibrium price and quantity of goods and services exchanged.
What is market equilibrium?
Market equilibrium is a condition, whereby quantity demanded
and quantity supplied are equal. Once the market equilibrium has been
achieved, there would be no tendency for the price and quantity to
change. In other words, market equilibriu1n is a situation when buyers
are willing to buy goods and services and sellers are simultaneously
willing to sell the goods and services. In short, market equilibrium
is a stability point since the equilibriu1n price and quantity are
determined and there ,vould be no tendency for both equilibrium
price and equilibrium quantity to change.

SAMPLE QUESTION 4.1

Define market equilibrium.

Solution:
• Market equilibrium is a condition, whereby quantity demanded and quantity supplied are
equal.
• There would be no tendency for the price and quantity to change .
• It is a situation when buyers are willing to purchase goods and services and sellers are
willing to sell the same goods and services at a given price.
4.2 DETERMINATION OF EQUILIBRIUM
PRICE AND EQUILIBRIUM QUANTITY
Market equilibrium is a situation, whereby quantity demanded and tr:I
quantity supplied are equal. Table 4.1 shows how market equilibrium
is determined and the condition of market disequilibrium. -·-·
,Q
C

..,-·
tr
Table 4.1 C
Quantity Quantity ,
Price Market Shortage and Analysis of market
Supplied Demanded
(USD) Condition Surplus equilibrium
(Unit) (Unit)

1 2 10 Qdd > Qss Shortage happens

Shortage of 8 units when Qdd > Qss.
2 4 8 Qdd > Qss Th is condition
Shortage of 4 units arises when price
is below the
equilibrium price.
3 6 6 Market equilibrium Market equilibrium
P* = USD3 is achieved when
Q* = 6 units Qdd = Qss.
4 8 4 Qdd < Qss Surplus happens
Surplus of 4 units when Qdd < Qss.
5 10 2 Qdd < Qss This condition
Surplus of 8 units arises when price
is above the
equilibrium price.

Based on Table 4.1, the market equilibrium condition can be

illustrated as shown in Figure 4.1.

Price (U5D) Figure 4.1

; Qdd < Qss ; 55 Market equilibrium
: Surplus :
s ----- ----r----�-----r----·------·
I I I I

·�· '
I I I I I

4 ------'·----- ___ ... ____ ____ J_______

I I I I I

I I I
I
I I I I I

:
P* 3 -----:-----:----�*- - - - ------:------·
:
c - -_t' ---;: ----:-------
I I I I

2 -----------
: I

1 ----- ----� Qdd > Qss �---- ,------·

1 I I I I
I I I I

: Shortage :
DD
o � - - - - - --- - - - --+Quantity (Unit)
2 4 6 8 10
Q*

Figure 4.1 shows how market equilibrium can be drawn using the
tabular infor1nation. The equilibrium price and equilibrium quantity
are achieved \vhen the de1nand curve (DD) intersects with the supply
 curve (SS), i.e. DD = SS. In this example, the equilibrium price is
USD3 and the equilibrium quantity is 6 units. This is the stability
point which means as market equilibrium is determined, there would
be no tendency for price and quantity to change. At this point, both
buyers and sellers are willing to buy and sell goods and services in the
n1arket. In addition, there are two other conditions as shown in Table
4.1, which are shortages and surpluses. These are problems that arise
when the market is not in equilibrium.

SAMPLE QUESTION 4.2

1 (a) What would happen if price is located below the equilibrium price?
(b) When price is above the equilibrium price,_ _ _ occurs and the market price will
have a tendency to_ _ _ towards the equilibrium price.

Solution:
(a ) When price is located below the equilibrium price, this situation is called shortage. There
would b e an upward pressure for the price t o rise towards equilibrium price.
••• (b) surplus; fall
•••

4.2.1
Shortage, or excess demand, is
a condition whereby qu<1ntity
demanded is greater than
quantity supplied.
Shortage
Shortage happens when quantity demanded is greater than quantity
supplied. This problem occurs because the price is situated below the
equilibriu1n price. For exa1nple, when price is at USD2, the quantity
demanded is 8 units while quantity supplied is 4 units. Thus, there is
a shortage of 4 units (4 - 8 = -4 units). When the price is not in the
equilibrium position, there ,,vill be forces to push the price towards the
equilibrium level. Specifically, there would be an upvvard pressure for
the price to increase towards the equilibriun1 price.
There are n,vo effects when price increases for both buyers and
sellers:
1 When price increases, the buyers will cut their quantity
den1anded because novv the price has become expensive, thus
leading to a decrease in quantity demanded. The quantity
demanded will reduce towards the equilibriun1 quantity (from 8
units to 6 units).
2 On the other hand, the sellers vvill increase their supply since the
price has increased and it is now profitable for them to increase
their sales. Therefore, the quantity supplied will increase to,,vards
the equilibrium quantity (from 4 units to 6 units).
This process will persist until quantity demanded equals quantity
supplied, and the price and quantity will return towards their
equilibrium level.
4.2.2 Surplus
Surplus occurs when quantity demanded is less than quantity supplied
(quantity supplied is greater than quantity demanded). This proble1n
Surplus, or excess supply, is a
condition whereby quantity
arises when the price is above the equilibrium price. For instance,
-·--·
supplied is greater than tr:I
at USD4, quantity den1anded is 4 units, while quantity supplied is quantity demanded. ,Q
C
8 units. This leads to a surplus of 4 units (8 - 4 = 4 units). When price
is located above the equilibrium price, there will be a downward ..,-·
tr
pressure for the price to reduce towards the equilibrium position.
C

There are nvo effects when price decreases towards the equilibrium
price:
1 When price decreases, the buyers will increase their demand since
the price has now become cheaper or more affordable. Therefore,
the quantity de1nanded will increase towards the equilibrium
quantity (from 4 units to 6 units).
2 Conversely, the sellers will reduce their supply since it is now
unprofitable to sell more units as the price has reduced. The
quantity supplied will reduce towards the equilibriun1 quantity
(from 8 units to 6 units).
This process ,.vill continue until the surplus is eliminated, and both
price and quantity ,.vill return towards their equilibrium level.

4.3 CHANGES IN DEMAND AND SUPPLY,

AND THE EFFECTS ON MARKET
EQUILIBRIUM
Once an equilibrium price has been established, it can only change
if there is a change in the conditions or determinants of demand and
The equilibrium price and
equilibrium quantity will
supply. change when the demand
As stated in Chapter 2, demand 1night change or shift due to or supply curve shifts or
changes in the preferences and tastes of consumers, income level, the
changes.

price of related goods, etc. Supply would also change and shift because
of the changes in the non-price determinants of supply. These changes
would affect the equilibrium price and quantity.
Basically, there are four situations which are:
1 Demand changes, but supply is unchanged.
2 Supply changes, but demand is unchanged.
3 Both demand and supply changes in similar proportions.
4 Both demand and supply changes in different proportions.

4.3.1 Demand Changes, but Supply is

Unchanged
Demand Increases and Supply is Held Constant
Suppose that there is an increase in the income level that would cause
the demand for normal goods to increase, as shown in Figure 4.2(a).
 Therefore, the demand curve ,,vill shift rightwards from DO to D1•
The equilibrium price will increase from P0 to P1 and simultaneously
quantity will increase from Q0 to Q 1 • The equilibrium level thus
changes from E0 to the new equilibrium level, E1•

Demand Decreases and Supply is Held Constant

Now suppose that there is a decrease in the size of the population,
causing the demand for goods to reduce and the demand curve to
shift left,,vards. As a result, the equilibrium price and the equilibrium
quantity will reduce tO\.Yards a new equilibrium level (from P0 to P2
and Q0 to Q2, respectively). The new equilibrium level is E2. This is
shown in Figure 4.2(b).

Figure 4.2 p p
Shift of demand curve
while supply curve remains s s
unchanged /
✓
i P1 ----.... -.. --------E 1

1 Po
--------
Eo

Po P2

/ D,
✓ Do
Do
D2
Q Q
0
Oo Q, 0
02 Oo

(a) Increase in demand with supply (b) Decrease in demand with supply
held constant held constant

4.3.2 Supply Changes, but Demand is

Unchanged
Supply Increases and Demand is Held Constant
Suppose that the cost of production in producing cloth has reduced.
This will cause the supply curve to shift rightwards from S0 to S 1 as
shown in Figure 4.3(a). Thus, the equilibrium price ,vill decrease fro1n
P0 to P, and the equilibrium quantity ,,vill increase from Q0 to Q1 . The
original equilibrium level, E0, will change to the new equilibrium level,
El.

Supply Decreases and Demand is Held Constant

Figure 4.3(b) sho,,vs th,e effects of a decrease in technology on the
production of shoes. When technology decreases, the supply curve
will shift leftwards and cause the equilibrium price to increase from
PO to P2. In addition, the equilibrium quantity will decrease from Q0 to
Q2, while the ne,,v equilibrium level will change from E0 to E2•
 p p Figure 4.3
Shift of supply curve while
demand curve remains
unchanged
tr:I

------- -----.'---
-·-·
,Q
C

..,-·
tr
''

C
D D

(a) Increase in supply with demand (bl Decrease in sU1pply w ith demand
held constant held constant

4.3.3 Demand and Supply Changes in

Similar and Different Proportions
In reality, demand and supply will change simultaneously to affect
the equilibrium price and quantity. We have to adjust the relative
magnitude of the increase or decrease in the demand and supply curve
to observe the impact of the changes on the new equilibriu1n price and
quantity. There are many combinations of changes, as follows:
Combination I: Demand and supply both increases
(a) A proportionate increase in both demand and supply.
(b) An increase in demand ,vhich is more than the increase of
supply.
(c) An increase in demand which is less than the increase of
supply.
Combination 2: Demand and supply both decreases
(a) A decrease in demand which is proportionate to the decrease
of supply.
(b) A decrease in demand ,vhich is more than the decrease of
supply.
(c) A decrease in demand which is less than the decrease of
supply.
Combination 3: Demand increases while supply decreases
(a) An iJ1crease in demand which is proportionate to the fall of
supply.
(b) An increase in demand ,vhich is more than tlhe fall of supply.
(c) An increase in demand which is less than the fall of supply.
Combination 4: Demand decreases while supply increases
(a) A decrease in demand which is proportionate to the increase
of supply.
(b) A decrease in demand which is more than the increase of
supply.
 (c) A decrease in demand which is less than the increase of
supply.

Combination 1: Demand Increases, Supply Increases

In Figure 4.4(a), demand increases due to an increase in the
preferences and tastes for chocolate cake, while supply increases due to
a reduction in the cost of production for chocolate cake. Suppose that
both demand and supply curves shift proportionately rightwards. As
a result, the equilibrium quantity increases from Q0 to Q1• Meanwhile,
the equilibrium price is unchanged, i.e. P 1 = P0• The new equilibrium
level is Er
If the increase in demand is less than the increase in supply, the
equilibrium price \.\7ill fall from PO to P2 while the equilibrium quantity
will increase from Q0 to Q2, as shown in Figure 4.4(b). However, if the
increase in demand is more than the increase in supply, the equilibriun1
price and the equilibrium quantity will rise (students are advised to
sketch the diagram). Note that the change in the equilibrium quantity
is greater than the change in the equilibrium price.

Figure 4.4 p p
Increase of demand and supply
So
curves a t the same and different So
proportions 52
� s, �

E
P1 = P0
Eo
i Po
P2 • a a• a aa aaa

/ D, D2
�
Do Do

0 Oo Q,
Q 0 Oo 02
Q

(a) Demand and supply increase at the (b) Demand increases less than the
same proportion increase in supply

Combination 2: Demand Decreases, Supply Decreases

Let us say that the demand of coffee decreases due to a decrease in
the price of tea. The supply also decreases due to a decrease in the
number of sellers of coffee. Assuming that both demand and supply
curves shift leftwards proportionately, the equilibrium quantity will
thus reduce from Q0 to Q 1 • The equilibrium price remains unchanged
at P1 = PO and the original equilibrium level changes from E0 to E1 • This
is shown in Figure 4.S(a).
If the decrease in supply is greater than the decrease in demand as
illustrated in Figure 4.S(b), the equilibrium price will increase from P0
to P2 and the equilibrium quantity will fall from Q0 to Q2• If the reverse
occurs with the decrease in supply being smaller than the decrease
in demand, both the equilibrium price and equilibrium quantity will
decrease. Remember that the increase or decrease in equilibrium price
is less than the decrease in the equilibrium quantity.
tr:I
p p Figure 4.5
Decrease of demand and -·-·
,Q
C
supply curves at the same and
different proportions
..,-·
tr
✓ C

o
� - � - - - �- - -
-+O �
o
- -
� -�- - -
- o
01 Oo 02 Oo

(al Demand and supply decrease at (bl Supply decreases more than the
the same proportion decrease in demand

Combination 3: Demand Increases, Supply Decreases

Figure 4.6(a) shows the effects of an increase in demand proportionate
to the decrease in supply. When the number of advertise1nents for
Pantene haircare products increases, this causes the demand curve for
Pantene to shift rightwards. In contrast, the cost of production also
increases, causing the supply of Pantene to shift leftwards. Therefore,
the equilibrium price will increase fron1 P0 to P 1, while the equilibrium
quantity will remain unchanged at Q1 = Q0•
Figure 4.6(b) shows that if the increase in demand is less than the
decrease in supply, the equilibrium price ,..,ill increase and equilibrium
quantity will decrease. Conversely, if the increase in demand is greater
than the decrease in supply, the equilibrium price and equilibrium
quantity will increase. The change in equilibrium price is greater than
the change in equilibrium quantity.

p p Figure 4.6
Increase and decrease of
demand and supply curves
respectively at the same and
different proportions

/ D1
D2
Do

-
Do
0 0 0 0
0 1 =Oo 02 Oo

(a) Demand increases and supply decreases (bl Demand increases less than the
at the same proportion decrease in supply
 Combination 4: Demand Decreases, Supply Increases
Suppose the demand for petrol decreases due to an increase in the
prices of cars, ,.vhile the supply of cars increases due to a technological
advancement in the automotive industry. AssumiI1g that the demand
and supply curves for petrol change proportionately. The demand
will shift leftwards and the supply curve will shift rightwards
proportionately as shown in Figure 4.7(a). The equilibrium price will
fall from PO to P1, while the equilibrium quantity is constant at Q1 = Q0•
If the decrease in demand is less than the increase in supply, the
equilibrium price will decrease 1nore than the increase in the equilibrium
quantity as illustrated in Figure 4.7(b). On the other hand, if the decrease
in demand is greater than the increase in supply, the equilibrium price
will decrease more than the decrease in the equilibrium quantity.

Figure 4.7 p p
Shift of demand and supply
curves a t the same and different
proportions
✓

1
P0

P2 ------
✓ D1 D2

-
�
Do Do
o 0 1 =Oo 0 0
0 Oo 02
(a) Demand decreases and su[Pply increases (b) Demand decreases less than the
at the same proportion increase in supply

SAMPLE QUESTION 4.3

With the aid of a diagram, show the effects on the supply of furniture if the price of wood
increases.

Solution:
p

'
...... ----�----
'
E.o

o '-----�-----------+o
01 Oo
 • When the price of wood (raw material) increases, the cost of production to produce
furniture will increase.

-·--·
• tr:I
The producer will reduce the production of furniture, hence the supply of furniture ,Q
will reduce. C

..,-·
• The supply curve shifts leftwards from 50 to 5 1• tr
• The equilibrium price increases from P0 to P, and the equilibrium quantity falls from
00 to 0,. The equilibrium position moves from E0 to E,. C

4.4 GOVERNMENT INTERVENTION IN

THE MARKET
In the market of demand and supply, prices are free to increase or
decrease to the equilibrium position. The equilibrium price and
equilibrium quantity are determined by the forces of demand and
supply. However, due to certain circumstances, the equilibrium price
may not be the most desirable price. Hence, sometimes the government
might intervene in the market through price control to set the price,
in order to protect consumers from unfair prices. Such price control
can also be called price regulation, fixed price or legal price.
Four government interventions include:
1 Fixing a higher limit of prices, or maximum price
2 Fixing a lower limit of prices, or minimum price
3 Imposition of taxes
4 Subsidies

4.4.1 Price Control

Price control refers to the process of fixing the price which is regulated
by the governn1ent. There are two types of price control:
1 Maximum price, also kno,-vn as price ceiling
2 Minimum price or price floor

Maximum Price (Price Ceiling)

A maximum price or price ceiling is the legal price set by the Pr iceceiling refers to the
governn1ent, which is set below the equilibrium price to prevent maximum pri ce set by the
producers from raising the price above it. government to prevent

Maxi1num price is implemented to protect consumers, usually

the prices of essential
commodities from rising
during food shortages to ensure low cost food for the poor. The above a certain level.
governn1ent usually sets a maximum price on essential commodities,
such as sugar, rice, cooking oil, chicken, fish, and so on. This is to prevent
the practice of setting unfair prices that ,-vould harm consumers and
the society as a vvhole. Maximum price is also in1plemented on rent
controls to ensure affordable accommodation for lo,-v income groups.
 Maximum price is set below the equilibrium price which means
that the producers or sellers cannot sell goods and services higher
than the n1aximum price. Figure 4.8 depicts the maximum price or
price ceiling in the market.

Figure 4.8 P (USO)

Maximum price or price ceiling
s

E*
(8.50) P*

:l
(7.50) P1 I-----;,,':--�--"'.�--- Maximum price/Pr ce ceiling
J:' i
T ''
'
Shor'ltage '
'
''
' D
0 _..___--'--__._ _ 0 (kg)
_ _ _
01 O* 02
(5) (7) (9)

Based on Figure 4.8, the maximum price (P) is set below the
equilibrium price (P*). Therefore, the sellers have to obey this legal
price set by the government. Let us say that the market price of 1 kg of
chicken is USD8.50. When the government sets the maximum price
at USD7.50 per kg, the seller must sell I kg of chicken at USD7.50, not
USD8.50. Here, �vhen the maximum price is below the market price,
there would be a shortage of goods and services. In this exan1ple, the
quantity demanded for chicken (9 kg) is greater than the quantity
supplied of chicken (5 kg). An excess demand or shortage of chicken
(4 kg) occurs due to the maximum price.

Advantages and Disadvantages of Maximum Price

Here are t\.vo main advantages:
I The maximum price will benefit consumers since they are able
to enjoy goods and services at cheaper prices. Let us revisit the
previous example. The market price for 1 kg of chicken is USD8.50
and the government set the maximum price at USD7.50. Thus,
consumers save USD 1 for each kg of chicken.
2 The government set a maximum price to prevent the market price
fro1n rising after a certain level, as this would harm consumers,
especially the poor. This is done for the sake of maintaining
justice and fairness that would benefit social welfare. For example,
during festive seasons, war and inflation, the government might
impose a maxin1um price so that the poor can afford to buy the
goods and services in the market.
Here are four main disadvantages:
1 Excess demand or shortages lead to the existence of black markets
or illegal markets. Since it is unprofitable to sell the co1nmodities
 locally, the producers might smuggle out or sell the commodities
to neighbouring countries at higher prices to gain more profit.
This in turn ""ill lead to larger excess demand or shortages and
will create problems in the local country. tr:I
2 Since there is no profit to be gained by the producers and they
must adhere to the lower prices set by the government, some -·--·
,Q
C

producers may cut their production of commodities and this ,,vill ..,-·
tr
cause greater shortages. C
3 The maximum price seems unfair to producers as they have to sell
their commodities at stipulated prices which are lower or cheaper,
yet they are liable for the costs of producing the commodities.
4 Producers n1ight engage in illegal activities, such as bribery,
corruption and hoarding of commodities. For example, some
sellers of sugar might hoard this commodity, especially during
festive seasons, thus creating an artificial shortage. This is done to
force the governn1ent to increase the price of commodities.

SAMPLE QUESTION 4.4

Define price ceiling. Explain the advantages and disadvantages of price ceiling.

Solution:
• Price ceiling refers to the legal price set by the government. This price is set below the
equilibrium price and aims to prevent producers from raising the price above the
equilibrium price.
• The advantages and disadvantages of the price ceiling are:

Advantages
I
It benefits consumers, as they are able
to enjoy goods and services at cheaper
prices.
E.g. If the market price of sugar is USD2
per kg and the government implements
USDl .SO as the price ceiling, then the
benefit enjoyed by consumers is USD0.50
per kg of sugar.
A price ceiling could prevent the price
from rising which would harm consumers.
Disadvantages
The existence of black markets and illegal
markets. Producers might smuggle goods
to other neighbouring countries since it
is unprofitable to sell those goods locally.
It creates serious shortages since the
producers might cut production, due to
lower profit.
Producers might engage in illegal
activities, such as bribery, corruption and
hoarding of goods. Hoarding of goods
creates artificial shortages and it is done
by producers to force the government to
increase the prices of the goods.
 Minimum Price (Price Floor)
A price floor is a minimum price fixed by the government to prevent
Price floorrefers to the
prices from falling belo,,v the legal minimum level. The minimum
price is set to protect producers, especially farmers who engage in
minimum price set by the
government to prevent the
prices of goods and services the agriculture sectors. Agriculture sectors are son1etimes subject to
from falling beneath a certain
natural disasters, such as floods, earthquakes and hurricanes, as well
as uncertainties in the price of resources. Hence, the government
level.

sets a minimum price to protect the farmers from the uncertainty of

production when the prices are too low in the free market. Figure 4.9
shows the n1inimum price or price floor in the market.

Figure 4.9 P (USO)

Minimum price or price floor
s
Surplus

(15.00) P2 I-- - :,.;_

�
-- - -....,,;<:- - - Minimum price/Price floor
E*
(10.00) P* -----------,-----
''
'
'

D
0�- - -
�-
0 -
o Q-
--* -
0�
2
- - -
---+ Q (kg)
(10) (1 S) (20)

Based on Figure 4.9, the minimum price is set at P2 which is above

the market price, P*. This will create the problem of surplus, where the
quantity supplied is greater than quantity demanded. For example, the
market price for 1 kg of paddy is USD10 and the government fixed the
minimum price at USD15 per kg. Therefore, the price of 1 kg of paddy
cannot be sold at any price lo,ver than USD15. Here, there would be a
surplus of 10 kg of paddy (20 kg - 10 kg).
Another example of minimum price or price floor is the concept
of minimum wage. Minimum ,.vage is the lowest wage allo,ved to be
paid by employers to their employees, in order to protect employees
from exploitation. For example, the n1ini1nun1 wage in peninsular
Malaysia in 2015 was RM900, and effective 1 July 2016, the Malaysian
government increased the minimum wage to RM 1,000 (New Straits
Times Online, 2016). Therefore, employers cannot pay their workers
less than RMl,000 per 1nonth. Minimum wage would benefit workers,
especially low skilled workers, by increasing their standard of living.

Advantages and Disadvantages of Minimum Price

Here are three 1nain advantages:
1 The income of prod·ucers or farmers is protected, especially in the
agriculture sectors. The agriculture industry is subject to supply
fluctuation; for example, ,.vhen less crops are produced due to
climatic conditions. Therefore, the price of crops is also subject to
 price fluctuations. To prevent prices from becoming too low i11 the
free market, the government sets a 1ninimun1 price and this will
protect the producers' income.
2 The government may store or keep the surplus of agricultural

-·--·
tr:I
produce for future consumption. For example, the government ,Q
C
may keep the surplus of paddy for future use if there is a shortage.
3 Lower paid workers are better off ever since the government set a ..,-·
tr
minimum wage to prevent their income from falling, apart from C
helping them to increase their standard of living. Other problems
such as poverty and crime can also be reduced.
Here are three main disadvantages:
1 Minimum price is unfair to consumers since they have to pay
more for the goods and services. Let us say, for instance, that
consumers pay USDS for a commodity before the imposition of a
price floor. However, after the government fixes a 1ninin1um price,
consumers then pay USDlO for the same commodity. In this ,.vay,
the minimum price becomes unfair to the consumers.
2 Minimum price would lead to wastage of resources because of
excess supply or surplus created in the economy. These surpluses
are either kept as stock, destroyed when perished or disposed
through dumping in other countries. Instead, the resources could
have been used to produce other commodities that have the
potential to benefit the society.
3 The concept of minimun1 wage could lead to the problem of
unemployment (surplus of labour), especiall)' among local
workers. It could also affect the government's effort to reduce
dependency on foreign workers. This is because when the
government increases the minimum wage, the costs of production
,.vill also increase for producers. To cut costs, the producers would
prefer to hire foreign ,.vorkers compared to the local workers,
since foreign workers are ,-villing to accept lower wages.

Kuala Lumpur, 30 October 2015: New private sectors are not to defer the
payment of minimum wages, scheduled for July 2016. Therefore, employers
have to comply with the minin1um wage ruling 'l>vithout giving any more
excuses, said Datuk Seri Richard Riot, the Human Resources Minister. He
mentioned that "There is no turning back on this policy", as the national
minimum wage was introduced three years back. He said this in his speech
which was read out by Datuk Seri Saripuddin, the ministry secretary-general,
at an official cere1nony held for the ne,.v National Wages Consultative Council
and National Wages Consultative Technical Committee programme.
 The minimum v.1age, as set in Budget 2016, increased from RM900 to
RMl,000 for the private sector in peninsula Malaysia and from RM800
to RM920 for Sabah, Sara,vak and Labuan. This ,vould be followed by an
announcement on the standardized minimum wage rate. "Several clauses of
minimum wages for those paid daily, piece-rated and related matters, will
be included in a new Order. The fine details of the Cabinet's decision will be
forwarded to the National Wages Consultative Council secretariat soon;' said
Riot. He also added that the increase in minimum wages could help to in1prove
the people's livelihood, which is the government's commitment.
"We hope the council members will continue to discuss this matter, and to
consider the national interest as the mini1num wage policy is an intervention
to turn the country into a developed nation by 2020;' he said.
According to Riot, as of August 2015, 182 employers had been charged
in court and action taken against 122 for failing to obey the minimum wage
ruling. After much discussions in the Cabinet, it is a balanced approach taken
by the governn1ent based on recon1n1endations given by the council 1nen1bers,
World Bank and other stakeholdlers.
Datuk Seri Saripuddin mentioned at a press conference later that there
was ample time for the employers to be prepared financially for this change
in the minimum \.vage structure. "The rates set is acceptable and fair to all;'
he added. According to Tan Sri Azman Shah Haron who was also present,
the minimum ,vage did not differentiate between local and foreign employees.
The president of the Malaysian Employers Federation further commented
that there was concern about a large sum of money going out of the country,
due to the minimum wage.
Source: Adapted from The Star Online, 2015.

Case questions
1 What is minimum wage? What kind of price control is it
known as?
2 How much is the minimum wage in 2015 and 2016?
3 With the aid of an appropriate diagram, explain the concept
of minimum wage.
4 List the advantages and disadvantages of the imposition of
. .
m1n1mum wage.
Solution
I Minimum wage is imposed by the government and it is compulsory for

-·--·
tr:I
employers to pay their employees at least the minimum wage, as set by ,Q
the government. Such price control is known as a price floor or minimum
C

price. When the government sets a minimum wage, employers cannot pay ..,-·
tr
less than the minimum wage. C
2 In 2015, the minimum wage in peninsula Malaysia ,-vas RM900 and in
Sabah and Sarawak it was RM800. In 2016, the minimum wage increased
to RMl,000 for peninsula Malaysia and RM920 for Sabah and Sarawak.
3
P (RM)

Surplus (Unemployment)
s
---..A..--�\
{
(1,000) P 1 t------'""'---------7"'---- Pr ice floor/Minimum price
(Minimum wage)
E*
(9 00) P* ------------------

O.______......;..________➔ Q
Q*

When the government imposes a minimum wage above the equilibrium

price, wages are higher than the market equilibrium price level.
Surplus of labour (unemployment problen1s) exists because the quantity
supplied is higher than quantity demanded.

4 Advantages:
• Employees' income will be protected.
• Poverty and crimes will be reduced.
• The people's standard of living will be increased.
Disadvantages:
• Unemployment problems occur.
• Outflow of money, due to employn1ent of foreign workers (cheaper).
SAMPLE QUESTION 4.5

What is price floor? Describe the advantages and disadvantages of a price floor.

Solution:
• A price floor is a minimum price fixed b y the government to prevent prices from falling
below the legal minimum level in the market.
• The minimum price is set to protect producers, especially farmers who engage in the
agriculture sectors.
• The price floor is set above the equilibrium price.

Advantages Disadvantages

The income of producers is protected Consumers have to pay more for goods
in the event that the prices of the and services.
agriculture sector are too low in the
market.
Surpluses would be kept and stored by It leads to wastage of resources, due to
the government for future consumption. excess supply.
Minimum wage will benefit low skilled Unemployment among local workers, due
workers by increasing their income and to minimum wage.
improving their standard of living .
•••
•••

4.4.2 Non-price Control

The government might itntervene in the market not only by controlling
the prices of certain goods and services, but also by imposing
non-price control regulations. Government intervention includes
levyiJ1g tax on various goods and services, such as cigarettes, alcohol,
other goods and services, payrolls, income and so forth.
Alternatively, a subsidy is an aid given by the government to
producers, in order to encourage production by reducing the cost of
production. Both taxes and subsidies will affect the market demand
and supply, hence reflecting the increase or decrease of the market
price as well as quantity.

Effects of Indirect Taxes on Price and Quantity

The government imposes two types of taxes in a nation, as follows:
1 Direct tax
2 Indirect tax
Direct tax is tax levied by the government directly to a person, who
cannot shift the burden of paying the tax to others. An example of
direct tax is income tax. Indirect tax, on the other hand, is imposed
by the government on producers and they can and might shift or pass
the burden of paying the tax to consumers. Some exan1ples of indirect
tax are sales tax, service tax, import duties, excise dU1ties and export
duties. tr:I
When the government decides to levy indirect tax on producers,
the costs of production ,vill increase and this will discourage the
-·-·
,Q
C

production of goods and services. Thus, to avoid making lower profit, ..,-·
tr
the producers v,rill reduce the supply of goods and services and, C
therefore, the prices of the goods and services will increase in the
market.
Figure 4.10 depicts the imposition of indirect tax and its effects on
price and quantity. When the government levies indirect tax, this will The imposition of indirect tax
to producers may increase the
cause the supply of goods and services to decrease and shift left,vards production cost and reduce
from S0 to S1. Assuming that demand is unchanged, the price of goods the supply, hence increasing

and services will increase fro1n P0 to P1, ,vhereas the quantity will
the prices of goods and
services.
decrease from Q0 to Q 1 • As stated earlier, the producer might shift
the burden of paying the tax to the consumers. In this example, both
producers and consumers share an equal burden of paying tax.

P (USO) S1 (Supply after tax) Figure 4.10

S0 (Supply before tax) Effects of indirect tax on price
and quantity
�ax- SD4

(18.00) P1
D Tax paid by consumer
i (16.00) Po I--- -
-,<._
D Tax paid by producer
(14.00) P2 1------V

0� -�-�- - - - - -
-+ Q (Unit)
Q, Go

(4) (6)

Figure 4.10 shows the exa1nple ofUSD4 indirect tax imposed by the
governn1ent on cigarettes. The supply of cigarettes reduces and shifts
Incidence of tax is the burden
of tax borne by cons1.,mers
leftwards as the production costs increases. The price of cigarettes and producers.
increases from USD16 to USD18 and the quantity reduces from 6
units to 4 units. Here, both producers and consumers pay the indirect
tax together. The question is how n1uch is the incidence of tax?
Incidence of tax refers to the burden of tax borne by consumers and
producers. In this example, the amount of tax paid by the producers
and the consumers is USD2 each. Both the producers and consumers
share equal burden of paying the tax. Table 4.2 sho,vs the pattern of tax
paid by both the producers and consumers.
'11' Table4.2
Analysis of the incidence of tax Price before tax= USDl 6
;
Quantity before tax= 6 units
.c:
u Per unit tax paid by consunner:
(USDl 8- USDl 6) = USD2
Total tax paid by consumer:
(USDl 8 - USDl 6) x 4 units= USD8
Per unit tax imposed by the
government:
(USDl 8- USD14) or (USD2 + USD2)
=USD4
Price after tax= USDl 8
Quantity after tax= 4 units
Per unit tax paid by producer:
(USDl 6 -USDl 4) = USD2
Total tax paid by producer:
(USDl 6 -USDl 4) x 4 units= USD8
Total tax revenue collected by the
government:
(USD4 x 4)= USD16

The incidence of tax is not necessarily equal for both consumers

and producers as per the previous example-there are situations
where the producers pay more taxes or the consumers are liable to
heavier taxes. The distribution of tax burden between producers and
consumers depends on the elasticity of de1nand and supply. Table 4.3
shows the different degrees of elasticity of demand and supply, with
tax incidence.

Table4.3 Degree of Elasticity Tax Incidence

Different degrees of elasticity of
demand and supply, Demand less elastic than supply Consumer pays more tax
with tax incidence (Inelastic demand)
Demand more elastic than supply Producer pays more tax
(Elastic demand)

Perfectly elastic demand Producer pays entire tax

Perfectly inelastic demand Consumer pays entire tax

Perfectly elastic supply Consumer pays entire tax

Perfectly inelastic supply Producer pays entire tax

 p p Figure 4.11 :1::

' -
S1 Degrees of elasticity of demand
"'1
So and supply, with tax incidence �
(I)
E,
8 tr:I

I
7
D -·-·
,Q
C

-·
5 ------ -- 0 2
41--�:V "'1
'' ''
'' '' C
---'---'-- - - -
- o :3
D
.__ Q
O 8 10 0 4 10

(a) Demand less elastic than supply (b) Demand more elastic than supply

p p

D
S1
So
'\
10 E1
8 t-- -
r.:-----r;:--- - -
D
E1 : Eo
4
2f-----Y

_ .___�- --+ Q
- - - L...-- - -
�- - -
--+ Q
0� 2 8 O 10

(c) Perfectly elastic demand (d) Perfectly inelastic demand

p p

E, Eo
12 s, 12

6
i So
6 E,
D
D

0 Q 0 Q
8 10 10

(e) Perfectly elastic supply (f) Perfectly inelastic supply

Figures 4.11 (a) to (f) illustrate the tax incidence ,-vith different
elasticity of demand. Figure 4.ll(a) shows that when demand is less
elastic than supply (represented by a steep demand curve), consumers
are liable to n1ore tax burden compared to producers. Since consun1ers
are not sensitive towards price changes, they are ,-villing to pay more for
the goods and services. Therefore, the consumers pay more tax when
the demand is inelastic. Table 4.4 shows the pattern of tax incidence
,vhen demand is inelastic.
 Table 4.4
Tax incidence when demand is Price before tax= USOS
less elastic than supply Quantity before tax= 10 units
Per unit tax paid by consunner:
(USOl 0- USOS)=USOS
Total tax paid by consumer:
(USOl O - USOS) x 8 units= US040
Per unit tax imposed by the
government:
(US010- US04) or (USOS + USOl)
=US06
Price after tax= USOl 0
Quantity after tax= 8 units
Per unit tax paid by producer:
(USOS - US04)=US01
Total tax paid by producer:
(USOS - US04) x 8 units= US08
Total tax revenue received by the
government:
(US06 x 8 units) = US048

On the other hand, when the demand is elastic (flat demand curve),
producers will pay more tax burden as opposed to consumers (see
Figure 4.11 (b )). This is because consumers are sensitive towards price
changes and would cut their consun1ption of goods and services as
price increases. Thus, to avoid losses, producers are ,,villing to pay more
tax when the demand is elastic. Table 4.5 explains the tax incidence as
consumers face elastic demand.

Table 4.5
Tax incidence when demand is Price before tax= USO?
more elastic than supply Quantity before tax= 1O units
Per unit tax paid by consunner:
(US08 - USO?)=US01
Total tax paid by consumer:
(US08 - USO?) x 4 units= US04
Per unit tax imposed by the
government:
(US08 - US02) or (USOl + USOS)
=US06
Price after tax = US08
Quantity after tax= 4 units
Per unit tax paid by producer:
(USO?- US02)=USOS
Total tax paid by producer:
(USO? - US02) x 4 units= US020
Total tax revenue received by the
government:
(US06 x 4 units)= US024

In addition, when demand is perfectly elastic (horizontal demand

curve) as illustrated in Figure 4.ll(c), producers pay the entire tax
which is USD6 (USDS - USD2). Conversely, with perfectly inelastic
demand (vertical den1and curve), consumers are liable for the entire
tax imposed by the government which is USD6 (USDlO - USD4).
This is shown in Figure 4.11 (d). Furthermore, perfectly elastic
supply (horizontal supply curve) means that consumers will pay the
entire tax. Thus, in Figure 4.ll(e), consumers pay USD6 of the tax
imposed by the government (USD12 - USD6). In contrast, perfectly
inelastic supply (vertical supply curve) reflects that producers pay
the entire tax. Figure 4.11 (f) depicts that producers pay USD6 of tax
(USD12 - USD6).
 SAMPLE QUESTION 4.6

The government imposed sales tax on cigarettes. The supply curve before tax is SO' and after
s,. tr:I

-·-·
tax it is
,Q
C
P (USD) s,
-·
tr
..,
C

20 ......................' E,
''
''
16 --- ------�---
''
15

�- - -
� - - - - - --+Q
O 10 12
State the answers to the following, based on the above diagram:
(a) The price and quantity after tax.
(b) The per unit tax paid by the consumer.
(c) The per unit tax paid by the producer.
(d) The per unit tax imposed by the government.
(e) Total tax revenue collected by the government.
(f) Who pays more tax, and why?

Solution:
(a) Price after tax= USD20; quantity after tax = 10 units
(b) USD20 - USD16 = USD4
(c) USD16 - USD15 = USD1
(d) USD20 - USD15 = USDS or USD4 + USDl = USDS
(e) USDS x 10 units= USDSO
_...._
•••
• • • (f) Consumer pays more tax because the demand is more inelastic than supply.

Effects of Subsidy on Price and Quantity

Subsidy is an aid given by the government to producers, especially
farmers, to encourage production of goods and services. Subsidy
could also help producers who engage in agriculture sectors to reduce
their cost of production because agriculture sectors face uncertainty in
terms of climatic conditions, seasonal factors and prices of agriculture
produce. Usually, the government will assist farmers by providing
them with the supply of fertilizer, insecticides and pesticides to help
reduce the cost of production. This assistance would protect the
farmers' income and increase their standard of living.
The effects of subsidy on price and quantity are totally the opposite
fron1 that of indirect tax. Sometitnes, it is called negative tax. When
the governn1ent gives subsidy to the producers, production costs
will reduce and the supply of goods and services will increase.

Subsidy is anaid given by the
government to producers to
reduce the cost of production
and encourage suppl y, thus
reducing the prices of goods
and services.
Therefore, the prices of goods and services will reduce after subsidy
takes into effect.
Figure 4.12 shows the effects of subsidy on price and quantity, which
work exactly the opposite of indirect tax. As the government imposes
USD4 of subsidy on paddy, the supply of paddy will increase and the
supply curve will shift rightwards. The price of paddy will fall fro1n
P0 (USD18) to Pb (USD16), whereas the quantity will increase from
Q0 (10 units) to Q1 (15 units). In this example, the USD4 subsidy is

shared equally between the consumers and producers, i.e. USD2 each.
Note that Pb is the price of the buyer, whereas P, is the price of the
seller. Therefore, (P Pb) is the amount of subsidy in1posed by the
-

government, which is USD4.

5

Figure 4.12 P (USD)

Effects of subsidy on price
and quantity S0 (Supply before subsidy)

S2 (Supply after subsidy)

(20.00) P, ------------- ----------- Subsidy = D4

1 (18.00) P0 ------------------- Eo
!�
':
'' ''
' '
(16.00) Pb ------------- -----�----- I E1

o�- - - - - -
�--- - - - - -
-Q (Unit)
Oo O,
(10) (15)

Table 4.6 illustrates the pattern of subsidy received by both

producers and consumers.
Table 4.6
Pattern of subsidy received b y Price before subsidy= USDl 8
both producers and consumers Quantity before subsidy= 10 units
Per unit subsidy received by
consumer:
(USD18 - USD16) =USD2
Total subsidy received by consumer:
(USDl 8 - USD16) x 15 units
= USD30
Price after subsidy= USDl 6
Quantity after subsidy= 15 units
Per unit subsidy received by producer:
(USD20 - USD18) = USD2
Total subsidy received by producer:
(USD20 - USD18) x 15 units
= USD30

Per unit subsidy given by the Total subsidy given by the

government: government:
(USD20 - USD16) or (USD2 + USD2) (USD4 x 15 units) = USD60
=USD4

The benefits of subsidy received by both consumers and producers

depend on the price elasticity of demand and supply. There are two
examples of the degree of price elasticity as stated in Table 4.7 and
illustrated in Figure 4.13.
 Table 4.7
Degree of Elasticity Benefit of Subsidy
Benefits of subsidy with
different degree of price
Demand is less elastic than supply Consumer receives more benefit of elasticity
(Inelastic demand) subsidy

-·--·
tr:I
,Q
Demand is more elastic than supply Producer receives more benefit of C

..,-·
(Elastic demand) subsidy
tr
C
p p Figure 4.13
Degrees of elasticity of demand
Ps ---------------- and supply, with subsidy

PS -------­
Po --------

- - ---- - - -
-G
O G0 0,
(a) Demand less elastic than supply (b) Demand more elastic than supply

SAMPLE QUESTION 4.7

Explain the effects of subsidy on vegetables and draw an appropriate diagram.

p
S0 (SS before subsidy)

5 1 (55 after subsidy)

PS -------------
!�
''
''
'' '
------------- -----�----
'

D
0-- - - - - -
�- -
�- - - - - - -
-G
Go 01

• Before the implementation of subsidy, the equilibrium price is at P0, the equilibrium
quantity is at Q0 and E0 is the equilibrium level.
• After the imposition of subsidy, the supply of vegetables will increase due to reduction
in the cost of production and, therefore, the supply curve shifts rightwards from S0 to s,.
• As a result, the price reduces from PO to P1 , the quantity increases from Q0 to Q1 and
the equilibrium level moves from E0 t o E 1 .
• Both consumer and producer share the benefits of subsidy.
4.5 PRICE CONTROL FROM AN ISLAMIC
PERSPECTIVE
In Islam, the equilibriium price and quantity are determined by
market forces, i.e. market demand and market supply. The fairness
or unfairness of the equilibrium price and quantity depends on the
producers and consumers themselves. If price is being n1anipulated
by the producers to serve their self-interest and this negatively affects
the society, then the market price is not just and fair to the consumers
as a whole. Therefore, Islam recognizes the determination of price
and quantity by market forces as fair, as long as both producers and
consumers are responsible, sincere and honest.
Ibn Khaldun clearly describes the concept of shortage of imported
goods in his famous work, Al-Muqaddimah. He mentions that if
the imported goods are few and rare (shortage), the prices of these
goods would increase. This n1eans that when the quantity of the
goods are limited, or in shortage, their prices will increase and this
is considered fair in Islam. He also explains that the prices of goods
depends on the distance between nations. If the distance between the
exporting countries and in1porting countries are near, then the cost of
transportation would be cheaper. Therefore, the drop in production
costs would lead to a decrease in the prices of the imported goods,
and vice versa. For example, the prices of goods would be cheaper if
Malaysia imports goods from Thailand rather than from the United
States, due to the difference in transportation costs.
Other than that, Ibn Taymiyyah also explains the concept of
shortage and surplus in detail. He states that the rise or fall in price
is not always due to injustice towards people, but also due to shortage
or surplus, or decline, in the imported goods demanded by people.
He mentions that if the desire or demand for goods increases, but the
availability of goods or supply decreases, then Islam recognizes that
the price will increase. Conversely, if the desire or demand for goods
decreases, but the availability of goods or supply increases, then the
price will decrease. In Islam, the scarcity or abundance of goods may
not be due to injustice and the rise or fall in price is fair in this case.
However, Islam rejec1i:s the practice where price is fixed or controlled
by anyone unless this is deemed necessary, thereby the government
might intervene for the benefit of society. Prophet Muhammad S.A.W.
rejected the request by the people of Madinah to fix the price in the
market. A hadith reported by Anas states that 'one person came to
Prophet S.A.W and requested Him to fix the prices in the market, but
He refused. Another person came and made the same request, and the
Prophet said it is Allah S.W.T. who pushes the price up or do,.,n, I do
not want to face Him with a burden of injustice: This hadith clearly
clarifies that the determi11ation of price should be made by the market
itself and is not in the hands or power of anyone.
 Islam forbids price controls since this practice is unfair for both
producers and consumers. For instance, a maximum price is unfair
to the producers since the prices of goods are too low and producers
are liable for the production costs, yet not the profits in return. On the
-·--·
tr:I
other hand, a minimum price is unfair to the consumers because they ,Q
C
would have to pay 1nore for the goods and services since the prices are
higher than the market price. ..,-·
tr
However, Islam allows the government to control prices if social Islam recognizes the
C
welfare is disrupted and it is proven that the increase or decrease of determination of price and
prices is due to market manipulation. For example, exorbitant pricing quantity by market forces and
is caused by the hoarding of goods by producers and, consequently, it does not allow prices to be
fixed by anyone unless it is
artificial shortage is created. In such situations, the government necessary to do so for social
may intervene and control the prices so that they will not increase, welfare.
especially for necessity goods i.e. Dharuriyyah goods (see Chapter 2
for a discussion on Dharuriyyah goods). Govern1nent intervention is
necessary to prevent unjust or unfair practices in the market.

A market is a place where both producers and consun1ers meet to buy and sell
goods and services. Market equilibrium exists when both quantity demanded
and quantity supplied are equal, which means that the consumers are willing to
buy the goods and services in the market while, at the same time, the producers
are willing to sell the goods and services. During 111arket equilibriu1n, the
point of stability is achieved and there would be no tendency for price and
quantity to change. T,-vo situations arise if the market is not in equilibrium.
Firstly, shortage occurs ,-vhen the quantity demanded is more than quantity
supplied. Thus, price ,.vill increase towards the equilibrium price while the
quantity den1anded will reduce and quantity supplied will rise. On the other
hand, surplus exists when quantity demanded is less than quantity supplied
and this would reduce the price to\.vards the equilibrium price. The quantity
demanded will rise, whereas the quantity supplied "vill fall.
Changes in demand and supply would make the equilibriu1n price and
quantity alter from their initial position. When demand increases while supply
is constant, both equilibrium price and quantity will increase, and vice versa. In
addition, as supply increases but demand remains unchanged, the equilibrium
price will fall, but quantity will increase. There is also the situation where
both demand and supply increase or decrease proportionately. When demand
and supply increase at the same proportion, the equilibrium quantity will
increase, but price is constant. If the opposite holds, the equilibrium quantity
will decrease, but price is constant. Furthermore, when de1nand increases and
supply decreases at the sa1ne proportion, the equilibrium price will rise while
the quantity remains unchanged. If the reverse is true, then the equilibrium
price will fall, but quantity remains constant.
 The government will intervene in the n1arket to control price fro1n
manipulation by anyone. There are two price controls known as the price ceiling
and the price floor. Price ceiling is a maximum price legally established by the
government to prevent prices of goods from rising above the maximum price
that has been set. The benefits of the price ceiling ,viii be enjoyed by consu1ners
since they pay a cheaper price for the goods that they purchase. However,
there are problems created by having a price ceiling, such as the existence of
black markets, illegal markets, hoarding activities and harmful producers. In
contrast, price floor is a minimum price legally determined by the government
to prevent prices of goods from falling below the minimum price that has
been set. The price floor will benefit producers because their income would be
protected, since the prices of goods sold ,-vill be higher than the market price.
Ho,-vever, the consumers would be worse off since they have to pay more for
the goods and services. The concept of minimum wage is an exa1nple of price
floor or minimum price.
Indirect tax as well as subsidy are non-price controls implemented by the
government. Indirect tax is levied by the government on producers and the
burden of paying this tax is shared by both the producers and consumers.
Indirect tax will cause the costs of production to rise and discourage the supply
of goods and services. The prices of goods ,-vill increase, while quantity will
reduce. The tax incidence depends on the elasticity of demand and supply.
When demand is less elastic than supply, consumers are liable for more tax
burden coinpared to producers. On the other hand, when demand is more elastic
than supply, producers are entitled to pay more tax rather than consumers.
Subsidy is an incentive or aid implemented by the government to encourage
production of goods and services. When subsidy is imposed, production costs
will reduce and therefore the supply of goods and services will increase. The
prices of goods will reduce, whereas the quantity will increase. The benefits of
subsidy are also shared by both the producers and consumers and this depends
on the elasticity of demand and supply as well. Consumers will receive more
benefits of subsidy ,vhenever the demand is less elastic than supply. Conversely,
producers will enjoy 1nore subsidy ,vhen de1nand is n1ore elastic than supply.
Islam recognizes the determination of the equilibrium price and quantity
by market forces. The intersection of demand and supply will determine the
price and quantity to be sold in the market and this is considered justice in
Isla1n. However, price control is not promoted in Islam since it may harn1 either
the consumers or producers. Government intervention in fixing the price is
permissible only if there is a necessity and social ,-velfare is being disrupted.
• Market equilibrium is a situation ,.vhere quantity demanded equals
quantity supplied, and there is no tendency for price and quantity to
increase or decrease. •

-
•

• Shortage (excess demand) is a condition, whereby the quantity den1anded

is greater than quantity supplied and there would be an upwards pressure
for price to increase towards the equilibrium price.
• Surplus (excess supply) is a situation when the quantity demanded is
less than quantity supplied (i.e. quantity supplied is greater than quantity
demanded) and there would be a downward pressure for price to reduce
towards the equilibrium price.
• The market equilibrium will change as demand an.d supply change.
• When demand increases but supply remains unchanged, both equilibriwn
price and quantity ,.vill increase, and vice versa.
• As supply increases and de1nand is unchanged, the equilibrium price will
reduce, whereas the equilibriwn quantity ,.vill rise; the reverse is true.
• If both demand and supply increase at the same proportion, the equilibrium
price will remain unchanged, but the equilibrium quantity will increase;
the opposite is true.
• When demand increases and conversely supply reduces proportionately,
the equilibriun1 price will rise, but equilibrium quantity will remain
unchanged, and vice versa.
• Two types of price controls: price ceiling and price floor.
• Price ceiling is a maximum price set legally by the government to prevent
prices of essential commodities from rising above the maximum price.
• Price floor is a minimum price legally established by the government to
help producers, especially farmers, by preventing prices of agriculture
products from reducing below the minimum price.
• Two kinds of non-price controls: indirect tax and subsidy.
• Indirect tax is one kind of tax imposed by the government on producers,
who might pass the burden of paying tax to consumers.
• The effects of indirect tax would be a decrease in supply and, therefore,
price ,.viii increase but quantity will reduce.
• Consumers are liable to pay more tax when the demand is inelastic
(demand is less elastic than supply).
• Producers will bear more tax burden when the demand is elastic
(demand is more elastic than supply).
• Subsidy is an aid or incentive fro1n the government to producers to
encourage the production of goods and services.
• When the government increases the provision of subsidy, supply will
increase due to reduction in the production costs and, thus, price ,.vill fall
and quantity ,.vill increase.
• Consumers will enjoy more benefits of subsidy when the demand is
inelastic.
• Producers will receive more benefits of subsidy when the demand is elastic.
 • Market • Price control • Minimum wage
• Market equilibrium • Price ceiling/Maximum • Non-price control
• Shortage price • Indirect tax
• Surplus • Price floor/Minimum • Subsidy
price

+ Exercises

Multiple-choice Questions
Answer the following questions.

1 If the price is below the equilibrium price, C leftwards; increase

there would be the problem of D leftwards; decrease
and the price will towards the
equilibriun1 price. 5 What ,-vould be the effect if the govern1nent
A surplus; increase reduces the subsidy given to farmers?
B shortage; increase A Supply of agriculture produce will
C surplus; decrease mcrease.
D shortage; decrease B Demand of agriculture produce will
increase.
2 When price reduces towards the equilibrium C Demand of agriculture produce will
price, the problem of will be resolved. decrease.
A surplus D Supply of agriculture produce will
B shortage decrease.
C excess demand
D unstable price 6 A severe flood caused serious damages to
vegetable crops. This will result in the
3 An increase in the number of buyers in the A demand for vegetables to drop.
market ,.vill cause B supply for vegetables to drop.
A movement along the demand curve. C quantity demanded of vegetables to drop.
B movement along the supply curve. D quantity supplied of vegetables to drop.
C the supply curve to shift rightwards.
D the demand curve to shift rightwards. 7 Market equilibrium is a situation where
A price is higher than the equilibrium price.
4 A sales tax on cigarettes imposed by the B quantity demanded is greater than
government will make the supply curve shift quantity supplied.
and the price to C quantity demanded equals quantity
A rightwards; increase supplied.
B rightwards; decrease D price is lower than the equilibrium price.
 8 Which of the following situations is likely 11 What is the price and quantity after tax?
,-vhen price ceiling is i1nposed by the A USD13; 7 units
government? B USDll; 7 units
A Quantity demanded becomes greater C USD13; 5 units tr:I
than quantity supplied.
B Quantity supplied becomes greater than
D USD15; 5 units
-·--·
,Q
C

quantity demanded. 12 What is the per unit tax paid by a ..,-·

tr
C Consumers would have to pay higher consumer? C
prices than the market price. A USD2 C USD4
D The producers' income is protected. B USD3 D USDS

9 Hoarding is an activity that tends to occur
when
A price is set higher than the equilibrium
price.
B the price ceiling is set by the
government.
C the price floor is set by the government.
D no price regulation is set in the market.
10 Suppose the government in1ple1nents a
minimum price for fishery products. Which
of the following situations is true?
A The price for fishery products will
increase.
B Quantity demanded for fishery products
will increase.
C The demand curve for fishery products
will shift to the right.
D The supply curve for fishery products
will shift to the right.
Questions 11 to 13 are based on the diagram.
13 Ho\v much is the government revenue
collected by the government?
A USDlO C USD30
B USD20 D USD40
14 Consumers pay more tax burden ,.vhen
A demand is less elastic than supply.
B demand is more elastic than supply.
C demand is perfectly elastic.
D supply is perfectly inelastic.
15 If the price of goods increases, the demand
for their substitutes would
A ren1ain unchanged.
B cause movement along the demand
curve.
C shift to the right.
D shift to the left.
Questions 16 to 18 are based on the diagram.
p

b S
P (USO)

Po ••••••••••••••
C
15 ------------ Eo a d
'
13 ------- -----:----- E Do
1

I 6 Which of the following factors causes the

11 -- ---------

D
demand curve to shift fron1 DO to D 1?
A An increase in tastes and preferences
o'-----'---'- -------- Q (Unit) B A decrease in income
5 7 C An increase in technology
D A decrease in the nu1nber of buyers
17 What causes the movement from point a to
point b?
A An increase in the number of sellers
B An increase in the price of own goods
C A decrease in technology
D A decrease in indirect taices
18 Which of the following situations results in
the reduction of advertisement?
A Movement from point a to b
B Move1nent from point b to c
C A shift from point c to d
D A shift from point d to c
19 Which of the following statements is
correct?
A If demand is perfectly inelastic, buyers
will pay the entire tax.
B When the supply curve shifts
rightwards, the equilibrium price and
quantity ,.vill both increase.
C If the demand curve shifts left,-vards, the
equilibrium price will increase and the
equilibrium quantity will decrease.
D When the supply curve is perfectly
elastic, producers pay the entire taic.
20 Suppose there is a shortage of football
match tickets, we can predict that
A the price of the football match tickets
will fall.
B the quantity of football match tickets
sold and purchased are the same.
C the price of football match tickets will
rise.
D the quantity demanded for football
match tickets will be less than the
quantity supplied.

Short-answer Questions
Answer the following questions.
I The table shows the market demand and supply schedules for rubber in Malaysia.

Price (USD/kg) ! Quantity Demanded (kg) i Quantity Supplied (kg)

100 5,000 500

200 4,200 1,000
300 3,100 1,600
400 2,000 2,000
500 1,500 3,200
600 500 4,400

(a) Draw the market demand and supply curves for rubber using graph paper.
(b) Determine the equilibrium price and quantity of rubber?
(c) What will happen if the government fixed the price of rubber at USDSOO? How much is tl1e
shortage or surplus? What is the price control implemented by the government?
(d) In a separate diagran1, show and explain the effects of an increase in technology on the
production of rubber.
2 The diagram shows the de1nand for and supply of smartphones. The government
imposed an indirect tax as represented by the leftwards shift fro1n S0 to S 1 in the supply
curve.
tr:I
P (USD)
-·-·
,Q
C

..,-·
s, tr
C

11 --------------, E1
1 0 ---------- --->-----
' '
s --- ----------
D

(Unit)
o � - - ,- �
00- -�1 5-
-0 - - - - -+ - Q
(a) Determine the equilibrium price and quantity before tax?
(b ) Deter1nine the equilibrium price and quantity after tax?
(c) Calculate the tax per unit liable by the consumer and producer?
(d) What is the total tax revenue collected by the government?
(e) Based on the above diagram, who pays more tax? Justify your answer.
3 The table shows the quantity of petrol den1anded and supplied at different prices.

Price (USO/Litre) Quantity Demanded (Litre) Quantity Supplied (Litre)

1.50 200 100

2 170 125
2.50 150 150
3 130 200
3.50 110 250
4 90 300

(a) Plot the demand and supply curves for petrol using graph paper. State the
equilibrium price and quantity.
(b) Suppose the government imposed a sales tax ofUSD0.50 per litre:
(i) Sho,-v the effect of the sales tax on the market equilibrium of petrol using
the same diagram in (a).
(ii) Determine the new equilibrium price and quantity.
(iii) Calculate the amount of tax paid by both the consumers and producers.
(c) Sho,,v the effect of an increase in the price of petrol on the demand for cars in a
separate diagram.
4 The table shows the hypothetical demand and supply schedules for rice i11 a market.

Price (USO/kg) Quantity Demanded (kg) Quantity Supplied (kg)

11 50 600
10 220 560
9 300 510
8 360 470
7 400 400
6 450 280
5 500 120

(a) Draw the demand and supply curves for rice using graph paper.
(b) State the equilibrium price and quantity for rice.
(c) Suppose the governn1ent i1nplements a subsidy that "vould increase the supply of
rice by 100 kg at each price level, show the effects in the same diagram in (a).
(d) Determine the new equilibrium price and quantity of rice.
(e) State the benefit(s) of the subsidy received by the consumer and producer.
5

Price
•
-.
The table shows the individual demand and supply schedules for durian in a market.

:y ded (kg) Quantity Supplied (kg)

(USO/kg) I I
Abby Lisa Leena Firm A Firm B Firm C

2 20 30 50 2 5 13

4 18 26 46 8 10 32
6 12 20 38 10 20 40
8 8 14 18 26 36 58
10 2 8 10 32 48 80

(a) Plot the market de1nand and supp•ly curves for durian based on the information
provided.
(b) Determine the market equilibrium price and quantity for durian.
(c) Suppose the government imposed USD4 as the price control:
(i) What is the price control i1nplemented by the government?
(ii) Detern1ine whether there \.Vill be a surplus or shortage of durian in the
market.
(iii) Calculate the amount of surplus or shortage.
(d) Show the effects of the foll0\.\1ing factors on the 1narket for durian using a separate
diagran1:
(i) The government increased the subsidy given to durian producers.
(ii) The preference for durian among consumers increased.
(iii) The durian season has ended.
Essay Questions
Answer the following questions.
1 Explain the effects of tax incidence on consun1ers and producers when the den1and is
inelastic using a suitable diagram.
-·--·
tr:I
,Q
2 With the aid of a diagram, discuss what maximum price is. Discuss two benefits and
C

two negative impacts of implementing a price ceiling. ..,-·

tr
3 Explain in detail the imposition of a price floor using a suitable diagram. Explain two C
advantages and two disadvantages of implementing such a price control.
4 Explain the effects of each situation below on the market demand and supply using
suitable diagrams:
(a) A new skirt design ,vhich increases the preference for the Asshanas clothing
brand among teenagers.
(b) A government ban on the supply of meat from Ne,,v Zealand.
(c) The increased price of chicken feed and how this affects the chicken market.
(d) The effects of the Goods and Services Tax (GST) on smartphone purchases.
5 What is market equilibrium? Using an appropriate diagran1, explain the effects of a
subsidy on the equilibrium price and quantity.
6 Discuss the concept of price control from an Islamic perspective.
Theory of
Consumer
Behaviour
At the end of this chapter, you should be able to:
gJ
E • Explain total utility and marginal utility.
8 • Define and explain the law of marginal utility.
-
::s • Differentiate cardinal and ordinal utility.
0
t:n • Describe the indifference curve and its properties.

·e
S::

�
• Describe the budget line and its properties.
• Explain how consumer's equilibrium is achieved.
.!

Utility is the satisfaction a
consumer receives from
consuming a product.
Total utility is the total
satisfaction from the amount of
a product consumed.
Marginal util ity is the change
in satisfacti on, resulting from
consuming an add,tional
amount of goods or services.
A util is an arbitrary unit of
utility.
I n Chapter 2, we have discussed the determinants of market demand
and learned how to derive the market demand curve. Market
demand curves represent the demand decisions at different prices
for all the consumers or households in the market. A consumer is an
individual while a household consists of one or more individuals.
In this chapter, we will examine individual demand or the demand
of a single consumer within the market. We will walk through a formal
study of microeconomics by examining the economic behaviour of the
consumer. The consumer is the basic economic unit that determines
which goods are purchased and how much (the quantity).
What factors influence consumer decisions and choices? Why do
consumers purchase some goods and not others? How do they decide
how much of each good to purchase? What is the aim of a rational
consumer in spending income? These are some of the important
questions that need to be explained.
5.1 UTILITY ANALYSIS
In this section, vve will discuss the meaning of utility, distinguish
between total utility and marginal utility, and exa1nine the important
differences between cardinal and ordinal utilities. The concept of
utility is used here to describe the consumer's satisfaction that is
obtained from product consumption.
5.1.1 Total Utility and Marginal Utility
The analysis of consumer tastes is a crucial step as tastes cannot be
measured quantitatively and explicitly. Hence, utility theory of demand
was introduced in the early 1870s, by William Stanley Jevons of Great
Britain, Carl Menger of Austria and Leon Walras of France. Utility
is the satisfaction a consumer receives from consuming a product.
Total utility (TU) refers to the total satisfaction from the amount of
that product consumed. Meanwhile, marginal utility (MU) refers to
the change in satisfaction, resulting from consuming an additional
amount of goods or services.
Let us imagine a thirsty man (consumer) who drinks one glass of
watermelon juice per day. This consumption gives the consumer a total
utility of 15 utils, where a util is an arbitrary unit of utility. For each
additional glass of water1nelon juice consu1ned, total utility will keep
increasing w1til the fifth glass, resulting in the utility amount being
unchanged. Consuming the sixth glass of watermelon juice then leads
::r
�

(I)

to a decline in total utility because of storage or disposal problems.

-
0

This information is shown in the total and marginal utility schedules

�

0
in Table 5.1. The third column of the table shows the marginal utility, C"l
resulting fro1n the consumption of each additional glass of watern1elon 0
::,
juice. Marginal utility is positive but declining until the fifth glass of rn
watermelon juice, for which it is zero, and becomes negative for the sixth
s::
glass of watermelon juice. (I)
..,
m
(I)

-·
Table 5.1
Watermelon Juice Total Utility Marginal Utility
Total and marginal utility
(per Glass) (TU) (MU)
schedules 0
0 0
s::
..,
1 15 15
2 25 10
3 31 6
4 35 4
5 35 0
6 33 -2

From the values given in Table 5.1, we can illustrate the total utility
curve and marginal utility curve as shown in Figure 5.1. The total and
marginal utility curves are derived by joining the midpoints of the bars
n1easuring TU and MU at each level of consumption. We can observe
the TU increasing at a steeper to flatter rate (smaller amount) and so the
MU declines in tandem. After consuming the fourth glass of watermelon
Satiation happens when
no more utility can be
juice, the consu1ner reaches the satiation point and MU is zero. Satiation gained, and any further
occurs when no n1ore utility can be gained, ,vhereby any further consumption will yield onl y

consumption will y ield only disutility. Even if the watermelon juice is

disutil ity.

free to the consumer, it would be irrational for the man, "¼7h o is now no
longer thirsty, to drink a sixth glass. He would also experience negative
marginal utility as an outcon1e. The negative slope or do,vnward-to­
the-right inclination of the MU curve reflects the law of diminishing Law of diminishing
marginal utility. marginal utility states

Law of diminishing marginal utility states that the utility gains for
that the utility gains for

the consumer from successive units of a particular product diminishes

consumer frorn successive
units of a particular
as total consumption of the product increases, while the consumption of product din1inishes as
all other products remains constant.
total consumption of the
product increases, while the
consumption of all other
products remains constant.
lO Figure 5.1 Total utility (TU)
Total and marginal utility curves
35

.c: 31
TU
u 25
''
-·
-- ',. --- - '
''
''

15 ''
- - 1 - - - -- -

''

Glasses of
L--'--- - - - - -
+-- - - --+ watermelon
-
1 2 3 4 5 6 juice

Marginal
utility (MU)

',• Diminishing
'

- - '.' marginal
:. ', utility
Point
'' -

of
'

15
satiation
10 Glasses of
/.--: ..:..._
6
o 1--!,__-�_..:........;:1-...::::..,oe-�S :-- _ _. watermelon
1 2 3 juice
MU

In Figure 5.1, the upper panel shows TU ,vhich increases as

consumption of output increases. However, TU increases at a lower rate
as shown by the reducing size of the dotted box area and, thus, the MU
curve declines in the lower panel. Total utility becomes constant ,vith the
consumption of the five glasses of watermelon juice, and so MU is zero.
After the five drinks, TU declines and MU becomes a negative value.

5.1.2 Cardinal Utility and Ordinal Utility

Cardinal utility states that uti'ity
can be measured by attaching
specific values or numbers of
utils to the consumption of a
good or a basket ofgoods.
Ordinal utility states that util ity
is not measurable, but can be
ranked.
Cardinal utility states that utility can be measured by attaching
specific values or numbers of utils to the consumption of a good or
a basket of goods. As an exan1ple, in earlier Table 5.1, we identified
that the individual received 15 utils from consuming one glass of
watermelon juice. He then received 25 utils, or 10 additional utils,
from consuming two glasses of ,vatermelon juice. Therefore, Table
5.l and Figure 5.1 reflect cardinal utility-they essentially provide an
index of satisfaction for the individual.
On the other hand, ordinal utility states that utility is not measurable,
but can be ranked. Ordinal utility specifies that consuming two glasses of
watermelon juice gives the individual more utility compared to consuming
one glass of the san1e drink. However, it does not specify exactly how much
additional utility the second glass ofwatermelon juice provides. Similarly,
someone may say that a glass of orange juice gives more utility than a glass
of watermelon juice, but not how many utils is received.
5.2 ORDINAL APPROACH ::r
�

The ordinal approach provides us with alternatives in utility

(I)
0
measurement, apart from cardinal utility. Cardinal theory assumes
that utility can be measured in units. In fact, consumers do not
0

measure utility. Instead, it is more common for consumers to state if 0

they prefer one good to another. As an example, rather than saying ::,
rn
that orange juice provides 10 utils, the consumer v.1ill simply say that s::
he/she prefers to drink orange juice instead of ,-vatermelon juice, (I)

whereby the watermelon juice gives 8 utils.

..,
m
Ordinal utility is a view of utility measurement based on the (I)

presun1ption that the satisfaction of ,-vants and needs is immeasurable

and subjective. Preferences for goods can be ranked (first, second, third,
-·
0
etc.), but not measured according to a specific number or index. In this s::
..,
regard, consu.mers need only specify whether one good is more or less
preferred to another. Ho,-v n1uch more or less a good is preferred is not
important.

5.2.1 Indifference Curves

The ordinal ranking of preferences provides a solid theoretical basis for
the analysis of market demand and the law of demand using modern
indifference curve analysis. For this reason too, many economists
prefer to use indifference curve analysis, ,-vhich does not require the
actual measurement of utility.
An indifference curve sho,-vs the various combinations of two goods
that give the same level of satisfaction. The consun1er is said to be An indifference curve shows

indifferent between any two combinations represented by points on an

the various corr1binations
of two goods that give the
indifference curve, meaning the combinations are all equally preferred. same level of satisfaction.
Before we discuss the way an indifference curve is derived fron1 an
indifference schedule, there are four assumptions that need to be looked
into.
Assumptions of the Indifference Curve
I Ability to rank preferences
The ability to rank preference means that a consumer is able to say
which option is preferred when given a choice. For example, when
a consumer is faced with any two baskets of goods, the consumer
can determine whether he/she prefers basket A to !basket B, B to A
or is indifferent between the t,,vo options.
2 Tastes of consumer which are transitive
We assume that the tastes or preferences of the consumer are The Oxford Dictionary of
consistent or transitive. This transitive relation (quality of being Economics (2003) defines
transitive) can be described as such: If the consumer states that
'transit ive relation' as
'a relation, denoted by R,
he/she prefers basket A to basket B, and also basket B to basket C, such that if ARB and BR C,
then that consumer ,-vill prefer A to C. then A RC'.

3 Non-satiation
This situation means that consumers are never satiated or satisfied.
Of two given baskets of goods, they will choose the basket that has
 more products, not the one with less. l11 other words, they will
consider themselves better off if they choose the forn1er basket.
Assun1ing basket A contains five apples and five oranges while
.c: basket B has five apples and four oranges, the consumer will opt
u for basket A.
4 Diminishing marginal rate of substitution
The marginal rate of substitution (MRS) is an assumption that a
consumer is willing to give up fewer units of another product as
he/she gets additio11al units of one product while maintaining the
same level of satisfaction. In the following Table 5.2, for example,
\.Ve can see that when the consumption of Good X is increasing,
fewer Good Ywill be given up.

Indifference Schedules and Curves

Let us assume that a consun1er consu1nes two goods, which yield equal
total satisfaction, as shown in Table 5.2.

Table 5.2
Combination Good X Good Y
Indifference schedule I
A 1 11

B 2 7

C 3 4

D 4 2

E 5 1

Fron1 the infor1nation in Table 5.2, we can portray the con1binations

of Good X and Good Yin an indifference curve as shown in Figure 5.2.

Figure 5.2 GoodY

Indifference curve
11

10

7
6

5
4
3
2

1 E
Good X
1 2 3 4 5
 Toe individual is indifferent towards combinations A, B, C, D ai1d E,
as all five combinations give him/her equal total satisfaction.
::r
�

(I)

-
0

Characteristics of Indifference Curves �

0
1 Indifference curves do not intersect C"l
Indifference curves are parallel and will not intersect vvith each 0
::,
other, due to the assumption of non-satiation and transitivity. rn
s::
GoodY (I)
..,
Figure 5.3
Indifference curves do not m
(I)
intersect

-·
0
s::
..,

12
.__ _:____... Good X
__________

Figure 5.3 shows indifference curves 11 and 12, and point C

where they intersect. This overlap of curves is not possible. By
using the non-satiation assumption, we can say that point A is
preferred to point B. Ho,,vever, since points B and C lie on the
same indifference curve (11), the consumer is in,different to the
combinations. This is because the utility derived at point C yields
the saine level of satisfaction [ (A = C) and (B = C)] which violates
the assumption of non-satiation and transitivity.
2 Higher indifference curves are preferred to lower indifference
curves
Every con1bination on an indifference curve yields the same level
of utility. If the an1ount of goods consumed increases, the utility
derived from the consumption also increases and the consumer will
move to a new indifference curve which represents a higher utility.

GoodY Figure 5.4

Higher indifference curves
represent higher levels of
satisfaction

,_____ 12

,_____ 11

'-- - - - - - - - - - -
---+ Good X

Figure 5.4 shows three indifference curves which yield different

levels of satisfaction. 12 indicates a higher level of satisfaction than
11, but a lo,,ver level compared to 13.
132

lO 3 Indifference curves are negatively sloped

Trade-off between one good
Marginal Rate of Substitution
The most important property of an indifference curve is the slope
and another while remaining down,,vard from the left to the right. In other words, the slope
on the same indifference curve.
.c: shows the amount of one good that is given up to get an additional
u unit of another good. The slope of the indifference curve is kno,,vn
as the marginal rate of substitution (MRS). Hence, the MRS is
the trade-off between one good and another while remaining on
the same indifference curve.
4 Indifference curves are convex to the origin
Indifference curves are usually convex to the origin. The convexity
of the curve reflects the marginal rate of substitution, i.e. the rate
at which the consumer must sacrifice units of one good in order to
obtain one more unit of another good.

Figure 5.5 GoodY

Indifference curves are convex
to the origin A 4unitsofY
11 -
\
B 3 units ofY
7

' �C 2 units ofY

4 -
----- ------
: '-::.. 0 1 unitofY
' ' '-•
' ' '
'
2 ------,------•------ �E

' '
1 -----�------�------�----- --.-

- ► Good X
-;-

L- -'--
- ---'-'_ _
__;__ _,_ _ --'-
1 2 3 4 5

Figure 5.5 shows that with each increase in units for X, we

have to decrease the consumption ofY in order to obtain the same
level of satisfaction. As the consumer moves from A to B, B to C,
then C to D, the indiividual is willing to give up less and less ofY to
obtain each additional unit of X.
5 Indifference curves do not touch the Y -axis and X -axis
One of the basic assumptions of an indifference curve is that the
consun1er purchases combinations of different commodities. He/
She is not supposed to purchase only one commodity. In the event
of such cases, the indifference curve ,,vill touch one axis. This
violates the basic assumption of indifference curves.

GoodY
Figure 5.6
Indifference curves do not
touch t h eY -axis and X -axis
A

o _;::::...:B::.._ ► Good X
-
L________
 In Figure 5.6, it is shown that the indifference curve 1 1 touches
both Y and X axes. At point A, the consumer purchases only OA
::r
�

(I)

units of Good Y, without any Good X. Similarly, at point B, the

-
0

consumer buys OB quantity of Good X, ,-vithout any Good Y.

�

0
Hence, 11 goes against the basic assumption-it is hypothetically C"l
supposed to show a con1bination of two goods. 0
::,
rn
s::
5.2.2 Budget Line
In the earlier section, we have learned how consumers' preferences can (I)
..,

be explained through the indifference schedule and curves. However, m

the theory of indifference curve only specifies the utilities gained from
(I)

the combinations of two goods without allowing the factors of income

limitation. Thus, in this section, we ,.vill deliberate further the theory
-·
0
s::
..,
of consumer behaviour using i11difference along with 1the budget line.
A budget line indicates the various combinations of 1two goods that a
constuner can purchase with a given amount ofincome. The budget line,
A budget line indicates the
various combinations of
thus, represents the budget constraints faced by the consumers. Let us tvvo goods that a consumer
assume the following: can purchase with a given
amount of income.
Px = Price of Good X
Qx = Quantity of Good X
PY = Price of Good Y
QY= Quantity of Good Y
I = Consumer's monetary inco1ne

GoodY Figure 5.7

A consumer's budget line

25 A (0, 25)

Budget line

B(20, 0)
,...__________,,____. Good X
0 20

Suppose that Px= USDS, Pv= USD4 and I= USDlOO. By spending

all inco1ne on Good Y, the consu1ner would purchase 25Y and OX. This
is denoted by endpoint A on the vertical axis of Figure 5.7. Alternatively,
by spending all income on X, the consumer would purchase 20X and
OY. This is denoted by endpoint B on the horizontal axis. By joining
endpoints A and B with a straight line, we will get the consumer's budget
line.
By assuming that a consun1er spends all of his/her income on Good X
and Good Y, ,-ve can express the budget constraints as: PxQ x + PYQY= I
lO Changes in the Budget Line
A particular budget line refers to a specific level of the consumer's
income and specific prices of two goods. If the consumer's income
.c: and/or the price of Good X or Good Y change, the budget line will
u
also change.
I Changes in consumer's income
If the consumer's income rises or falls while the prices remain
constant, this ,-vill cause the budget line to move in a parallel
manner.
Figure 5.8 shows the shifting of an initial budget line
represented by AB. A decrease in the consumer's income will
shift the budget line leftward to A1B 1, ,-vhile an increase in the
consumer's income will shift the budget line rightward to A2B2 .

Figure 5.8 GoodY

Changes in consumer's income
and how the budget line shifts

L _
_
_ _
___:,.__ _
....o._
B
_ _�--+ Good X
B2

2 Changes in the price of goods

(a) Price of Good X (Px) changes
In the case where only Px changes, the vertical or Y -intercept
remains constant and unchanged. The budget line will shift
leftward if Px rises and will shift rightward if Px falls.

GoodY GoodY
Figure 5.9
Shifting of budget line I= USDlOO I= USDlOO
when Px changes Py= USD4 Py = USD4
25 'A 25 A
'' Px changes from - -- Px changes from
'
'' USDS to USDlO -- USDS to USD2.50
'' - --
-' --
'' -
\ +- � ',, -
L _ '- _
_ _ _..o...:B:.._ B .......
_ :....._
► Good X .__
_ .,__
_ _ � �Good
_ - X
10 20 20 40
 (b) Price of Good Y (Py) changes ::r
�

In the case where only PY changes, the horizontal or (I)

X-intercept ren1ains constant and unchanged. The budget

-
0

line will shift downward if PY rises and will shift upward

�

0
if PY falls. C"l
0
::,
Figure 5.10 rn
GoodY
I= USDlOO
GoodY
I= USDlOO Shifting of budget line
s::
Px = USD5 Px = USD5 when Pv changes
25 A 50
Py changes from
'
--- Py changes from
(I)
..,
m
t-- - t
USD4toUSD10 - -- - USD4to USD2
-- - (I)
--
-·
10 25
-'-
- .... 0
s::
'
..
.. B ,B
20
GoodX
20
GoodX
..,

(c) Both prices of Good X (Px) and Good Y (Py) change

In the case where both the prices of Goods X and Y changes,
the vertical and horizontal intercepts ½'ill be changed
simultaneously. These changes will correspond with the
points stated in (a) and (b) above.

GoodY GoodY Figure 5.11

I= USDlOO I= USD100 Shifting of budget lines when
Px changes from Px changes from both Px and Pv changes
25 A 50 'B

t t \,
USD5 toUSD2.50 ' USD5 to USDlO
Py changes from Py changes from
USD4 to USDl 0 ' USD4to USD2
10 -� - 25 A
-
A - -,--- B _ __,_.::..... -,-....:::,,,;..,;,A_
--'---- -► ..,:,.,: ::...._ ---+- GoodX .__ _,.GoodX
'--- -"-'
20 40 10 +- 20

S.2.3 Consumer Equilibrium

In this section, we will bring together the tastes and preferences of
the consumer (given by his/her indifference curves) and the income
and price constraints faced by the consumer (given by his/her budget
line) to examine how the consumer can determine which goods to
purchase and in what quantities, in view of n1aximizing his/her utility
or satisfaction.
Consumer equilibrium is attained when a consumer chooses a Consumer equilibrium is
combination of goods that maximizes his/her utility at a given level of attained when a consumer
income. This can be explained when a consumer's budget line is tangent chooses a combination of

to the indifference curve.

goods that maximizes his
utility at a given level of
income.
lO Figure S.12 GoodY
Consumer equilibrium

.c:
u p

The consumer maximizes A

utility or achieves his or her
equilibrium at point E, where
the indifference curve 11 is
Ye ------
tangent to the budget line
PO. Indifference curve 12 is the
highest that the consumer can
reach with his or her budget
line.Thus, the consumer should
consume Xe and YE.
'-- - - - -'- - - - - --"
-- - --+ Good X
0 Xe Q

A rationale consumer will choose a combination on the highest

indifference curve possible, given by his/her budget line. In Figure 5.12,
the point C ,vhich is at the indifference curve 13 denotes the highest level
of utility compared to 1 1 and 12 • However, point C is unattainable because
of the budget constraint, i.e. it lies outside the budget line, PQ.
The only possible combinations will be points A, B and E which
converge with the budget line, PQ. Since points A and B lie on the lower
indifference curve 11 , the consumer will maxin1ize the utility at point E,
where the indifference curve 12 is tangent to the budget line, PQ. Thus, the
consumer is said to be in equilibrium at point E, with XE and YE quantity.

The study of the economic behaviour of the consumer is significant in the

derivation of market demand. The study can be carried out by examining the
consumer's tastes. The consun1er's tastes can be related to utility concepts or
indifference curves. According to the cardinal theory, utility provides an index
of satisfaction for a consumer, whereas the ordinal theory only ranks various
consumption bundles.
Indifference curves are a crucial tool of analysis because they are used to explain
ordinal theory. An indifference curve shows the various con1binations of two
goods that give the consumer the same level of satisfaction. Higher indifference
curves refer to greater satisfaction levels as compared to lo,-ver indifference curves.
Meanwhile, the budget line shows the various combinations of two goods that a
consumer can purchase with a given a1nount of inco1ne.
When the indifference curves are combined ,-vith a budget line, the consumer
equilibrium can be attained. Consumer equilibrium is attained when a consumer
chooses a combination of goods that maximizes his/her utility at a given level of
income. This can be explained when a consun1er's budget line is tangent to the
indifference curve.
• Utility is the satisfaction a consumer receives from consuming a product.
• Total utility refers to the total satisfaction from the amount of that product
consumed.
•

-
•

• Marginal utility refers to the change in satisfaction, resulting from

consuming an additional amount of goods or services.
• Util is an arbitrary unit of utility.
• Satiation occurs when no more utility can be gained, whereby any further
consumption ,.vill yield only disutility.
• Law of di1ninishing marginal utility states that the utility gains for the
consumer fron1 successive units of a particular product ditninishes as total
consumption of the product increases, while the consumption of all other
products remains constant.
• Cardinal utility states that utility can be 1neasured by attaching specific
values or numbers of utils to the consumption of a good or a basket of
goods.
• Ordinal utility states that utility is not measurable, but can be ranked.
• An indifference curve shows the various combinations of two goods that
give the sa1ne level of satisfaction.
• Four assumptions of indifference curves: Ability to rank preferences,
tastes of consumer which are transitive, non-satiation, and diminishing
1narginal rate of substitution.
• Five characteristics of indifference curves: Indifference curves do not
intersect, higher indifference curves are preferred to lower indifference
curves, indifference curves are negatively sloped, indifference curves are
convex to the origin, and indifference curves do not touch the y -axis and
x-axis.
• A budget line indicates the various con1binations of two goods that a
consumer can purchase with a given amount of income.
• Consumer equilibrium is attained when tJ1e consumer chooses a
con1bination of goods that maxin1izes his/her utility at a given level of
income. This can be explained when a consumer budget line is tangent to
the indifference curve.

+ Key concepts

• Utility • Satiation • Ordinal utility

• Total utility • Law of di1ninishing • Indifference curve
• Marginal utility marginal utility • Budget line
• Util • Cardinal utility • Consumer equilibrium
lO
.c:
u Multiple-choice Questions
Answer thefollowing questions.
1 According to the la,-v of diminishing
marginal utility, the marginal utility
associated with consuming successive units
of a good will
A increase as the amount consumed
decreases.
B remain constant as the amount consumed
increases.
C eventually decline as the amount
consumed increases.
D eventually increase as the amount
consumed increases.
2 When 1narginal utility is decreasing but
positive, total utility is
A increasing at a decreasing rate.
B increasing at an increasing rate.
C decreasing at a decreasing rate.
D decreasing at an increasing rate.
3 An indifference curve explains
A the maximum utility that can be achieved
for consuming a product.
B the maximum utility that can be achieved
for a given budget.
C the combination of two goods giving
equal utility to a consumer.
D the best number of consun1ption between
prices of good.
4 The study of consumers as they exchange
something of value for a product or service
that satisfies their needs ,vith their scarce
income is the definition of- - -
A production theory
B market demand
C the law of de1nand
D consumer behaviour
5 When the second glass of orange juice does
not provide as much satisfaction as the first
glass of orange juice, this illustrates_ __
A opportunity cost
B diminishing marginal utility
C the budget line
D consumer equilibrium
6 Which of the following statements is correct?
A The indifference curve is up,-vards
sloping.
B The indifference curve is convex to the
or1g1n.
C If an indifference curve touches the Y -or
X -axis , this means utility is maximum.
D An indifference curve may intersect with
other indifference curves.
7 The graph shows part of a consun1er's
indifference map for units of Good X
and Good Y, where 11 and 12 represent
indifference curves.
GoodY
D
-------1,
• C
A
'-- - Good X
----------
Which of the following statements is correct?
A The consun1er prefers A to D.
B The consumer prefers C to D.
C The consumer prefers C to B.
D The consumer prefers D to B.
8 In the graph, AA is the initial budget line 12 When the price of X is USD4 and tl1e price
and BB is the new budget line. Which of the of Y is USD 10, ,¥hich of the follo"ving
::r
�

(I)
following changes might have occurred? combinations ,.vould be the intercept of axes
-
0

(X, Y) if you have an income ofUSDIOO?

�

GoodY 0
A (lOX, 25Y) C (20X, SY)
B (SX, 20Y) D (25X, lOY)
C"l
A
::,
0
rn
13 s::
Good A (I)
..,
B
m
(I)

'-- - -
A ➔ -- -- ---- B
-'--- - - ..:.......
--+ Good X
A
-·
0
s::
A Pxdecreased, PY is constant, income ..,
increased.
4

B Pxincreased, PY decreased, income is

constant.
C Px decreased, PY increased, income is '--
Y*
----''-- - ---'"-,---
-
8
-
- + Good B
constant.
D Pxis constant, PY increased, income Assume the consumer's income is USD80,
decreased. calculate the value of Y* if the price of A is
USDIO and the price of Bis USD20.
9 A parallel leftward shift of a consumer's A 5 units C 3 units
budget line could indicate that B 4 units D 2 units
A the price of both goods have decreased
in the same proportion. 14
B the price of one product has increased in Good A
relation to the other.
C the consumer's income has decreased.
D the marginal utilities derived from both
products have decreased.

10 An increase in the income of a buyer will

n1ove his/her
A budget line to the right.
B budget line to the left.
B

C indifference curves to the left. L--------�----► Good B

D indifference curves to tl1e right. Which of the following statements is correct

about the diagram?
11 Total utility is maximum when marginal
A The consumer prefers B to A.
utility is
B The consumer prefers A to B.
A positive.
C Points A and Byield the same level of
B zero.
satisfaction.
C maximum.
D Bis a point of consumer equilibrium.
D negative.
lO 15 When an indifference curve is tangent to C USDl.50
the budget line, it means that D USD2.00
A buyers are satisfied with the product.
.c: B buyers have spent all their income, but 17 The price of X at point B is ____
u not maximizing their total utility. A USDS.00
C buyers have not spent all their income, B USDS.50
yet maximized their total utility. C USDl0.00
D buyers have spent all their income and D USDl0.50
maximized their total utility.
_
18 The price ofX at point A is_ _ _
Questions 16 to 18 are based on the diagram. A USDlS.67
The consumer's income is USDl,000. B USD16.67
C USD17.67
Qy
D USD18.67

19 The value ofY0 is_ _ _

_
1,000 A 800
B 700
C 600
150 D 500

20 At the price of USD4 for a hamburger and

USD3 for a can of soft drink, a consumer can
afford to buy 11 hamburgers and 9 cans of
soft drinks. If the consumer is 1naxin1izing
his/her utility at this combination of food
L-- ---'-----' -'-
'---- - - -..:....____.Qx
and drink, what is his/her income?
0 30 40 60 100

A USD81
_
16 The price of Y is_ _ _ B USD71
A USD0.50 C USD61
B USDl.00
D USDSl

Short-answer Questions
Answer the following questions.
1 Fill in the blanks.
(a) An indifference curve shows the combinations of t,-vo goods yielding the same level of

(b) The higher the indifference curve, the_ _ _ _ _ _ _ the satisfaction will be.
(c) A_ _ _ _ _ _ _ shows the combinations of two goods that can be purchased with a
. .
given income.
(d) If you remain consuming more and more of a product as your marginal utility becomes
negative, your total utility wi!J be_ _ _ _ _ _ _ _ _
(e) A consun1er's equilibrium can be achieved when an indifference curve is_ _ _ _ _ _ _
to the budget line.
2 Based on the table, answer the following questions.
::r
�

Ice Cream (Cup) Total Utility Marginal Utility

(I)
0
i
0
1 8
2 14
::,
0

3 18 rn
s::
4 20 (I)

5
..,
20 m
6 18
(I)

(a) Calculate the n1arginal utility at every cup of ice cream.

-·
0
s::
..,
(b) Illustrate the total utility and marginal utility curves.
(c) At ""hich cup of ice cream will the point of satiation be yielded?
(d) What happens to total utility when marginal utility is negative?
3 The schedule of utility is obtained from Steve's consumption of sandwiches and tropical
JUICes.

Total Utility
Quantity (Unit)
Sandwich Tropical Juice

1 20 25
2 40 40
3 55 50
4 60 56
5 64 58
6 65 59

(a) Calculate the margi11al utility for each good.

(b) What is Steve's n1arginal utility from consuming the fourth unit of sandwiches?
(c) Assuming the price of both goods is USD2 each and Steve has USDlO to spend,
how many units of sandwiches and tropical juices should Steve purchase to
maximize his utility?
(d) If the price of the tropical juice decreases to USDl per unit, ho�v 1nany units of
sandwiches and tropical juices will Steve purchase? Assun1e the budget ofUSDlO
remains constant.
lO 4 The table shows the n1arginal utility for Good X and Good Y. The price of X is USD6
and the price of Y is USD3. Assume thait the consumer's income is USD42.

.c:
u
1 22 1 16
2 19 2 14
3 18 3 10
4 12 4 8
5 10 5 7
6 8 6 6
7 6 7 5

(a) Calculate the marginal utility per US dollar of Good X and Good Y.
(b) How many units of Goods X and Y will the consumer buy to maximize utility?
S Based on the diagram, assume the consumer's monetary incon1e is USDlOO and the
price of Good X is USDS.
GoodY

50

25

I
I

10 -----:--------
I
I

'I
-1
--
--'- -
-"'--- - - - -
-+GoodX
B
'-- �-
z
(a) Find the value of B.
(b) What is the price of Good Y at point B?
(c) What is the value ofT at point B?
(d) \IVhat is the value of Z at point A?
(e) Give two reasons why the consumer's level of utility can move from point B to
point A.

Essay Questions
Answer the following questions.
I Define the indifference curve and explain its four assu1nptions.
2 Explain the four characteristics of the indifference curve.
3 Differentiate between cardinal utility and ordinal utility.
4 Briefly explain the la,.v of diminishing marginal utility.
5 With the aid of a diagram, explain a consumer's budget line.
6 Using the indifference curve and budget line, explain ho,v a consumer can achieve the
equilibrium level.
r

Production,
Cost and
Revenue Theory
Ul At the end of this chapter, you should be able to:
e(l) • Describe short-run production.
8• Define the law of increasing and diminishing marginal returns.
:S • Differentiate the stages of production.
0
• Explain the concept of short-run costs.
o,

·e
S:: • Discuss long-run average costs.

«s
• Discuss economies and diseconomies of scale.
 W e have learned in the previous chapters that buyers gain utilities
from buying goods and services. However, every supply of
goods and services has to come from a source or place. Goods are
produced by organizations through the production process. All goods
and services have a cost-for the organizations and the consumers.
When firms produce goods, they incur costs that vary, depending on
the production quantity. In this chapter, we will go through the factors
of production, short-run production costs and long-run production
costs. We will also study 1rhe production functions, i.e. the relationship
between outputs and inputs.

6.1 SHORT-RUN PRODUCTION

1 Factors of production
Production
A process oftransforming
inputs into outputs.
Production is generally an activity ,vhich involves utilizing
production factors or scarce resources to produce goods and services
to satisfy the needs and wants of society . In other words, production
is a process of transforming inputs into outputs: the factors of
production or scarce resources used are the inputs, \.vhereas the
goods and services produced are the outputs. The follo,...,,ing is a
basic example to illustrate the process of production: Figure 6.1
shows the ingredients needed (inputs), such as flour, eggs, butter
and baking chocolate, to produce a chocolate cake (output).

Figure 6.1
Production of a chocolate cake

I
 Inputs are represented by land, labour, capital and 'ti
"'t
entrepreneurship, as shown in Table 6.1. Meanwhile, Figure 6.2
--·
0
C.
shows how inputs can be further categorized into fixed inputs C
0
and variable inputs, which are used in a short-run production. 0
Production may be capital intensive or labour intensive. The ::s

-
�

ultimate goal for any firm to engage in production activities is to (")

0
maxin1ize profit. rn

::s
• Natural resources on earth used to produce goods or Table 6.1 C.
Factors of production
services (gifts of nature).
• Examples of resources are land, air, sea, rain, forest,
sunlight, climate and soil. ::s
C
(I)
• Human effort (mental and physical) that is used in the
�
production of goods or services. :,­
(I)
• Examples of labour are cleaners, nurses, photographers, 0
"'t
pilots, factory workers, etc.
• Man-made goods, such as the tools and machiner y used
to produce goods or services, or man-made material
sources of production.
• Examples of capital are plants, equipment, buildings and
stores.
• A person who coordinates and organizes all other factors
of production and absorbs the risks to produce goods or
services to earn maximum profit.

Input Figure 6.2

Ty pes of input in a short-run
production

Fixed input Variable input

A fixed input is an input ,-vhich cannot be altered in ter1ns of

quantity in the short run and does not change as output (such as Fixed Input
land, capital, and the fir1n's plant) changes. However, a fixed input
An input that cannot be
altered in the short run.
can be altered in the long run. The costs of fixed inputs are called
fixed costs. On the other hand, a variable input is an input which Variable Input
can be altered in tern1s of quantity in the short run, depending on An input that can be altered
in terms of quantity in the
how much a firm chooses to produce. Labour and raw materials short run, depending on
are two examples of variable inputs. The costs of variable inputs how much a firm chooses to
are called variable costs.
produce.

2 Production function
A production function refers to the relationship between inputs
and outputs, as input increases, output will also increase 1n
tandem. Therefore, the production function is written as:
Output = f (Inputs)
Q = f (Land, Labour (L), Capital (K), Entrepreneur)

""'
(0
Cl,
co
Short Run
.c:
t) A peri od in which there is a
combi nati on of at least one
fixed input with one or more
variable input(s}.
Long Run
A time period that is long
enough for all factors of
production to be varied, and all
are variable inputs.
Total Product
The maximum output that can
be produced by firms.
Average Product
The output per unit of variable
input.
Marginal Product
The change in total product
when one more unit ofa
variable factor is employed.
3 Time range
Time range is categorized into short run and long run.
Short run is a period in which there is a combination of at least
one fixed input with one or more than one variable input. Thus,
to increase output, a manufacturer can change his variable inputs
but not his fixed inputs. For exan1ple, in the production of wheat
(Q), the inputs used are land (K) and labour (L), where land is
a fixed input while labour (L) is a variable input. Therefore, the
production function can be simplified as follo,,vs:
I Q =J(L,.K ) I
We assume capital K is constant.
Long run is a period in which there is no fixed factors of
production. It is a time period that is long enough for all factors
of production to be varied and all are variable inputs. Land and
capital are categorized as fixed inputs in the short run, but in the
long run, they are variable inputs. In other words, land, labour,
capital and entrepreneurs are all variable factors of production
in the long run. Firms can build new factories or purchase ne"v
machinery in the long run.
4 The laws of production
There are two laws of production:
(a) The law of diminishing marginal returns
(b) The law of returns to scale
6.1.1 Law of Increasing and Diminishing
Marginal Returns
The law of diminishing returns refers to the short-run production
function-where there is at least one fixed factor or input. This law
is also known as the la,v of variable proportions. Before ,ve explore
the la,,v of increasing and din1inishing marginal returns, we have
to understand the concept of total product, average product and
marginal product.
Total product (TP) is the maximum output that can be produced by
firms using different combinations of inputs.
Average product (AP) is the output per unit of variable input or total
product divided by quantity of variable factor.
TP Where, TP = Output
AP =
01, QL = Quantity of variable factor
Marginal product (MP) is the change in the total product ,vhen one
more unit of a variable factor is en1ployed, with all other inputs used
remain constant.
 Land I
: Labour I TP
I, AP
II MP
II Law of Marginal Returns Table 6.2 'ti
"'t

--·
The relationship between 0
fixed and variable inputs with C.
1 1 3 3 3 total product, average product C
0
Law of Increasing and marginal product in the
1 2 7 3.50 4 production of wooden chairs 0
Marginal Returns ::s

-
1 3 33 11 26 for Aurora Enterprise �

(")
0
1 4 52 13 19 rn
1 5 66 13.2 14
Law of Diminishing
::s
1 6 76 12.6 10 C.
Marginal Returns
1 7 80 11.43 4
1 8 80 10 0 ::s
C
1 9 78 8.67 -2 Negative Marginal (I)

Returns
�
1 10 72 7.2 -6 :,­
(I)
0
Table 6.2 shows the production of wooden chair by Aurora
"'t

Enterprise. When the firm has only one labour, three ,-vooden
chair can be produced. The total product continuously increasing
as Aurora Enterprise adds the amount of labour. At three units of
labour, marginal product is at its maxin1um point. At four units of
labour, 1narginal product starts to decline and here is ,vhen the law of
diminishing marginal returns sets in. vVhen the amount of labour is
eight, the total product reaches its maximum production. If Aurora
Enterprise employs additional labour after reaching the maxi1num
total product, the firm will suffer losses because the number of labour
is more than sufficient. At eight unit of labour, MP becomes zero and
it becomes negative with the ninth labour employed.
In the short run, the law of diminishing returns states that at a
certain point in the production process, "''hen more uniits of a variable
input are added to a fixed a1nount of input, the total production ,viii
increase at a decreasing rate. Diminishing returns to labour occurs
when the n1arginal product of labour starts to fall.
MP Figure 6.3
Law of diminishing marginal
returns

- - Law of diminishing
Law of increasing +----+t marginal returns
marginal returns

L-- - - - -
- � - - - - '--
----' ➔ Quantity of
6 labour

In other words, if one variable factor of production ( e.g. number of

labour) increases while other factors (e.g. plants and building) remain
constant, the output per unit of the variable factor will eventually
 diminish. For instance, when labour is added to a machinery, the total
""'
(0

product cost ,vill increase at an increasing rate. Hov.rever, if the number

Cl,
co
of labour employed keeps on increasing, the total product cost will
.c: The Law of Diminishing increase at a decreasing rate ,vhile the marginal product begins to fall.
The law of diminishing marginal returns is associated with the
t)
Marginal Returns
States that as more units of a
variable factor are comb ined
total product, average product and marginal product. The meaning
w ith afixed factor, marginal of la,v of diminishing marginal returns is shown clearly by using the
product will fall after a certain total product, average product and marginal product curves. They are
explained specifically in Figure 6.5 on the stages of productions.
point.

Relationship Between TP, MP and AP

1 Relationship bet,veen TP and MP
MP is the slope ofTP. When TP increases at an increasing rate (a),
MP increases in tand,e1n. When TP is at its maxin1um (d), MP is at
zero (b). When TP increases at a decreasing rate, the MP will fall.
TP steeper : MP rises
TP flatter : MP falls
TP at its maximum : MP is at zero
2 Relationship bet,veen AP and MP
When MP is increasing, AP is increasing. When MP is above AP,
AP is rising. When MP cuts AP at AP's n1aximum point (c), MP is
equal to AP. When MP is below AP, the AP will fall.
MP > AP : AP rises
MP = AP : AP at its maxi1num
MP < AP : AP falls
Figure 6.4 Total product
Stage 2
Relationship between TP,
AP and MP '
•d
'
Stage 1 Stage 3
a

L...-=:::.._______;____ ....i,_
_________,. Labour

Average product and

marginal product

AP

MP
 'ti
"'t
SAMPLE QUESTION 6.1

--·
0
C.
C
Calculate the average product and marginal product. 0

Average Product of Marginal Product of 0

Labour Total Output

-
Labour Labour
(")
0
0 0 rn

1 67 ::s
C.
2 138
3 207
4 238 ::s
C
(I)
Solution: �
:,­
(I)
Average Product of Marginal Product of 0
Labour Labour "'t

0
67 67
69 71
69 69
------••• 59.S 31

6.1.2 Stages of Production

There are three stages of production, i.e. Stage 1, Stage 2 and Stage 3,
according to the efficient use of inputs. It is best explained by using the
previous Table 6.2 and Figure 6.4 to make stages of production easier
to understand.

Law of Marginal; Stages of Table 6.3

Land Labour TP AP MP
Returns :'Production The relationship between
fixed and variable inputs with
1 1 3 3 Law of total product, average product
and marginal product in the
Increasing
1 2 7 3.50 4 production of wooden chairs
Marginal
for Aurora Enterprise.
1 3 33 11 26 Returns Stage 1
1 4 52 13 19
1 5 66 13.2 14 Law of
Diminishing
1 6 76 12.6 10
Marginal
1 7 80 11.43 4 Returns Stage2
1 8 80 10 0
1 9 78 8.67 -2 Negative
Marginal Stage3
1 10 72 7.2
--- Returns
-6
 In the short run, the three stages of production are illustrated in
""'
(0

Figure 6.5.
Cl,
co
.c: Figure 6.5 Production
t) (TP, AP, MP)
Three stages of production
curve in the short run Stage Stage Stage
1 2 .....-T-
.......
d 3
TP

a
, C
''
''
'
'
The Law of , _
Diminishing ''
Returns
''
' b
AP
--"'
::..._
----1.
_______ _ ___:_::..:......,�- -
-----+ Quantity of
0 5 labour (QL)
MP

Stage 1 Stage 1 begins from the or1g1n until the AP curve reaches its
maximum point or until the point ofintersection bet\veen MP and
Known as the law of increasing
n1arginal returns.
AP curves occur. When the number of variable inputs, i.e. labour
employed, are small relative to its fixed input, i.e. land which is
under-utilized. With the second unit of labour employed, the MP
,.vill increase due to greater efficiency in the use of land and labour
as both inputs are used in better proportions.
In Table 6.3, with only one unit of labour, the total output produced
are three units. When the second n1an is added to the workforce,
the total output rises to seven units. With a third unit of labour is
employed, the total product increases further to 33 units. This will
give rise to the law of increasing marginal returns because extra
workers allow the firm to organize the "vorkforce 1nore efficiently
by specialization or di\rision of labour. In Stage 1, there is a sharp
increase in the TP curve because the TP curve is increasing at an
increasing rate. Note that, the MP curve rises but it begins to fall
after the third unit of labour is employed. In addition, the AP curve
continues to rise as long as the MP curve is greater than the AP curve.
Eventually, when the fourth unit of labour is employed, with
this additional unit of variable input to its fixed capacity, the la,.v of
diminishing marginal returns sets in. This is because an extra worker
adds less to the total output than the previous worker as the "vorkers
are unable to cope with the fixed inputs (such as workspace and
machines) that result in the declining marginal labour productivity.
A rational producer will continue to produce at this stage, as he
can still increase TP by increasing the quantity of labour used.
 'ti
Stage 2 begins after MP intersects AP (point c) at its maximum Stage 2 "'t

--·
0
until the MP curve equals to zero (point b). The TP curve is at its
Known as the law of C.
diminishing marginal returns. C
maxi1num point (point d) ,vhen MP curve is equal to zero. The 0
value of AP and MP ,vill decrease but still remain positive. The 0
AP curve is above the MP curve. At Stage 2, when more labour
::s

-
�

(variable inputs) are added to land (fixed input), TP will increase (")
0
at a decreasing rate. This implies that the additional units of labour rn
employed will result in a decreasing MP, meaning every ne,v worker ::s
employed contributes lesser and lesser to the TP. C.
A rational producer ,vill stop production at this stage because
production (TP) has reached its maxin1um point. Stage 2 is the
most efficient stage of production because the combination between ::s
C
fixed and variable inputs is efficient, as both inputs are fully utilized. (I)

At this stage, there is no ,vastage and unemployn1ent.

�
:,­
(I)
0
"'t
Stage 3 begins when the MP is negative. The TP curve starts to fall. Stage 3
The AP will also fall, but still remains positive. The AP ,vill never be Known as the law of
negative marginal returns.
negative as long as the TP is positive.
At Stage 3, the fixed input such as land or workspace will be over­
crowded as more workers (variable input) are added to the (fixed
input). Eventually, the TP will stop increasing and starts to decline.
Table 6.3 shows that the TP starts to decline from 78 units to 72
units and the MP becomes negative when the ninth and tenth units
of workers are employed. A rational producer will not produce any
output at this stage because by employing an additional one more
unit of labour to the fixed input, the total product will decrease and
the MP becon1es negative. Hence, the combination bet,-veen the
fixed and variable inputs is not economical because the workspace
becomes overcro,vded as more workers are employed.
The three stages of production, i.e. Stage 1, Stage 2 and Stage 3, can
be summarized as follows:

• Begins from the origin until the AP curve reaches its maximum
point.
• TP increases at an increasing rate.
• MP reaches its maximum and declines.
• AP increases and intersects MP when AP is at its maximum.
• Ends when AP= MP
• Producer will continue to increase production as he/she can
still increase TP.

• Starts after AP= MP

• TP increases, but at a decreasing rate, until i t reaches its
maximum.
• MP declines until MP= 0
• AP starts to decline, but is still positive.
• Ends when TP is at its maximum and at the same time MP= 0
• A rational producer will choose to stop production at this
stage as he is able to maximize the output.
• Most efficient stage.
""'
(0

• Starts when MP is negative.

g. •
,.c: TP is declining.
t) • AP is declining.
• Overcrowding-Addition of one more unit of labour to fixed
input, total product will decrease.

6.2 SHORT-RUN COSTS

1 Definition of costs of production
Costs of production are payments made by firms to the factors of
production used in producing the output of goods and services.
The extent to "vhich a firm can adjust the factors of production
will depend on the time period involved, whether it is in short run
or long run.
Short run is a period ,-vhere at least one of the inputs must be
fixed. Long run is a period ,-vhere all inputs are variable. There are
fixed inputs and variable inputs as discussed earlier in this chapter.
Payment for the cost of fixed inputs is called fixed cost. Likewise,
payment for the cost of variable inputs is kno,,vn as variable cost.
The cost of production is related to the factors of production.
There are two categories of costs of production:
(a) Implicit cost
Implicit Cost
Implicit cost is not an accounting cost and is only viewed
Is not an accounting cost and as an economiic cost. It is the opportunity cost of using
is only viewed as an economic resources owned by the firm and is not sho,-vn or reported.
The examples of implicit cost is a business firm owning a
cost.

,,varehouse and using the same warehouse for its operations.

Hence, the implicit cost for this firm is the rental income if
the warehouse iis rented out to other fir1ns.
(b) Explicit cost
Explicit Cost Explicit cost is the real payn1ent for any transactions
The real payment for factors which are purchased for production purposes and will be
of production which are documented accordingly. Examples of explicit costs are
payments for ,-vages, fuel, electricity and expenditure in
purchased for production.

purchasing ra\.v materials.

2 Economic and accounting profits
To calculate the accounting profit, the cost accountants will focus
only on the accounting costs and profit of the co1npany. Economic
costs are not usually recorded in the accounting books of firms or
enterprises. Econom.ic profit is the differences between monetary
costs and opportunity costs a firm endures and the revenue a firm
obtains.
 Profit = Total revenue - Total cost 'ti
Economic Profit = Total revenue - Total cost
"'t

--·
0
C.
= Total revenue - (Explicit cost + Implicit cost) C
0
Accounting Profit = Total revenue - Total explicit cost
0
3 Short-run costs of production
Short run can be defined as the tin1e period over which a production
-
(")
0
uses at least one fixed input ,vith one or more variable inputs. In
Short Run rn
Can be defined as the
the short run, the firm cannot increase its production by changing tim e period over which a
::s
its fixed factors such as plant or n1achinery. The producer has to production usesat least one C.
increase his variable inputs such as labour and ra,v materials to
fixed input with one or more
variable input(s).
increase its production. Short-run costs can be divided into fixed
costs and variable costs as shown in Figure 6.6. ::s
C
(I)
�

Figure 6.6 :,­

(I)
Variable Costs Types of short-run costs 0

•
-Vary with output. "'t
-Producers can in crease the
vari able inputs by
increasing the quantity.
-E.g. Raw materials

There are seven types of costs in the short-run time dimension.

There are total fixed costs, total variable cost, total cost, average
fixed cost, average variable cost, average total cost and marginal
cost.
(a) Total fixed cost (TFC)
Total fixed cost refers to cost spent on fixed iinputs, such as
rental, interest payment and insurance premium. There is no
relationship ben.veen total fixed cost and the level of output.
Total fixed cost ren1ains constant regardless of the total of
output.

Output I Total Fixed Costs (USD)

0 5,000
100 5,000
250 5,000
300 5,000
440 5,000
580 5,000
990 5,000
 Figure 6.7 Cost (USD)
""'
(0
Total fixed costs
Cl,
co
.c:
t)

5,0001-- - - - - - - - - - -
TFC

0'---------------. Output

Figure 6.7 shows the total fixed cost curve which has
a straight line. Let us assun1e that rental for Firm A is
USDS,000 per month. At zero level of production, Firm A
still has to pay the rent. Even as output changes, rental ( total
fixed cost) remains constant at USDS,000.
(b) Total variable cost (TVC)
Total variable cost refers to the cost spent on variable inputs
such as cost of ra,AJ materials and wages to labour. It is the
cost of input that changes with output. There is a direct
relationship behAJeen TVC and the output level. When
Q = 0, TVC = 0. When output increases, TVC also increases.
Output Total Variable Costs (USO)

0 0
100 300
250 550
300 780
440 900
580 1,100
990 2,500

Cost (USD)
Figure 6.8
Total variable costs TVC

0 '-- - - - - - - - - -----+
- Output
 Figure 6.8 shows the shape ofTVC. Initially, it increases at 'ti
a decreasing rate and then at an increasing rate. It is affected
"'t

--·
0
C.
by the law of diminishing returns. C
0
0
SAMPLE QUESTION 6.2

-
(")
0
What is total variable cost? Give an example to support your answer. rn

Solution: ::s
A total variable cost is payment for variable input and the cost is dependent output. If a firm C.
wants to increase the output, then the variable cost will increase as well. The example of
variable cost is cost of buying raw materials .
••• ::s
••• C
(I)
�
:,­
(c) Total cost (TC)
(I)
0
"'t
Total cost is the sum of total fixed cost and total variable
cost.
TC=TFC+TVC
There is a direct relationship between TC and output.
When output increases, TC increases. Simi]arly, if output
decreases, TC also decreases. TC will not start from zero as
TFC is incurred. TC is influenced by TVC over the TFC.
The total cost curve initially increases at a decreasing rate
and then at an increasing rate, due to the la,v of din1inishing
returns.
When Q = 0, TFC = 50 and TVC = 0, therefore:
TC =TFC+TVC
TC= 50+0
TC =50
TC =TFC
Cost (USO) Figure 6.9
Relationship between TC,
TC TVC andTFC
TVC

sot<----------r----TFC

\L._ Output
0
_ _ _ _ _ _ _ _ _ _ __

Figure 6.9 shows the relationship between TC, TVC and

TFC. The TC curve will not start from the origin.
When output Q = 0, TC = TFC
 (i) Average fixed cost (AFC)
""'
(0

AFC is fixed cost per unit of output. TFC is constant as

Cl,
co
production increases, thus AFC falls when production
.c: increases. 'fwo formulas can be used for AFC:
t)
AFC= ATC-AVC
or
AFC = TFC
Q
When Q = 0, the AFC will not start from zero as the
producer still has to pay for TFC. As output increases,
the total fixed cost spreads over more and more units,
and therefore, average fixed cost decreases because of the
spreading of fixed costs. Table 6.4 shows the decreasing
rate of AFC.

Table 6.4
Q I TFC AFC= TFC/Q
Average fixed cost

1 so so
2 so 25
3 so 16.67
4 so 12.5
5 so 10

Figure 6.10 Cost (USD)

Average fixed cost

o'--- - - - - - - - - - -
-+Output

AFC is a hyperbola-shaped curve as shown in Figure

6.10. The AFC curve is sho\.vn as a declining curve which
never touches the horizontal axis. This is because fixed
cost can never be zero.
(ii) Average variable cost (AVC)
Average variable cost (AVC) can be defined as the
variable cost per unit of output.
 AVC =AC-AFC 'ti
or
"'t

--·
0
C.
AVC = TVC
C
0
Q 0
Therefore, TVC = A VC x Q ::s

-
�

Figure 6.11 illustrates the AVC curve. The AVC decreases

(")
0
in the first stage of production, reaches n1ini1nun1 and then
rn

increases. It is a U-shaped curve because of the la,,v of ::s

diminishing marginal returns. C.

Cost (USO) Figure 6.11

Average variable cost (AVC) ::s
C
curve (I)
AVC
�
:,­
(I)
0
"'t

(iii) Average total cost (ATC)

Average total cost (ATC) is defined as the total cost per
unit of output. There are two formulas for ATC:
ATC = AFC+ AVC
or
ATC = TC
Q

Cost (USO) Figure 6.12

Average total cost
ATC
AVC

ATC minimum
--------._AVC minimum

.___ __ AFC

0 .________________. Output

ATC is a U-shaped curve because it consists of AFC

and AVC which is affected by the law of diminishing
marginal returns. Figure 6.12 shows the U-shaped curve
 of ATC. Initially as the output increases, the ATC will
""'
(0

fall since both AFC and AVC are falling. At higher levels
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co
of output, the AFC continues to fall but at a declining
.c: rate until it reaches its minimum point because the
combination between fixed and variable inputs is
t)

efficient. AVC rises once output exceeds the opti1num

capacity of the plant and the rising AVC ,-vill offset the
still declining AFC. Therefore, ATC rises and the ATC
curve is also U-shaped. Note that as the AFC declines,
the gap between AVC and ATC becomes narrow.
(iv) Marginal cost (MC)
MC is the additional cost resulting from producing an
additional unit of output. There are two formulas for
MC:

MC = Change in TC
Change in Q
or

MC = Change in TVC
Change in Q
The formulas above sho,,v that MC is the changes in
variable cost {TVC) by producing an additional unit of
output. The MC curve is U-shaped. It ,-vill initially fall as
output increases, reach a minimum point and then MC
will start to rise due to an increase in the total variable
cost as sho"vn in Figure 6.13. The U-shaped curve of
MC is due to the law of diminishing marginal returns. It
can be explained through the relationship between the
marginal product of labour (MP) and the marginal cost
(MC) curves.

Figure 6.13 Cost (USD)

Marginal cost curve

MC

O '-- - - - - - - - - - - -+-
- Output
 Table 6.5 shows the calculation and changes of the 'ti
various types of costs in the short run as output increases
"'t

--·
0
from O unit to 9 units.
C.
C
0
0
Table 6.5 Short-run costs schedule of a firm

-
' ' ' (")
Q TFC TVC TC AFC AVC ATC , MC 0
' rn
0 so 0 so 0
::s
1 so 30 80 so 30 80 30 C.

2 so 55 105 25 27.S 52.5 25

3 so 77 127 16.67 25.67 42.33 22 ::s
C
4 so 102 152 12.S 25.5 38 25 (I)

so
�
5 132 182 10 26.4 36.4 30 :,­
(I)
6 so 169 219 8.3 28.17 36.S 37
0
"'t

7 so 216 266 7.1 30.86 38 47

8 so 278 328 6.3 34.75 41 62
9 so 363 413 5.6 40.33 45.9 85

Cost (USO)
Figure 6.14
Relationship between AVC,
MC ATC and MC
ATC
AVC

� - - - - - - - - - -- Output
0

Relationship between Inarginal cost curve, average

variable cost curve and average cost curve:
• when ATC is falling, MC is falling and then rising,
but is below ATC
• when ATC is rising, MC is above ATC
• when MC cuts ATC from below, it IS at ATC
minimum point:
MC= ATC, ATC is at its miniinum
• when MC cuts AVC from below, it IS at AVC
minimum point:
MC= AVC, AVC is at its minimum
""'
(0
SAMPLE QUESTION 6.3
Cl,
co Answer the True/False questions.
.c:
t) 1 The marginal cost curve intersects with the average total cost curve when the average
total cost is at its maximum.
2 The average variable cost curve intersects with the marginal cost curve when the marginal
cost curve is a t its minimum.

Solution:
1 False

••• 2 False

6.3 RELATIONSHIP BETWEEN

SHORT-RUN PRODUCTION AND
SHORT-RUN COSTS
The cost curves and the production curves are inter-linked. The cost
curves of AVC and MC can be derived from the production curves of
AP and MP respectively. There is an inverse relationship between AVC
with AP and MC with MP.
1 Relationship between average product of labour (AP) and
average variable cost (AVC) curves
Figure 6.15 AP
Relationship between AP maximum
APandAVC
I

Rising Falling

AP
o.__
_ _ _ _ __ _ _ _ _
_ Variable input

AVC
AVC

Rising

!\AVC minimum
o�- - - - -- - - - -
--+ Output
 Figure 6.15 shows that the AP curve is an inverted U-shape while 'ti
the AVC curve is U-shaped. The relationship between productivity
"'t

--·
0
C.
and cost are as folio.vs: C
• As output rises, AP increases but AVC decreases because of
0

spreading of fixed cost.

0
• As output increases further, AP is at its maximum level, while
-
(")
AVC is at its minimum level. Both fixed and variable inputs 0
rn
are in the best combination.
• As output increases continuously, AP decreases but AVC ::s
C.
will start to increase due to the la,-v of diminishing marginal
returns. Hence, the AVC curve is U-shaped.
2 Relationship between marginal product of labour (MP) and ::s
marginal cost (MC) curves C
(I)
As shown in Figure 6.16, the MP curve is an inv,erted U-shape �

while the MC curve is U-shaped. The relationship between MP

:,­
(I)

and MC are as follows:

0
"'t

• When output increases, MP increases due to specialization,

which leads to an increase in efficiency. MC decreases due to
spreading of fixed cost. Both fixed input and variable input are
used in better proportions.
• As output increases further, MP is at its maxin1um, ,vhile MC
is at its minimum. Both fixed and variable inputs are in their
best combination.
• vVhen output increases further, MP will start to decrease due
to the inefficient use of the inputs and the la,v of diminishing
marginal returns. Hence, MC begins to rise.
MP Figure 6.16
Relationship between
MPmaximum MP and MC
/

Decreasing

MP
�- - - - - - -
o� - - - - - - --+ Variable input

MC
MC

Increasing
Decreasing

! \ MC minimum
''
o�--------------
--+ Output
""'
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6.4 LONG-RUN PRODUCTION
Cl,
co
Long run is a time period which is sufficient in length to permit all
inputs to be varied. Firms can increase the scale of all its inputs. There
.c:
Long Run
are no fixed factors in the long run. Capital is variable as the firm can
t) A time period which is
suffici ent in length to permit all
inputs to be varied, and a firm add more machines to the long-run production process. The flexibility
of producers to transform fixed inputs to variable inputs is the key
can increase the scale of all its
inputs.
feature in the long-run production period.
Long run is a time period where there is no fixed inputs. There are
only variable inputs. It means that firms can increase or decrease their
production by changing all their inputs. The production function in
the long run is:
Q =/(land, labour, capital, entrepreneur), where output is a function of
land, labour, capital and entrepreneur as all inputs are variable factors.
The law of returns to scale is applicable in the long run. In
production, returns to scale refers to a technical relationship between
inputs and outputs measured in physical units. There are three stages
of returns to scale:
1 Increasing returns to scale
The returns to scale are increasing when the increase in output
is more than proportional to the increase in inputs. Associated
with increasing returns to scale is the decreasing costs due to the
econo1nies of scale. For example, a 10% increase in inputs ,vill
result in more than a 10% increase in output. It takes place due to
the economies of scale.
2 Constant returns to scale
An increase in inputs will cause a proportionate increase in the
level of output. Associated with constant returns to scale is the
constant cost due to the constant econon1ies of scale. For exan1ple,
a 10% increase in inputs will also result in a 10% increase in output.
3 Decreasing returns to scale
An increase in input will cause a less than proportionate increase
in the level of output due to the disecono1nies of scale. For example,
a 10% increase in inputs will result in a less than 10% increase
in output. Increasing costs industry is associated with decreasing
returns to scale. It takes place due to diseconon1ies of scale.

6.4.1 Economies and Diseconomies of Scale

Economies and diseconomies of scale are measured in terms of a firm's
long-run average cost (LRAC).
 I Law of Returns to Scale
Figure 6.17 'ti
""t

--·
Law of returns to scale 0
C.
I C
0
0
Economies of Diseconomies

-
scale of scale (")
0
I I rn

::s
Internal External Internal External C.
economies economies diseconomies diseconomies

::s
Economies of Scale C
Economies of scale refers to the cost advantages of a large scale
(I)
�

production. As output increases, the long-run average cost of

Economies of Scale :,­
The advantages of large scale (I)
production will fall, resulting in increasing returns. Economies of production.
0
""t
scale can be divided into two types: internal economies of scale and
external economies of scale.
1 Internal economies of scale
Internal economies of scale rises as a result of a firm's internal
decision to gro,-v in size. When the output of the firm increases,
its long-run average cost falls, as it is able to benefit fron1 the
follo,-ving economies of scale:
(a) Labour economies/Division of labour
Labour econon1ies refers to the specialization of labour and
allows the workers to concentrate and specialize in jobs that
they are more capable. A worker who concentrates on one
task is more efficient and productive than the san1e worker
'1-vho is burdened with several tasks. Hence, the division of
labour creates specialization which results in increasing
returns and decreasing cost.
(b) Marketing economies
Marketing economies is the economies of buying and selling
in bulk. By buying raw materials in bulk, large scale firms
'I-viii obtain discounts to reduce the costs of production. By
selling goods in large amounts to local and foreign markets,
large firms can undertake advertising and sales promotion
to increase their returns.
(c) Purchasing/Financial economies
A large firm can raise capital more easily than a small firn1.
It is able to obtain loans with a lo'l-ver interest rate, longer
maturity period and even without collateral security from
a financial institution. Large firms can also obtain more
capital. S01ne private co1npanies turn into public li1nited
companies to obtain more capital.
 (d) Managerial/Administrative economies
""'
(0

Large firms can set up different departments according to

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their needs such as sales department, personnel department,
.c: quality control department, marketing department and
others. Employment of professionals, such as accountants,
t)

economists, business administrators, lawyers, etc., are made

possible. Therefore, these ,vill ensure higher productivity
and greater efficiency leading to a reduced cost and higher
returns.
(e) Risk-bearing economies
A large firn1 can diversify into different product lines in
order to spread its risks, for exa1nple, producing multiple
products such as television sets, speakers, video, radio and
others.
(f) Research and development economies
Output and quality of products can be improved through
research and development. Firms will improve the quality
of their existing products and upgrade the technique of
production through innovation programmes. Invention of
new products also helps to increase returns.
(g) Technical economies
Large-scale firms can afford to use the most modern,
sophisticated and efficient productive machinery and
equipment con1pared to the small firms. They can afford to
purchase and e1nploy highly skilled workers to operate the
machinery. They could also utilize the equipment effectively,
for instance, in a non-stop assembly-line operation, as they
produce a high volume of production.
2 External economies of scale
External economies of scale are caused by external factors to the
firn1 itself. It is related to the scale of industry or market as a
whole. When an industry grows in size, certain benefits become
available to all the firms in the industry. For instance, Himalayan,
Evian, Volvic and 011:her brands dealing in beverages. As such,
there will be a fall in the long-run average costs resulting in
increasing returns.
There are several factors contributing to the external econon1ies
of scale:
(a) Economies of concentration
Economies of concentration refer to the concentration
of firms or a particular industry in one area. \,\Tith
concentration, firms will be able to save on transportation
cost and advertising costs to advertise their location and
products. This "viii result in increasing returns to scale and
decreasing cost to industry.
 (b) Supply of skilled ,vorkers 'ti
The pool of labour ,-vill search for jobs in the location.
"'t

--·
0
C.
The industry will be able to obtain skilled workers without C
0
advertising in the newspapers.
0
(c) Infrastructure

-
Infrastructure refers to the facilities available to the industry (")
such as road, port, railways, po,-ver station, water supply,
0
rn
telecommunications and others. A complete and equip
infrastructure will ensure the s1nooth operation of the ::s
C.
""hole industry. Hence, firms ,-vill be able to save a significant
amount of their fixed costs and production can be carried
out efficiently. ::s
C
(d) Existence of specialist companies (I)

With the expansion and establishment of a firm involved in �

:,­
n1ass production, specialist companies will exist to supply (I)
0
the needs of the firm. For example, several small companies "'t

were established to produce con1ponents for Sharp-Roxy,

the multinational con1pany.
(e) Economies of information
To expose consumers to ne,-v products or to boost sales,
firms in the industry will work together with one another
to organize trade fairs, meetings, conferences, seminars and
publication of journals. Hence, producers wil] be exposed to
new ideas and ne"" inforn1ation.

Diseconomies of Scale
Diseconon1ies of scale exists when an increase in output causes a
Diseconomies of Scale
fir1n's long-run average cost to rise. Efficiency declines as a result of Exists when an increase in the
the internal and external diseconon1ies of scale. output causes a firm's long­

1 Internal diseconomies of scale

run average cost to rise.

( a) Manage1nent difficulties
The main factor that causes diseconomies of scale is
n1anagerial problems in controlling and co-coordinating a
firm's operation efficiently when there is mass production.
Large plants require additional supervision which increases
the cost of production. Bureaucratic organization leads to
communication problems, slowness in making decision ""ill
result in lower output and higher cost.
(b) Low morale
With the specialization of labour, work beco1nes routine and
monotonous, causing workers to lose interest in work and
productivity to decrease.
(c) Higher input price and marketing diseconomies
\l\'hen there is a mass production, firms ,-vill purchase a
substantial amount of rav,r materials, causing prices of raw
 materials and semi-finished goods to rise. This ,,vill raise the
""'
(0

cost of production. Firms may also require more extensive

Cl,
co
advertisements to promote their goods to compete with the
.c: stiff competition in the industry. As such, advertising cost
n1ay increase.
t)

(d) Higher ,vages of specialists and professionals

Specialists, professionals and skilled workers ,-vith many
years of experience usually demand higher wages, causing
the cost of production to rise. In order to have innovation
and product development, firms have to employ these
"vorkers and bear the rising cost of production.
(e) Technological problems
Technological problems arise when firms produce in large
scale and over-utilize a certain machine with a certain
capacity of production. The n1achine may break down due
to extensive use and may require high maintenance cost.
2 External diseconomies of scale
External diseconon1ies of scale refer to the disadvantages
that result from the expansion of the whole industry, causing
decreasing returns and increasing cost. The following are factors
which attribute to external diseconomies of scale:
(a) Social problems
If social problems such as pollution and traffic congestion
arise, the government will impose taxes, fines and strict
regulations 011 the firms. Hence, the firms will incur
additional costs to resolve the social problems in compliance
with government requirements.
(b) Wage differential within the industry
To obtain experienced and skilled worker, firms have to
pay higher wages to attract new workers and prevent their
existing vvorkers from moving on to other firn1s. Hence, the
cost of production of firms will increase tremendously. This
will result in decreasing returns to scale.

6.5 LONG-RUN COSTS

Long run is a period ,-vhere all inputs are variable factors, and there is
no fixed input. This means that, in the long run, firn1s can alter their
fixed factors such as expanding plant size if the demand is high. Hence,
only long run total cost is incurred.
(a) Long-run total cost (LRTC)
The LRTC is the cost of production that has been incurred in the
long run. It starts from the origin because there is no total fixed
cost. Initially, the LRTC will increase at a decreasing rate and then
at an increasing rate due to the law of returns to scale.
 LRTC Figure 6.18 'ti
""t
LRTC

--·
Long-run total cost 0
C.
C
0
0
::s

-
�

(")
0
rn

::s
C.

oL-- - Output
- - - - - - - - - - - - --+
::s
(b) Long-run average cost (LRAC) C
The LRAC is the long-run total cost per unit of output which
(I)

sho,-vs the minin1um cost of producing any given output when all
�
:,­
(I)
the inputs are variable. The formula for LRAC is: 0
""t

LRAC = LRTC
Q

6.5.1 Derivation of Long-run Average Cost

Curves
The LRAC is derived by a series of short-run average cost curves
(SRAC). In the long run, firms can choose the best plant size which
can minimize the average cost. Assume that there are three plant sizes
which are represented by SRAC 1 , SRAC2 and SRAC3 in the long run as
shown in Figure 6.19. The LRAC is U-shaped.
Cost (USD) Figure 6.19
Derivation of LRAC from SRAC

LRAC

:o

o�- -
�_
Q,._, ...,.Q_
_ --0� - -0�
- .,,_
- -0_ _ Output
_ _
2 3 4 s

Figure 6.19 shows that long-run average cost curve can be derived
by joining tangential points of all the short-run average cost curves
because at the tangency point, output is produced most cheaply.
When the firm has a plant size of SRAC 1, total output is Q 1 and
cost is at point A. If the firm wants to increase output to Q2, it can still
operate on SRAC1 or change to SRAC2 as the costs incurred for both
SRAC are the same. At point B, Plant 1 is only efficient up to Q2•
 If the firm is expanding output to Q3, plant size SRAC2 will be used
""'
(0

because SRAC2 is better as it incurs a lower cost. The average total cost
Cl,
co
for SRAC 1 is at point C as compared to SRAC2 which used lower cost
.c: at point D.
If the firm ,-vants to produce at Q4, it can either choose SRAC2 or
t)

SRAC3 as the costs incurred are the same at point E. Plant 2 is efficient
only up to Q4• At Q5, the firm will again face h-vo choices, either over­
utilize plant SRAC2 or underutilize plant SRAC 3• SRAC3 is cheaper as
cost incurred is at point G, ,vhich is much lower compared to point
F of SRAC2• Thus, the long-run average cost curve can be obtained
by joining all points from A, B, D, E and G. The firn1 selects the
plants which give the lo.vest average cost at given output level. It is an
envelope curve of short-run average cost curves.
Figure 6.19 only shows three plant sizes; in reality, there are many
plant sizes as factors are highly divisible. Thus, the long-run average
cost curve can be shown by a smooth envelope curve as shown in
Figure 6.20.
Figure 6.20 Cost
SRAC 1
Derivation of LRAC from SRAC
forming smooth envelope curve

SRAC5

:E
'-- - --='-- - - - - - - - -----+
------- - 0utput
01

Long-run average cost curve is derived by joining tangential points

of all the short-run average cost curves. Note that to the left of Q1,
SRAC intersects with LRAC before the minimum point of SRAC.
Only at one point, i.e. point E, the minin1um of LRAC and the SRAC
are equal.

6.6 RELATIONSHIP BETWEEN

LONG-RUN PRODUCTION AND
LONG-RUN COSTS
6.6.1 Relationship Between Long-run
Average Cost (LRAC) and the Law of
Returns to Scale
The long-run average cost is the long-run total cost per unit of output.
The long-run average cost curve (LRAC) is U-shaped as illustrated
in Figure 6.21. Firms enjoy the economies of scale as their output 'ti
increases. Therefore, LRAC will decrease and there ,.vill be increasing
"'t

--·
0
C.
returns to scale. C
0
As output increases further, LRAC will approach a minimum
point, contributing to the constant returns of scale and constant cost.
0
::s
With further increment of output, firms will be faced ,vith decreasing
-
�

(")
returns of scale. LRAC will rise, resulting in decreasing returns to scale 0
rn
and increasing cost.
::s
C.
LRAC (USD) LRAC Figure 6.21 :a
Relationship between LRAC and
the law of returns to scale �
"'
::s
C
LRAC\ \ /ARAC rising due to
/ decreasing return to
en
fallin:g \ �
scale
due to
. . en
:,-

increasing
returns to scale
I\ LRAC minimum due to 0
"'t
constant returns to scale
O� - - - - - -- - - - - - - - - --+ Output
Returns
•
: / Constant

ling
�

Returns to scale
o '---------'------------ Output

Economies and diseconomies of scale are measured in terms of a

fir1n's long-run average cost (LRAC).

Cost (USD) Figure 6.22

Measurement scale in LRAC
LRAC

Increasing cost
Deer� B industry
ost industry (decreasing
(increasing : returns to
returns Constant:cost industry scale)
' (constant returns to scale)
to scale) :
'.
Econon,1es of scale Diseconomies af scale

o�--��-----�------
- - -
--+ Output
Q, 02 Q3

Figure 6.22 shows the measurement scale in the long-run average

cost curve. From zero production to the Q2 unit of production, this firm
is experiencing a decreasing average cost of production. Economies of
scale refer to cost advantages of a large scale production. As output
 increases, the long-run average cost of production falls, resulting in
""'
(0

increasing returns. Economies of scale can be divided into two types:

Cl,
co
internal economies of scale and external economies of scale as ,ve
.c: discussed earlier in the long-run production.
From the Q2 unit of p-roduction on,.vards, the firm will experience
t)

an increased average cost of production. Diseconomies of scale exist

,,vhen an increase in output causes a firm's long-run average cost to rise.
Efficiency declines because of the internal and external diseconomies
of scale.

SAMPLE QUESTION 6.4

Answer the True/False questions.

1 In the long run, total cost is equal to zero when output is equal to zero.
2 The long-run average cost curve is tangent to the lowest points on all possible
short-run average total cost curves.
3 The law of diminishing returns is a long-run concept.
4 Returns to scale is a short-run concept.

Solution:
1 True
2 True
3 False

••• 4 False

A new ,.vave of innovation in energy exploration has been incited by the

depressed price of oil. Energy companies were focusing on pumping crude
and drillil1g ,veils within a short period of ti1ne within their capability.
However, the focus of the companies deviates onto the efficiency to get the
most petroleum for the least amount of money when the price of a barrel was
as low as USDSO per barrel. Advanced technology ,viii definitely facilitates
them particularly in this line of work.
The customers, Halliburton Co. and Schlumberger Ltd., which are the two
of the biggest oil-field-services companies, yearn for technology that can save
their pocket money. In order to ensure the new wells will bring the crudest
for the buck, some of them even utilize lasers and other high-tech equipment
and data analytics before they driill. There are also a number of them who are
searching for new techniques that can allocate them to wring more crude from
both ne"'' and old wells.
 'ti
""t

--·
0
Halliburton officials explained improvements in fracking technology in C.
C
another recent earnings call, together with the use of fibre-optic tools to monitor 0
the process of fracking while ensuring that it is working absolutely well. 0
::s
There are about 10,000 horizontal shale oil and gas wells estimated by

-
�

(")
Schlumberger which have been drilled in the past five years, to be the 0
candidates for refracking, which currently is working.
rn
ll)
::s
Software and microbes C.
The main key is to maximize the amount of oil a well produces. For new wells, :a
engineers are relying n1ore on the softv;are and sensors to deter1nine exactly
the right places to use different amounts of sand, water and chemicals.
�
::s
C
In recent years, companies have begun to double or triple the amount of (I)

sand they use to hold open the fissures that allo,v oil to flow through dense
�
:,­
rock, which has often resulted in much higher production-but also higher
(I)
0
costs. The new technology can help companies figure out the right balance ""t
'<
between cost and production, says Gene Beck, Vice President of Bakken
development and production at Statoil.
The companies have tried a new yet costly way in recent years to increase
the oil production by doubling or tripling the an1ount of sand they use to hold
open the fissures that allow the oil to flow through dense rock. Beck stated that
the cost and production can be stabilized in a rightful way ,vith the help of new
technology.

Source: Adapted fron1 The Wall Street Journal, 2015.

Case question
Explain how a new technology can help reduce the cost of
production.

Solution
This company has been in the long-run dimension because it is already known
as a big con1pany. Therefore, the company enjoys the economies of scale
through ne'\>v technology, which will eventually help it to save some money
and reduce cost.

6.7 REVENUE IN ECONOMICS: MEANING

AND CONCEPT
In the industry, the most crucial way for assessing an accomplishment
and progress is to observe the total revenue. Revenue means the money
received by the fir1n from trading of goods and services.
 1 Total revenue (TR)
""'
(0

Total revenue refers to the total amount of money received from

Cl,
co
the trade or sale of goods and services. It is equal to the price
.c: multiplied by the output sold. The formula is as below:
t)
TR= Price x Total output
TR= p X Q
2 Average revenue (AR)
Average revenue is the total revenue per unit of output sold. The
formula is as below:

AR= TR = p X Q = p
Output Q
AR = P, as long as all the units are sold at the same price.
Therefore, in economics, average revenue curve is usually referred
to as the demand curve of a firm.
3 Marginal revenue (MR)
M arginal revenue is the change in total revenue \.vhen one more
unit of output is sold. For example, if Firm JJ sold one more glass
vase and their revenue increased from USD700 to USD740, the
marginal revenue ,-vill be equal to USD40. Marginal revenue
is essential because it helps firms to recognize the relationship
between the number of units sold and the total revenue.

MR= Change in TR
Change in Q
4 Relationship between price (P), average revenue (AR) and
marginal revenue (MR)

Assumption: All output is sold at the same price,

so den1and for the product is perfectly elastic.

Figure 6.23 Revenue(USD)

P=AR= MR

P 1------------AR = MR

� ---+ Output
---------

Figure 6.23 shows that AR = Price = MR. Since MR is the

addition to TR of selling one extra unit and every extra unit sold
yields the same price, therefore MR= P = AR. Profit is maxi1nized
 where the difference between TR and TC is positive and the
greatest. Once this level of output is achieved, the firm will have no
incentive to increase or decrease production. This level of output is
known as the equilibrium output where MR = MC, i.e. where the
revenue earned from selling an additional unit of output is equal
to the cost incurred in producing it. We \,viii discuss this section
in detail in Chapter 7 for the different types of market structures.

Production of goods is determined by the cost of production which sequentially

depends on the prices of inputs or the factors of production. Cost of production
is determined by the physical relationship between inputs and outputs. In the
theory of production, we basically discuss the relationship bet\.veen inputs and
output. The three stages of productions also help firms to get clearer pictures
on which stage is the most efficient stage to produce goods. Thus, the theory
of production has a great significance to industries.
Specifically, fixed cost ,;,rill not change according to outputs but variable
cost will directly relate to the volume of outputs. This chapter also helps us to
understand ho,,v a firm combines all inputs in order to produce a given output
in the most efficient ,,vay with minimu1n cost.

• Production is an activity which involves utilizing production factors or

resources to 1nake goods and services to satisfy the needs and wants of •
society.
• Factors of production are represented by land, labour, capital and -
entrepreneur.
• Production function refers to the relationship between inputs and outputs.
• Short run is a period where there is a combination of at least one fixed
input ,-vith one or more than one variable input.
• Long run is a period where there are no fixed factors of production.
• The la,v of diminishing marginal returns states that as more units of
variable input are combined \Vith a fixed input, after a certain point, the
marginal product will fall.
• Total product is the maximum output that can be produced by a firm using
different combinations of inputs.
• Average product is the output per unit of variable input or total product
divided by the quantity of variable factor.
• Marginal product is the change in total product when one more unit of a
variable factor is employed, with all other inputs used being held constant.
""'
(0 • Implicit cost is not an accounting cost but is only viewed as an economic
cost.
• Explicit cost is the real payment for factors of production which are
Cl,
co
.c:
t) purchased for production.
• Seven types of costs in the short-run time dimension: total fixed costs,
total variable cost, total cost, average fixed cost, average variable cost,
average total cost and marginal cost.
• The long-run average cost (LRAC) is the long-run total cost per unit of
output which shows the min.imum cost of producing any given output
when all inputs are variable.
• The la,v of returns to scale refers to a technical relationship in production
between change in output and proportionate change in all factors of
production.
• Economies and diseconomies of scale are measured in terms of a firm's
LRAC.
• Total revenue refers to the total amount of money received from the sale
of goods and services.

+ Key concepts

• Production • La,-v of diminishing • Total cost

• Inputs/Factors of marginal returns • Total fixed cost
production • Law of returns to scale • Total variable cost
• Output • Total product • Marginal cost
• Short run • Average product • Long-run average cost
• Long run • Marginal product • Economies of scale
• Stages of production • Diseconomies of scale

+ Exercises

Multiple-choice Questions
Answer the following questions.

1 The short run is a time period in which 2 Which of the following items is an implicit
A all factors of production are fixed. cost to a firn1?
B the total of output is fixed. A Utilities bills
C at least one input is fixed. B Time during the weekend spent by the
D all factors of production are variable. owner on his/her firm.
 C Cost of hiring an external trainer. 8 The average fixed cost at three units of 'ti
D Total fixed costs output is ___
"'t

--·
0
C.
A USDlO C
3 Which of the following statements is true? B USD20
0
A All factors of production are fixed in the C USD30 0
long run. D USD40

-
(")
B The total of output is fixed in the long run. 0
C At least one input is fixed in the short run. 9 The average fixed cost at five units of output
rn

D All factors of production are variable in lS _ _

_ ::s
the short run. A USDS C.
B USD4
4 In a production process, the marginal C USD6
product of labour equals D USD7 ::s
C
A total output divided by total labour. (I)

B total labour divided by total output. 10 The marginal cost at four units of output is �
:,­
C change in total output divided by total (I)
0
labour. A USDlO "'t

D change in total output divided by change B USD20

in total labour. C USD30
D USD40
Questions 5 to 10 are based on the table.
II Total Variable 11 Marginal product and average product curve
_
Total Cost
Labour Output
: Cost (USO) I (USO) intersects when average product is_ _
A at its maxi1num point
0 0 0 30 B at its minimum point
C zero
so
D negative
1 2 20
2 7 70
3 11 60 90 12 The average fixed cost is equal to the
A total cost divided by total output.
B total variable cost divided by total output.
4 13 80

C marginal cost divided by total output.

5 The total fixed cost is - -- D total fixed cost divided by total output.
A USD20
B USD30 13 The total cost of a firm is USD650 and the
C USDSO average fixed cost is USDlO. Both costs
D USD70 are for 10 units of output. What is the total
variable cost to produce 10 units of output?
6 The total cost at four units of output is_ _
_ A USD640
A USD99 B USD650
B USDIOO C USDSSO
C USDl 10 D USD350
D USD120
14 The law of diminishing returns states that
7 The total variable cost at two units of output A all factors of production are fixed in the
IS ___ long run.
A USD20 B as a firm uses more of a variable resource,
B USD30 given the quantity of fixed resources,
C USD40 the marginal product of the firm '\>vill
D USDSO eventually fall.
""'
(0 C at least one input is fixed in the long run. D why the long-run average cost curve is
D in the short run, the average total cost of U-shaped.
Cl, the firm will be zero.
18 Which of the following is not an internal
co
.c:
t)
15 When the total product curve is decreasing, source of economies of scale?
the A Economies of concentration
A marginal product is negative. B Economies of labour
B average product is negative. C Economies of financial
C marginal product is zero. D Economies of technical
D average product is zero.
19 The production function shows a
16 A firm facing economies of scale over a relationship between
range of output will have a A two goods.
A declining long-run average cost curve. B revenue and marginal cost.
B rising long-run average cost curve. C revenue and cost.
C fluctuating long-run average cost curve. D input and output.
D declining short-run average cost curve.
20 ln the short run, when the output of a firm is
17 Economies and diseconomies of scale explain zero,_ _ _
A why the average fixed cost curve is falling. A variable cost will be zero
B why the average variable cost curve is B total cost will be zero
U-shaped. C none of the costs will be zero
C why there are three stages of production. D all costs will be zero

Short-answer Questions
Answer the following questions.
1 Fill in the blanks with the most suitable ans,...,ers.
(a) ,,Vhen 1narginal product beco1nes negative, total product_ _ _ _ _ __
(b) At least one input is_ _ _ _ _ _ in the short run.
(c) All resources are _______ in the long run.
(d) The main goal of production is to 1naxin1ize_ _ _ _ _ _ _
_
(e) ,!\Then total product is at its maximum, marginal product is_ _ _ _ _ _
2 The table shows the total variable cost (TVC) schedule. The total fixed cost (TFC) is USD200.
Complete the table.

Output (Q) I TVC (USD) · TC (USD) AFC (USD) I AVC (USD)

0 0
1 60
2 80
3 90
4 100
5 140
6 210
3 The table shows the relationship between total product of Good Z and the number of 'ti
"'t
workers employed.
--·
0
C.
C
0
Capital Labour · Total Product I Average Product ! Marginal Product
I 0

-
100 0
(")
100 1 10 0
rn
100 2 16
::s
100 3 14 C.

100 4 11

100 5 8 ::s
C
100 6 5 (I)
�
100 7 2 :,­
(I)
100 8 0 0
"'t

100 9 -4

(a) Calculate the total product and the average product.

(b) Beyond ,-vhat number of workers ,-vill the diminishing returns set in?
(c) For a rational producer, which stage will he/she choose? Why?
4 The table shows the cost schedule for Eclipse Enterprise.
Total Average
Total Fixed Average Average
Output Variable Total Cost Variable
Cost Fixed Cost Cost
(Unit) Cost (USD) Cost
(USD) (USD) (USD)
(USD) (USD)

0 20
1 50

2 70
3 86
4 110
5 150

6 206
7 270

(a) Complete the following cost schedule for Eclipse Enterprise.

(b) Sketch the average total cost, marginal cost and average variable cost curves in a
diagram.
(c) Which time period is the firn1 operating in? Why?
 5 Sketch and complete the three stages of production.
""'
(0

Cl, Production
co
.c: (TP/AP/MP)
t) Stage Stage Stage
1 2 3

'----------'------'----- Quantity of
labour (QL)

Essay Questions
Answer the following questions.
I Using a diagram, explain the three stages of production.
2 Differentiate between an implicit cost and an explicit cost and give examples.
3 Explain four sources of economies of scale.
4 Explain two internal and two external sources of diseconon1ies of scale.
5 Elaborate on the economies and diseconomies of scale using the long-run average cost
curve.
Theory of
the Firm and
Market Structure
tn At the end of this chapter, you should be able to:
� • Describe total approach and marginal approach.
8• Explain perfect competition characteristics and equilibriu.m in
the short run and long run.
:,
O • Explain monopoly characteristics and equilibrium in the short

·e
g> run and long run.
• Describe all types of price discrimination.
CO • Differentiate the differences between monopoly and perfect
�
competition.
• Explain monopolistic competition characteristics and
equilibrium in the short run and long run.
• Explain oligopoly characteristics, the concept of kinked demand
curve (assumptions) and equilibrium in the short run.
I n Chapter 6, we have discussed the theory of production which
deals with how a producer makes the decision on production of
goods and services in tthe short run as well as in the long run, and
the cost of producing goods and services throughout the production
process. Now, we will examine how firms make their decisions on what
price to charge and how much output to produce, depending on
the character of the firm or industry in which it is operating. In this
chapter, we will analyze the different types of firms in terms of
characteristics, determination of equilibrium price, and quantity in the
short and long run. At one extreme, there are markets which consist of
many firms which supply common or identical products; at the other
extreme, there is a single producer which dominates the market by
producing a unique product. This chapter will help you to understand
how price and quantity are determined in the market by different firms.

7.1 THEORY OF THE FIRM

7.1.1 Definition of a Firm
A firm is an institution that hires or buys factors of production, such as
labour, land, capital, raw materials and entrepreneurs, and organizes
them to produce and sell the final goods and services. A firm is
engaged in the production process with the objective of maximizing
profit. However, the fir1n is not only focusing on 1naxin1ization of
profit, but at the same time, is also looking forward to minimizing its
cost. Therefore, the main goals of a firm are:
(a) Maximizing profit, and
(b) Minimizing cost.
The formula shows ho,-v profit is determined:
Total Profit (Tn) = Total revenue (TR) - Total cost (TC)
Total profit (Tn) is obtained by subtracting total cost (TC) from total
revenue (TR). When total revenue is greater than total cost, this means
a firm is earning profit. On the other hand, if total revenue is less than
total cost, the firm is said to be facing losses. Therefore, it is important
for a firm to compare its total revenue and total cost so that it will
receive enough revenue to cover its cost of production. This is known as
breakeven or zero profit, ,-vhere the total revenue equals total cost.

TR > TC = Profit
TR<TC = Loss
TR = TC = Breakeven
7.1.2 Equilibrium of a Firm ::r
�

The determination of equilibrium of a firm is different compared to (I)

0
the determination of equilibrium under market demand and supply.
A firm is in equilibrium when it earns maximum profit or minimum
losses. Therefore, when profit is at n1aximum, the equilibrium price
and equilibrium quantity are achieved. In determining the equilibrium
-::r
0

(I)

of a firm, there are two approaches available: ....

"1
(a) Total approach, and
(b) Marginal approach. D>
::s
Q.
Total Approach
Total approach is a method used to determine the equilibrium price D>
"1

-s::
and output of a firm by comparing total revenue ,vith total cost. This is
�
Under total approach, a firm (I)

known as the simplest method of attaining the equilibrium of a firn1.

is in equilibrium when total

-
profit is at rnaximum (total
The total profit or loss of a firm is calculated by taking the difference revenue -total cost). "1

between total revenue and total cost experienced by a firm. A firm is 0

in equilibrium whenever the value of total profit is at maximum after "1
subtracting total cost from total revenue.
(I)

Maximum Trr = TR - TC
Before we examine the equilibrium of a firm, w e need to know
that there are different types of markets, i.e. the perfect market and
the imperfect n1arket. Table 7.1 illustrates the determination of
equilibrium price and quantity in the perfect market.

Total Table7.1
Quantity Price Total Cost Total Profit Equilibrium of a firm in the
Revenue
(Unit) (USO) (USO) (USO) perfect market under total
(USO)
approach

0 200 0 so -so
1 200 200 200 0
2 200 400 250 150
3 200 600 300 300
4 200 800 450 350
5 200 1,000 500 500
6 200 1,200 650 550
7 200 1,400 950 450
8 200 1,600 1,300 300
9 200 1,800 1,800 0
10 200 2,000 2,300 -300

Table 7.1 indicates the equilibrium of a firm in the perfect market.

The firm is in equilibrium when the total profit is at maximum. The
maximum profit in the table is USDSSO, thus the equilibrium price of
the firm is USD200 and equilibrium quantity is 6 units. The situation
 can be explained i11 the diagram as depicted in Figure 7.1. The
total revenue and total cost are increasing and upward sloping. The
maximum profit is achieved when total revenue is higher than total
cost. The losses happen whenever total revenue is less than total cost.

Figure 7.1 P (USD)

A firm's equilibrium in the
perfect market under total Loss (TR < TC)
approach

o"'----- -------------
-+ Q (Unit)

Table 7.2 illustrates the condition of a firm's equilibrium in

the imperfect market. The equilibrium price is USD300 and the
equilibrium quantity is 6 units at the 1naxin1um total profit ,vhich is
USD840.

Table 7.2 Quantity ' Price Total Revenue Total Cost Total Profit
Equilibrium of a firm in the
(Unit) (USO) (USO) (USO) (USO)
imperfect market under total
approach
0 200 0 300 -300
1 240 240 400 -160
2 280 560 560 0
3 310 930 650 280
4 350 1,400 780 620
5 320 1,600 890 710
6 300 1,800 960 840
7 280 1,960 1,250 710
8 250 2,000 1,400 600
9 220 1,980 1,550 430
10 200 2,000 2,300 -300

Figure 7.2 shows how a firm's equilibrium is achieved in the

in1perfect market. The maximum profit is obtained ,-vhen total revenue
is greater than total cost, whereas losses occur when total revenue is
less than total cost.
 P (USD) Figure 7.2
A firm's equilibrium in the ::r
�

(I)

--::r
Loss (TR < TC) imperfect market under total 0
approach �
0

(I)

Profit ....
"1
(TR> TC)

D>
::s
Q.
Loss (TR < TC) 3:

--
oL..
- - - - - - - - - - - - -+
- - Q (Unit) D>
"1
�
(I)

Marginal Approach
The determination of a firn1s equilibrium under marginal approach
-
s::
"1

involves marginal revenue (MR) as well as n1arginal cost (MC). A firm Under marginal approach, a 0

is in equilibrium when marginal revenue equals marginal cost.

firm is in equilibrium when "1
marginal revenue equals (I)

Marginal Revenue (MR) = Marginal Cost (MC)

marginal cost (MR= MC).

Table 7.3 shows the determination of a firn1s equilibrium in the

perfect market by using marginal approach.

Quantity Price Marginal Revenue Marginal Cost Table 7.3

Equilibrium of a firm i n the
(Unit) (USD) (USD) (USD) perfect market under marginal
approach
0 200
1 200 200 110
2 200 200 90
3 200 200 80
4 200 200 120
5 200 200 150
6 200 200 170
7 200 200 200
8 200 200 260
9 200 200 350
10 200 200 410

Based on Table 7.3, the firm is in equilibrium ,vhen marginal

revenue is equal to marginal cost at USD200. Note that under perfect
market, marginal revenue (MR) is equal to average revenue (AR)
and the demand curve (D). The equilibrium price is USD200 and
the equilibrium quantity is 7 units. Figure 7.3 shows 11:he equilibrium
 condition under the perfect market. T11e intersection poi11t
between marginal revenue and marginal cost is at point E. Point E
is the equilibrium point of the firm in the perfect market. P* is the
equilibrium price and Q* is the equilibrium quantity.

Figure 7.3 P (USD) MC

A firm's equilibrium in the
perfect market under marginal
approach

P*I--- - - - - E _
- L._ _ _
_ MR= AR= D

.__ __,_ _
_____ _* _ _ _ _
_ Q (Unit)
Q

The determination of a firm's equilibrium in the imperfect market

is attained when marginal revenue equals 1narginal cost as stated
in Table 7.4. The firm's equilibrium is achieved at USD200 when
marginal revenue equals marginal cost, therefore the equilibrium
price is USD330 and the equilibrium quantity is 6 units.

Table 7.4 Quantity Price I Marginal Revenue Marginal Cost

Equilibrium of a firm in the (Unit) (USO) (USO) (USO)
imperfect market under
marginal approach
0 200
1 460 460 110
2 430 400 90
3 390 310 80
4 375 330 150
5 356 280 170
6 330 200 200
7 310 190 250
8 285 110 290
9 260 60 350
10 238 40 410

Figure 7.4 depicts the equilibrium of a firm in the imperfect market.

The equilibrium is attained at the intersection point of marginal
revenue and marginal cost at point E*. The equilibrium price is at P*
and the equilibrium quantity is at Q*.
 P (USD) Figure 7.4
A firm's equilibrium in the ::r
�

(I)
imperfect market under

--::r
MC 0
marginal approach �
0
••
••
•• (I)
•
!E*
AR=D ....
"1

D>
MR
�--- �*---------+Q (Unit)
::s
Q.
0
3:
Based on the explanation previously, the determination of the
--
D>
"1

equilibriun1 of a firm is si1nilar for both the perfect market and the
�
(I)

imperfect market, where marginal revenue equals marginal cost. The

only difference is that the marginal revenue curve for the perfect
-
s::
"1

market is perfectly elastic or horizontal, whereas the marginal revenue 0

curve for the imperfect market is dov,rnward sloping. The firm can "1
increase its profit as long as marginal revenue is greater than n1arginal
(I)

cost by increasing its output. Ho,.vever, when marginal revenue is less

than marginal cost, the firm can reduce its losses by cutting the level
of its output.

7 .2 MARKET STRUCTURE
7 .2.1 Definition of a Market
A market is a place where both producers and consumers meet to deal
with business transactions. The market ,.vill facilitate both producers
and consumers in their buying and selling process.

7 .2.2 Definition of Market Structure

Market structure can be defined as the size and distribution of sellers
and buyers in the market, producing various goods and services.
Market Structure
The size and distribution
Market structure explains different types of firms ,vhich are producing ofsellers and buyers in the
either homogeneous products, differentiated products or even a market, producing various
unique product; have f11ll power to control the price or no power to
goods and services.

control the price at all; and the entry of new firms as well as the exit of
existing firms in the industry itself. For instance, in perfect competition
the price is unable to be fixed because there are numerous sellers
causing the size of each individual seller in the industry to becon1e
too small to influence the market, ,.vhereas a monopoly is having
full power to control the price since the firm is the single seller of a
unique product in the whole industry. Therefore, economists group
industries into four distinct market structures, namely pure or perfect
con1petition, monopoly, monopolistic competition, and oligopoly.
 The characteristics of each market structure are explained briefly
belo\.v:
I Pure or perfect competition
Pure or perfect competition involves a large number of sellers,
Four Types of Market
Structures
1 Pure/Perfect competition but the size of each firm is small. Due to that reason, they cannot
2 Monopoly
influence the price as the price is deter1nined by market forces.
Monopol istic competition
They produce homogeneous or identical products and there are
3
4 Ol igopoly
free entry of ne,.v firms and exit of existing firms in the industry.
2 Monopoly
A monopoly is a single seller or sole seller of a unique product. The
product that it produces is a product that has no close substitutes.
Therefore, it can influence the price of the product and is known
as a price maker. There are barriers to entry and exit of firms in
the industry.
3 Monopolistic competition
Ivlonopolistic competition is characterized by a relatively large
number of sellers, but not as large as perfect competition. They
produce differentiated products which have close substitutes in
the n1arket. They have less control over price and there are free
entry and exit of firms in the industry.
4 Oligopoly
An oligopoly involves a fe,.v number of sellers in the industry which
produce either ho1nogeneous or differentiated products. The
decisions on determining the price and quantity of firms under an
oligopoly depend on the decisions made by rival firms, ,.vhich is
defined as mutual interdependence. This mutual interdependence
characteristic makes this market structure different from the other
three types of market structures.

7.3 PERFECT COMPETITION

7.3.1 Characteristics
I Large number of sellers
A basic feature of the perfectly competitive market is the existence
Characteristics of Perfect
Competition
1 Large number of sellers of a large number of sellers and buyers in the market. However,
2 Homogeneous/ the size of each firm is sn1all. Due to that reason, no firm in the
perfectly competitive market can influence or determine the price
Standardized/Identical
products
3 Price taker of goods that it produces. They do not have significant power to
4 Free entry and exit control or fix the price of the products. The price of commodities
is determined by 1narket forces which are market demand and
n1arket supply.
2 Homogeneous/Standardized/Identical products
In the perfectly competitive market, all firms produce standardized
products (homogeneous or identical). As the products are identical
in terms of packaging, quality, design, colour, etc., consumers
cannot differentiate the products fron1 one firm to another firm.
 Thus, the producer cannot control the price and they cannot
charge different prices for the same product. For example, the
::r
�

(I)

wheat produced in Brian's Farm would be identical to the wheat

--::r
0

produced in John's Farm. Therefore, the price of wheat from these

�
0
two farms would be homothetic in nature.
3 Price taker (I)

Perfectly con1petitive firms have no significant control over the ....

market price of the commodities produced. Each of the perfectly
"1

competitive firms produces a small fraction of the total output, thus D>
::s
it cannot influence the total supply and the price of the commodities Q.
produced. In short, a perfectly competitive firm is a price taker 3:
where ilie price of goods is determined by market demand and
--
D>
"1

supply. Once the price has been determined by the market, the price
�
(I)

would be fixed and ,-vould not be changed in any way.

4 Very easy entry and exit
-
s::
"1

New firms can easily enter the industry which means nev.1 firms face 0

no barriers to entry. There are no significant barriers in terms of "1

legal control by the government, licences, permits, finances, patents

(I)

or technology. This shows that if many firms in the whole industry

are making profit, it ,-vill attract new firms to enter the industry and
the number of perfectly competitive firms will grow larger. On the
oilier hand, whenever firms in the industry are facing significant
losses, it wiJI create panic among the existing firms in the industry
and ilius influence them to exit fron1 the industry. This \.Vill make
the number of perfectly competitive firms shrink in ilie industry.

7 .3.2 Price Determination in Perfect

Competition
The specific feature of perfectly competitive firms is that they are price
takers. They are too small to influence the price of commodities in the
market. They sell homogeneous or identical products and therefore no
single producer can affect the price of the co1n1nodities in the 1narket.
The price of the products is determined by market demand and market
supply as illustrated in Figures 7.S(a) and (b).

P (USD) P (USD) Figure 7.5

Market demand and perfect
competition
s

E*
P* ----------------- -------------------------------------
p
1--- - - - - - A
-R =MR= D

D
- - - Q (Unit) + Q (Unit)
o�- - - - - - -
o�- - - -�
0* ----.
(a) Market demand (b) Perfect competition
 The equilibrium price of a product is determined by the intersection
point between market den1and and market supply of the total industry
at point E*. P* is the equilibrium price and Q* is the number of
outputs of the product. As a price taker, the individual firm in the
perfectly competitive market will sell the goods produced at P* which
is the price that has been determined by the market. The price of the
product would be fixed at P*. It is to be noted that the average revenue
curve and the marginal revenue curve '"'ould be constant at P* and
it is the demand curve of the perfectly competitive firm. Therefore,
the demand curve for the perfectly competitive firm is horizontal or
perfectly elastic.

7.3.3 Perfect Competition Short Run

Equilibrium (Profit Maximization)
Short run is a period, \.vhereby there are variable inputs and at least
one fixed input in the production process. Perfectly competitive firms
are faced "¼7ith fixed prices of goods and their objective to maximize
profit is achieved by adjusting the output or supply of the goods in the
n1arket. The determination of profit maximization in the short run
can be based on total approach as well as marginal approach. We will
examine the profit maximization or short run equilibrium of perfectly
competitive firms in this section.

Total Approach (Total Revenue -Total Cost)

Table 7.5 shows the hypothetical data on output, total revenue, total
cost and total profit for the producer of wheat. The profit is maximized
at USD40 and, therefore, the profit-maximizing price is fixed at
USDlOO and the profit-maxi1nizing output is at 4 units. Figure 7.6
depicts the short run profit maximization condition in a perfectly
competitive firm.

Table 7.5
Short run profit maximization
Quantity Price · Total Revenue · Total Cost Total Profit
(kg) (USO) (USO) (USO) (USO)
for wheat production under
total approach
0 100 0 40 -40
1 100 100 160 -60
2 100 200 230 -30
3 100 300 260 40
4 100 400 360 40
5 100 500 490 10
6 100 600 650 -50
7 100 700 860 -160
8 100 800 1, 1so -350
 TC Figure 7.6
TR/TC TR Short run profit maximization in ::r
�

(I)
perfect competition firm using

--::r
0
total revenue and total cost �
approach 0

(I)
400
Maximum profit ....
"1
360 (USD40)
D>
::s
Q.
3:

--
"'--- - - - - -"- -----
- Q (Kg) D>
4 "1
�
(I)

-
Marginal Approach (Marginal Revenue=
Marginal Cost) s::
"1

Marginal approach is another n1ethod to determine the short run profit 0

maximization of a perfectly competitive firm. As stated previously, the "1

firm will achieve equilibrium whenever marginal revenue and marginal

(I)

cost are equal. When marginal revenue is equal to marginal cost, profit
is 1naximized. Table 7.6 and Figure 7.7 illustrate the detern1ination
of the short run profit maximization of a perfectly competitive firm
under marginal approach.

Total
'
Total , Marginal Marginal Total Table 7.6
Quantity Price Short run profit maximization
Revenue Cost , Revenue Cost Profit
(kg) (USO) for wheat production under
; (USO) I (USO) j (USO) i (USO) (USO)
marginal approach

0 100 0 40 -40
1 100 100 160 100 120 -60
2 100 200 230 100 70 -30
3 100 300 260 100 30 40
4 100 400 360 100 100 40
5 100 500 490 100 130 10
6 100 600 650 100 160 -50
7 100 700 860 100 210 -160
8 100 800 1,150 100 290 -350

Table 7.6 shows that a perfectly competitive firm achieves

equilibrium when marginal revenue equals 1narginal cost at USDlOO.
At this point, the profit is at a maximum (USD40). Therefore, the
profit-maximizing price is USDlOO and the profit-maxin1izing output
is 4 kg.
C--. Figure 7.7
; Short run profit maximization
- in perfect competition using
g, marginal revenue and marginal
.C: cost approach
u
Three Types of Short Run
Profit
1 Supernormal profit i s
achieved when AR> AC and
TR> TC at MR= MC.
2 Subnormal profit is incurred
when AR < AC and TR <TC
at MR= MC.
3 Normal profit is obtained
when AR= AC and TR= TC
at MR= MC.
MR/MC
MC
E*
- MR= AR= D
�- - - -
1001------\-- - - - - -
0�--------4�----- Q(Kg)
Q,
Figure 7.7 shows that the short run equilibrium is attained at the
intersection point of MR and MC at point E*. The profit-maximizing
price and output is achieved at USDlOO and 4 kg respectively as MC
cuts MR from below. Q 1 is called the minimization point as MC cuts
MR from above.
Once we have understood the determi11ation of the short run
profit maxi1nization, we can further explore the types of short run
equilibrium that is possibly enjoyed by the firm. There are three
possibilities of short run profit:
1 Supernormal profit
Supernormal profit is also known as econon1ic profit; it is the profit
earned when total revenue is greater than total cost. It can also
be attained ,-vhen price or average revenue is more than average
cost at the equilibrium position. There are two conditions to earn
supernormal profit:
(a) Marginal revenue equals n1arginal cost: MR= MC
(b) Average revenue is greater than average cost: AR> AC
2 Subnormal profit
Subnormal profit or negative profit or losses is incurred by the
firn1 whenever total revenue is less than total cost and also average
revenue is less than average cost at the point of equilibrium;
marginal revenue equals marginal cost. There are two conditions
"vhereby losses are incurred:
(a) Marginal revenue equals marginal cost: MR= MC
(b) Average revenue is less than average cost: AR< AC
3 Normal profit
Normal profit or zero profit or breakeven point is realized ,-vhen
total revenue and total cost are equal and at the same time, average
revenue and average cost are equal at the equilibrium position;
marginal revenue equals marginal cost. Normal profit is the level
of profit that is just enough to persuade firms to stay in the industry
in the long run, but is not high enough to attract new firms.
 There are t"vo conditions which show that a firm earns normal
profit:
::r
�

(I)

(a) Marginal revenue equals marginal cost: MR= MC

0

(b) Average revenue equals average cost: AR= AC

A summary of the short run profit conditions are shown in
Table 7.7.
-::r
0

(I)

....
"1
Table 7.7 :3
Condition of Short Condition of Short
Short Run Profit Summary of the short run profit D>
Run Profit (TR and TC) Run Profit (AR and AC) conditions ::S

Supernormal profit TR>TC AR>AC

D>
Subnormal profit TR<TC AR<AC "1

-s::
�
(I)
Normal profit TR=TC AR=AC

The three possibilities of short run profit are illustrated in Figures

-
"1

0
7.8(a) to (c). The rule for profit maximization, MR= MC, applies for
the three possibilities. The difference between supernorn1al profit, "1
(I)
subnormal profit and normal profit can be detected by comparing the
AC curve with the AR curve.
In Figure 7.8(a), a perfectly competitive firm achieves its
equilibrium level at point C, where MR = MC. Here, we can see that
the AR at point C is higher than the AC at point D. The firn1s profit­
maximizing price is attained at A and the profit-maximizing output
is at Q. The firm is said to be earning supernormal profit as shown in
the shaded area ACDB because AR exceeds AC.
P (USD) Figure 7.S(a)
Supernormal profit in perfect
MC competition

AC

A (10) 1--- - -
----
-
. ----
-+-- - -+-
- -
- P =AR= MR= D
Profit

'- Q (Unit )
o ---------Q
,.....,-
(l� O)�-----•

Supernormal profit is earned when AR > AC and TR > TC at the equilibrium

level of MR= MC.
TR =USD10x10 TC =USDSx10 Tit =TR-TC
= USD100 = USDSO =USD100 - USDSO
= USDSO
(supernormal profit)
 The condition of subnormal profit is shown in Figure 7.8(b). The
profit-maximizing output is obtained at Q and the profit-maxin1izing
price is at A when MR= MC. The firm is said to experience subnormal
profit or losses because the AR at point C is less than the AC at point
D. The loss is shown in the shaded area ABDC.
Figure 7 .S(b) P (USD)
Subnormal profit in perfect
competition MC

AC

B (1 S)
Loss
A (10) 1--- - - - --7l"'
- :-- - - - - -MR= AR= D
C

0 Q (Unit)
Q (10)

Subnormal profit is realized when AR< AC and TR< TC at the equilibrium level
of MR=MC.
TR =USD10x 10 TC =USD15 x 10 Trr =TR-TC
=U5D100 =USDl SO =U5D100 - U5D150
=-USDSO
(subnormal profit)

The last type of profit is normal profit which is illustrated in

Figure 7.8(c). At MR= MC, the profit-maximizing output and price
are achieved at points Q and A respectively. The AR = AC gives the
condition of nor1nal profit or zero profit.
Figure 7.S(c) P (USD)
Normal profit in perfect
competition MC

AC

o.__ ...,__
______ _____
__ Q (Unit)
Q (10)

Normal profit is achieved when AR =AC and T R =TC at the equilibrium level
of MR=MC.
TR=U5D10 x 10 TC =USD10x10 Tit =TR-TC
= USDlOO ;;; USDl 00 = USDl 00 - USDl 00
=USDO
(normal profit)
7 .3.4 Shutdown Condition ::r
�

Firms in the perfectly competitive market may face subnormal profit (I)

--::r
0
or losses when average revenue is less than average cost. When the �
fir1n experiences losses, there would be two conditions, i.e. whether 0
the firm can still continue its operation or to shut down its operation.
We need to kno,v that there are two types of cost known as fixed cost (I)

and variable cost. Fixed cost needs to be paid regardless of the level of ....
the fir1n's production. Conversely, the variable cost is cost that needs
"1

to be paid when the firm produces goods and services. As the output D>
::s
increases, the variable cost will also increase. Q.
The condition of shutting do,vn or not depends on the average 3:
variable cost. When the average revenue (or price) is higher than the
--
D>
Shutdown happens when the "1

average variable cost as shown in Figure 7.9, the fir1n can still continue average revenue or pnce 1s �
(I)
less than the average variable
its operations even though it is experiencing losses. This is because the

-
cost.
firm can still pay wages for the ,vorkers, buy ra"v materials and pay for s::
"1

the other operating expenses. 0

If the firn1 ceases production, total revenue is equal to zero as total "1

revenue= price x quantity= 0, and the firm must pay all the total fixed
(I)

cost even if there is no production. Thus, losses as shown in Figure 7.9

is the area of total fixed cost = (USD15 - USD5) x 10 = USDI 00.
If the firm resumes production, total revenue= USDlO x 10= 100,
total variable cost = USD5 x 10 = 50, and losses= (USDlO - USD5)
x 10 = USD50. Since losses of USD50 is less than USDlOO, the firm
should continue production.
P (USD) MC Figure 7.9
AC Shutdown point in perfect
competition (losses, but
continues operating)
AVC

Loss area if 15 1-___.;,______.;;;a;,,..,_,

�
opera tions� MR= MC
✓
continue 1 o 1----.....,..-----f-"' .,,..-,:;-P=AR= MR= DD curve
(TC> TR) - -

(Unit)
o�- - - - - - - �
-0, -
- - - -+Q
-

On the other hand, the firm should shut down when the average
revenue (or price) is less than the average variable cost as depicted in
Figure 7.10. This means that the firm cannot cover its variable cost,
e.g. it is unable to pay workers' wages, buy raw materials or pay for
other operating expenses.
In Figure 7.10, if the firm continues operation:
Total Revenue = USDlO x 10 = USDIOO
Total Cost = USD15 x 10 = USD150
 Profit = Total revenue - Total cost
= USDlOO - USDlSO
= -USDSO (loss)
Variable Cost = Average variable cost x Quantity
= USD12 x 10
= USD120
Total Fixed Cost = Total cost - Variable cost
= USD150 - USD120
= USD30
Hence,
Losses= (USD12 - USDlO) x 10 = USD20, ,.vhich is part of the
total variable cost, and
(USD15 - USD12) x 10= USD 30, which is all of the total
fixed cost
The firm is making a loss of USDSO because average revenue= price
is less than average cost (total revenue is less than total cost) at the
point of equilibrium (marginal revenue= marginal cost). Hence, the
firm will stop (cease) production because average revenue = price is
less than the average variable cost. The total revenue received by the
firm cannot cover both the variable cost and the fixed cost.
This means that when the price is less than the average variable
cost, if the firm still continues production, it has to pay not only the
total fixed cost, but also part of the total variable cost.
If the firm stops operations, total revenue = 0, total variable cost =
0, and losses= total fixed cost= USD30.
Loss of USDSO > USD30, thus the shutdo,vn point is the point
where the average variable cost equals average revenue (or price).
Figure 7.10 P (USD)
Shutdown point in perfect MC
competition (losses and stops AC
production)
AVC
Loss area 15 ------------ ------------
(TC> TR}
Total fixed c
� 12
Total
variable c,ost E
101-- _ _ _ _ _ _ P = AR =MR = DD curve
____,,__
- - - -
'MR=MC

(Unit)
�1�
o'-- - - - -
0 - - - - - -+
- Q

7.3.5 Long Run Equilibrium

Long run is the period of time that is long enough for new firms to
enter the i11dustry and all factors of production are variable factors.
Long run equilibriu1n is the condition, "vhereby the firm can make
necessary changes to the production process. In the long run, all
::r
�

(I)

inputs are variable. The long run equilibrium rule is marginal revenue
--::r
0

equals marginal cost.

�
0
A perfectly competitive firm will only earn normal profit in the long
run, due to the freedom of entry of new firms and the exit of existing (I)
firms in the industry. The long run equilibrium or profit-maximizing ....
condition is illustrated in Figure 7.11.
"1

D>
P (USD) Figure 7.11 ::S
Long run equilibrium in perfect C.
LRMC competition :S:

--
D>
"1
LRAC �
(I)

-
s::
"1

0
"1
(I)

O� - - - � - Q (Unit)
- - - - - - - -+
Q*

How do the free entry of new firms and the exit of existing firms in
the industry cause the perfectly co1npetitive firm to only earn norn1al
profit in the long run? The effects of entry and exit are explained in
detail below.

Effect of Entry
The long run equilibrium depends on ilie short run situation of the
market. In the short run, when a perfectly competiti,1e firm achieves
supernormal profit, it ,-vill attract many ne,-v firms in the market to enter
into the same market. This is due to the objective of the firms to maximize
their profit. As 1nany firms enter the market, the nwnber of sellers or
suppliers in the market will increase. Therefore, the equilibrium market
price will decrease and the perfectly competitive firms ,-vill also reduce
their prices because they are price takers. The price will continue to fall
until zero profit is made (i.e. P = LRAR = LRAC). Thus, in the long rw1,
perfectly con1petitive firms will only earn normal profit due to the free
entry effect. This effect is illustrated in Figures 7.12(a) and (b).

P (USD) P (USD) Figure 7.12

LRMC Market equilibrium and perfect
competition

LRAC
20 ................. ...... 20 �-::--
- - -,t----,,t- LRAR = LRMR = D
-
1 0 ............ . .......... 10 LRAR, = LRMR, = D,
''
'

D
o� ·:
---- + Q (Unit)
- � - - - - -
- Q (Unit)
10 15 0
(a) Market equilibrium (b) Perfect competition

Figure 7.13
Market equilibrium and perfect
competition
A perfectly competitive firm
earns normal profit in the long
run, due to freedom of entry
and exit.
Figure 7.12(a) explains the market equilibrium in the whole
industry. The equilibriun1 price is USD20 and the equilibrium quantity
is 10 units as determined by the intersection between market demand
and supply. As illustrated in Figure 7.12(b), a perfectly competitive
firm experiences supernormal profit at the initial price. This will
attract 1nany new firms to enter the market in order to make profit
as well. As a result, the number of suppliers increases in the market
and the supply curve shifts rightwards. The equilibrium price reduces
to USD10 and the equilibrium quantity increases to 15 units. The
de1nand curve for a perfectly competitive firm decreases to D1 (LRAR1
= LRMR1 ), hence the perfectly co1npetitive firm earns zero or normal
profit due to free entry iln the long run.
Effect of Exit
The effect of exit occurs when the perfectly con1petitive firm faces
subnormal profit or loss. When the market experiences subnormal
profit, this will cause existing firms to exit from the market since they
are afraid of making losses. With a decrease in supply, the equilibrium
market price increases. Hence, perfectly competitive fir1ns are able
to sell with a higher priice until the new price (or LRAR) is equal to
LRAC. A perfectly competitive firm earns normal or zero profit in the
long run, due to the effect of exit. This effect is explained in Figures
7.13(a) and (b).
P (USO) P (USO)
LRMC
'
20 ················ ·············· ·····
S0
20 l-------':::::,,..-1--""'-
LRAC
LRAR2 = LRMR 2 = 02
:
1 O ........ . . ........ 10 1---- LRAR = LRMR = 0
.
-
-+-- - -
•
0
0 .__
_ _
_._�- - -
10 15
- 0
Q (Unit) Q (Unit)
(a) Market equilibrium (b) Perfect competition
Figure 7.13(a) depicts the market equilibrium situation where
market demand intersects with market supply. The equilibrium price
and equilibrium quantity are determined at USDlO and 15 units
respectively. At this market price, the perfectly competitive firm faces
subnormal profit or a loss at D. This causes the existing perfectly
competitive firms in the industry to incur losses and exit from the
market. As a result, the number of suppliers reduces and the supply
curve shifts leftwards. The equilibrium price increases and this causes
the demand curve for perfectly competitive firms to increase to D2
(LRAR2 = LRM�), as sho,-vn in Figure 7.13(b). Thus, the perfect
competition market earns normal or zero profit in the long run.
 7.1 ::r
�
SAMPLE QUESTION
(I)
0

-::r
Based on the diagram, answer the following questions.
0
P (USD)
MC AC (I)

AVC
....
"1
30
D>
25 1------',..__- -+---;?,L__
- - _ _ _ _ _ _ _ P = AR = MR = DD curve ::s
Q.

D>
"1

-s::
�
(I)
5 ----------------

-
"1
� - -+Q (Unit)
--�-- - - - - - - - - -
O so 75 90 0
(a) Which type of market structure is the firm operating in? "1
(b) Determine the profit-maximizing price and quantity. (I)

(c) Calculate the total profit or loss of the firm.

(d) Identify the type of profit earned by this ti rm.
(e) Determine the shutdown price.

Solution:
(a) Perfect competition, because the demand curve is horizontal or perfectly elastic.
(b) Profit-maximizing price= USD25
Profit-maximizing quantity= 90 units
(c) TR = USD25 x 90 TC = USD30 x 90 Tn = TR -TC
= USD2,250 = USD2,700 = USD2,250 - USD2,700
=-USD450
(d) Subnormal profit, because AR< AC and TR < TC at MR= MC.
(e) Price should be below USDl 5 to shut down (P= AVC).

7.4 MONOPOLY

7 .4.1 Characteristics
I Single seller and large number of buyers
A pure monopoly exists when a firn1 is the sole producer or single
Characteristics of a
Monopoly
seller in the whole industry. The firm is the only producer of the 1 One/Single seller
goods and services to be purchased by a large number of buyers. 2 Unique products, wi th no
Since it is the only seller, it will face no competition and it can
close subst itutes
3 Price maker
influence the market easily. 4 Barriers to entry
2 Unique product/No close substitutes
5 Minimum advertising
needed (for certain types
In a monopoly, a firm produces a unique product which has no of commodities)
close substitutes in the market. For example, in Malaysia the only
 supplier of electricity is Tenaga Nasional Berhad (TNB). There
are no other products that can be the substitutes of electricity in
Malaysia and therefore TNB is the sole producer of electricity in
Malaysia.
3 Price maker
In a pure n1onopoly, a firn1 faces no competition since this firm is
the only producer of the unique product. Therefore, this firm can
determine the market price of the goods and services produced. It
has full power to control the market price. For example, if the firm
experiences an increase in the cost of production, the fir1n has the
n1arket power to increase the price, in order to avoid incurring a
higher cost of production or making losses.
4 Barrier to entry
In a pure monopoly, a firm has no competitors since there are
barriers to entry of new firn1s joining the industry. Toe barriers
are comprised of va.rious forms such as legal, technology, control
over raw material, patent and copyright, licenses, etc.
5 MiJ1imum advertising needed
Toe types of products will determine whether there is a need for
advertising. If the types of products produced are water supply,
electricity, telecommunications services, etc., there is no need for
advertisement since the consumers are well aware of the market
and where to obtain such goods and services. However, for
products such as luxury imported cars, luxury special furniture,
luxury brands of mobile phones, etc., there is a need for some
advertisement to inform consumers of the existence of such goods
and services in the market.

7.4.2 Barriers to Entry

Barriers or restrictions on entry refer to the prevention of other
firms or sellers from entering the industry. In a monopoly, all
potential competitors are blocked from entering the industry
due to strong barriers to entry. A weaker barrier to entry
may permit the entry of a few firms into the industry as in an
oligopoly. There are several types of barriers to entry as follows:
I Economies of scale
Economies of scale occur whenever the average cost decreases as
production expands. This may only be experienced by a few large
firms, or in the extreme case, by a sole producer. In a monopoly,
the entry of ne'\-v firms is impossible due to economies of scale
that the firm experiences. Therefore, a monopoly is protected
from competition in the industry. For example, if new firms
try to enter the industry, they need to start their operation on
a large scale, '\-Vhiclh is difficult to perfor1n since they are new
in the industry. Therefore as small scale producers, they can
 hardly achieve nor1nal profit and survive in the in,dustry, a11d will
eventually fail.
::r
�

(I)
0
2 Ownership or control over raw materials/resources
A monopolist may prevent potential rivals through the control
or o,vnership of raw materials. For instance, a sugar producer in
Malaysia controls the resources and therefore 1nakes new entry
-::r
0

(I)

almost impossible. ....

"1
3 Patents and copyright
A patent refers to the exclusive right of its invenil:or to use or to D>
::s
allow others to use his or her invention. Patent laws are established Q.
to prevent potential competitors from imitating or using his or D>
her invented product and therefore will provide a monopoly "1

pov.rer for the life of the patent. In addition, a copyright refers

-s::
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(I)

to the exclusive right to the books' author, music composer, film

producer, etc. Copyright will also prevent potential rivals from
-
"1

copying the products invented by the original owners and make 0

entry impossible. "1

(I)
4 Licenses
Governments will restrict the entry of ne,v firms by imposing a
legal license. For instance, the imposition of licenses on television
stations may prevent new potential firms from entering the
industry, and encourage a monopoly.

7 .4.3 Monopoly Demand Curve

The crucial difference between a perfectly competitive firm and a pure
monopolist lies on the demand side of the market. As learnt earlier,
perfectly competitive firms face a perfectly elastic or horizontal
demand curve since the size of the sellers are too small to influence
the price. Therefore, price, marginal revenue and average revenue are
constant in perfect competition.
Conversely, the demand curve for a monopoly firm is downward
sloping which depends on the law of demand. Consumers always
respond to the lower price by increasing the quantity den1anded,
and vice versa. Take note that the firm's demand curve represents the
industry's demand curve. The monopolist will set the price based on
the elasticity of demand and its relation to total revenue.
As illustrated in Figure 7.14, the purely monopoly firm will set
higher prices for the products if the demand is inelastic. This is
because when consumers face inelastic demand, they have no choice
and have to buy the products regardless of the price. Therefore, the
fir1n ,vill increase its total revenue as price increases when the de1nand
is inelastic. On the contrary, when the demand is elastic, the price will
be lowered since consumers are sensitive towards price changes and
will respond by reducing their quantity demanded. Therefore, to avoid
a reduction in total revenue, the monopolist will set lower prices for
elastic demand.
 Figure 7.14 P (USD)
Relationship between marginal
revenue, price elasticity of
demand and total revenue

Unitary elastic, Ed = 1

Inelastic, Ed < 1

AR=D

o'--- - - - - - - - - - - - - -
-+ Q (Unit)

MR

TR
MR>O MR<O

0.__ _.__
______ .,___-+ Q (Unit)
______

Figure 7.14 shows the relationship between the de1nand curve,

marginal revenue curve and total revenue. The marginal revenue
curve lies below the demand curve. When marginal revenue is positive
(MR > O), the demand is said to be elastic. At this point, as price
decreases, the total revenue will increase. On the other hand, when
marginal revenue is negative (MR < 0), den1and is inelastic which
indicates that as price increases, the total revenue will increase as
well. Lastly, the total revenue is unchanged when price changes when
demand is unitary elastic, "vhere marginal revenue is equal to zero
(MR = O). Table 7.8 sun1marizes the relationship between marginal
revenue, price elasticity of demand and total revenue.

Table 7.8 Price Elasticity of

Summary of relationship Marginal Revenue Total Revenue
Demand
between marginal revenue,
price elasticity of demand and
total revenue Positive (MR> 0) Elastic demand (Ed > 1) Increases as price
decreases
Zero (MR= 0) Unitary elastic (Ed = 1) Unchanged as price
changes

Negative (MR < 0) Inelastic demand Increases as price

(Ed < 1) increases
7 .4.4 Monopoly Short Run Equilibrium ::r
�

(Profit Maximization) (I)

0
Now, we will analyze the short run equilibrium of a monopoly firm.
Short run is a period, whereby there are variable inputs and at least one
fixed input in the process of production. Similar to perfect competition,
-::r
0

short run equilibrium can be explained by two approaches, namely

(I)

total approach and marginal approach. ....

"1

D>
Total Approach (Total Revenue - Total Cost} ::s
Q.
As discussed before, total approach can be determined by looking
at the total profit experienced by the firm. The firm is said to be D>
"1
in equilibrium when total profit is n1aximum. Table 7.9 shows the
-s::
�
(I)
profit maximization in the short run of a firm in the monopoly
market.
-
"1

Table 7.9 "1

Price Total Revenue Total Cost ' Total Profit (I)
Quantity Short run profit maximization
(USD) (USD) (USD) (USD)
in a monopoly under total
approach
0 300 0 220 -220
1 260 260 270 -10
2 220 440 330 110

3 180 540 380 160

4 140 560 460 100

5 100 500 500 0

6 60 360 540 -180

The difference between total revenue and total cost represents the
total profit experienced by the firm. Based on Table 7.9, the highest
total profit earned by the firm is USD160. This indicates that the
profit-maximizing price is USD180, whereas the profit-maximizing
quantity is 3 units.
Figure 7.15 shows the condition of short run profit maximization
for a firm in the monopoly market. The vertical distance between total
revenue and total cost reflects the total profit obtained by the firm.
When quantity is at 3 units, the difference between total revenue and
total cost is at the highest. This brings the maximum profit ofUSD160.
This is also the area ""here the firm experienced equilibrium in the
short run.
 Figure 7.15 P (USO)
Short run profit maximization
in a monopoly under total
approach TC

TR
540 --------------------------

380 ------------ -----------

o�------..:..--------o (Unit)
3

Marginal Approach (Marginal Revenue = Marginal

Cost)
As discussed before, the determination of short run equilibrium under
margi11al approach can be obtained when marginal revenue equals
marginal cost (MR= MC). A firm will maxin1ize profit when marginal
revenue is equal to n1arginal cost. Table 7.10 sho,.,s the short run profit
maximization under marginal approach for a firm in the monopoly
market. The profit-maximizing price is determined at USD180 and
the profit-maximizing quantity is obtained at 3 units. At this point,
the marginal revenue equals marginal cost at USDlOO. The total
profit is maximized when marginal revenue is equal to marginal cost
(MR= MC).

Table 7.10 Total Total Marginal Marginal Total

Short run profit maximization Price
Quantity Revenue Cost Revenue Cost Profit
in a monopoly under marginal (USD)
(USD) (USD) (USD) (USD) I (USD)
approach

0 300 0 200 0 0 -200

1 260 260 290 260 90 -30
2 220 440 350 180 60 90
3 180 540 450 100 100 90
4 140 560 590 20 140 -30
5 100 500 780 -60 190 -280
6 60 360 1,030 -140 250 -670

Figure 7.15 depicts the short run equilibrium determination

under marginal approach. The average revenue and demand curve
of a monopoly is downward sloping according to the la,., of demand.
The marginal curve lies below the average revenue curve. The firm
achieves equilibrium and maximum profit when marginal revenue
and marginal cost are equal. This is shown at the i11tersection poi11t
between MR and MC a t point E*. The profit-n1axin1izing quantity is
determined at Q* and the profit-maximizing price is at P*.
 P (USD) Figure 7.16
Short run profit maximization ::r
�

MC (I)
in a monopoly under marginal

--::r
0
approach �
0

(I)

....
"1

D>
::s
AR=D Q.
3:
o·'--- - 0-
--
- -- - - - - - •
- Q (Unit) D>
* -
-'-- l (3 "1
�
MR (I)

-
Now ,-ve can analyze the types of short run profit of a monopoly. As Three Types of Short Run
mentioned earlier, under perfect competition, a monopoly will also Profit
0
s::
"1

earn three kinds of profit known as supernormal profit, subnormal

1 Supernormal profit is
earned when AR> AC and
profit and normal profit. This is illustrated in Figures 7.17(a) to (c).
"1
TR> TC at MR= MC. (I)

Figure 7. l 7(a) shows that the monopolist earns supernormal profit 2 Subnormal profit is
experienced when AR < AC
or economic profit because AR is greater than AC. The equilibrium of andTR <TC at MR=MC.
a monopoly is deter1nined at point E* where MR= MC. The profit­ 3 Normal profit is attained
n1aximizing quantity is at Q and the monopolist charges the price at when AR = AC and TR= TC
at MR=MC.
A. The shaded area ACDB represents the supernormal profit earned
by the monopolist.

P (USD) Figure 7.17(a)

Supernormal profit in a
MC monopoly

AC

A (20)

AR=D

o,_ __._
_ _ _ _ __,,.
__________
_ Q (Unit)
Q (15)
MR

Monopoly earns supernormal profit when AR> AC and TR> TC at MR= MC.
TR=USD20x15 TC =USD10X15 Trr =TR-TC
=USD300 =USD150 =USD300 - USD150
= USDisO
(supernormal profit)
 In Figure 7.17(b), the monopolist experiences subnormal profit or
negative profit or simply called losses since AR is less than AC at the
equilibrium position MR = MC (point E*). The profit-maximizing
output is obtained at Q and the profit-maximizing price is at B. The
monopolist faces subnormal profit as reflected in the shaded area ADCB.
Figure 7.17(b) P (USD)
Subnormal profit in a monopoly

MC
AC

D
A (25) ••

B (20) C

AR=D

o� ----- .... Q (Unit)

_,,___ _ _ _ _ _ _ _
Q (15)

MR

Monopoly faces subnormal profit when AR< AC and TR< TC at MR=MC.

TR =USD20 x 15 TC =USD25 x 15 Tit =TR - TC
=USD300 =USD375 =USD300 - USD375
=-USD75
(subnormal profit)

Figure 7. l 7(c) i11dicates the situation of normal profit or zero profit

or breakeven position. At the equilibrium point, MR= MC, the profit­
maximizing output and price are at Q and A respectively. Here, the AR
equals AC, hence the m•onopolist earns only normal profit.

Figure 7.17(c) P (USD)

Normal profit in a monopoly MC

AC

A (20) ••••

AR=D

O�
_ ___..
_ _ _ ....,,� -------
----+ Q (Unit)
Q (15)
MR
 Monopoly obtains normal profit when AR= AC and TR=TC at MR= MC. ::r
�

TR=USD20x15 TC =USD20x15 Tit =TR-TC (I)

0
= USD300 = USD300 = USD300 -USD300

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= USDO
(normal profit) 0

7 .4.5 Monopoly Long Run Equilibrium (I)

Long run is a period, whereby all inputs are variable because there is ....
"1

ample time for the firm to make necessary changes to the inputs. Long
run equilibrium also follows the sa1ne rule as short run equilibrium
D>
::s
where marginal revenue is equal to marginal cost (MR= MC). In the Q.

long run, a monopolist will earn supernormal profit because of the D>
barriers to entry that exist in industries in the monopoly market.
"1

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�
The reason why a monopolist only earns supernormal profit is
(I)

because when there is restriction on entry of new fi r ms, the monopolist

does not have any competitors. Therefore, due to no competition, the
-
"1

monopolist can increase or decrease the price, depending on the cost

0

that they incur. For instance, if the production cost i11creases, the "1
(I)
monopolist n1ay increase its price in order to avoid minimum profit
or losses. This means a monopolist can make all the necessary changes
to cost due to restriction on entry of new firms into the industry.
As illustrated in Figure 7.18, the long run equilibrium of a
monopoly is achieved when long run marginal revenue equates
Monopoly earns supernormal
profit in the long run, due to
long run marginal cost (LRMR = LRMC). This is shown at point E*. barriers to entry.
The profit-maximizing price is obtained at point A and the profit­
maximizing output is achieved at point Q. The shaded area ACDB
represents supernormal profit that is earned by the 1nonopolist i11 the
long run, due to barriers to entry.
P (USD) Figure 7.18
LRMC Long run equilibrium in a
monopoly

A LRAC

LRAR=D

o� - - �� _.._- - - - - - -+
- - Q (Unit)
Q

LRMR

7 .4.6 Price Discrimination

Our discussion so far has assumed that the n1onopolist charges each Price discrimination is
consumer with the same price or single price. However, under certain a situation, whereby a
producer charges different
circumstances, the 1nonopolist may charge different prices fro1n prices for different groi.,ps of
different buyers for the sa1ne products to 1naximize profit. This is consumers.
called price discrimi11ation which is the practice of selli11g the same
product at different prices to different consumers that are not justified
by cost differences. For example, flight tickets would be expensive for
adults and cheaper for children. The practice of price discrimination
is subject to several und!erlying conditions.

Conditions of Price Discrimination

The opportunity to practice price discrimination is not available to all
sellers or firms. Price discrimination is only applicable to a monopoly
since there is no competition experienced by the monopolist and
it can make all the necessary changes to the price, according to the
cost that it bears. Price discrimination is possible when the follo,.ving
conditions are recognized.
I Existence of monopoly power
Only firms with 1nonopoly po,ver can practice price discrimination.
The firm should have the ability to control price and output in
order to perform price discrimination.
2 Market segregation
The monopolist should be able to segregate or segment the buyers
into distinct groups or classes. Each buyer must have a different
ability and willingness to pay for the product. The buyers would be
separated according to the different elasticity of demand.
3 Different degrees of elasticity of demand
The seller in the monopoly market will charge different prices
according to different degrees of elasticity of demand. The
objective of doing so is to maximize profit. The monopolist may
charge higher prices for inelastic demand si11ce they will receive
higher returns because buyers are not sensitive towards price
changes. On the contrary, the monopolist will charge lo,.ver prices
for elastic demand because the buyers are sensitive towards price
change. To avoid losses or minimum profit, the firm will charge
lower prices ,vhen de1nand is elastic.
4 No resale
Buyers cannot resell products in the market to gain profit. If goods
are purchased at cheaper or lov,r prices, buyers cannot and should
not resell the same goods at higher prices in the market. When this
occurs, the monopolist will face competition from the buyers (who
are paying the higher prices). This would then reduce the prices of
the products and hinder the practice of price discrimination. This
situation suggests that price discrimination is possible in the services
sector, such as the transportation industry and n1edical industry,
\.Vhere the act of resale is impossible. For instance, adults cannot use
children's tickets to watch movies in a cinema.
5 Low cost of market separation or segmentation
The n1onopolist 1nust make sure that the cost of separating or
segregating the market is low to ensure profit is able to be gained.
This is because the monopolist ,.vill bear the cost of separating
 the different groups of buyers and charging different prices from
different classes of buyers.
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�

(I)

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Different Degrees of Price Discrimination 0
Price discrimination can be categorized into three degrees as follov,rs:
I First degree price discrimination (I)
First degree price discrimination is practiced when a monopolist ....
charges separate or different prices for the same products sold
"1

and will sell the products to the buyers who are willing to pay D>
the maximum price. This situation is applied in an auction. For ::s
Q.
example, an antique sculpture is open to be sold in an auction and 3:

--
those who bid the maximum price will buy the antique sculpture. D>
"1

2 Second degree price discrimination

�
(I)

Second degree price discrimination occurs whe11 the goods and

services are divided or separated into different blocks or groups.
-
s::
"1

Each block or group is charged a different price. For exan1ple, 0

parking charges are different every hour. For the first 1 hour, the "1

charge would be USD2. For the second hour, the price is slightly
(I)

reduced to USDl, and for the following hours, the price decreases
further to USD0.50. The second degree price discrimination is
applicable to photocopy services, electricity charges, car rental,
tuition fees, internet charges, and so on.
3 Third degree price discrimination
Third degree price discrimination is performed by dividing
markets into different subgroups or sub-markets. The price
charged for different subgroups is based on the price elasticity
of demand. When demand is inelastic, a monopolist ,.vill charge
higher prices, whereas low prices are charged for elastic demand.
For instance, a flight ticket or movie ticket is cheaper for children
and more expensive for adults. Therefore, the third degree price
discrimination is applied in transportation services, entertainment
sectors, medical services, etc.

7 .4.7 Comparison Between Perfect

Competition and Monopoly
I Characteristics
A perfectly competitive firm has a large number of sellers and buyers.
Ho,-vever, the size of each firm is small in the industry. As a result,
perfect competition is a price taker where the price is determined
by 1narket forces (market demand and market supply). They sell
standardized or homogeneous products that are hardly differentiated
in terms of packaging, labelling, colour, etc. There is also freedom of
entry by ne"v firms and exit of existing firms in the whole industry.
Conversely, a monopolist is a si11gle seller ,-vho produces a unique
product which has no close substitutes in the market. Therefore,
a monopolist is a price maker since it faces no con1petition in the
industry. There are restrictions to entry and exit.
 2 Demand curve
The den1and curve for a perfectly con1petitive firm is perfectly elastic
or horizontal, o"ving to the fact that it is a price taker. On the other
hand, ilie demand curve for a monopoly firm is downward sloping
according to the la,,v of demand and price elasticity of demand.
3 Long run equilibrium
In the long run, firms in the perfectly competitive market earn
only normal profit due to the freedom of entry and exit. On the
contrary, a monopoly firm obtains supernormal profit in the long
run since there are barriers to entry of new firms and therefore tl1e
n1onopolist faces no competition. Thus, it has the market power to
change the price as cost changes.
4 Price and quantity
The price charged in perfect competition is lo"ver coinpared
to a monopoly, while the profit-maximizing output in perfect
con1petition is higher than a monopoly.
5 Efficiency
A perfectly competitive firm produces outputs at which price
equals marginal cost. This indicates that the fir1n achieves efficient
allocation of resources. This means that perfect competition
produces at the lowest point of average cost. In contrast, a
monopolist charges prices greater than the marginal cost. The
monopolist needs to use more resources to produce at the output
which is lower than perfect competition.
Table 7.11 summarizes the differences between perfect competition
and monopoly.
Table 7.11 Perfect Competition Monopoly
Comparison between perfect
competition and monopoly
Characteristics Characteristics
1 Large number of sellers 1 Single seller
2 Price taker 2 Price maker
3 Produces standardized or 3 Produces unique products
homogeneous products without substitutes
4 Free entry and exit 4 Barriers to entry and exit
Long Run Equilibrium Long Run Equilibrium
Normal profit due to free entry and Supernormal profit due to barriers to
exit entry and exit

Price and Quantity Price Discrimination

Lower price charged, but the Higher price charged, but the
equilibrium output is more than equilibrium output is less than
monopoly perfect competition

Efficiency
More efficient allocation of resources
than monopoly since P = MC
---------------
Efficiency
Less efficient than perfect
competition since monopoly needs
more resources to produce less
output, and P > MC
 SAMPLE QUESTION 7.2 ::r
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(I)
0

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The diagram shows the short run equilibrium for Steel Inc.
P (USD) 0

MC
(I)

....
"1

D>
13 AC ::s
Q.

D>
"1

-s::
AR=D �
(I)

-
"1

-----='<-- - - - -
-----+Q (Un it) 0
o'--- -
�,0=----:1 -=-5
"1
MR (I)

(a) Which market structure does the firm operate in? Justify your answer.
(b) Determine the profit-maximizing price and output.
(c) If the firm's average fixed cost is USD6 at the equilibrium, calculate the total variable cost
of the firm.
(d) Calculate the profit earned by the firm and name the type of profit the firm is making.
(e) List three characteristics of this market structure.
Solution:
(a) Monopoly, because the demand in downward sloping.
(b) Profit-maximizing price= USDl 3
Profit-maximizing output=10 units
(c) TC = USDl 1 x 10 TFC = USD6 x 10 TVC = TC -TFC
= USDl 10 = USD60 = USD110 - USD60
= USDSO
(d) TR = USDl 3 x 10 TC = USDl 1 x 10 Tn =TR-TC
= USD130 = USDl10 = USD130 -USD110
= USD20
The firm earned supernormal profit becaU1se AR> AC and TR > TC at MR= MC.
••• (e) Single seller; produces unique products with no close substitutes; barriers to entry; price
maker

7.5 MONOPOLISTIC COMPETITION

7 .5.1 Characteristics Characteristics of

Monopolistic Competition
1 Relatively large number of sellers 1 Rel atively large number of
Monopolistic competition is an industry that is characterized by sellers
a relatively large number of firms. However, the number of firms
2 Differentiated products
3 Less control over price
in monopolistic competition is not as large as perfect con1petition. (price-output policy)
The firms have a small market share or in other words, the size of 4 Easy entry and exit
5 Advertising is needed
 each firm is small and therefore no single firm can influence the
market price of the product.
2 Differentiated products
Firms in monopolistic competition produce differentiated products
\>Vith close substitutes available in the market. Unlike perfect
co1npetition that produces identical and homogeneous products,
there is a variety of goods and services available in n1onopolistic
competition, and consumers have many choices of products. The
products are differentiated in terms of packaging, labelling, brand
names, benefits of usage, advertising, etc. For example, there are
various shampoo choices available in the market, such as Pantene,
Sunsilk, Head & Shoulders, roreal, etc.
3 Less control over price
Duetothefairlys1naJlsizeofeveryfirminmonopolistic competition,
they cannot determine the prices of goods and services. They have
less control over the prices of products. Each firm will follo,.v an
independent price-output policy. In other words, monopolistically
competitive firms do have some or limited control over the market
price due to product differentiation and potential substitutes for
their products. For example, there is a situation where consumers
prefer a specific product and are willing to pay more to satisfy
their preferences. There is also a situation ,.vhere consumers will
find substitutes for a product "vhenever the price increases.
4 Easy entry and exit
It is relatively easy for new firms to enter into monopolistically
competitive industries as compared to pure monopoly. The
existence of new fir1ns in the industry is made possible by
producing substitutes of the existing products or creating new
brands. The entry of ne,.v firms and the exit of existing firms in
monopolistic competition are not as easy as in perfect competition.
This is because monopolistically competitive firms produce
differentiated products, whereas the perfectly co1npetitive firms
produce standardized products.
5 Advertising is needed
The monopolistic competitors need to advertise their products
to create awareness among the consumers about the existence
of the products. This is to create and increase den1and for the
products. This act is known as non-price competition to create
brand consciousness among consumers. The firm practices non-
price competition in terms of advertisements, discounts, free gifts,
pro1notions, etc.

7.5.2 Monopolistic Competition Demand

Curve
The demand curve for a monopolistically co1npetitive firm is
downward sloping. The down,.vard sloping demand curve is due to
product differentiation. However, the demand curve is different
compared to a monopolist. Monopolistic competition faces an elastic
::r
�

(I)

demand curve because this firm produces close substitute products.

--::r
0

Therefore, the price elasticity of demand is slightly higher compared

�
0
to the monopolist. On the other hand, the monopolist's demand curve
is less elastic since it produces no close substitute product and faces (I)
no rivals at all. ....
In addition, the demand curve in monopolistic competition is
"1

less elastic compared to perfect competition. This is because perfect D>

competitors produce homogeneous products and have no power ::s
Q.
to control the price, whereas monopolistic competitors have fe,-ver 3:

--
rivals and produce differentiated products. Therefore, the demand D>
"1
curve for a perfectly competitive firm is the perfectly elastic demand �
(I)
curve.

-
In short, the price elasticity faced by these firms depends on
the nun1ber of rivals or competitors and the degree of product 0
s::
"1

differentiation. As the number of rivals becomes larger, the greater the "1
price elasticity of each firm's demand will be. Figure 7.19 depicts the (I)

demand curve of a monopolistically co1npetitive firm.

P (USD) Figure 7.19

Demand curve of a
monopolistically competitive
firm

AR=D

MR
---+Q (Unit)
o'-----------------

7 .5.3 Monopolistic Competition Short Run

Equilibrium (Profit Maximization)
The monopolistically competitive firm has a downward sloping
demand curve, due to product differentiation that has a variety of close
substitutes. The firm's objective is to maximize profit and minimize
losses. The rule of profit maxin1ization or short run equilibrium is
the same as discussed previously, where marginal revenue equals
marginal cost (MR= MC). This is illustrated in Figure 7.20. The firm
experiences equilibrium at point E*; "vhereas the equilibrium price
and equilibrium quantity are at P* and Q* respectively.
 Figure 7.20 P (USD)
Equilibrium determination in MC
monopolistic competition

AR=D

MR

'-- - - - --'-
-
* - - - - - ---
+ Q (Unit)
0

Monopolistically competitive firms also experience three types of

profit which are supernormal profit, subnormal profit and nor1nal
profit. The short run equilibriu1n of monopolistic competition is
shown in Figures 7.2l(a) to (c).
The firm is making supernormal profit when AR exceeds AC at the
equilibrium point MR= MC as sho,vn in Figure 7.2l(a). The profit­
n1axi1nizing price is detern1ined at A and the profit-maxi1nizing output
is achieved at Q. The shaded area ACDB represents the supernormal
profit earned by monopolistic competition.
Figure 7.21 (a) P (USD) MC
Supernormal profit in
monopolistic competition

AC

A (10)

B (5)

MR

o '-- - - - - Q (Unit)
- '--- - - - - - - - +
Q (15)

Monopolistic competition earns supernormal profit when AR > AC and

TR> TC at MR= MC.
TR =USD10x 15 TC =USDS x 15 T1t =TR-TC
= USD150 = USD75 = USDl SO - USD75
=USD75
(supernormal profit)

In Figure 7.2l(b), the firm is experiencing subnormal profit

because AR is less than AC at the equilibrium position MR= MC.
The equilibriu1n price and equilibrium output are obtained at poi11ts
A and Q respectively. The firm incurs losses reflected in the shaded
area BDCA.
 P (USO) Figure 7.21 (b)
AC
Subnormal profit in
::r
�

MC (I)

--::r
monopolistic competition 0
�
0 0
B (15) --------------------= --f----t--
•
---
Loss :
A ( 1O) -------- ------------ 'C (I)

AR=O ....
"1

D>
::s
Q.
MR
3:

--
D>
"1
�
(I)
'-
. - - - -- - Q (Unit)
---'-- - - - - - - - - -
O Q (15)

-
s::
"1
Monopolistic competition faces subnormal profit when AR< AC and TR< TC 0
at MR=MC.
TR= USOlO x 15 T C =U501Sx 15 Tit =TR-TC "1
(I)
=USOlSO =US0225 =USOl SO - US0225
= -US075 Three Types of Short Run
(subnormal profit) Profit
1 Supernormal profit is
achieved when AR> AC
The firm is facing normal profit because AR and AC are equal at and TR> TC at MR=MC.
the equilibrium point MR= MC. The equilibrium price is determined 2 Subnormal profit is
at point A and the equilibrium quantity at Q. The revenue obtained incurred when AR< AC and
TR<TC at MR= MC.
by the firm is just enough to cover its cost. This is shown in Figure 3 Normal profit is obtained
7.2l(c). when AR=AC and TR=TC
at MR=MC.

P (USO) Figure 7.21 (c)

AC Normal profit in monopolistic
competition
MC

A (1 O) ---------

AR=O

MR

0'----------'-----------
Q (15)
➔ Q (Unit)

Monopolistic competition obtains normal profit when AR= AC and TR= TC

at M R =MC.
TR= USOlO x 15 TC =US010 x 15 Tit =TR-TC
= USOl 50 =US0150 =USOl 50 - USOl 50
= USDO
(normal profit)
 7.5.4 Monopolistic Competition Long Run
Equilibrium
In the long run, monopolistically competitive firms will only
earn norn1al profit due to freedom of entry and exit. The long run
equilibrium of the firm depends on the short run equilibrium. The
hvo effects which are the entry effect and the exit effect are described
below.

Effect of Entry
When the monopolistilcally competitive firms in the industry are
making supernormal profit in the short run, this will attract many new
firms to enter the market with the objective of maximiziJ1g profit. This
will cause the demand curve of 1nonopolistic con1petition to fall and
shift leth,,rards. This is because the firms have a smaller share of total
demand and experience many substitutes in the market. The reduction
in the firms' demand reduces the firms' profit. The process will persist
until the firms' de1nand curve is a tangent to its average cost curve.
Hence, in the long run, the monopolistically competitive firms will
only earn normal profit due to the entry of new firms in the industry.

Effect of Exit
When the monopolistically co1npetitive fir1ns suffer losses or negative
profit, some of the existing firms will exit from the industry as they are
afraid of making the same losses. Therefore, the demand curve of the
monopolistically competitive firm will increase as fewer substitutes are
available and the share of total de1nand is expanded. The process will
continue until the losses disappear and the demand curve is a tangent
to the average cost curve. This indicates that under monopolistic
competition, firms earn normal profit in the long run because of the
effect of exit of fewer firms from the industry. Figure 7.22 shows the
long run equilibrium o f monopolistic competition.

Figure 7.22 P (USO)

Long run equilibrium in
LRMC
monopolistic competition

LRAC
C
P = LRAC ---------

LRAR = D

LRMR
Q (Unit)
A monopolistically competitive O '-- - - - - --------
0
--'c- -
firm earns normal profit in the
long run, due to freedom of The long run equilibrium is achieved at the intersection point
entryand exit. between MR and MC at point E*. The equilibrium quantity is achieved
at Q and the price is constant at P. The monopolistically co1npetitive
fir1n earns norn1al profit in the long run when AR equals LRAC due to
::r
�

(I)

freedom of entry and exit.

0

7 .5.5 Similarities and Differences Between

Monopolistic Competition and Perfect
-::r
0

(I)

Competition ....
"1
Monopolistically competitive firms as well as perfectly competitive
firms have some similarities and differences in terms of features, D>
::s
control over market prices, demand curves, long run equilibriu1n, etc. Q.
Here are five similarities: D>
(a) Monopolistic competition and perfect competition have a large "1

number of firms or sellers.

-s::
�
(I)

(b) There are free entry of new firms and easy exit of existing firms in
the industry.
-
"1

(c) The rule for profit maximization for both markets is similar where 0

marginal revenue is equal to marginal cost. "1

(d) These two markets experience three types of profit in the short
(I)

run known as supernor1nal profit, subnor1nal profit and norn1al

profit.
(e) Due to freedom of entry and exit, both markets earn only normal
profit in the long run.
Meanwhile, here are four differences:
(a) Perfectly competitive firn1s produce homogeneous or
standardized products, whereas monopolistically competitive
firms produce differentiated products.
(b) In perfectly competitive fir1ns, the demand curve is perfectly
elastic or horizontal, whereas monopolistically con1petitive
firms have a do,.,nward sloping demand curve. The equilibrium
price, marginal revenue and average revenue are equal in perfect
competition, but marginal revenue lies below the average revenue
curve under 1nonopolistic co1npetition.
(c) The equilibrium price for perfect competition is constant because
each firm has no power to control the price and is a price taker.
Conversely, in monopolistic competition, firms have less power
to control market price and they follow their ovvn price-output
policy.
(d) Monopolistic competition needs advertisement and is involved in
non-price competition since they produce differentiated products
which have substitutes in the market. On the contrary, perfect
competition does not have to advertise their products since they
sell identical or homogeneous products, whereby every consumer
has perfect information and kno\.vledge about the products.
SAMPLE QUESTION 7.3

The diagram illustrates a profit-maximizing firm in a monopolistically competitive market.

P (USD) MC

AC

AR=D
5 -------------------

MR
O,_ ..__
_____
50
_ _:_
_
65
_
..;_
75
_.Q (Unit)
_____

Based on the above diagram, answer the following questions:

(a) Determine the equilibrium price and quantity.
(bl Calculate the total revenue and total cost at the equilibrium.
(c) Calculate the profit or loss and state the type of profit.
(d) Is the firm operating in the short run or long run? Give a reason.

Solution:
(a) Equilibrium price= USD9
Equilibrium quantity= 50 units
(b) TR = USD9 x 50 TC = USD9 x 50
= USD450 = USD450
(c) Tit =TR-TC
= USD450 - USD450
=USDO
The firm earns normal profit since AR= AC andTR= TC at MR= MC.
(d) The firm is operating in the long run since the firm is earning normal profit. The firm earns
••• normal profit i n the long run, due to freedom of entry and exit.
•••

7.6 OLIGOPOLY
Oligopoly exists when there are only a few firms in the market which
dominate the sales of a product because entry of any new firms is
difficult or impossible. An oligopoly produces either homogeneous or
differentiated products, whereby the price and output decision of one
firm ,.vill affect other firms. Examples of the oligopoly market are the
automobile, steel, cement and petroleum industries. If there are only
two firms that exist in the industry, ,.ve refer to them as duopoly.
7.6.1 Characteristics ::r
�

1 Fe,v large firms or producers

(I)

--::r
0
The number of firms is few in the industry, but the size of each
Characteristics of an
Oligopoly �

firm is large. The firm dominates the market because their market 1 Few large firms 0
share is large. Even though they are few in the industry, they have 2 Homogeneous or
the po,ver to control the whole industry. For example, there are
differentiated products (I)
3 Mutual interdependence
few petroleum companies in Malaysia, namely Petronas, Shell, and price rigidity ....
"1
Caltex, Petron, etc. 4 Barriers to entry
D>
2 Homogeneous or differentiated products ::s
An oligopoly may produce either standardized products or
Q.

differentiated products. Examples of oligopoly that produce

3:

--
D>
homogeneous products are the petroleum, ce1nent, steel, copper
"1
�

and aluminium industries. Examples of firms in oligopoly which

(I)

produce differentiated products are the automobile industry,

household appliances, tires, electronic appliances, sports
-
s::
"1

0
equipment, etc.
3 Mutual interdependence and control over price
"1
(I)

Oligopolies have some control over price because there are

few firms in oligopolistic industries. Oligopolistic firms must
consider their rival's decisions in terms of price, output, sales
target, advertising, etc. This special feature is known as n1utual
interdependence. It is a situation when each oligopolistic firm's
profit is not entirely based on its own sales strategies or price,
but their decisions depend on their competitor's decisions. For
instance, when McDonald's decide their marketing and advertising
strategies, it will consider how KFC and Burger King might react.
In other words, oligopolistic firms base their decisions on how
they think their rivals might react.
4 Barriers to entry
The same barriers to entry which apply in a monopoly are also
experienced by oligopolistic firms. Ho,vever, the barriers of new
firms in the industry are not as restrictive as a monopoly. The entry
of new firms in a monopoly is impossible. The barriers to entry
are due to economies of scale, high capital requirement, forced to
merge, ownership of patent, copyright, legal sanction, etc.

7 .6.2 Price Rigidity and Kinked Demand

Curve
The concept of kinked demand curve in an oligopoly was introduced
by Professor Sweezy, who explains that the concept of price rigidity
causes the demand curve to be kinked. The kinked demand curve is
also known as the Sweezy model. The concept of price rigidity explains
the behaviour of an oligopolistic firm which has no incentive either to
increase or decrease the n1arket price of the products in the industry.
 There are two assumptions that reflect the theory of a kinked demand
curve:
(a) If an oligopolistic firm reduces the price of its product, the rivals
,.vill react by reducing the price of their products as ,.vell to avoid
losing customers.
(b) If an oligopolistic firm increases the price of its product, the
rivals will react by not increasing the price of their products, but
instead maintaining the same price. In doing so, the rivals will gain
customers from the oligopolistic firm that increases the price.
Due to these two asslllmptions, each oligopolistic firn1 faces a kinked
demand curve. A kinked demand curve can be defined as a den1and
curve faced by an oligopoly and it is assumed that rivals will match the
price cut, but ignore the price increase. Figure 7.23 depicts the kinked
demand curve faced by an oligopoly.

Figure 7.23 P (USO)

Oligopoly kinked demand curve

A Elastic demand, E. > 1

Po --------------------------------- E

Inelastic demand, Ed < 1

Q (Unit)
o'----------0-
0-- ..,,,0---

Figure 7.23 explains the behaviour of the kinked demand curve of

an oligopoly. AED represents the kinked demand curve. The demand
curve faced by an oligopoly depends on the price elasticity of demand.
The price above PO represents elastic demand, whereas the price below
PO corresponds with inelastic demand. Whenever price increases
above P0 , which is at the kink point, it will lead to a large drop in the
quantity demanded. This is based on the second assun1ption where the
rival will maintain the same price if an oligopolistic firm increases the
price of the products. This shows that as an oligopolistic firm increases
the price of its product, the rival will not follow but will maintain the
sa1ne price. Therefore, consu1ners will compare the price of the firn1s
and will purchase the goods from the other firms because the price
now looks cheaper i n other firms.
Alternatively, as price reduces below P0, there will be a small increase
in the quantity den1anded since all firms will also reduce the price of
their products below P0 (below the kink point). Therefore, consumers
will face the same price for products from all oligopolistic firms. This
is based on the first assumption where the rival(s) will follow the price
cut of an oligopolistic firm to avoid losing custo1ners.
::r
�

(I)

The concept of price rigidity is best explained in a diagram. Figure

--::r
0

7.24 illustrates the price rigidity of an oligopoly. The kinked demand

�
0
curve faced by an oligopoly creates a gap in the marginal revenue
curves. The marginal curve lies below the kinked demand curve of (I)
the firm. The gap in marginal revenue as represented a t points a and b ....
lies below the kink point (belov.7 point E*). Point a reflects the upper
"1

limit of marginal revenue, ,,vhereas point b represents the lower limit D>
of marginal revenue. ::s
Q.
The equilibrium is achieved at the intersection between marginal 3:
revenue and marginal cost (MR = l\tIC). At MC0, the equilibrium is
--
D>
"1
obtained when MC0 = MR. At this point, the equilibrium price is at �
(I)
P* and equilibrium output is at Q*. When marginal cost reduces to

-
MC1, the equilibrium is attained at MC1 = MR and there ,vould be no
change in the equilibrium price and output. 0
s::
"1

This indicates that as long as the marginal cost curve lies within the "1
range of the marginal cost curve and passes through the gap between (I)

the marginal revenue, the equilibrium price and output ,viii remain
unchanged. This explains that the price and quantity will be insensitive
to a sn1all change in cost, but ,-vill respond to a large change in cost.
This stability of price as ""ell as quantity is known as price rigidity and
explains the behaviour of the kinked demand curve.

P (USD) Figure 7.24

Gap in marginal revenue
MCo

MC 1

P* -------------------

AR=D
0L-----==::::::::::::::::=JQ�* �--��::.. Q (Unit)
MR

7 .6.3 Oligopoly Short Run Equilibrium

(Profit Maximization)
As discussed in the other three markets, oligopolistic firms may also
experience supernormal profit, subnormal profit and normal profit in
the short run. Short run equilibrium is achieved at the intersection
point beh-veen marginal revenue and marginal cost (rule of equilibrium
is MR= MC). Figures 7.25(a) to (c) sho,v the types of profit earned by
an oligopoly.
 Figure 7.25(a) explains supernormal profit obtained by an oligopoly.
Supernormal profit is achieved when average revenue exceeds average
cost at the intersection bet,.,een marginal revenue and marginal
cost. The profit-maximizing price is determined at A and the profit­
maximizing quantity is represented at Q. The shaded area ACDB
reflects the supernorn1aJ profit experienced by the firm.
Figure 7.25(a) P (USO)
Supernormal profit in an
oligopoly MC

AC
A (10)

O .__ _ Q_�( lO�) --�------+ Q (Unit)

______
MR

Supernormal profit is obtained when AR> AC and TR> TC at MR= MC.

TR =US010x20 TC =US05x20 T1t =TR-TC
= US0200 = US0100 = USD200 -USDl 00
= USDlOO
(supernormal profit)

As shown in Figltre 7.25(b), subnormal profit occurs ,.,hen AR is less

than AC at the equilibrium point (MR= MC). Points A and Q represent
the profit-maximizing price and output respectively. The shaded area
ADCB shows the subnormal profit experienced by the firm.
Figure 7.25(b) P (USO)
Subnormal profit in an MC AC
oligopoly

D
A (1 S)

B (10)

AR=O
o.__ --'-___,_
_________ ____,_
_ _ _
➔Q (Unit)
Q (20)
MR

Subnormal profit faced by an oligopoly when AR< AC andTR< TC at MR= MC.

TR =US010x20 TC =US015x20 Tit =TR-TC
= USD200 = USD300 = USD200 - USD300
=-USOlOO
(subnormal profit)
 Nor1nal profit as illustrated in Figure 7.25(c) is attained when
AR equals AC at the equilibriun1 position (MR = MC). The profit­
::r
�

(I)

maximizing price and output is sho,.vn at points A and Q respectively.

0

It is necessary for the firm to stay in business since its ]Price is equal to
average cost. -::r
0

(I)
P (USO) Figure 7.25(c)
Normal profit in an ....
"1
MC oligopoly
D>
::s
Q.
AC
D>
"1

-s::
�
(I)
A (10)

-
"1

0
"1
(I)

MR

Normal profit is attained when AR= AC and TR= TC at MR= MC.

TR =USD10x20 TC =USD10x20 Tit =TR-TC
=USD200 =USD200 =USD200 - USD200
= USDO
(normal profit)

Table 7.12 summarizes the features of the four types of 1narket

structure.
Table 7.12 Summary of the characteristics of perfect competition, monopoly, monopolistic competition and oligopoly

Perfect Monopolistic
Feature Monopoly Oligopoly
Competition Competition

Number of Large One Many Few

sellers
Types of product Standardized/ Unique without close Differentiated Standardized or
Homogeneous/ substitutes differentiated
Identical

Control over None; known as price Full control; known as Less control and Limited control
price taker price maker follows own price due to mutual
policy interdependence
(price rigidity)
Conditions of Very easy or no Impossible or blocked Relatively easy Difficult or
entry obstacles significant obstacles

Non-price None Minimum advertising Needs advertising Some advertising

competition due to competition especially for
differentiated
products
c-,.
Perfect Monopolistic
Feature Monopoly Oligopoly
Competition Competition

Examples Agriculture products, Local utilities, such Retail products, food, Automobile,
such as wheat, corn, as electricity, local clothing, shoes, etc. petroleum, steel,
beans, etc. phone services, water tyres, household
supply, etc. appliances, etc.
Equilibrium MR=MC MR=MC MR=MC MR=MC
conditions
Short run Supernormal profit, Supernormal profit, Supernormal profit, Supernormal profit,
equilibrium subnormal profit and subnormal profit and subnormal profit and subnormal profit
normal profit normal profit normal profit and normal profit
Long run Normal profit due to Supernormal profit Normal profit due to None
equilibrium free entry and exit due to barriers to free entry and exit
entry
Product Efficient since P=AC Not efficient since Not efficient Not efficient
efficiency P>AC
Shutdown AR (P) < AVC AR (P) < AVC AR (P) < AVC AR (P) < AVC
conditions

SAMPLE QUESTION 7.4

The diagram shows the profit-maximizing of an oligopolistic firm.

P (USO)

MC0
15 -------------------- -----------

, .. .. .....-.. ... .. .-=- .-:::.::.- ::.::- ·=· :::- -:::-�r::::;;n

AC
12

10 ---------------------------------
8
OL_ ---,-,, a,,--:,,,_....,2�2-:2""0,-----
________ -+ Q (Unit)
-

(ii)
(a) Label curves (i) and (ii).
(b) Determine the equilibrium price and output when marginal cost is at MC0•
(c) Suppose the cost of the firm increases from MC0 to MC1 , determine the new equilibrium
price and output.
(d) Calculate the total profit or loss at the equilibrium point and name the type of profit the
firm is making.
 ::r
�

(I)

--::r
0
Solution:
�
(a ) (i) Average revenue curve= Demand curve
0
(ii) Marginal revenue curve
(b) Equilibrium price= USDl 5
(I)
Equilibrium output= 18 units
(c) New equilibrium price= USDl 5 ....
"1
New equilibrium output= 18 units
(d) TR = USD15 x 18 = USD270 Tn =TR-TC D>
TC= USD11 x 18= USD198 = USD270 - USD198 = USD72 ::s
Q.
The firm is earning supernormal profit because AR> AC and TR> TC at MR= MC. 3:
•••
--
D>
"1
••• �
(I)

-
s::
"1

0
"1
(I)

A firm is an institution that hires the factors of production and organizes these
inputs to produce the final goods and services with the objective of maximizing
profit. A market is a place whereby both sellers and buyers meet to be involved
in business transactions. In addition, market structure refers to the size and
number of sellers and buyers in the market for particular goods and services.
A firm achieves its equilibrium in h-vo approaches, namely total approach
and marginal approach. In total approach, a firm is said to be in equilibrium
when the total profit is at maximum. On the other hand, in marginal approach,
equilibrium of a firm is determined when 1narginal revenue and 1narginal cost
are equal.
There are four types of market structure, i.e. pure or perfect competition,
pure monopoly, monopolistic competition and oligopoly. These four types of
market structures are differentiated in terms of their characteristics.
Perfect con1petition is a market structure that has a large nun1ber of small
sellers which produce standardized products; allows free entry of ne,-v firms
and free exit of existing firms; and are known as price takers. The demand
curve for perfectly competitive firms is perfectly elastic or horizontal. The price
is determined by market forces and the fir1n faces fixed prices in the market.
Under perfect competition, a firm earns supernormal profit in the short run
when average revenue exceeds average cost and total revenue exceeds total cost
at the equilibrium position where marginal revenue equals marginal cost. The
firm faces subnormal profit when average revenue is less than average cost and
total revenue is less than total cost at equilibrium. Norn1al profit is obtained
by the firm when average revenue and average cost are equal and total revenue
and total cost are equal at the equilibrium position.
 Whenever the firm is experiencing subnor1nal profit or losses, there are
conditions of whether to continue its operations or to shut it do,.,n. If the
price or average revenue is more than the average variable cost, the firm can
continue its production. However, if the price or average revenue is lower than
the average variable cost, the firm needs to shut its production down since they
cannot cover the variable cost. Perfect con1petition will only earn normal profit
in the long run due to easy entry of new firms and free exit of the existing firms.
The second type of market structure is a monopoly, ,,vhich can be characterized
as a single seller for the whole industry which is producing unique products
with no close substitutes in the market. The firn1 represents the whole industry.
A monopoly is a price maker because it has full power to control the price
and it faces high restrictions on entry and exit. The demand curve faced by a
monopoly is do,-vn,-vard sloping following the law of demand. It also considers
the price elasticity of de1nand when setting the price or quantity. When demand
is inelastic, the firm will set a higher price since total revenue is increasing. On
the contrary, the firm will fix a lower price for elastic demand because total
revenue ,-vill increase when price decreases. In the short run, a monopoly
will also experience supernormal profit, subnormal profit and normal profit.
However, in the long run, a 1nonopoly will only earn supernormal profit due to
barriers to entry and exit. A monopoly also may practice price discrimination
by selling or charging different prices from different buyers for the same
products.
Monopolistic con1petition is a 1narket structure ,vhich has a large nu1nber of
small sellers by selling differentiated products with close substitutes available.
It has less power to control price and follows its own price-output policy.
There is free entry into and exit from the market. The demand curve faced by
monopolistically competitive firms is downward sloping, but more elastic than
the den1and curve of a monopoly since they produce differentiated products
,.,ith more substitutes available in the market. A monopolistic firm may also
experience supernormal profit, subnormal profit and normal profit in the short
run, but the firm earns only normal profit in the long run due to freedom of
entry and exit of fir1ns in the industry.
The last market structure which is known as an oligopoly has a few large
sellers in the industry and produces either homogeneous or differentiated
products. They have a specific feature of mutual interdependence ,.,here every
decision of one firn1 depends on the decisions of the rival firms. Due to that
reason, oligopolistic firn1s face price rigidity where the increase or decrease of
price of the goods and services are almost impossible. Price rigidity explains
the behaviours of the kinked demand curve which is based on two assumptions
where the rival will follow price cuts and ignore price increases of other
oligopolistic firms. There are also barriers to entry and exit, but they are not
as restrictive as a monopoly. The oligopolistic firms also may experience three
types of profit in the short run which are supernormal profit, subnormal profit
and normal profit.
• A firm is an institution that purchases or hires all factors of production to
produce final goods and services in the market.
• The main objective of the firm is to maximize profit and minimize losses.
•

-
•

• A market is a place where both buyers and sellers meet to deal with
business transactions.
• Market structure can be determined when each firm is differentiated in
terms of number and distribution size of sellers and buyers for certain
goods and services.
• There are four types of market structure, namely perfect competition,
monopoly, monopolistic competition and oligopoly.
• In perfect competition, there are a large number of small sellers in the
industry which produce standardized or identical products. The perfectly
competitive market is a price taker, and allows very easy entry and exit of
firms in the market.
• The demand curve is perfectly elastic or horizontal and the price is
constant in the industry.
• Equilibrium of a firm is obtained in two approaches known as total
approach and marginal approach.
• Total approach refers to the situation where the difference benveen
total revenue and total cost is at a maximum, which means the firm is in
equilibrium when total profit is maximized (Tn = TR - TC).
• Equilibrium of a firm in marginal approach can be determined when both
marginal revenue and marginal cost are equal (MR= MC).
• Short run equilibrium or profit is classified into three types which are
supernormal profit, subnormal profit and normal profit.
• Supernormal profit or economic profit is obtained when average revenue
is greater than average cost, and total revenue is n1ore than total cost at the
equilibrium position of marginal revenue equals marginal cost.
• Subnormal profit or negative profit or loss is incurred when average
revenue is less than average cost, total revenue is lower than total cost at
the equilibrium point where marginal revenue is equal to marginal cost.
• Normal profit or zero profit or breakeven is attained when average
revenue equals average cost, and total revenue and total cost are equal at
the intersection of marginal revenue and marginal cost.
• Shutdown point is determined when price or average revenue is less than
average variable cost.
• Perfectly competitive firms earn only normal profit in the long run, due
to free entry and exit of firms in the industry.
• A monopoly can be characterized by a single seller, produces a unique
product with no close substitutes available, is a price maker and has
barriers to entry and exit of firms in the industry.
• Monopolists face down,vard sloping demand according to the law of
demand.
• The monopolist will set the price according to price elasticity of demand.
• When demand is inelastic, a monopoly will increase the price of goods
and services to increase total revenue.
• When demand is elastic, a monopoly will reduce the price of goods and
services to increase total revenue.
• Monopolists may also experience supernormal profit, subnormal profit
and normal profit in the short run.
• In the long run, a monopoly ,.vill only earn supernormal profit since there
are barriers to entry and exit of firms in the industry.
• Price discrimination can only be practiced by a n1onopoly fir1n by selling
or charging different prices from different buyers for the same goods and
services.
•

• Monopolistic competition has a large number of sellers, produces

differentiated products with more close substitutes available in the market,
has less control over price and there is freedom of entry and exit of firms
in the industry.
• The demand curve faced by a monopolistically competitive firm is
do,vnward sloping, but more elastic compared to monopoly since in
monopolistic competition, firms sell differentiated products with close
substitutes available in the 1narket, whereas 1nonopoly firms produce no
close substitute products.
• In tl1e short run, monopolistic competition earns three types of profit
which are supernormal profit, subnormal profit and norn1al profit.
• In the long run, monopolistic competition only earns normal profit, due to
tl,e effects of free entry and exit of firms in the iI1dustry.
• An oligopoly is a market where there are a few large sellers selling either
homogeneous or differentiated products, with barriers to entry and exit of
firms in the industry, and mutual interdependence characteristics.
• The oligopolistic firm faces the kinked demand curve due to price rigidity.
• Price rigidity explains the behaviour of the kinked den1and curve of an
oligopolistic firm based on n,vo assumptions: (i) the rival will follow price
cuts and (ii) ignore price increases.
• Price rigidity refers to the situation of the firms which have no incentive
either to increase or decrease the market price of goods and services.
• Oligopolistic firms may experience supernormal profit, subnormal profit
and normal profit.
+ ::r
�

-
Key concepts (I)
0

0
• Firm • Monopoly • Nor1nal profit
• Market • Monopolistic • Shutdo,-vn point
::r
(I)

• Market structure competition • Price discrimination ....

• Oligopoly
"1
• Total approach • Mutual interdependence
• Marginal approach • Supernormal profit • Price rigidity
D>
::s
• Perfect competition • Subnormal profit • Kinked demand curve
Q.

--
D>
"1
�
(I)

+ Exercises
s::
"1

0
"1
(I)

Multiple-choice Questions
Answer the following questions.

1 Which of the follo,-ving is a characteristic of Questions 4 and 5 are based on the diagram.
perfect competition?
A Barrier to entry P (USO)
B Produce homogeneous products
C Price maker MC
D One seller in the whole industry AC

40 - --------------------------- D
2 Perfect con1petition and monopoly are AVC
similar in terms of 30 ---------------
C
A long run profit. 20
B price determination. :B
'
C the demand curve. 10 -- --- ••A ''
''
''
D the profit maximization condition, 0 100
- � � - Q (Unit)
-- - - -
200 300 400
MR=MC.
4 Suppose the perfectly competitive firm's
3 If a perfectly competitive firm produces 1narket price is USD20, the firm \.Vill produce
20 units of goods at the n1arket price of
_ _ _ units of output.
USD15, the marginal revenue faced by the A 100
firm is ---
B 200
A USD20 C 300
B USD15 D 400
C more than USD15
D less than USD15
c-,. 5 If the firm produces at USD40, what type of 9 Determine the equilibrium price and
profit does the firm earn? output experienced by the firm.
A Supernormal profit A USD4; 12 units
B Subnormal profit B USD6; 15 units
u C Normal profit C USDlO; 10 units
D Undecided D USD12; 12 units

6 Which of the following market structures 10 The firm will suffer subnormal profit when
will have the most difficult entry of new the price is set at_ _ _
firms? A USDS
A Monopoly B USDlO
B Monopolistic competition C USD12
C Oligopoly D USDlS
D Perfect competition
11 A monopolistically competitive firm and
7 Which of the following statements is true a (n) ___ firm earn the same long run
for a monopolist? profit.
A It has efficient allocation of resources. A perfectly competitive
B It sells large quantities unlike perfectly B monopolist
competitive firms. C oligopolist
C It earns zero profit in the long run. D duopolist
D The market price is higher than the
market price in perfect con1petition. 12 Which of the following industries is
the best example of a monopolistic
8 Which of the following conditions is competition?
necessary for a monopolist to practise A Electricity suppliers
effective price discrimination? B Copper industries
A Produce standardized products C Agricultural industries
B May have different price elasticity of D Perfume industries
demand
C Must be in a perfect market 13 The demand curve of a monopolistic
D The de1nand curve should be horizontal competition is_ _ _ than a 1nonopoly,
due to the existence of
- - -
Questions 9 and 10 are based on the diagram. A more elastic; product differentiation
B more elastic; homogeneous products
C less elastic; complementary goods
P (USD)
MC
D less elastic; advertisement expenditure

14 Which of the following factors is a

15 AC characteristic of monopolistic competition?
12 A Large number of small sellers
B Producer of identical products
10 AVC

C Price maker
6 --,'
'
s D A firm that practices barriers to entry
4 AR=D

15 One basic feature that may differentiate

monopolistic co1npetition from perfect
MR
O'- -
� - --' -
�-�- - -
---+Q (Unit)
10 12 15 20 competition is that monopolistically
competitive firms are_ _ _
 A smaller in size 17 What is the profit-maximizing price and
B able to restrict the entry of new firms output when marginal cost is at MC0?
::r
�

(I)
C able to differentiate their products
--::r
0
A Po; Q o
D price takers B P,; Q1
�
0
C P2; Q1
16 The kinked demand curve of an D Pz; Q2
oligopolistic firm explains the existence of
(I)

A few sellers in the industry. 18 When there is a small change in the cost,
....
"1

B substitute products. there would be

C large advertising expenditures. A no change in price and quantity.
D>
::s
D the inability to change its price. B a small change in price and quantity. Q.

C a large change in price and quantity. 3:

--
D>
Questions 17 to 19 are based on the diagram. D price changes, but quantity is "1
�

The diagram shows the profit-maximizing unchanged. (I)

condition of an oligopolistic fir1n.

19 What is the profit-maximizing price and
-
s::
"1

P (USO)
output if marginal cost increases to MC2? 0

A P0; Q1 "1

B P1 ; Q1
(I)

MCo C P2, Q1
D P3; Q,
P2 --------
P1 _________:::,_.,.,_�-�:
'' 20 According to the assumption of the kinked
P o
'
-----------r------1----- dema11d curve, when one oligopolistic firm
increases its price, other oligopolistic firms
AR=O will
A increase their prices as well.
B not follo,.,v, but maintain the same prices
L-- -c:-'---�-��- ➔
- 0 (Unit)
O Oo 01 02
as before.
MR C increase advertising expenditures.
D exit from the industry.

Short-answer Questions
Answer thefollowing questions.
1 The diagram shows the profit-1naxin1izing conditions of a fir1n.
P (USO)
MC
AC

25 -------------------------------� ::;-,- '

'
-.J:---� AVC
''
''
'
20 l- - -
�.._......
- - - "- MR= AR= 0
--,'1'.--+-- - - - "'7"
'
13 ------------------------- :
15 ------------------------ ,[': -
..:'.:'. -�-·-;_____

o.________so'--,-o'-.....
0-- , -------+ o (Unit)
2 0
 (a) Identify the type of n1arket structU1re that the firm is operating in and justify your
answer.
(b) State the profit-maximizing price and output for the firm.
(c ) Calculate the amount of profit or loss at the equilibrium position and state the
type of profit.
(d) Is the firm operating in the short run or long run? Give your reason.
(e) Determine the total fixed cost at the equilibrium point.
(f) Based on the above situation, should the firm continue or shut do,vn its
operations? Why?
2 Based on the table, answer the following questions.

Output TR AR MR TC MC
(Unit) (USD) (USD) (USD) (USD) (USD)

0 0 10
1 40 20
2 80 35
3 120 65
4 160 100
5 200 140
6 240 205
7 280 283
8 320 365
9 360 461

(a) Calculate the marginal revenue and marginal cost at each output level.
(b) Which market structure is the firm operating in? Justify your answer.
(c) Determi11e the profit-maximizing price and quantity at equilibrium.
(d) Calculate the profit or loss experienced at the equilibrium point.
(e) Is the firm achieving supernormal profit, subnormal profit or normal profit?
Give your justification.
3 (a) Co1nplete the table.

p Quantity TR MR TC MC
(USD) (Unit) (USD) (USD) (USD) (USD)

250 100 5,000

230 200 20,000
210 300 37,000
180 400 57,000
160 500 79,000
140 600 104,000
 (b) Deter1nine the profit-n1aximizing price and output for the fir1n. ::r
�

(c) Calculate the total profit or loss experienced by the firn1 at the equilibrium point. (I)

(d) Identify the type of profit obtained by the firm and justify your answer.
--::r
0
�

4 The diagram illustrates the short run equilibrium of an imperfectly competitive firm. 0

(I)

P (USO) ....
"11
"1
A
:3
D>
::s
Q.
3:

--
D>
'' B "1
'' �
'
6 ----- ---- ---:--------- (I)
'
s ___________::a
__�-�,e__+..:>"K 00
'',�
''
-s::
s::
"1
'' C
'' 0
''
'' "1
'' ' (I)
,D :
o'--- - - -
-'- '-
- --'-' - - - - - -+Q
4o so 7�
0 8-o - (Unit)

(a) Label the following curves in the diagram.

A:- - - - - - - -
B:_ _ _ _ _ _ _ _
_
C:_ _ _ _ _ _ _ _ _
D:_ _ _ _ _ _ _ _ _
(b) Determine the profit-maximizing price and quantity.
(c) Calculate the total profit or loss experienced by the firm.
(d) Is the firm operating in the short run or long run? Why?
(e) List two characteristics of this n1arket structure.
5 The diagram shows the profit-maximizing condition in a monopolistically
competitive market.
P (USO)

MC AC

2 '
0 -------- -----------•--------
AR=O

MR

0 '--- - - -,
-� -
0
0 0
-
20�
- - Q (Unit)
- - - ---+

(a) Determi11e the equilibriu1n price and quantiil:y.

(b) Calculate the profit or loss experienced at the equilibrium point.
 (c) Is the firm realizing economic profit or loss at the equilibrium position?
(d) In your opinion, is this a short run or long run equilibrium? Give your reason.
(e) Explain two characteristics of this firm.
6 The diagran1 shows the short run equililbriun1 position of a monopolistically
competitive firm.
P (USD) MC

AC

11
9 ------+-
'''
'
6 ------·-------------

Q (Unit)
O
'-- '--
----' - ---'- -
- � -----'-
- - -+
-
S 15 18 22

(a) Label curves Y and Z.

(b) Why is the demand curve for a monopolistically competitive firm relatively
elastic compared to a monopoly? Give your reason.
(c) State the equilibrium price and output. Calculate the total revenue and total cost
at the equilibrium level.
(d) Calculate the total profit or loss and state the type of profit attained by the firm.
(e) With the aid of a diagram, show the long run equilibrium of this firm.
7 The diagram illustrates the cost and revenue curves for Zena's Corporation.
P (USD)

'' MC
B --------------- _____ L ____________ K
:G
''
'' AC
''
''
'
:H
C ------------------ --·------------
' L
D
'' AR=D
'
E ----------------------�J ___________ N
(Unit)
o'-- - - - -=-
- 0--"-<--
P - �
- - -Q
-

MR

(a) Name and define the market structure that the firm is operating in.
(b) The profit-maximizing quantity of this firm is_ _ _units.
 (c) The profit-maxi1nizing price of the firm is_ _ _
::r
�

(d) The area of total revenue is_ _ _ _ , whereas the area of total cost is_ _ _ _ (I)

(e) Identify the type of total profit and shade the total profit area in the diagram.
--::r
0
�

8 Based on the diagram, answer the following questions. 0

P (USO) (I)
AC
....
"1

D>
MC
::s
1 00 •........ •........·...... ........•..•....•..•........• ..-�----- Q.
3:

--
D>
"1
�
(I)
50 ------------------------------------.---------

-
••
40 ------------------------------------'
30 --------------- AR=D 0
s::
"1

"1
-
0 -----+ Q (Unit) (I)
1 _
OL------ S...1. 0_____.0�
0 :---:]:--,:2""

MR

(a) What market structure is this firm operating in?

(b) Determine the equilibrium price and output.
(c) Calculate the total revenue and total cost at equilibrium.
(d) Calculate the total profit or loss that the firn1 is n1aking. Na1ne the type of profit
or loss.
(e) State n,vo assumptions of this market structure.
(f) The model which belongs to this market structure 1s also known as the
----- - model.

Essay Questions
Answer thefollowing questions.
1 Explain the characteristics of a perfectly con1petitnve firm.
2 Discuss the differences between a perfect con1petition and a monopoly.
3 Discuss the shutdown point of a firm in a perfect competition, with the aid of a suitable
diagram.
4 Using a suitable diagram, explain the long run equilibriun1 of a monopoly.
5 Compare the distinct features of a monopoly and a monopolistic competition.
6 Describe the short run profit-maximizing conditions of the monopolistically
competitive firm. Illustrate your answer with suitable diagrams.
7 Explain why a perfectly competitive firm earns norn1al profit in the long run, with the
aid of diagrams.
8 ''.An oligopolistic firm faces a kinked demand curve:' Explain this statement using an
appropriate diagram.
Theory of
Distribution
U2 At the end of this chapter, you should be able to:
� • Explain the theory of marginal productivity.
8 • Describe the rewards for factors of production.
• Calculate the marginal product of labour.
'g
tn • Determine the wage equilibrium and profit maximization.
• Determine and explain the concept of interest.
-� • Describe and explain the neoclassical theory of interest and
� Keynes's theory of interest.
�
• Explain the Ricardian theory of rent and the modern theory of
rent.
• Describe and explain the concept of profit.

Marginal Productivity Theory
Explains that in equilibr i um,
each productive labour
receives their rewards
according to their marginal
productivity.
Total Physical Product
The total output of goods and
services produced by hiring the
factors of production.
E conomic resources are the essentials of economic activity.
Economic resources are the resources required to produce goods
and services, and are known as factors of production: land, labour,
capital and entrepreneurs. When we evaluate these resources as
per their productivity, we obtain the resource price or the rewards
for factors of production, namely wage, interest, rent and profit.
This chapter will explain in detail the theory and concept of how
households earn wages, interest and rent, and entrepreneurs obtain
profit in the economy.
Before we analyze the concept of wages, interest, rent and profit in
detail, we need to comprehend the theory of marginal productivity.
Then, the determination of the rewards for factors of production
will be examined, followed by the equilibrium condition and profit
maximization which will be easy to explore afterwards.
8.1 THEORY OF MARGINAL
PRODUCTIVITY
The theory of marginal productivity explains ho,v rewards or
payments for the four factors of production are determined. The
marginal productivity theory contributes a significant role in factor
pricing. This marginal productivity theory of distribution ,-vas
developed by J. B. Clark, an American economist in the late 19th
century. The theory was further advocated and discussed by other
economists. The marginal productivity theory explains that in
equilibrium, each productive labour will be rewarded according to
their marginal productivity. This means that the demand for each
factor of production is closely related to the productivity of the
factor of production itself. The higher the productivity of each factor
of production, the higher the demand for the factors of production.
There are positive relationships between the productivity of factors
of production and the demand for factors of production. The theory
of marginal productivity can be understood clearly by having
knowledge of different concepts or types of marginal productivity.
The distinct concepts or types of marginal productivity are explained
as follows:
1 Total physical product (TPP)
Total physical product refers to the total output of goods and
services produced by employing the factors of production, i.e.
labour, capital, land, entrepreneurs and raw materials.
2 Marginal physical product (MPP) �

Marginal physical product can be defined as the addition to total

::r

Marginal Physical Product (I)

physical product resulting from employment of a unit of factor

0
The addition of total physical
of production, ,,vhile other factors of production remain constant. product by employi ng an
0
Let us look at an example for better understanding. One labour
-·-
add itional un it of a factor,

..,-·
while the quantity of other
can produce 10 kg of rice and the additional labour hired can factors remain unchanged.
produce 15 kg of rice. In this case, the 1narginal physical product
of the second worker is 5 kg of rice:
(15 kg - 10 kg)
--·
0
(2-1)
3 Marginal value product {MVP) Marginal Value Product
Marginal value product is obtained by multiplying n1arginal
Obtained by multiply ing
marginal physical product
physical product with price. with the price of goods and
services.
MVP = MPP x Price
4 Total revenue product (TRP)
Total Revenue Product
The total revenue received
Total revenue product refers to the total revenue received by by employ ing factors of
hiring or employing factors of production. production.

5 Marginal revenue product (MRP)

Marginal revenue product is the addition of total revenue by Marginal Revenue Product
employing one unit of factor of production, ,,vhile other factors of The addition of total revenue
production remain unchanged. by employing an additi onal
Let us look at the example of marginal revenue product. When
unit of factor of production,
while holding other faltors
IO workers are able to produce perfumes worth USD500 and constant.
11 workers can produce perfumes worth USD700, the n1arginal
revenue product is USD200:
(USD700 -USD500)
(11-10)
The marginal revenue product can also be obtained by
multiplying marginal physical product and price if a firm is
operating under a perfect market. The value of price, average
revenue and marginal revenue are identical. On the other hand,
under an imperfect market, marginal revenue multiplied with
marginal physical product will give the value of marginal revenue
product.
MRP = MPP x Price (Perfect market)
MRP = MPP x MR {Imperfect n1arket)
6 Average revenue product (ARP) Average Revenue Product
Average revenue product is defined as the average revenue per Known as the average
unit of a factor of production.
revenue per unit of factor of
production.

ARP = TRP
Total inputs
co
.c:
u 8.2.1 Wages
Real Wage
The purchasing power of
money received by workers.
Demand for Labour
Determined by marginal
revenue product; slopes
downwards, thus representing
a negative relationship
between wage rate and the
demand for labour.
8.2 REWARDS FOR FACTORS OF
PRODUCTION
Payment to labour in terms of 1noney payment is considered as ,vages
to labour. Wages can be defined as the payment to labour, or workers
or en1ployees, for contributing their skills and energy mentally and
physically at the disposal of an employer. The skills and energy used
by the workers should be at the employer's discretion and the amount
of wages should be in line ,vith the terms stipulated in the contract for
the service of the workers. The concept of ,vages can be categorized as
nominal ,vage and real ,vage.
Nominal Wage versus Real Wage
No1ninal wage is wage measured in terms of 1noney value, e.g. in US
dollars. For example, an architect ,vorks in an architecture company
and receives USD3,500 per month as nominal wage. Nominal "''age is
also known as money ,vage. However, nominal wage or money wage
alone cannot give the accurate real earnings of a ,vorker. Therefore, to
ascertain the real earnings of workers, we need to know the real wage
of workers.
Real wage refers to the purchasing power of money received by
workers. It is applied to the total necessities, benefits, facilities and
comforts that workers n1ight enjoy. For instance, what an architect
who receives USD3,500 would be able to purchase from the market
with that amount. The real wage may also take into account any extra
payment or subsidiary earnings that he/she may receive, the regularity
or irregularity of en1ployment, the conditions at the workplace (e.g.
being pleasant, comfortable, respectable or otherwise), and future
prospects of ,vorking in a particular company. Real wage can be
obtained by using the following formula:
Nominal wage
Real Wage=
Price level
Determination of Wages
It is crucial to unders1tand the market demand of labour and the
market supply of labour to determine the wage rate of labour. The
analysis of market demand and supply of labour is discussed in the
following section.
Demand for Labour
Demand of labour is a derived demand. Derived demand can be
defined as the demand for factors of production; for instance, labour to
be used in the production of goods and services. Labour is demanded
by firms, producers or suppliers to produce goods and services in
the economy. A firm's demand curve of labour is determined by the
marginal revenue product. Marginal revenue product (MRP) is the �

additional total revenue gained by en1ploying an additional unit of

::r
(I)

labour, holding other factors of production unchanged. The n1arginal

--·
0

revenue product curve is also the demand curve of labour. It is

�

-..,-·
obtained by multiplying the additional labour that is employed with 0
the additional revenue fron1 the extra unit of output produced.
MRP= MPPxMR
The mathematical expression corresponding to the given formula
Marginal Revenue Product
The additional total revenue
gained by employing an 0
--·
is as follows: additional unit of labour,
holding other factors of
MRP= MPPxMR production unchanged.

= t.TP x t.TR
-
t.L t.Q
t.TR
t.L
Therefore,
MRP = t.TR
t.L

We need to know that the price of labour is known as the wage that
an employer is willing to pay for a unit of labour hired. For instance, an
employer hires labour one by one to increase the total product. After a
certain point, the law of diminishing marginal returns will set in. Each
labour hired will lead the total product to increase at a decreasing rate.
The employer will stop employing additional labour at the point where
the cost of employing a labour just equals the additional total product
resulting from the goods and services produced by the labour hired.
Hence, the ,.,age rate that the employer will pay for a labour ,.,ill be
equal to the marginal product of labour. Figures 8.1 (a) and (b) refer to
the determination of the demand curve of labour.

Wage rate Wage rate Figure 8.1

D Determination of the demand
curve of labour

--- ----- --'',-- ---

'
w, ------------•------- z ----------'',------�----
' ' '
MRP
D
�L-
o�- - - - L- -1--L
2 0 L
(a) Firm's demand curve (b) Industry's demand curve

Figure 8.1 illustrates the demand of labour by firm and industry.

DD represents the demand curve of labour which slopes down,.,ards.
The downward sloping demand curve of labour explains that as wage
co rate increases from O to o,t,,r2, the quantity of labour demanded will
reduce from OL1 to OL2 and alternatively, when wage rate falls from
OW2 to OW 1, the demand of labour will rise from OL2 to OL1• Therefore,
.c: there is an inverse relatiionship between ,-vage rate and the demand of
u labour. The higher the wage rate, the lower the labour demanded will
be, and the lower the wage rate, the higher the labour de1nanded.

Supply of Labour Supply of Labour

Comes from ind ividuals and Supply of labour in the economy comes from individuals or households
who seek to earn wages or salary. Supply of labour refers to the quantity
households who seek to
earn wages or salary; it can
be perfectly elastic (in a pure of labour who are willing to work at a particular wage rate. The supply
competitive market), upward
of labour may be analyzed from three different perspectives.
sloping (in an industry) and
backward bending (in the
1 Supply of labour in the perfect market
The supply of labour in the purely or perfectly competitive market
entire economy).

is perfectly elastic or horizontal. This is because the number of

sellers in the perfectly competitive market is large, but the size of
each firm is small, hence no single seller can influence the price of
goods and services. The price is therefore fixed in the market. This
reflects the supply of labour in the perfectly competitive n1arket as
horizontal or perfectly elastic, and is sho,-vn in Figure 8.2.

Figure 8.2 Wage rate

Supply of labour in perfect
competition

W -- - - - - - - - - -
- 55

0 �-----------� Labour

2 Supply of labour to an industry

The supply curve of labour in the industry is upward sloping. This
indicates that the higher the wage rate, the higher the quantity
supplied of labour will be, and the lower the wage rate, the lower
the quantity supplied of labour will be. This also shows that the
n1arket supply curve is positively related to wage rate since the
higher ,-vage rate ,-vill attract more individuals who are willing
to work, and vice versa. As shown in Figure 8.3, SS represents
the supply of labour which is upward sloping. As wage increases
from OW2 to OW 1, the supply of labour will also increase fron1
OL2 to OL1 •
 Wage rate Figure 8.3 �
Supply of labour to an industry ::r
s (I)

--·
0
w, �

-..,-·
Wo ---------------
0

o'--- - - -
s
-'---'- - + Labour
- 0
--·
L2 L0 L1

3 Supply of labour for the entire economy (back,vard-bending

supply curve)
The supply curve for the entire economy depends on several
factors, namely economic factors, social factors, political factors,
size of population, working hours, leisure preferences and so on.
The supply of labour 1nay increase as wage rate increases, but at
a certain point, even when the wage rate increases, the supply of
labour may decrease because the labour refuses to work due to the
reasons mentioned earlier. For instance, due to health conditions,
a worker would want to have more leisure time even though the
wage rate increases. Figure 8.4 depicts the backward-bending
supply curve of an industry.

Wage rate Figure 8.4

Backward-bending supply curve

w2 --- -- __.,._ _7_

-=--=- - =-=--=-=- �
- - _:-:,_-.,.....__

•
Wo -- - - - - - - - - - - -- -- - - - -:-• - - - - - - ---
••
••
•
w --------------------�-----
1 • •

o.________....____._____. Labour
L2 '-o L1

Determination of Equilibrium Wage

The equilibrium ,vage rate is detern1ined by the market den1and and
market supply of labour. When market demand and market supply of
Equilibrium Wage
Determined by the
labour are equal, then the market equilibrium ,.vage will be attained. As intersection point betl'lleen
previously discussed, the market demand curve of labour is downward market demand forlabour

sloping, representing that the higher the wage rate, the lo,ver the
and market supply of labour.

quantity demanded for labour would be, and vice versa. On the other
hand, the market supply of labour is upward sloping, showing that the
higher the wage rate, the higher the quantity supplied of labour will
be, and vice versa. This indicates that there are negative relationships
co between market demand of labour and wage rate, whereas there are
positive relationships between market supply of labour and wage rate.
Figure 8.5 depicts the determination of wage rate by 1narket demand
.c: and n1arket supply of labour.
u
Figure 8.5 Wage rate
Determination of equilibrium
wage rate s

W* -------·- ----------E*

D
O.__ __,. Labour
___________
L*

The above Figure 8.5 shows how the wage rate is determined
by market demand and supply of labour. Point E* represents the
intersection point between market demand and supply of labour and
is used to determine the wage rate and quantity of labour that will be
employed. The ,-vage rate is obtained at OW* and L* is the quantity of
labour to be employed.
Under perfect competition, the determination of equilibrium wage
rate is slightly different. This is because under the perfect market,
the market demand of Jabour is downward sloping and the marginal
revenue product represents the demand curve of labour. On the
contrary, the supply of labour is perfectly elastic or horizontal. The
intersection point between marginal revenue product and supply of
labour reflects the equilibrium wage rate (OW*) and quantity of labour
(L*) to be hired. This is shown in Figure 8.6.

Figure 8.6 Wage rate

Determination of equilibrium
wage rate under the perfect
market

E*
¾,---- - -5
W*f--- - - - -- -

MRP=D
O '-- ----------
-Labour
L*

Marginal Wage Cost Profit Maximization

The addiiional total cost The determination of profit maximization depends on the marginal
obtained when an additional revenue product and the marginal wage cost (MWC). The n1arginal
worker is en1ployed.
wage cost is defined as the additional total cost that would be obtained �

when an additional worker is employed. The formula to calculate the

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marginal wage cost is as follo,vs.

0

/1 Wage rate
0
MWC=
-·-
D. Labour
..,-·
--·
The equilibrium wage rate and the quantity of labour to be
employed to maxin1ize profit are detern1ined at the point where the
marginal revenue product (MRP) equals marginal wage cost (MWC). 0
The profit maximization condition is attained at the intersection point
between marginal revenue product and marginal wage cost. If the
marginal revenue product is greater than the marginal vvage cost, the
firm is said to gain because the productivity of labour is greater than
the cost. This means that the production of goods and services ,-vould
be at a rapid pace. Conversely, when the marginal rev,enue product is
less than the 1narginal wage cost, the firm is said to face losses because
the productivity of the workers is less than the cost. This indicates that
the production of goods and services is at slo,-ver pace.

MRP=MWC
MRP > MWC = Firm gains
MRP < MWC = Firm losses

The following is an example of vvage rate determination and the

profit 1naximization condition. The concept of wage rate and profit
n1aximization can be explained using Table 8.1. For example, a firm
locally produces blouses. Let us assume that the fi r m is operating
under perfect competition and the price of a unit of blouse is USD20.

Table 8.1
Total Average Marginal Marginal
Quantity of Determination of the average
Physical Physical Physical Revenue
Labour physical product, marginal
Product Product Product Product physical product and marginal
(L)
(TPP) (APP) (MPP) (MRP) revenue product

1 90 90 90 1,800
2 220 110 130 2,600
3 390 130 170 3,400
4 500 125 110 2,200
5 600 120 100 2,000
6 660 110 60 1,200
7 700 100 40 800

Based on Table 8.1, the average physical product is calculated by

taking the total physical product and dividing by the quantity of labour
(TPP/L). The n1arginal physical product is obtained ¼•hen the change
in total physical product is divided by the change in the quantity of
co labour (L\TPP/L\L). The last column is the marginal revenue product
which is attained by mLtltiplying the marginal physical product with
price (MPP x P).
.c: Suppose the wage rate is determined at USD2,000, therefore the
u quantity of labour to be employed to minimize cost and maximize
profit is 5 units of labour. It is attained by equating marginal revenue
product with marginal wage cost (MRP = MWC). The condition of
profit maximization is illustrated in Figure 8.7.

Figure 8.7 Wage rate

Profit maximization condition
under perfect competition

E*
2,0001--- - - - -
....:s,,_- - - - s
-

MRP=D

o� --+ Labour
----------
5

SAMPLE QUESTION 8.1

The table shows a perfectly competitive firm which sells handbags at the price of USD100
each.

Marginal Physical Marginal Revenue

Labour Total Product (Unit)
I Product (Unit) Product (USO)

0 0
1 20
2 39
3 57
4 74
5 90
6 105

(a) Complete the above table.

(b) If the wage rate is determined at USD1,600, how many workers should the firm
employ to maximize profit?
(c) If the wage rate increases to USD1,900, how many workers would the firm be hiring
to maximize profit?
(d) Sketch the profit maximization condition i n a diagram.
 Solution: ...
0
(a)
0
labour
Total Product
(Unit)
Marginal Physical
Product (Unit)
Marginal Revenue
Product (USO) -·-
...-·
0
1
0
20
0
20
0
2,000 --·
0
2 39 19 1,900 ::,
3 57 18 1,800
4 74 17 1,700
5 90 16 1,600
6 105 15 1,500

(bl Profit maximization condition:

MRP=MWC
1 ,600 = 1,600
Therefore, 5 workers would be employed.
(c) If wage rate increases to USDl ,900, the MWC has increased.
Profit maximization condition:
MRP=MWC
USDl ,900 = USDl ,900
Therefore, only 2 workers should be hired.
(d)
Wage rate

1,9001--- - -
.,,.,._
_ _ _ _ _ _ _ S1

1,6001-----+----"""---- S 0

MRP=D
0'-- ----------
2 5
---+Labour

8.2.2 Interest
The return on capital or reward for capital is interest. Interest is the
Interest
return received by the capital owner. The interest is expressed in ter1ns The reward paid to the owner
of percentage and referred to as the interest rate. For example, the of capital.
interest rate for hire purchase is 4% this year. There are several types of
interest rate, such as nominal interest rate, real interest rate, effective
interest rate, annual interest rate, and so on. The distinct features of
these interest rates are based on some key econo1nic factors.
246
co Nominal Interest Rate
The actual monetary pr i ce
borrowers pay to the lender for
.c: the use of the lender's money.
u USD1,000 loan, the borrowers will payUSD30 as interest to the lender.
Real Interest Rate
Determines the purchasing
power from bonds and loans.
Effective Interest Rate
Takes the power of
compounding into account.
Gross Interest Rate
The amount paid by the
borrower to the lender or the
return on capital borrowed.
Net Interest
The payment of interest after
certain elements are deduc ted
from gross interest; also known
as pure interest.
Nominal interest rate is the simplest type of interest rate, which is
also known as the coupon rate for fixed income investn1ent. It is the
actual monetary price that borrowers pay to the lender for use of the
lender's money. For instance, if the nominal interest rate is 3%, for a
Real interest rate is fairly simple, but slightly 1nore complex than
nominal interest rate. The real interest rate states the real rate that the
lender or investor receives after inflation rate is taken into account
(interest rate exceeds inflation rate). The investors and lenders could
increase their purchasing power with bonds and loans at the real rate
of interest. The mathematical formula of real interest rate is:
Real Interest Rate = Nominal interest rate - Inflation rate
Assuming that the nominal interest rate is 5% and the inflation
rate is 3% for a bond con1pounded annually, the real interest rate
is only 2%. On the contrary, if the nominal interest rate for a bond
compounded annually is 3%, whereas the inflation rate is 4%, the real
rate of interest is said to be -1 %. This indicates that it is possible for the
real interest rate to be negative if the inflation rate exceeds the nominal
interest rate.
Effective interest rates are very useful for investors and lenders.
This is because effective interest rates take the po,-ver of compounding
into account. Suppose a bond pays the interest rate of 8% annually
and this bond is co1npounded semi-annually, an investor who invests
USDl,000 in this bond will thus receive an interest of USD40 after the
first six months (USDl,000 x 4%). In the next six months, the investor
will receive an interest of USD41.60 (USDl,040 x 4%). Therefore, the
investor will receive a total return ofUSDSl.60 (USD40 + USD4I.60)
for that particular year. This shows that while the nominal rate is at
8%, the effective interest rate is 8.16%, ,-vhich n1eans that the difference
between nominal interest rate and effective interest rate increases as
the compounding period increases.
Now let us look at the differences between gross interest and net
interest. Gross interest is the amount paid by the borro,-ver to the
lender or the return on capital borrowed. The interest payment by the
borrower to the lender is not exclusively made for the use of capital
only. Net interest is the payn1ent of interest after certain elements
are deducted from gross interest. Net interest is also known as pure
interest. Net interest is exclusively paid for the use of capital. There are
several elements that need to be excluded from gross interest to obtain
the net interest, such as risk of lending, payment of management cost,
payment of inconveniences, and so forth.
Determination of Interest Rate
There are several theories of interest rates that have been developed
by econon1ists. Among these are the classical theory of interest,
neoclassical theory of interest and Keynesian theory of interest.
Toe following section discusses the neoclassical theory of interest �

(also known as the loanable funds theory of interest) and the Keynes'
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liquidity preference theory of interest.

0

0
Neoclassical Loanable Funds Theory
-·-
Toe neoclassical loanable funds theory was expounded by the famous
Swedish economist, Knut Wicksell. This loanable funds theory was
Neoclassical Loanable
..,-·
--·
Funds Theory
developed to improve the classical theory of interest. Loanable funds The total money that people
can be defined as the total money that people or entities have decided have decided to save or lend
0
to save or lend out to borro,vers to be used as an investment rather
out to borrowers to be used as
an investrnent rather than for
than personal consumption. According to the theory of loanable personal consumpt ion.
funds, the interest rate is the price determined by the demand for and
supply of loanable funds.

Demand for Loanable Funds

Toe demand for loanable funds comes from the borro,-ver's side.
According to the theory of loanable funds, the demand for loanable
Demand for Loanable Funds
Comes from the borrower's
funds arises for three purposes: investment purposes, hoarding side; it slopes downwards,
purposes and consumption purposes. People as well as organizations indicating an inverse
seek loans to be used for investment purposes. For instance, an
relationship between interest
rate and investment, and vice
individual may look for a loan to purchase a house as an investn1ent, versa.
while a business may require a loan to pay for capital assets (e.g.
machinery, equipment, factories and buildings) to run its business.
Therefore, the desire to borrow for financing the investn1ent constitutes
the demand for loanable funds.
When the interest rate is high, the demand for investment ,-vould
be low and therefore there would be fewer investors; the reverse is also
true. This indicates that there is an inverse or negative relationship
between interest rates and investments. Toe same effect applies to the
demand for loanable funds for the purpose of consumption. Therefore,
the demand curve for loanable funds slopes down,-vards to represent
an inverse relationship beh,veen the volume of invest1nent and the
interest rate, and vice versa.

Supply of Loanable Funds

Supply of loanable funds comes from the savers, i.e. people and
organizations such as businesses and governments, who decide not Supply of Loanable Funds
to spend their money. Instead, they will use their savings money for
Comes from the saver's side;
it slopes upwards, which
investment purposes. Tuey will lend their money to borro,,vers at a reflects a positi ve relationship
rate of interest to make an investment. The supply of loanable funds is between the vo;ume of
savings and interest rate, and
derived from four basic sources: savings, dishoarding, disinvestments v1Ce versa.
and bank credit.
Savings constitute the most important source o f the supply of
loanable funds. Savings is the part of income that is not used for the
purchase of goods and services. It is obtained by taking the difference
between income and expenditure. The higher the interest rate, the
higher the savings will be. A higher interest rate ,,vill encourage people
co
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u be higher at 10% interest rate rather than 5% interest rate. Thus, there
Equilibrium Interest Rate
Is achieved when the demand
forloanabl e funds equals the
supply of loanable funds.
Figure 8.8
Determination of equilibrium
interest rate
Keynes's Liquidity Preference
Theory of Interest
States that interest rate is
payment assets in the most
li quid form.
and businesses to save more since the return on savings ,.vill be more as
well. For example, if the interest rate on savings is 10% per annum, this
will encourage people to save more as compared to only 5% interest
on savings per annum. This is because the return on savings would
is a direct or positive relationship between interest rate and savings.
This indicates that the supply of loanable funds slopes upwards to
reflect the positive relationship between the volume of savings and the
interest rate, and vice versa.
Determination of Equilibrium Interest Rate
The equilibrium interest rate is determined when the demand for
loanable funds equates the supply of loanable funds. The intersection
point between the demand for and supply of loanable funds determines
the equilibrium interest rate. Figure 8.8 depicts the determination of
the equilibrium interest rate.
Interest rate
R* ------------------E*
O� - Loanable funds
- - - - - - - - - -+
M*
The equilibrium interest rate is obtained from the intersection
point between the demand for loanable funds (DL) and the supply of
loanable funds (SL). The equilibritun point is achieved at point E* and
the equilibriun1 interest rate is attained at R*. The demand for and
supply of loanable funds is at M*.
Keynes's Liquidity Preference Theory of Interest
The liquidity preference theory was propounded by John Maynard
Keynes. This is a new theory on the rate of interest developed by
Keynes. According to Keynes's liquidity preference theory of interest,
interest rate is payment assets in the most liquid form. This means that
people would want to hold money which is the 1nost liquid asset rather
than less liquid assets such as bonds and shares. In short, liquidity
refers to the convenience of holding cash. Therefore, this contributes
towards the demand for holding money by people. The demand for
money is downward sloping since the interest rate is the opportunity
cost of holding 1noney.
Demand for Money �

According to Keynes, there are three motives behind the desire for
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Demand for Money
holding cash or liquid assets by the public or demand for money:
0
Depends on transaction
transaction motive, precautionary motive and speculative n1otive. motive, precautionary motive
0

-·-
and speculative rnotive.
I Transaction motive
Transaction motive refers to the demand for money or the need
..,-·
of cash for current transactions by individuals and businesses.
--·
Transaction Motive
The demand for n1oney or
Individuals receive an inco1ne n1onthly to purchase goods and the need of cash for current
services from the market. Therefore, people need the most liquid transactions by individuals
0
assets or ready cash to buy these goods and services on a daily basis.
and businesses.

Individuals hold cash to bridge the gap between income receipt and
their expenditure. This can also be called an income motive.
Business entities also need money and demand money for their
business purposes, such as to purchase raw materials and to make
payments for transportation costs, maintenance costs, wages, rent
and so on. This motive is also known as the business motive.
The demand for 1noney under transaction 1notive depends
on the individual's income level. The higher the income of an
individual, the higher the demand for money vvould be, since
more transactions ,-vould be carried out when income is higher;
the opposite is also true.
2 Precautionary motive
Precautionary motive refers to the desire for holding money
Precautionary Motive
in case of unforeseen contingencies, emergencies, accidents, The desire for holding
unemployment, illnesses, natural disasters, and s o on. Similarly, money to face unforeseen
firms also keep cash as a reserve to face future unfavourable contingencies, emergencies,
accidents, unemployment,
conditions or situations and unexpected deals for precautionary illnesses, natural disasters, etc.
reasons. The demand for money under the precautionary motive
is directly related to tl1e income level of an i11dividual as well.
3 Speculative motive
Speculative motive refers to the desire of an individual to hold liquid
assets or money to take advantage of changes in interest rates and
Speculative Motive
The desire of an ind ividual to
bond prices. The prices of bonds and interest rates are negatively hold liquid assets or money to
related. If the price of a bond is expected to increase, the interest take advantage of changes in

rate is expected to reduce and therefore an individual needs cash to

interest rates and bond prices.

purchase more bonds or shares. On the other hand, if the price of a

bond is expected to fall, the interest rate is expected to rise and thus
people will sell their bonds to avoid losses. In other words, according
to Keynes, the higher the interest rate, the lower the speculative
demand for n1oney ,-vould be and, conversely, the lo,-ver the interest
rate, the higher the speculative demand for money will be.
Supply of Money
Supply of Money Is controlled by government
The supply of n1oney is controlled or determined by government policies and the central bank;
policies and central banks of nations. The supply of money consists
is independent of interest
rate and the supply curve is
of coins, bank notes and demand deposits with banks. The supply perfectly inelastic (vertica l
of money depends on the currency as well as the policy on credit straight line).
co
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u Determination of Interest Rate
Equilibrium Interest Rate
Obtained byequating demand
for and supply of money.
Figure 8.9
Interest rate determination
Rent
The reward for a fixed supply
of land in its most productive
perspective.
creation implemented by the central bank. The supply of money is
independent of the rate of interest. Therefore, the supply curve for
money is perfectly inelastic or a vertical straight line.
The intersection point between demand for and supply of 1noney
determines the equilibrium rate of interest. Note that the demand
curve of money slopes dov,nwards, indicating that the interest rate is
the opportunity cost of holding money, while the supply of money is
perfectly inelastic because the quantity of money is determined by the
central bank. Figure 8.9 shows the determination of the interest rate
where Ms represents the supply of money and Md is the demand for
money. Both curves, M. and Ma, intersect at E0 ,-vhere the equilibrium
interest rate of OR0 is established.
Interest rate
M,
R,
Ro -----------�----- Eo
''
·······----�-----------
'
''
''
''
o�- - - �-�-�- - - -+
- Quan t i t yof
Q, 00 Q2 money
When there is deviation from the equilibrium position, an
adjustinent would take place and the equilibriun1 point £0 will be re­
established. Suppose that at point E 1 , the quantity supplied of money at
OQ0 is greater than the quantity demanded for money at OQ 1• Thus, the
interest rate will decline from OR 1 until the initial equilibrium interest
rate is reached at OR0 . On ilie otl1er hand, at E2, the quantity supplied
of money at OQ2 is smaller than the quantity demanded for n1oney at
OQ0• As a result, the interest rate of OR2 ,-vill start to rise until it reaches
the equilibrium interest rate of OR0.
8.2.3 Rent
Economists have different definitions for rent. David Ricardo defined
rent as the price paid for the use of land. It is the re,-vard for a fixed
supply of land in its most productive perspective. The neoclassical
economist, Alfred Marshall, defined rent as the income derived from
the o,-vnership of land and other free gifts of nature. In popular usage,
apart from renting land, rent also refers to the payment for the hire
of goods and services such as rent for houses, automobiles, television
sets or lawnmo"vers to be returned to its owner in the sa1ne physical
condition.
David Ricardo's Law of Rent �

David Ricardo formulated the law of rent around 1809. This law, called
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0
the Ricardian theory of rent, provides an exposition of the source and
magnitude of rent, and is established as one of the most important 0
principles of econon1ics.
-·-
Ricardo defined rent as a 'portion of the produce of earth which David Ricardo's Law of Rent
..,-·
--·
is paid to the landlord for the use of the original and indestructible States that rent is a 'portion of
powers of soil'. According to the Ricardian definition, rent is a payment the produce of earth which
is paid to the landlord for
for the use of only land. the use of the original and 0
The assumptions of the Ricardian theory of rent are outlined as indestructible powers of soil'.
follows:
(a) The supply of land is completely fixed and limited. Hence, the
total supply of land is perfectly inelastic and unresponsive to any
changes in rent.
(b) Land is specifically used for growing one crop only such as corn.
Thus, there is no other alternative uses for the land, meaning the
land is to be used for growing of corn only or otherwise left idle.
(c) There exists perfect competition in the market for land as all
lando,<\'ners will let out their land however little the rent, rather
than leave it idle. Individual landowners and farmers have no
influence over the rent.
(d) Land differs in quality with respect to fertility and location.
(e) Rent is paid to the landowner for the 'original and indestructible'
po"ver of the soil.
(f) There is no cost of production for the land.
The Ricardian theory assumes that rent arises due to two reasons. If
land is homogeneous in terms of uniforn1 quality and same location,
scarcity rent occurs. This is because the scarcity of land relative to
demand will give rise to rent. However, if land differs in quality with
respect to fertility and location, then the scarcity of superior grades of
land will give rise to differential rents.
The Ricardian theory faced criticism due to its assumptions which
were not applicable in reality. Rent is not only restricted to land, but
also to other factors of production. Rent cannot simply be based on
the natural variation of the fertility of different pieces of land. Ricardo
ignored the competing uses for some land, thus it is not necessarily the
least fertile land that will go out of cultivation first.

Modern Economic Theory of Rent

The modern theory of rent was 1nodified from the Ricardian theory of
Modern EconomicTheory
rent, first developed by J. S. Mill and subsequently by other economists, of Rent
such as Jevons, Pareto, Marshall, Joan Robinson, and so forth. Modern States that land is scarce and
economists stated that land is scarce and is not in perfect elastic supply. is not in perfect elastic supply.
and rent is paid because the
The various rates of rent are influenced by the scarcity of the products produce of the land is scarce
that land can yield, not by the differences in the fertility of land as in relation to its demand.
claimed by Ricardo. Rent is paid because the produce of land is scarce
in relation to its demand, thus land earns scarcity rent.
co Modern economists apply rent to all the factors of production; rent
is not paid for the use of land alone, but also for labour, capital and
entrepreneurship.
.c:
u Determination of Rent
Modern economists presented the determination of rent in two forn1s,
as follows:
1 General concept of rent
General Concept of Rent Rent is determined by the market forces of demand and supply for
Suggests that rent and the factors of production.
the demand for a factor of Demand for the factors of production is derived demand, as it
is demanded indirectly to produce final goods. There is a negative
production are negatively
related because when rent is
higher, the demand for a factor relationship between rent and de1nand for a factor of production
of production will be lower, because when rent is higher, the den1and for a factor of production
v.1ill be lower, and vice versa. Thus, the demand curve for a factor
and vice versa, whereas the
supply of a factor of production
is upward sloping because of production is downward sloping from left to right, as sho,-vn in
as rent increases, the supply
of a factor of production will
Figure 8.10.
increase as welI, and vice versa. The supply of a factor of production is upward sloping because
as rent increases, the supply for a factor of production will
increase, and vice versa. This is because there are alternative uses
for a particular factor of production such as land.
When demand for and supply of a factor of production
Equilibrium Rent intersect, then equilibrium rent occurs. In Figure 8.10, DD is
the demand for a fa,ctor of production, while SS is the supply of a
Achieved when the demand
for and supply of a factor of
production is equal. factor of production. The equilibrium point is at E, with OR as the
equilibrium rent while OQ is the equilibrium quantity.

Figure 8.10 Rent

Rent equilibrium
ss

E
R ...............................

DD
'-------------+Land
0 0

2 Economic rent
Economic Rent
A sur pl us which arises due to
the difference between actual
earnings and transfer earnings.
The modern concept of rent is applicable not only to land, but
also to all other factors of production, i.e. labour, capital and
entrepreneurship. All factors of production earn 'economic rent',
but modern economists generally use the term 'rent'.
Rent is a price for a factor of production, while economic rent
is a surplus which arises due to the difference between actual
earnings and transfer earnings. Thus, economic rent is considered
as a payment in excess of transfer earnings, that is:
Economic Rent =Actual earnings (or Total income) - Transfer earnings �
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Each factor of production has its alternative uses. For instance,

(I)
0
land can be used for planting crops or building apartments. As
Transfer Earnings
The amount of n1oney which
such, when we transfer a factor from one use to another, we have 0

-·-
any particular factor or unit

..,-·
to sacrifice the earlier income earned from it. This sacrifice of could earn in its best paid
earnings is defined as transfer earnings. Thus, transfer earnings
alternative use.

is the amount of money ,-vhich any particular factor or unit could

earn in its best paid alternative use. Additionally, transfer payment
can be defined as the minimum price which must be paid to keep a
--·
0
factor of production in its present use or employ1nent.
For instance, a piece of land used for planting corn is earning
USDSOO and its next best use for planting potato earns USD400.
The transfer earnings is USD400, therefore it gives a surplus
of USD 100 in its present use. This is sho,-vn in the following
calculation:
Economic Rent= Actual earnings - Transfer earnings
=USDSOO - USD400
= USDlOO
Figure 8.11 illustrates the concept of transfer earnings and
economic rent. DD is the demand curve for a factor of production,
while SS is the supply curve for a factor of production. The
equilibrium poi11t occurs at point E, with the equilibrium price at
OP and equilibrium quantity at OQ. Econon1ic rent is the area of
OPEQ, ,-vhich is above the supply curve and below the equilibrium
factor price OP . Transfer earnings is the area ofOEQ, ,-vhich is below
the supply curve. The actual earnings or total income received
by the factor of production is ER + TE, i.e. the area of OPEQ;
price x quantity= OP x OQ.

Rent Figure 8.11

Economic rent and transfer
ss earnings

E
p

ER /

/ TE
DD
0'-- ----
Q -----
-Land

Actual Earnings or Total Income

= Transfer earnings + Economic rent
= OEQ + OPE
=OPEQ
co Economic rent as a surplus over transfer earnings will be different
under the three possibilities of elasticity of supply, which is explained
as follows:
.c: (a) Determination of economic rent under a perfectly elastic
u
supply curve of a factor of production
When the supply of the factor of production is perfectly elastic,
i.e. a horizontal straight line as shown in Figure 8.12, there will be
no surplus or no rent because the actual earnings and the transfer
earnings are equal.

Figure 8.12 Rent

Perfectly elastic supply curve

E
Rl--- - - -
....:..::- - - - -
55

Transfer
earnings
DD
'------- - - - - +
- Land
0 0

Figure 8.12 illustrates the supply curve SS of a factor of

production which is perfectly elastic, represented by a horizontal
straight line. DD is the demand curve. SS and DD intersect at
point E, with OQ representing the factor of production used and
OR representing the equilibrium rent. The total income is OREQ
\.vhich is equal to the transfer earnings of OREQ. Thus, there is no
surplus or rent because the transfer earnings and the total income
are equal. This case can be applied to supply of land to a firm. If
the firm is not paying a rent of OR, the land will be transferred to
other uses or to other firms.
(b) Determination of economic rent under an inelastic supply
curve of a factor of production
If the supply of a factor of production is perfectly inelastic,
represented by a vertical straight line as shown in Figure 8.13,
the transfer earnings is zero because the entire income is surplus,
and all the earnings are economic rent. This exainple refers to a
case \.vhen the land has no alternative use at all and the supply of
land is fixed.
Figure 8.13 shows a vertical straight line v,rhich represents a
perfectly elastic supply curve SS. DD is the demand curve. Both DD
and SS intersect at point E, with OR representing the equilibrium
rent and OQ representing the equilibrium of factor used which is
land. The total earnings is OREQ. Since the factor of production
is fixed in supply and cannot be transferred to other uses,
 the entire earnings of OREQ is economic rent and thus transfer �
. .
earnings 1s zero.
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0

Rent Figure 8.13 0

-·-
..,-·
Perfectly inelastic supply curve
ss

--·
0
R --------------- E

Econo mic
rent
DD
- '--
o'--- - - - 0
- Land
- - - +

(c) Determination of economic rent under an upward sloping

supply curve of a factor of production
If the supply curve of a factor of production is upward sloping,
then a portion of the total income is from economic rent and a
portion is from transfer earnings.
Figure 8.14 shows an upward sloping supply curve which
intersects the demand curve DD at point E. The factor of
production used is OQ and the rent per unit is OP. The total
earnings is OREQ. The transfer earnings is OEQ. The surplus is
econon1ic rent of ORE.

Rent Figure 8.14

Upward sloping supply curve
ss

E
R
ER

TE
DD
-
"'-- - - - - Land
-----+
0 0

Thus, ,ve can conclude that economic rent arises in the sense of
surplus when the supply of a factor of production is less than perfectly
elastic.

Quasi-Rent
The concept of quasi-rent ,vas developed by Alfred Marshall, who
defined quasi-rent as surplus earnings generated by the factors of
production, except land.
256

co Quasi-rent is the temporary economic rent that is earned in the

short run as it occurs only as a temporary phenomenon. Quasi-rent
Quasi-rent
The short run economic profit
or temporary economic rent refers to the short-run economic profit or temporary economic rent
.c: that will disappear in the long
which is enjoyed by the owner of a particular kind of skill, machinery
u run.
or barriers to entry in the short run because the increase in demand
will disappear in the long run. Skill, capital equipment or other factors
of production are elastic if enough time is given because this temporary
scarcity in supply can be increased in the long run. Thus, quasi-rent
will disappear in the long run.
Quasi-rent is only a temporary surplus that is earned in the short
run by capital equipment such as machinery because the supply of
capital equipment cannot be increased in the short run. Ho,-vever, the
supply of capital equipment can be increased in the long run to meet
the increased demand, resulting in the loss of excessive earnings in the
long run.
For the case of land which is permanently fixed in supply and non-
reproducible, its supply curve is perfectly inelastic in the short run as
well as in the long run. Therefore, the surplus earnings or economic
rent earned by land persists in the long run.
Quasi-rent has also been defined by Marshall as the excess of total
revenue in the short run over total variable costs.
Quasi-rent= Total revenue earned - Total variable costs
The short-run earnings of quasi-rent \viii disappear in the long run
as shown in Figure 8.15. ATC is the short-run average total cost curve
while AVC is the short-run average variable cost curve as explained
in Chapter 5. It is assumed that firms are price takers in perfect
competition and the price is determined at OP, with the price line PK
which represents the average revenue and marginal revenue curve for
the individual firm. The equilibrium point is at E and OQ is the level
of output.

MC ATC
Price/Cost
Figure 8.15
Quasi-rent ''
'
'''
''
,
E, '--
p 1-- -� - - - - - ,, -.-- --r-,<
,
A .'= L-
P1 1- =
- - - - -..:....:,. i:----,, - -K1
F1-- - - - - - -
,�'+-�B
,

P2 l----==-........
H 1--"-s:::-- ---
,/' M
,....,,, ''-- :::--r;:c
-==' :::::.._-1--l----- K2

--- ,-­

.1-
0 ----
�- - -+ Quantity
�-1-- - -
02 a, a
 Quasi-rent can be summarized as shown in Table 8 .. 2. �
::r
(I)

--·
0
Price Equilibrium I
: Quantity
I
'

Total
Total
Table 8.2
Quasi-rent with different price �

Price Variable Quasi-rent 0

-..,-·
Line Point Revenue levels
(1) 141 Cost (7) = (5) - (6)
(2) (3) (5) 0
(6)

p PK E
A
Q OQEP
OQlAPl
OQBF
OQl Cl-I
FBEP
HCAPl
0
--·
M OQ2MP2 OQ2MP2 0 (Zero)

Table 8.2 shows that when the price for the product falls from
P to P1, the quasi-rent is reduced. When the price falls to P2 , at the
minimum point of the AVC curve, the total revenue earned is just
equal to the total variable cost, thus the quasi-rent falls to zero. The
firm will shut down production if the price falls below OP2 • No quasi­
rent is earned in the long run because all factors are variables in the
long run, and in equilibrium the price must equal the long run average
cost. Thus, quasi-rent only occurs in the short run.

It is reported by a real estate agent that the rental rate of condominiums

decreased consistently from RM12,000 to RM6,000 for similar sized units.
Meanwhile, Roy Teo, the senior real estate negotiator at Property Hub,
said that despite the current obstacles, those who have engaged in the
'right property' invest1nent in the previous three to four years will not face
problems either to sell or rent out their property today. However, if these
property owners lack holding power over their property, they will face losses
due to the current conditions.
According to Georg Chmiel, the iProperty Group Managing Director and
Chief Executive Officer, the volume of transactions have reduced this year
since the introduction of cooling measures in 2013. The iproperty.com Asia
Property Market Sentiment Survey showed that the buyers and investors of
property are delaying their decisions to buy until 2016.
In an e-mail, he states, "Factors such as the increase in cost of living,
weakening ringgit, the current economic and political climate, cooling
measures as ,vell as the GST and stringent bank regulations are the likely
factors which have and will continue to weigh on buying sentiment. We think
the [property] sector will only recover to\vards the second half of 2016:'
He also added, due to less demand for high-end luxury property currently,
property owners opt to rent out their property to meet the monthly mortgage
payments. The trend of renting out their property units below the market
value could possibly persist until 2016.

Source: Adapted from 1\1alay 1\1ail Online, 2015.

co

.c: Case questions

u
(a) Define rent.
(b) Based on the case study, what are the factors that contribute towards the
proble1n of property rental?
(c) How do property owners attract demand for property rental?
(d) State the formula to calculate economic rent.
(e) Briefly explain the concepts of economic rent and transfer earnings, and
include a suitable diagra1n.

Solution
(a) Rent is a reward or the return on the factor of production known as land.
(b) (i) Increased cost of living
(ii) Weakening ringgit
(iii) Economic and political issues
(iv) Cooling measures
(v) Goods and Services Tax (GST) and strict bank regulations
(c) Property owners offer lower rental for their property than the market
value.
(d) Economic Rent= Actual earnings - Transfer earnings
(e) Transfer earnings refer to the amount of income which a particular factor
could receive in its next best use, while economic rent is the income
received by the owner which is above the value of transfer earnings.

Rent
s

E
R
ER /

/ TE D
0
�----------+Land
Q

8.2.4 Profit
Profit is the return on entrepreneurship. Entrepreneurship is the act
of undertaking innovation, business and finance in economic activity.
In other words, profit is the money a business makes after accounting
for all the expenses. Regardless of whether the business is a couple of
youths running a night burger stall or a publicly traded multinational �

company, consistently earning profit is every co1npany's goal.

::r
(I)

Profit is also defined as the surplus remaining after total costs are
0

deducted from total revenue, and the basis on ,-vhich tax is computed 0
and dividend is paid. It is the best known measure of success in an
-·-
enterprise.
Profit is reflected in reduction in liabilities, increase in assets, ..,-·
and/or increase in owners' equity. It furnishes resources for investing
in future operations, and its absence may result in the extinction of a
--·
0
company. As an indicator of co1nparative performance, however, it is
less valuable than return on investment (ROI).
Profit has several meanings in economics. At its most basic level,
profit is the reward gained by risk-taking entrepreneurs ,-vhen the
revenue earned from selling a given amount of output exceeds the
total costs of producing that output. This sin1ple staten1ent is often
expressed as the profit identity, which states that:
Total Profit = Total revenue (TR) - Total cosit (TC)
However, the concept of profit needs clarification because there is
no standard definition of what counts as a cost. In general, profit can
be categorized into accounting profit ,-vhich is the difference between
the purchase price and the costs, and economic profit which has two
related but distinct 1neanings: normal profit and economic profit.
Normal Profit
In markets which are perfectly competitive, the profit available to a
single firm in the long run is called normal profit. This exists when
total revenue (TR) equals total cost (TC). Normal profit is defined as
the mini1nun1 reward that is just sufficient to keep the entrepreneur
supplying their enterprises.
The accounting definition of profit is rather different because
the calculation of profit is based on a straightforward numerical
calculation of past monetary costs and revenues, and makes no
reference to the concept of opportunity cost. Accounting profit
occurs when revenues are greater than costs, and not equal, as in the
case of normal profit.

Supernormal (or Economic) Profit

If a firm makes more than normal profit, it is called supernormal
profit. Supernormal profit is also called economic profit, and abnormal
profit, and is earned ,-vhen total revenue is greater than the total costs.
Total costs include a reward for all the factors, including normal profit.
This means that when total revenue equals total cost, tlhe entrepreneur
is earning normal profit, which is the minimum reward that keeps the
entrepreneur providing their skill, and taking risks.
The level of supernormal profit available to a fir1n is largely
determined by the level of competition in a market-the more
competition, the less chance there is to earn supernormal profit.
co Supernormal profit can be derived in three general cases:
(a) Firms in perfectly con1petitive markets in the short run, before
their profits are eroded do,,vn to a normal level by new entrants.
.c: (b) Firms in less competitive markets, such as monopolistic
u
competition and competitive oligopolies, earning head start
profits when they participate in innovation or cost reduction.
These will eventually be eroded away, providing further incentive
to innovate and become more cost efficient.
(c) Firms in highly uncompetitive markets, such as collusive
oligopolies and monopolies, who can erect barriers to entry to
protect the1nselves from con1petition in the long run and earn
persistent above normal profits.
Definition of Economic Profit (or Loss)
The difference between the revenue received from the sale of an
output and the opportunity cost of the inputs used. This can be used
as another name for economic value added (EVA).
Breaking Down Economic Profit (or Loss)
This should not be confused with accounting profit, ,vhich is what
most people generally mean when they refer to profit.
In calculating economic profit, opportunity costs are deducted
from revenues earned. Opportunity costs are the alternative returns
foregone by using the chosen inputs. As a result, there can be a
significant accounting profit with little to no economic profit.
For example, say you invest USD100,000 to start a business, and
in that year you earn USD120,000 in profits. Your accounting profit
would be USD20,000. However, say that in the same year, you could
have earned an income of USD45,000 if you had been employed.
Therefore, you have an economic loss of USD25,000 (USD120,000 -
USDl00,000 - USD45,000).

The theory of marginal productivity explains in detail how all four factors
of production receive rewards, i.e. labour receive wages, return on capital
is interest, the reward for land is rent, and entrepreneurs receive profit. The
marginal productivity theory suggests that each productive factor will be
rewarded according to its marginal productivity. There are several important
concepts related to the marginal productivity theory, which are total physical
product, marginal physical product, marginal value product, total revenue
product, marginal revenue product and average revenue product. The
equilibrium factor price or reward for factors of production can be obtained
v,rhen the demand and the supply of factors of production are equal.
The equilibrium wage rate can be determined by the demand and supply of
labour. Firms de1nand labour in the production process. The marginal revenue
product determines the labour demand curve. The marginal revenue product
is the additional revenue obtained from employing an additional unit of labour. �

The den1and curve or the 1narginal revenue product curve is downward sloping
::r
(I)

indicating that the higher the ½1age rate, the lo,-ver would be the demand for
--·
0
"1

labour due to increment in cost of production, and vice versa. On the other
'<
0
hand, supply of labour comes from households as well as individuals who want
to earn wages and salary. The supply curve of labour can be vie"ved from three
different angles. The first is the supply of labour is perfectly elastic when the
0
--·
--·
"1

firm is in perfect competition. Secondly, the supply curve is upward sloping for
an industry and lastly, the backward-bending supply curve represents supply 0
of labour for the whole economy. Profit-maximization is achieved vvhen the
marginal revenue product equals the marginal wage cost. The marginal wage
cost is the additional total cost incurred by employing an additional unit of
labour.
Interest is the reward paid to the owner of the capital upon its service as
one of the factors of production. Economists have discussed the concept of
interest in various theories, such as the neoclassical loanable funds theory and
the Keynes's liquidity preference theory of interest. The neoclassical loanable
funds theory explains how the determination of interest rate is done, i.e. it
is determined by the de1nand for loanable funds and the supply of loanable
funds. There is a negative relationship between investment and interest rate
and therefore the demand curve for loanable funds slopes do,-vnwards.
Conversely, there is a positive relationship bet,-veen savings and interest rate,
thus the supply curve of loanable funds is upward sloping. In Keynes liquidity
preference theory of interest, the equilibrium interest rate is attained fro1n the
intersection between demand for and supply of money. The demand for money
is downward sloping, whereas the supply of money is perfectly inelastic.
Rent is the payment made for land. Economists have discussed the concept
of rent in several theories, namely David Ricardo's law of rent and the 1nodern
theory of rent. According to Ricardo, rent arises due to two reasons. Firstly, if
the land is homogenous, then scarcity will occur. Secondly, Ricardo assumes
that land differs in quality as well as rent. The modern theory of rent suggests
that land is subject to scarcity and therefore is not in perfect elastic supply, and
land earns scarcity rent.
Modern economists state that land is scarce and it is not in perfect elastic
supply. The various rates of rent are influenced by the scarcity of the products
that land can yield, not by the differences in fertility of land as claimed by
Ricardo. Rent is paid because the produce of the land is scarce in relation to its
demand. Thus, land earns scarcity rent. Rent is not only paid for the land, but
also for other factors of production, i.e. capital, labour and entrepreneurship.
Under the general concept of rent, there is a negative relationship between rent
and the demand for a factor of production. When rent is high, the demand
for a factor will be low, and vice versa. Under the modern theory of rent, the
concept of economic rent applies. Economic rent is a surplus ½1hich arises due
to the difference between earnings and transfer earnings. Hence, the economic
rent is made up as a payment in excess of transfer ear11ings. The determination
of econon1ic rent varies under the three different elasticities of supply, which
are perfectly elastic supply, perfectly inelastic supply and the upward sloping
supply curve. The concept of quasi-rent "vas developed by Alfred Marshall who
suggested that quasi-rent arises when the surplus earnings are generated by
the factors of production, except land. In the short run, quasi-rent is kno,.vn
as the temporary economic rent that is enjoyed by the owner of certain skills,
machinery or barriers to entry. However, in the long run, the quasi-rent will
disappear.
Profit is the reward received by an entrepreneur who is able to take risks
in the production process and lhas particular skills and expertise in dealing
with businesses. The total profit is obtained by deducting total cost from total
revenue. There are different concepts of profit which are known as normal
profit, supernorn1al profit and subnormal profit (or loss).

• The theory of marginal productivity states that the re,.,vards for factors of
production or the equilibrium factor cost is made according to its marginal
productivity.
• Total physical product (TPP) refers to the total output produced by
employing the four factors of production.
• Marginal physical product (MPP) is the total physical product of
employing an additional unit of a factor while the quantity of other factors
of production remains unchanged.
• Marginal value product (MVP) refers to the monetary value of marginal
physical product and is attained by multiplying the marginal physical
product with price.
• Total revenue product (TRP) is defined as the total revenue gained by
hiring the four factors of production.
• Marginal revenue product (MRP) is the additional revenue obtained
when the additional unit of a factor is employed holding other factors of
production constant.
• Average revenue product (ARP) refers to the average revenue gained per
unit of factor of production.
• Wage is the reward received by labour for their services in the process of
production of goods and services.
• Nominal wage refers to the ,.vage in terms of money value, e.g. US dollars.
• Real wage is measured in terms of purchasing power received by labour.
• Interest refers to the return to capital owner for their services in the
production process.
• Nominal interest rate is known as the coupon rate which is the actual
monetary price that borrowers pay to the lender for the use of lender's
money .
• Real interest rate is the rate received by lender or investor after inflation
rate is taken into account.
• Effective interest rate takes into account the power of compounding
interest.
• Gross interest is the payment 1nade by the borrower to the lender, and it is
not exclusively made for the use of capital only.
• Net interest is the payment of interest after certain elements are deducted

--·-
�

from gross interest and it is paid exclusively for the use of capital.
::r
(I)

• Loanable funds refer to the total money that people have decided to save
0
"1
'<
or lend to the borrowers to be used as an investment. 0
• Keynes's liquidity preference theory states that people demand money or

--·
0
hold n1oney in terms of the most liquid assets to make purchases of goods
and services. -·
"1

• Transaction motive is the demand for money or the need of cash for
current transactions by individuals and businesses.
• Precautionary motive refers to the desire of holding money by individuals
and firms for unforeseen contingencies, emergencies, accidents,
unemployment, illness, natural disasters, etc.
• Speculative motive is defined as the desire of individuals to hold liquid
assets or money to take advantage of the changes in interest rates and bond
prices.
• Rent is defined as the payment made for land.
• Transfer earnings is the amount of income received by a factor for its next
best or alternative use.
• Economic rent is income received by the owner of the land or the payment
of the excess of transfer earnings.
• Quasi-rent is a temporary economic rent which is earned in the short run
and will disappear in the long run.
• Profit is the reward received by an entrepreneur who has the ability to
plan, organize and manage businesses, "vhile being able to take risks in the
production process.

+ Key concepts

• Marginal productivity • Nominal wage • Transaction motive

theory
• Total physical product
• Marginal physical
product
• Marginal value product
• Total revenue product
• Marginal revenue
product
• Average revenue
product
• Wage
• Real wage
• Interest
• Nominal interest rate
• Real interest rate
• Effective interest rate
• Gross interest
• Net interest
• Neoclassical loanable
funds theory
• Keynes's liquidity
preference theory
• Precautionary motive
• Speculative motive
• Rent
• Ricardian law of rent
• Modern economic theory
of rent
• Transfer earnings
• Economic rent
Quasi-rent
• Profit
co
.c:
u
Multiple-choice Questions
Answer the following questions.
1 Which of the following rewards of factors of
production is correct?
A Wage is the returns on entrepreneurship.
B Rent is the returns on land.
C Interest is the returns on labour.
D Profit is the returns on capital.
2_ _ is measured in terms of money value.
_ information.
A Real wage
B Gross '¼'age
C Nominal wage
D Actual wage
3 The_ _ _ is also a demand curve of labour.
A total productivity of labour
B marginal product of labour
C total revenue product
D marginal revenue product
4 Suppose the marginal product of labour is
30 units and the price of output is USD15
per unit, hence the marginal revenue
product of labour is
A USD450
B USD2
C USD0.50
D USD25
5 If the marginal revenue product of labour is
greater than the wage rate, then
A the firm is experiencing profit.
B the firm is facing losses.
C more labour should be employed.
D less labour should be employed.
6 In a perfectly co1npetitive market, the
employer should hire additional quantity of
labour until
A the wage rate is greater than marginal
product.
B the wage rate is less than marginal
product.
C marginal revenue product equals
n1arginal wage cost.
D marginal wage cost exceeds marginal
revenue product.
Questions 7 to 9 are based on the following
Katrina is an owner of a company that produces
bread. The firm is operating in a perfectly
competitive market. The total product of
producing bread is 4 units when the first worker
is employed. The total product increases to
8 units when the second worker is hired and
15 units ,-vhen the third ,-vorker is hired. The
total product is 25 units when a fourth ,-vorker is
hired. One unit of bread is sold at USD2 and
the wage rate per unit of worker is USD20.
7 The marginal productivity of the third
worker is- - -·
A 5
B 6
C 7
D 8
8 The marginal revenue product of labour for
the fourth worker is- --
A 4 x USD2 = USD8
B 7 x USD2 = USD14
C 8 x USD2 = USD16
D 10 x USD2 = USD20
9 The best number of workers that should be
hired by Katrina is_ __
A 1
B 2
C 3
D 4
10 The marginal revenue product of labour is C individuals are willing to consume more �

when the interest rate is higher.

::r
(I)

upward sloping D individuals are willing to save more

0
A
B down,vard sloping when the interest rate is lower. 0
C perfectly elastic
-·-
D perfectly inelastic 15 Which of the following is not a source of
loanable funds? ..,-·
--·
Questions 11 to 13 are based on the table.
A Savings
Labour TPL MPL TRP B Investment
(Unit) (Unit) (Unit) (USO) C Consumption 0

D Government budget
1 20 so
2 15 68 16 refers to the desire for holding
n1oney in unforeseen circu1nstances.
47 12 82
A Precautionary motive
3
4 56 72 B Speculative motive
5 4 67 C Transaction motive
D Investment motive
11 How much is the marginal product of
17 The supply of land is_ _
_
labour for the fourth worker?
A perfectly elastic
A 9
B perfectly inelastic
B 10
C downward sloping
C 12
D upward sloping
D 15
18_ _ _ is a temporary economic rent in the
12 If the wage rate is USD 14, how many
short run.
workers will be hired by the firm to
A Economic rent
maximize profits?
B Quasi-rent
A 1
C Transfer earnings
B 2
D Gross rent
C 3
19 Interest is determined by a_ _ _ ,
D 4
according to the theory of interest.
13 How many units of output are produced
A commercial bank
when the second unit of labour is
B firm
en1ployed?
C central bank
A 20
D government-linked company
B 30
C 35 20 The difference bet1,veen labour and an
entrepreneur is that an entrepreneur is able
D 46
to_ _ _ and_ _ _
14 The demand for loanable funds suggests
A take risk; maximize profit
that
B gain revenue; maximize cost
A the demand for investment is lower
C maximize cost; sales
when the interest rate is higher.
D minimize sales; cost
B nominal interest rate exceeds real
interest rate.
co Short-answer Questions
Answer thefollowing questions.
1 (a) The demand curve of labour is represented by_ _ _ _ _ _ _
.c:
u (b) In a perfectly co1npetitive market, the supply curve of labour is

(c) In the labour market, profit is maximized ,-vhen______ _

(d) Suppose that in a perfect competition, the price of a T -shirt is RMlO each. The
average physical product (APP) is 120 units for the third ,vorker and 130 units
for the fourth v,rorker. Therefore, the marginal physical product (MPP) and the
marginal revenue product (MRP) for the fourth worker is______ _
and_ _ _ _ _ _ _ , respectively.
(e) As interest rate gets higher, the demand for investment and consumption are
_______ , while the demand for savings is_ _ _ _ _ _ _
(f) People demand liquidity based on three motives: _______
- - - - - - - and- - - - - - -
(g) - - - - - - - is the an1ount of income which the land could earn from its
alternative use.
(h) _ _ _ _ _ is the price p aid for land, whereas _ _ _ _ _ 1s a
part of income received by each factor of production.
(i) _ _ _ _ _ _ _is the econon1ic rent earned in the short run.
(j ) An_ _ _ _ _ _ _is a person who contributes the skills of organizing,
managing and coordinating a business, and ,-vho is able to take
_ _ _ _ _ _ _to earn_ _ _ _ _ _ _
2 The table shows the information of a perfectly competitive company.
Marginal Product Marginal
Labour Total Product Total Revenue
of Labour Revenue Product
(Unit) (Unit per Day) (USO)
(Unit) (USO)

0 0 0
1 so 100
2 70 140
3 86 172
4 98 196
5 107 214
6 112 224

(a) Complete the table.

(b) State the law that influences the short-run production.
(c) Determine the price of each product sold.
(d) If the ,-vage rate is USD24, how n1any workers ,-vill the firm hire to maximize
profit?
(e) If the wage rate decreases to USD18, how many workers ,-vould the firm hire?
(f) Prepare a diagram to show the equilibrium of this firm.
3 (a) Complete the table.

Labour Total Product

Marginal Product
of Lab,our
Average Product of
Labour
...
0

(Unit) (Unit) 0
(Unit) (Unit)
-·-
0
0
...-·
1
2
8
21 --·
0
39 ::,
4 53
5 62
6 68
7 68
8 64

(b) At what quantity of labour do diminishing marginal returns set in?

(c) Suppose that the price of the product is constant at USD4 per unit and the ,-vage
rate is USD36, how many units of labour would be employed?
(d) Prepare a diagram to sho,v the equilibrium of this firm.
4 (a) Complete the table showing information on Kiara Firm, which operates in a
perfectly competitive labour market.

Marginal
Labour Total Product Marginal Product Total Revenue
Revenue Product
(Unit) (Unit) (Unit) (USO)
(USO)

0 0
1 60 60 30
2 110 25
3 40 75 20
4 180 90
5 20 10
6 210 10 105 5

(b) Assuming that the wage rate is USD 15 per worker, how many workers should the
firm hire to maximize profit?
(c) At what price is each product sold?
(d) Assuming that the ,-vage rate increases to USD25 per worker, how many ,-vorkers
should the firm hire to maximize profit?
(e) Prepare a diagram to sho,v the equilibrium of this firm.
co 5 The table shows the quantity of labour and the total product of Com Shop.
Marginal Revenue
Labour Total Product Marginal Product
.c: (Unit) (Unit) (Unit)
Product
u (USO)

0
1 300
2 535
3 712
4 847
5 946
6 1,020
7 1,074
8 1,110
9 1,137
10 1,161

(a) Suppose that the firm is operating in a perfectly competitive market and sells its
output at the price ofUSD5. Complete the table.
(b) Suppose that the ,-vage rate isUSD270 per worker, hov.1 many workers should the
firm hire at the equilibrium? Prepare a diagram to show the equilibrium of this
firm.
(c) If the price increases toUSDlO and the wage rate is fixed atUSD270, how n1any
workers should the firm hire at the equilibriun1? Show the change in the diagram.

Essay Questions
Answer the following questions.
1 What is marginal productivity theory? Explain in detail the determination of wage
equilibrium with the aid of a diagram.
2 Describe the neoclassical loanable funds theory and how it differs from the liquidity
preference theory of interest.
3 Explain the modern theory of rent using appropriate diagrams.
4 What is transfer earnings? Explain the concepts of economic rent and transfer earnings.
5 Briefly explain the concept of quasi-rent.
6 Briefly describe the concepts of normal profit and supernormal profit.
Introduction to
Macroeconomics
At the end of this chapter, you should be able to:
ffl
E • Interpret the meaning of macroeconomics.
8 • Distinguish the differ•ences between macroeconomics and
m1croeconom1cs.
. .
'5
State and explain the objectives of 1nacroeconomics from the
·-
� • conventional and Islamic perspectives.
s::

.!
 T he noticeable economics definition and the differences between
microeconomics and macroeconomics have been explained briefly
in Chapter 1. Both microeconomics and macroeconomics make up
the main scope of economics as shown in Figure 9.1. In this chapter,
we will focus on the macroeconomic perspective. This perspective can
be viewed from the conventional and Islamic philosophy with their
macroeconomic goals. It is important to understand that these two
philosophies have distinctive views and to learn the differences.

Figure 9.1
Main scope of economics Economics

Microeconomics Macroeconomics

9.1 INTRODUCTION TO
MACROECONOMICS
Macroeconomics is part of the economic perspective that focused on
the economies of scope in a broader insight. It deals with the economy
Aggregate
Refers to sums or total.
as a whole. Macroeconomics studies how the economy behaves
in a broad outline and is concerned ,-vith aggregates by adding up
numerous 1narkets.
Macroeconomics is concerned with the aggregate level behaviour
which makes it distinctly different from microeconomics. Aggregate is
a term in macroeconomics that refers to the sum or total. For example,
macroeconomics focuses on national income, aggregate consumption,
aggregate investment, total employment and the overall level of prices.

9.1.1 Definition of Macroeconomics

Macroeconomics can be defined as a branch of economics that studies
decision-1naking for the economy as a whole. These include studies
of the overall level of economic activity, such as the determination
of national income, aggregate consumption and investment,
unemployment, inflation and international trade.
9.1.2 Differences Between Microeconomics
-::3-
and Macroeconomics "'1

--·
0
\tve discussed macroeconomics in the earlier chapters. In this chapter C.
s::
and the subsequent chapters, we will identify the differences between Microeconomics 0

-
The branch of economics that
microeconomics and macroeconomics in greater detail. studies decision-making by a
0
::3
Microeconomics is the branch of economics that studies decision­ single individual, household,
making by a single individual, household, firm, industry or level of
firm, industry or level of 0
government.
government. It deals with the detailed behaviour and focuses on the
narrow scope of economic activity. Macroeconomics can be defined as a
0
"'1
0
branch of economics that studies decision-making for the economy as a (1)
0
whole. It studies how the economy behaves in a broad outline. 0
::3
For example, 1nicroeconomics studies the wages or income of
-·
0
labour, whereas n1acroeconomics examines the national income.
Macroeconomics
The branch of economics
If microeconomics focuses on the supply and demand of labour in that studies decision-making
0

an industry, macroeconomics looks at the total employment in the for the econon,y as a whole .
economy. With regard to pricing, microeconomics is concerned with
It studies how the economy
behaves in a broad outline.
the price of individual goods and services, whereas macroeconomics
focuses on the aggregate price level.
The differences between macroeconomics and microeconomics are
summarized in Table 9.1.

Table 9.1 Differences between microeconomics and macroeconomics

Scope of
Production Price Income Employment
Economics

Microeconomics Production output in Price o f individual Wages or income Employment

individual industries goods and services of labour and by individual
and businesses distribution of businesses and
income and wealth industries

Macroeconomics National production Aggregate price National income Employment and

or output level unemployment in
the economy

9.2 OBJECTIVES OF MACROECONOMICS

To ensure long-term economic stability, every economy should be
reliant on its strong macroeconon1ic funda1nentals which can be
achieved by focusing on its macroeconomic objectives. In this chapter,
the macroeconomic objectives can be viewed from two perspectives,
i.e. the conventional and Islamic perspectives.
0,
9.2.1 Macroeconomic Objectives from the
Conventional Perspective
The five objectives o f macroeconomics fro1n the conventional
.c: perspective are:
u
I To achieve full employment
Full employment does not mean that there is no unemployed
or jobless people in the economy. Full employment refers to the
level of en1ployment rate where there is no existence of cyclical or
involuntary unemployment. Thus, it is difficult to assume that full
employment refers to 100% of the labour force being employed.
Some people are unemployed as they could be moving on to new
jobs and chose to resign (ten1porarily unen1ployed) or they could
be looking for another job.
The potential benefits of full employment in an economy
are that available resources can be optimized efficiently. If more
resources are employed, more output can be produced. Higher
output produced can translate into an improved economic gro,vth.
On the other hand, the flip side is unemployment. Theoretically,
if full employment cannot be achieved at 100% then it will be
impossible for unemployment rate to reach 0%. The crucial
consequences of unemployment to the econon1y are wastage of
available resources and social problems.
2 To achieve price stability
Phenomenon of inflation or an increase in the general price level
is a challenge to every nation. A high degree of inflation rate that
is associated with a sustained increase in the general price level
can be disastrous to an economy. Many quarters are affected
by the negative consequences of inflation. To the consumers,
inflation directly influences their purchasing power. The quantity
of goods and services purchased will be less if the inflation rate
is high. Pensioners and fixed income earners, too, are affected by
inflation as it can deteriorate their real income with persistent
. .
price increase.
Thus, n1aintaining price stability is really important to
policymakers. Theoretically, it refers to the efforts of ensuring
that the inflation rate in the country is kept as low as possible.
This involves certain macroeconomic policies such as fiscal
and monetary policies. Maintaining price stability is necessary
to avoid uncertainty and disruptions in the economy. It also
means consumers and businesses can safely pursue long-term
consumption and production plans.
3 To achieve economic growth
Econon1ic growth can be described as an expansion in national
output over a given period of time. This growth can be measured
 by calculating the percentage increase in national income for the -::3-
current period as co1npared to the previous period. A nation that "'1

--·
has achieved economic growth will reflect a positive economic
0
C.
performance. This shows that the economic environment is
s::
0
productive not only in terms of output and an increase in income,
but also in labour productivity.
However, an economy will not ah-vays encounter an upward
0
-
::3
0
trend over time as economies tend to experience short-term ups Business Cycle
A business cycle portrays a
and downs in their performance. This is called a business cycle. A series of cycles of economic
0
"'1
business cycle portrays a series of cycles of economic expansion expansion and contraction. 0
(1)
and contraction, it is the periodic and irregular up-and-down There are four phases in 0
0
a business cycle: trough,
movements in an economic activity. There are four phases in a expansion, peak and ::3
-·
0
business cycle: the trough, expansion, peak and recession. The recession.
business cycle is illustrated in Figure 9.2. 0
An expansion is a period during which aggregate output
expands, whereas a recession is a period during ,-vhich aggregate
Expansion
A period during which
output declines. During the expansion phase of the business cycle, aggregate output expands.
total employment, total production and sales ,-vill experience
growth in real terms, after excluding the effects of inflation. Recession
However, the consequences of a recession to the econon1ies are A period during which
devastating, whereby they indicate negative signs of lower demand, aggregate output declines.
fewer output, laid off workers and finally, create an unemployment
crisis. The unemploy1nent rate increases during recession and Peak
decreases during an expansion. By contrast, the inflation rate The highest point of a
increases during an expansion and decreases during a contraction. business cycle, where the
business is producing at full
The peak refers to the highest point of a business cycle, where capacity and the economy is
the business is producing at almost full capacity and the economy at full empl oyment.
is at ahnost full employment. On the other hand, the trough
refers to the lowest point of a business cycle, where the business Trough
is operating belo,-v capacity and unemployment is at a high level. The lowest point of a business
cycle, where the business is
operating below capacity and
unemployment is at a high
Aggregate output
level.

Figure 9.2
A business cycle

Trend growth
In a typical business cycle,
the economy expands as it
Trough moves through point A fron1
the trough to the peak. When
the economy moves from
the peak down to the trough,
Trough through point B, the economy
Time is said to be in recession.
0,
.c:
u Income inequality is a major concern for policymakers to resolve,
5 To achieve equilibrium in the foreign sector
The Oxford Dictionary of
Economics (2003) defines
'balance of payments' as
'an overall statement of
a country's economic
transactions with the rest of
the world over some period,
often a year'.
4 To achieve an equitable distribution of income
The economic success of a nation cannot rest solely on the degree
of its economic gro,.,th. It is necessary to ensure that the economic
gro,�h of a nation is shared equally among the population.
particularly in n1ultiracial countries, such as Malaysia, Singapore,
Australia and the United States.
Generally, policyn1akers try to ensure that there is no wide gap
between the rich and the poor. The policymakers will formulate
a policy of income redistribution to narrow the gap between the
higher income and the lower income groups. This is to ensure that
the population enjoys an equal standard of living. Disparities of
income will create social friction and give rise to many problems.
Taxes are imposed to reduce the income gap between the
higher inco1ne group and lower income group, in order to control
inequality. The higher income group will pay more taxes than the
lower income group. Taxes received by the government ,.,ill be
channelled to the less fortunate as welfare assistance. The objective
is to achieve equitable income distribution through these methods.
Foreign sector means economic transactions or activities that take
place beyond the political boundaries. It includes transactions,
such as imports and exports, investments in other countries and
inter-country tourisn1. A country will try to get an overall surplus
of balance of payments (BOP) that indicates greater inflow than
outflow of money.
If a country faces a BOP deficit, it means that the country will

have to borrow from other countries and this will lead to high debt
problems, whereas a prolonged BOP surplus will lead to inflation.
Thus, it is important for a country to understand and determine the
favourable scale of their BOP.

9.2.2 Macroeconomic Objectives from an

Islamic Perspective
There are five objectives of macroeconomics from an Islamic
perspective:
1 Social justice
Social justice aims to achieve spiritual salvation to human
happiness. It is based on the principle that all existence in the
universe belong to Allah. Man, God's vicegerent on earth, has
been granted the ownership of these bounties. He 1nust therefore
use whatever is given to him as a trustee and not as an absolute
o,-vner.
 Since Islam considers mankind as one family, therefore all
members in this family are alike in the eyes of God . There is no
-
::3
"'1

--·
difference between the rich and the poor, between the high and
0
C.
the low, or between the white and the black. There is to be no
s::
0
discrimination due to race, colour or position. The only criterion of 0
a man's worth is the character, ability and service to humanity. ::3
2 Equitable distribution of income
0

Islam insists on a powerful built-in income redistribution

mechanism; nevertheless some income inequality is allowed since 0
"'1
it promotes individual initiative. Social justice in Islam is rooted in
0
(1)
man's faith. A man of faith auton1atically has a duty to do justice. 0
0
Income redistribution, voluntary or compulsory, is not only an ::3
-·
0
economic necessity, but also a means to spiritual salvation.
The concept rests on its value of maximizing human happiness. 0
In Islam, happiness is not derived fro1n the possession of material
goods, but from contentment and gratitude.
3 Universal education
Acquisition of knowledge is obligatory in Islam. Thus, every child,
irrespective of his birth, must be given an equal opportunity to
education. Man's claim to superiority over all creations is based on
this superior knowledge.
In an Islamic economy, the government must subsidize or provide
free education to ensure that education is available to all, regardless
of one's financial standing and possession of properties.
4 Optimal rate of economic growth
Growth in an Islamic economy is comprehensive and includes the
moral, spiritual and material aspects of a man's life. In ter1ns of
capital formation, it includes hu1nan capital and material capital.
Man is central to all economic activities. This consideration should
influence the composition of investment because the expenditure on
education is regarded as an investment.
5 Maximization of employment generation
An Islamic economy must ensure that economic growth results
in maximum contribution to the creation of ne"¼7 employment
opportunities. The objective is, however, not to attain full
employment at the cost of economic efficiency.
Additional employment in the long run must be generated in a
technically efficient manner with suitable technology, in line with
resource endowment. Ensuring sufficient employment also includes
the need to provide educational and training opportunities in the
specific fields.
Macroeconomics studies how the economy behaves in a broad outline. It is
concerned with the aggregate level behaviour which differentiates it from
microeconomics. Macroecono1nics can be defined as a branch of economics
that studies decision-making for the economy as a "vhole.
In order to ensure long-term economic stability, every economy should
be reliant on their strong 1nacroeconomic fundamentals. This can be
achieved by focusing on the macroeconomic objectives. The five objectives
of macroeconomics from the conventional perspectives are: to achieve
full employment, to achieve price stability, to achieve economic growth, to
achieve an equitable distribution of income, and to achieve an equilibrium in
the foreign sector. The five objectives from an Islamic perspective are: social
justice, equitable distribution o f income, universal education, optin1al rate of
economic gro,-vth, and the maximization of employment generation.

• Macroeconomics is concerned with the aggregate level behaviour ,,vhich

differentiates it from microeconomics.
• Aggregate is a term in macroeconomics that refers to the sum or total.
• Microeconomics is the branch of economics that studies decision-making
by a single individual, household, fir1n, industry or level of government.
• Microeconomics studies the wages or the income of labour, focuses on the
supply and demand of labour in an industry, and is concerned with the
prices of individual goods and services.
• Macroeconomics can be defined as a branch of economics that studies
decision-making for the economy as a whole.
• Macroeconomics studies tlhe national income, concerns with total
employment and focuses on the aggregate price level. In order to ensure
long-term econon1ic stability, every econo1ny should be reliant on its
strong macroeconomic fundamentals ,.vhich can be achieved by focusing
on its macroeconomic objectives.
• Macroeconomic objectives can be vie"ved from two perspectives which
are the conventional and Islamic perspectives.
• The five objectives of macroeconomics from the conventional perspective
are to achieve full employment, to achieve price stability, to achieve
economic growth, to achieve an equitable distribution of income, and to
achieve an equilibrium in the foreign sector.
• The five objectives of 1nacroeconomics fro1n the Islamic perspective
are social justice, equitable distribution of income, universal education,
optimal rate of economic growth, and the maximization of employment
generation.
 -
-::3
---·
"'1
0
C.
s::
0
• Aggregate • Price stability • Social justice 0
• Microeconomics • Business cycle • Universal education ::3
• Macroeconomics • Equitable distribution • Optimal rate of economic 0

• Economic growth of income growth

• Equilibrium in the • Maximization of
0
• Full employ1nent "'1

foreign sector employment generation

0
(1)
0
0
::3
-·
0

+ Exercises
0

Multiple-choice Questions
Answer the following questions.

I vVhich of the following statements best A individual economic units

defines macroeconomics?
A Macroeconomics is the study of how
governments maximize their revenue.
B Macroeconomics is the study of the
consu1nption patterns of low-income
households.
C Macroeconomics is the study of the entire
economy.
D Macroeconomics is the study of how
individual prices are detern1ined.
B a typical firm
C a typical household
D the entire economy
5 These are all conventional n1acroeconomic
objectives, except
A to achieve price stability
B to achieve universal education
C to achieve economic growth
D to achieve a healthy balance of payment

2 Macroeconomics is concerned with all of the
following, except
A the growth of real output
B the level of unemployment
C the general level of prices
D production methods and costs
3 Which of the following is a focus of the study
of macroeconomics?
A Inflation
B Average cost
C Individual demand
D Factor market
4 Macroeconomics focuses on the study of
economics from the standpoint of_ _ _
6 Which of the following is not an objective
of macroeconomics from an Islamic
perspective?
A To maximize employment generation
B To achieve universal education
C To achieve economic justice and freedom
D To produce many business firms
7 Macroeconomics is_ __
A the study of market regulations
B the study of an economy-wide
pheno1nena
C the study of how households and firms
make decisions and how they interact
D the study of money and financial markets
 8 Macroeconomics is concerned with the
...
0,
study of
A how Malaysians respond to oil price
changes
u B production methods and costs
C the effects of reduction of wages on
agricultural output
D the general price level
9 Which of the following topics is related to
macroeconomics?
A The price of cooking oil.
B The wage rate of a fresh graduate.
C Unemployment in the nation.
D The production of automobiles.
10 Which of the following is more likely to be
studied in macroeconomics?
A The percentage of the labour force that is
out of work and the differences in average
inco1ne from country to country.
B The effect of taxes on the prices of airline
tickets, profitability of automobile-
manufacturing firms, and employment
trends in the food-service industry.
C The price of beef, wage differences
between genders and antitrust laws.
D How consumers maximize utility and the
prices that are established in markets for
agricultural products.
11 Macroeconomics is concerned ,vith all of the
following, except
A general economic factors that deter1nine
income
B general price levels
C the production decisions involving
consumer goods in a market
D savings and investments from the
standpoint of the whole economy
12 Which of the following relates to the study of
macroeconomics?
A Demand and supply of sugar.
B The effects of subsidies on the level of
production.
C The types of profit earnings by business
firms.
D The impact of depreciation in the
exchange rate.
13 The goal of macroeconomics is ___
A to explain the economic changes that
affect a particular household, fir1n or
market
B to explain the economic changes that
affect many households, firms and
markets simultaneously
C to devise policies to deal with 1narket
failures, such as monopoly, externalities,
common resources and public goods
D All of the above
14 An Islamic government should adopt all of
the follo,ving, except
A control the activities of producers and
sellers, especially during festivals
B ignore excessive price changes of various
controlled items
C guarantee the safety of lives and properties
of all individuals in the country
D provide adequate facilities for every
individual in the country, .vhere possible
15 Which of the following is not the objective
of macroeconomics from an Islamic point of
view?
A Universal education
B Social justice
C Economic growth
D Favourable balance of payment
16 Which of the following is associated ,vith
macroeconomics?
A Income elasticity of demand
B The aggregate output production in the
economy
C Types of market structure
D The theory of production and cost
17 Macroeconomic theories study all of the
follov.•ing, except
A consumer behaviour in maximizing utility
B international trade activities
C unemployment and inflation
D the equilibrium of money markets
18 The macroeconomic objectives from the B the entire economy -::3-
conventional perspective include_ _ _ C individual econo1nic units "'1

--·
A achieving inequitable distribution of D price theory and production possibilities
0
C.
.income s::
0
20 The determination of price and the
-
B achieving economic justice and freedom 0
C achieving universal education behaviour of individual 1narkets are studied ::3
D achieving steady and sustained economic in_ _ _. On the other hand, topics such as 0
growth business cycles, unemployment and inflation
are studied in --- 0
19 Conventional macroeconomics is a study of A macroeconomics; microeconomics "'1
0
B den1and; supply analysis (1)
0
A the demand and supply of goods and C microeconomics; macroeconomics 0
.
services D None of the above
::3
-·
0

Essay Questions
Answer the following questions.
I What are the five macroeconomic objectives from the conventional perspective?
Explain.
2 What are the five macroeconomic objectives from an Islamic perspective? Discuss.
3 Illustrate the business cycle using a diagram and explain the four phases.
4 From the Islamic point of view, explain:
(a) Social justice and equitable distribution of income
(b) Universal education
5 Discuss the differences between microeconomics and macroeconomics.
 Measuring
National Income
and Output
Ul At the end of this chapter, you should be able to:
� • Describe the circular flow of income in two-, three- and four-
0 sector economies.
t)
:, • Identify the concepts of measuring national income.
O • Measure national income by using the three approaches.

·e
g> • Distinguish between personal income and disposable income.

«s
• Distinguish between nominal income, real income, per capita

s income, and growth rate.

• Describe the uses of national income statistics.
• Elaborate on the problems in measuring national income.
I n Chapter 9, we learned that national income is one of the main
scopes of macroeconomics. The concept of national income is most
significant in macro-accounting. This macro concept is basically used
to measure the economic performance of an economy because it
serves as a better yardstick of the economy's overall performance.
Theoretically, measuring national income will entail a large amount
of data-collection and calculation because it involves the measurement
of the total product and services carried out over a large region.
Therefore, it is important to understand the concepts and mechanisms
that are being used.
In this chapter, we will walk through the process of measuring
national income by understanding the circular flow of income,
methods to measure national income, as well as uses and problems in
measuring national income.

10.1 COMPONENTS OF
MACROECONOMICS
Since macroeconomics deals with the economic activities in a broad
perspective, it is very challenging to understand how it works. For ease
of comprehension, let us divide the participants in the economy into
four broad groups:
I Households
Households own all the factors of production: land, labour, capital
and entrepreneurship, and provide factors of production to firms
and the government to receive payment in the form of rent, wages,
interest and profit. Households spend their income by buying
goods and services produced by firms and pay their taxes to the
government, and save a small portion of their income.
2 Firms
Firms are private organizations that hire the inputs (land, labour,
capital and entrepreneur) from the households and provide the
output (goods and services) to the households and government.
Firms will earn revenues from the sales of output. In addition,
firms pay wages, interest and dividends to households as well as
taxes to the government.
3 Government
The government collects taxes from households and firms.
Government revenue is spent on development and operational
purposes, such as ,velfare activities, provision of public utility,
 defence and education, among others. Toe government also buys :s:
factors of production fro1n households for public consumption. (1)
ll>
rn
4 Rest of the world or foreign sector
The rest of the \ovorld refers to the international or foreign sector. -·::3
..,
C

This sector involves the import and export of goods and services
which cause the inflo,vs and outflo,vs of inco1ne in the circular zll>
flow of households, firn1s and the government. For example, an -·
0
export refers to the firms in Malaysia v.1hich sell goods and services ::3
ll>
to the rest of the world and an import refers to the purchase of
goods and services from the rest of the world. The value of exports 0
(X) n1inus the value of imports (M) is called net exports. 0
(1)
ll>
::3
10.2 CIRCULAR FLOW OF INCOME IN
-
C.
TWO-, THREE- AND FOUR-SECTOR 0
ECONOMIES
-
C

C
It is very important to understand how the circular flow of income Circular Flow of Income
functions before we measure the national income of a country. Let An economic model that
us illustrate the national income concepts by using the concept of shows how money nows
through the economy.
circular flow of income.
Circular flo,,v of income is an economic model depicting how
money flo,.vs through the economy. It describes the movement of
factors of production and factors of payn1ent.

10.2.1 Circular Flow of Income in a

Two-sector Economy
The two-sector economy, also known as a sin1ple econo1ny, consists of
just two kinds of economic agents: households and firms.
The principal roles played by households and firms in the circular
flow are as follows:
[Households)
• Own all factors of production and receive factor payment from
fir1ns
• Spend all income to purchase goods by making payments to firms
[ Firms )
• Hire factors of production from households by paying factor
payment
• Sell goods and services to households, and receive revenue in
return
• Pay any profits n1ade to households
 Figure 10.1 Factors of Producf,on
Circular flow of diagram in
two-sector economy Payments

Household Firm

Goods & Services

Fa ctor Payments

The flo,.v of factors of production from households to firms and the

flo,.v of goods and services from firms to households are 1natched by
the equivalent flow of money-firms paying income to households
(Y) and households paying the firms for consuming the goods and
services (C).

10.2.2 Circular Flow of Income in a

Three-sector Economy
The three-sector economy is also called a closed economy. The
difference between the two-sector and three-sector economies is the
involven1ent of an additional sector, known a s the government sector.
The principal roles played by the government and other sectors in
the circular flow are as follows:

( Households J
• Provide factor services to firms and the government, and receive
factor payment in return
• Receive transfer payment from the government
• Make payment for goods and services purchased from firn1s and
the government
• Pay taxes to the government

( Firms
)
• Receive revenue from households and the government by sales of
goods and services
• Receive subsidies from the government
• Make payment to households for factor services
• Pay taxes to the government

( Government J
• Purchase goods and! services from firms
• Collect taxes from households and fir1ns
• Pay transfer payment and subsidies to households and firms
 Factors of P rod uct1on
. /Payments Figure 10.2 :s:
Circular flow of diagram in (1)
ll>
• , rn
-·::3
three-sector economy
Labour/Taxes )
Goods &
Services/Taxes ..,
C

Household ... ,, Government " � Firm

Wages/Servi ces/ Payment/Services(\
zll>
-·
Transfer payment Subsidies
" ,,
0
Factor PaymentsIGoods & Services ::3
ll>
The government collects taxes from households and firms. The
government also makes payments. It buys goods and services from 0
fir1ns, pays wages and interest to households, and makes transfer
0

payments to households. A transfer payment refers to a redistribution (1)

of income, which is used by the government to allocate money

ll>
::3
for old age or disability pensions, student grants, unemployment
-
C.
compensations and subsidies (paid to exporters, far1ners or 0

-
C
n1anufacturers). If government revenue is less than its payments, the
government is dissaving. Conversely, saving occurs if government
C

revenue is more than its payments.

10.2.3 Circular Flow of Income in a

Four-sector Economy
The four-sector economy is also known as an open economy. The
difference bet,.,veen the three-sector and four-sector economy is the
involvement of an additional sector, known as the foreign sector.
The principal roles played by the foreign sector and other sectors in
the circular flo,-v are as follo,-vs:

[ Households J
• Provide factor services to firms, the government and foreign
sector, and receive factor payment in return
• Receive transfer payment from the government and foreign sector
• Make payment for goods and services purchased from firms and
the foreign sector
• Pay taxes to the government
• Make payment for imports
(
_ F_
_irm_s
__)
• Receive revenue from households, the government and foreign
sector by sales of goods and services
• Receive subsidies from the government
• Make payment to households for factor services
• Pay taxes to the government
• Make payment to the foreign sector for imports

Figure 10.3
Circular flow of diagram in a
f o u r -s ector economy
Summary of Circular Flow
of Diagram
Households receive
income from firms and the
government, purchase goods
and services from firms, and
pay taxes to the government.
They also purchase fore ign·
rnade goods and services
(imports). Fi rms receive
payments from households
and the government for goods
and services; pay wages,
dividends, interest and rent
to households, as well as pay
taxes to the government. The
government recei ves taxes
from firms and households,
pays firms and households for
goods and services, including
wages to government
workers, and pays interest
and transfers to households.
Finally, people in other
countries purchase goods and
services that are produced
domestically (exports).
Gross Domestic Product
(GDP)
The total market value of
all final goods and services
produced within a given
period of time by factors o f
producti on located within a
couritry.
( Government J
• Receive revenue from firms, households and the foreign sector for
sales of goods and services
• Impose taxes or fees
• Make factor payment to households and firms
• Make transfer payn1ent and subsidies
( Foreign Sector J
• Receive revenue from households, firms and the govern1nent for
exports of goods and services
• Make payment to households for factor services
• Make payment for import of goods and services from fir1ns and
the government
<
Factors of Production/Payments
•
Labour/faxes ) Goods&
Services/Taxes
y '
'"'-
Household Government Firm
Payment/
Wages/Services Services
' y
Import Export
+
Factor Payments/Goods & Services
Factor payments - Export
Export Foreign
Sector Import
Import
Households spend some of their income on imports (goods and
services produced in the rest of the world). Similarly, the people in
foreign countries purchase exports (goods and services produced by
domestic firms and sold to other countries).
10.3 CONCEPTS OF NATIONAL INCOME
I Gross domestic product (GDP) and gross national product
(GNP)
Gross domestic product (GDP) is the total market value of all
final goods and services produced within a given period of time
by factors of production located within a country. GDP excludes
goods and services produced by Malaysian citizens working
overseas, but includes value of output produced by foreign workers
in Malaysia.
Gross national product (GNP) is defined as the total market
vali1e of all final goods and services produced by the residents of
a country during a given period of tin1e. In other ,.vords, GNP is
 the total amount of income earned by the residents of the country Gross National Product
regardless of where they are. However, the income earned by (GNP)
(1)
ll>
foreign ,-vorkers ,-vorking in Malaysia will not be included in the rn
-·::3
The total market value of
GNP.
all final goods and services ..,
C
produced by the residents of a
Table 10.1 illustrates the differences between GDP and GNP. country during a given period
The key isolation of GNP that differs from GDP is the net factor zll>
-·
of tim e .

income from abroad. Net factor incon1e from abroad is the

0
difference between the income received from abroad and the
Net Factor Income from
Abroad ::3
income paid abroad. To calculate GNP, we must add the net factor
ll>
The difference between the
income fro1n abroad to the GDP. income received from abroad
and the income paid abroad. 0
GNP = GDP + Net factor income from abroad
0

GNP= GDP+ (Factor income received from abroad

(1)
ll>
- Factor income paid abroad) ::3

-
C.
0

-
Table 10.1 The differences between GDP and GNP C

MALAYSIA MALAYSIA
©+© ©-[©]

GDP is the value of output produced by factors of +

production located within a country.
Or
In other words,
"GDP measures the total amount of income earned
within a country regardless of the citizenship
(Local Resident + Foreign Resident):'
Example:
The GDP of Malaysia includes income earned by
Malaysian residents and foreign residents.
However, the income earned by Malaysian residents
working abroad is excluded in the GDP.
OTHER
COUNTRIES
©
GN IP is defined as the total market value of all final goods
and services produced by the residents of a country
during a given period of time.
Or
In other words,
"GNP measures the total amount of income earned by the
residents of the countr y regardless of where they are'.'
Example:
The GNP of Malaysia includes income earned by Malaysian
residents in their home country and abroad.
However, the income earned by foreigners working in
Malaysia is excluded in the GNP.

© - Denotes income of Malaysian residents

© - Denotes income of foreign residents

2 Market price and factor cost

Market Price
The measurement of GDP can be in the form of market price or The current price in the market
factor cost. Market price refers to the current price in the market through the forces of demand
through the forces of demand and supply. Market prices are the and supply.
 actual prices paid by the consumers. Factor cost is the price of
output that is valued based on the cost of factors of production.
Therefore, factor cost is kno,-vn as the actual price earned by
producers or sellers.
The market price differs from the factor cost due to indirect
taxes and subsidies. The 1narket price of goods will be greater
than the factor cost by the amount of indirect taxes imposed on
those goods. On the other hand, subsidies granted to the firm will
reduce the market price lo,-ver than the actual cost incurred on
output. Thus, subsidies will make the market price lower than the
factor cost.

Table 10.2
The differences between market
price and factor cost
Rice Cigarette
(USO) (USO)
Market price 2.50/kg Market price 10.00/pack
( +) Subsidies 0.50/kg ( )-Sales tax (54%) 3.50/pack
Factor cost 3.00/kg Factor cost 6.50/pack

GDP at factor cost= GDP at market price - Indirect taxes+ Subsidies

GNP at factor cost= GNP a t market price - Indirect taxes+ Subsidies

3 Gross national product (GNP) and net national product (NNP)

Net National Product
The value of national income
which is adjusted by the
value of depreciation or
gross national income minus
deprecia tion.
The measurement of national income can be in the value of gross
and net. This is because national income specifically measures
the value of output over a period of time and is associated with
the factors of depreciation. The term net national product (NNP)
means the value of national income has been adjusted by the value
of depreciation or net national product is gross national product
minus depreciation.
When the national income is 1neasured in a gross value such as
gross domestic product (GDP) or gross national product (GNP),
it does not take depreciation into account. Thus, gross domestic
product (GDP) and gross national product (GNP) values are
comparatively higher than net do1nestic product (NDP) and net
national product (NNP) respectively. In essence, the accurate
value of national income must not contain depreciation as it will
not show the real level of income of a country. The other term
for depreciation is capital consumption or consumption of fixed
capital which refers to a reduction in the value of an asset, due to
wear and tear with the passage of time.
NDP at market price= GDP at market price - Depreciation value
NNP at market price = GNP at market price - Depreciation value
4 Personal income (PI) and disposable personal income (DPI) :s:
Personal income (PI) is the real inco1ne earned by households
(1)
ll>
before they pay their personal income taxes. It is also known as
-·
rn
C
the value of national income minus certain amount of incomes
..,
::3
that are not going to household. These incomes do not reach
the individuals, but they are included in the national incon1e zll>
accounting. Those examples of incomes that are not going to -·
0
household are as follows: ::3
ll>
• Corporate income taxes-a certain portion of corporate
profits that are paid out as corporate incon1e tax before being 0
distributed among shareholders. 0
• Retained earnings-after-tax corporate profits that are not (1)

distributed as dividends to the shareholders. Sl)

::3
• Employees Provident Fund-contributions of a certain

-
C.
percentage of the worker's inco1ne to the provident pension 0

-
C
funds. The aim is to create a fund or savings retirement scheme
for the future benefits of employees. C
• Social security contributions-contributions of a certain
percentage of the worker's income to provident funds or
pension funds. The aim is to protect the employees against
industrial accidents including accidents ,-vhich occur ,-vhile
working, occupational diseases, invalidity or death due to any
cause.
• Insurance premium-a certain percentage of income that is
used to pay for insurance.
Personal income is used for consumption, to pay for taxes
or as savings. Personal inco1ne is derived from national incon1e
by deducting the amount of income that is excluded fron1 the
household and adding transfer payments made by the government.
Personal Income (PI) = National Income + Transfer Payments
- Corporate Income Ta.-xes - Retained
Earnings - E1nployees Provident Fund
(EPF) - Social Security Contributions
(SOCSO) - Insurance Premium
Meanwhile, disposable personal incon1e (DPI) is the incon1e
available for personal consumption expenditure and personal
Disposable Personal Income
The real income earned by
savings. In other words, disposable personal income is the value of households before they pay
personal income minus personal income tax. Households cannot personal income taxes. In other
words, disposable income is
spend all income received because they need to pay some direct the value of personal income
and indirect taxes. Therefore, the total disposable income for an minus personal ncome text.
economy can be calculated as follows:
Disposable Personal Income (DPI) = Personal Income - Personal
Income Tax

Compensation of Employees
Wages and salaries paid to
households by firms and
the government, as well as
various supplement to wages
and salar ies such as the
contributions that employe rs
make to social insurance and
the employees' pension fund.
Proprietor's Income
Income of unincorporated
businesses, either of sole
proprietorship or partnership.
Rental Income
Income recei ved by the
households and businesses
that supply property
resources.
10.4 METHODS OF MEASURING
NATIONAL INCOME
National income broadly refers to the sum of individual income of a
country's population. Although this understanding is fundamentally
correct, it is however less precise. The accurate meaning of national
incon1e is comn1only referred to as the concepts of gross domestic
product (GDP).
Gross domestic product is the total market value of all final goods
and services produced within a given period of time by factors of
production located within a country. The GDP can be con1puted in
three ways:
I Income approach
2 Expenditure approach
3 Product or output approach
Since the income approach, expenditure approach and product
approach are the three methods of measuring the same thing, they
must thus be identical. This can be expressed as an accounting identity:
National National National
Income Expenditure Product
10.4.1 Income Approach
Income approach measures national income by looking at the GDP
from the perspectives of the stuns of income received from the
production of the output. This approach involves adding up all the
total income received by all economic agents for their contribution of
factors in the production of national output. For example, rent, "vages,
interest and profits are the factors of payment for land, labour, capital
and entrepreneur respectively.
The major components in the national income are:
I Compensation of employees
It is the largest component in the national income. Compensation
of e1nployees includes wages and salaries paid to households by
firms and the government, as well as various supplement to wages
and salaries such as the contributions that employers make to
social insurance and the employees' pension fund.
2 Proprietor's income
Proprietor's income is the incon1e of unincorporated businesses,
either of sole proprietorship or partnership.
3 Rental income
Rental consists of income received by households and businesses
that supply property resources. It includes the n1onthly payments
tenants make to landlords and lease payment corporations pay for
the use of office space. The figure used in the national accounts
is net rent-gross rental income minus depreciation of the rental
property.
4 Corporate profits :s:
Corporate profits are the earnings of the owners of corporations. (1)
ll>
Corporate Profits
They can be subdivided into three categories: rn
• Distributed profits (Dividends)-these are parts of corporate
The earnings of owners
of corporations.They can
be subaivided ,nto three
-·::3
..,
C

profits that are paid to the shareholders.

• Undistributed profits (Retained earnings)-these are parts of
categories: distributed profits,
zll>
corporate profits that are not distributed to the shareholders.
undistributed profits and
corporate incorne taxes. -·
0
• Corporate income taxes-these taxes are levied on ::3
ll>
corporations' net earnings.
5 Net interest 0
0
Net interest is the interest households receive on savings deposits Net Interest
and corporate bonds minus the interest househonds pay on their The interest households (1)

borro,-vings. It also consists of money paid by private businesses to rece ive on savings deposits ll>
::3

-
the financial institutions.
and corporate bonds minus C.
the interest households pay 0
In the income approach, gross domestic product (GDPfc)

-
on their borrowings. It also C
is calculated by adding up all the five components of income consists of the money paid
by private businesses to the
including depreciation.
C
financial institutions.
In the income approach, net domestic product at factor cost
(NDPfc) is the sum of all incomes received from the production
of the output. The term factor cost is used because it is the cost of
factors of production that is used to produce final goods.
Formula:
GDP at factor cost= [Compensation of Employees + Net Interest
+ Rental Income + Corporate Profits +
Proprietor's Income] + Depreciation
INCOME APPROACH

NDP at factor cost= [Compensation of Employees + Net Interest

+ Rental Income + Corporate Profits +
Proprietor's Income]
INCOME APPRO ACH
Table 10.3 sho,vs the national income calculation using income
approach.
The following are the forn1ulas for calculating national inco1ne,
personal income and disposable personal income:
1 NDPfc= Compensation of Employees + Net Interest + Rental
Income + Corporate Profits+ Proprietor's Income
2 GD Pfc= NDPfc+ Depreciation
3 GDPmp = GD Pfc+ Indirect Taxes - Subsidies
4 National Income (NI) = NDPfc+ Net Factor Income Abroad
 5 Personal Income (PI) = National Income + Transfer Payments
- Corporate Income Taxes - Retained/
Undistributed Earnings - Employees
Provident Fund (EPF) - Social Security
Contributions (SOCSO) - Insurance
Premium
6 Disposable Personal Incon1e (DPI) = Personal Income - Personal
Income Tax

Table 10.3 Item USO (Million)

Calculation of national income
using the income approach
Compensation of employees (+ ) 500
Rental income (+) 200
Net interest (+) 150
Proprietor's incomes (+) 95
Corporate profits (+)
(Distributed profits+ Undistributed profits+
Corporate income taxes)

Distributed profits 125 250

Undistributed profits 100

Corporate income taxes 25
Net domestic product at factor cost 1,195
Net factor income from abroad (+)
(Factor income received - Factor income paid)
400
Factor income received from abroad 900
Factor income paid abroad 500
National income 1,595
Transfer payments (+ ) 100
Corporate income taxes (-) 25
Undistributed profits (-) 40
Social secur ity contributions (-) 10
Employees Provident Fund (-) so
Personal income 1,520
Personal income taxes (-) 20
Disposable personal income 1,500
SAMPLE QUESTION 10.1 (1)
ll>
rn
USD (Million) -·::3
..,
C

zll>
-·
Compensation of employees 4,150
Interest 700 0
Personal consumption expenditure 1,650
::3
ll>
Government services 250
0
Income received from abroad 600 0
Transfer payment 500 (1)
ll>
Undistributed profits 620 ::3

-
C.
Rent 370 0

-
C
Indirect taxes 450
Income paid to abroad 480 C

Depreciation 200
Employees Provident Fund 650
Distributed profits 520
Proprietor's income 850
Tax on companies' profit 200
Personal income taxes 650
Insurance premium 200

Based on the table above, calculate the:

(a) Gross domestic product at factor cost
(b) Gross national product at factor cost
(cl National income
(d) Disposable personal income

Solution:
(a) Gross domestic product at factor cost
GDPfc = [Compensation of Employees + Net Interest + Corporate Profits + Rent +
Proprietor's Income)+ Depreciation
= (4,150 + 700 + (620 + 520 + 200)+ 370+ 850) + 200
= USD7,610 (million)
(bl Gross national product at factor cost
GNPfc = GDPfc + Net Factor Income Abroad (NFYA)
= 7,610+(600-480)
= USD7,730 (million)
(c) National income
NI = GNPfc -Depreciation
= 7,730-200
= USD7,530 (million)
 (d) Disposable personal income
DPI = Personal Income - Personal Income Taxes
= (NI + Transfer Payment - Undistributed Profits - Employees Provident Fund -Tax
on Companies Profit - Insurance Premium) - Personal Income Taxes
= (7,530 + 500 - 620 - 650 - 200 -200) - 650
= USDS,710 (million)
•••
•••

10.4.2 Expenditure Approach

Expenditure approach measures national income by looking at the
GDP from the perspective of total spending on the final goods and
services. In the expenditure approach, we add up all the expenditures
on the final output throughout a year. This approach comprises four
components:
Personal Consumption 1 Personal consumption expenditure (C)
Expenditure Personal consun1ption expenditures can be referred to as all
All expenditures by expenditures by households on durable consumer goods (e.g.
househo lds on durable
consumer goods, automobiles, smartphones and computers), non-durable consumer
non-durable consumer goods goods (e.g. rice, milk and bread) and consumer expenditures for
and consumer expenditures services (e.g. utilities, transportation and medical services). It is
for services.
also known as private consumption.
2 Gross private domestic investment (I)
Gross Private Domestic
Investment, a common term used in economics, refers to the
Investment purchase of new capital by fir1ns-housing, plants, equipment and
The purchase of new capital inventory. It also refers to the purchase of capital goods by firms
by firms: housing, plants,
equipn,ent and inventory. for use in production and the changes in the firn1s' inventories.
Gross private domestic investment comprises three components:
(a) Non-residential investment-expenditures by firms for
machines, tools, plants and equipment.
(b) Residential investn1ent-expenditure by households and
firms on new houses and apartment buildings.
(c) Change in business inventories-the amount by which
firms' invento-ries change during a period. Inventories are
goods that the firms produce now, but are n1eant for sale
later. Change in business inventories is also known as change
in stock.
3 Government expen.diture (G)
Governn1ent expenditure or pub lie consumption refers to the
expenditure incurred by federal, state and local governments
Government Expenditure
The expenditure incurred
by federa l, state and local for final goods and services. These expenditures consist of t,-vo
governments for final goods components:
and services. It is also known
as public consumption. (a) Expenditures for goods and services that the government
consumes in providing public services
 (b) Expenditures for social capital, such as schoons and highways, :s:
which have long lifetin1es (1)
ll>
rn
However, government transfer payments are not included
in the components of government expenditures because these
Transfer Payments
The transfer which is made -·::3
..,
C

without any exchange of

transfers are not purchases of goods and services. In other goods or services. Examples of zll>
words, the transfers are made without any exchange of goods or
services. They are merely the transfer of government receipts to
government transfer payments
are welfare expenditures
(financial aid), social security
-·
0
certain households. Examples of government transfer payments benefits, pensions and
::3
ll>
are welfare expenditures (financial aid), social security benefits, scholarships.
pensions and scholarships. 0
0
4 Net Export (X - M)
Net export is the difference between the value of exports and the (1)

value of imports. Imports occur when households spend some

ll>
Net Export ::3

-
C.
of their income on goods and services produced in the rest of
The difference between the
value of exports and the value 0
the world, while exports exist when people in foreign countries

-
of imports. C
purchase goods and services produced by domestic firms and sold
to other countries.
C

In the expenditure approach, gross domestic product (GDP) is

calculated by adding up all the four co1nponents of expenditure
as follows:
Formula:
GDP at market price = C + I + G + (X - M)
EXPENDITURE APPROACH
In the expenditure approach, the gross domestic product at market
price (GDPmp) is the sum of all components. The term market price
is used because it represents the expenditure of all economic agents for
the final goods at current market price. Table 10.4 shows the national
income calculation using the expenditure approach.
The following are the formulas for calculating national income,
personal income and disposable personal income:
1 GDPmp = C + I + G + (X - M)
2 GNPmp = GDPmp + Net Factor Income Abroad
3 GNPfc = GNPmp + Subsidies - Indirect Taxes
4 National Income (NI) = GNPfc - Depreciation
5 Personal Income (PI) = National Income + Transfer Payments
- Corporate Income Taxes - Retained/
Undistributed Earnings - Employees
Provident Fund (EPF) - Social Security
Contributions (SOCSO) - Insurance
Premium
6 Disposable Personal Income (DPI) = Personal Income - Personal
Income Tax
 Table 10.4 Item USO (Million)
Calculation of national income
using the expenditure approach
Household expenditure (C) (+) 26,700
Private investment (I) (+) 10,700
Government expenditure (G) (+) 9,700
Export (X) (+) 23,700
Import (M} ( )- 13,700

Gross domestic product at market price 57,100

Net factor income received from abroad (+)

(Factor income received - Factor income paid)
8,100
Factor income received from abroad 11,700
Factor income paid abroad 3,600
Gross national product at market price 65,200

Tax on expenditure ( )- 16,600

Subsidies (+) 9,600

Gross national product at factor cost 58,200

Capital consumption ( )- 3,600

National income 54,600

Transfer payments (+) 2,800

Corporate income taxes (-) 13,800

Retained earnings (-) 1,100

Employees Provident Fund (-) 2,060

Social contribution (-) 1,460

Personal income 38,000

Personal income taxes ( )- 1,430

Disposable personal income 36,570
SAMPLE QUESTION 10.2 (1)
ll>
rn
USO (Million) -·::3
..,
C

zll>
-·
Household consumption 7,000
Private inventory investments -500
0
Depreciation 1,600 ::3
ll>
Public development expenditure 2,500
0
Net exports 5,500 0
Indirect taxes 4,500 (1)
ll>
Private fixed investments 6,500 ::3

-
C.
Transfer payments 2,500
0

-
C
Personal income taxes 3,500

Public operating expenditure 2,000 C

Subsidies 4,000
Retained earnings 1,300

Insurance premium 1,000

Corporate taxes 1,700

Contribution to EPF 1,600

Social security contributions 1,100

Calculate the:
(a) Gross domestic product at market price
(b) Gross domestic product at factor cost
(c) If the value of gross domestic product at factor cost is equal to RM 18,000 million, calculate
the value of net factor income from abroa1d
(d) National income
(e) Personal income
(fl Disposable personal income

Solution:
(a) Gross domestic product at market price
GDPmp = C + I + G + (X - M)
= 7,000 + ( -
500 + 6,500} + (2,500 + 2,000) + (5,500)
= USD23,000 (million)
(b) Gross domestic product at factor cost
GDPfc = GDPmp + Subsidies - Indirect taxes
= 23,000 + 4,000 - 4,500
= USD22,500 (million)
(c) Net factor income abroad
NFYA = GNPfc - GDPfc
= 18,000 - 22,500
= -USD4,500 (million)
 (d) National income
NI = GNPfc - Depreciation
= 18,000 - 1,600
= USD16,400 (million)
(e) Personal income
Pl = NI + Transfer Payments - Corporate Income Taxes - Retained Earnings - EPF -
Social Security Contributions - Insurance Premium
= 16,400 + 2,500 - 1,700 - 1,300 - 1,600 - 1,100 - 1,000
= USDl 2,200 (million)
(f) Disposable personal income
DPI = Pl - Personal Income Taxes
= 12,200 - 3,500
••• = USDS,700 (million)
•••

10.4.3 Product or Output Approach

Under the output or product or value added approach, national
incon1e is measured by adding up the net value of all the goods and
services produced in the country, sector by sector during a year. Under
this approach, only the money value of final goods a11d services
are included in the calculation. The value of raw materials and
intermediate goods are subtracted fron1 the value of gross domestic
product to avoid double counting.
There are three sectors contributing to the GDP:
I Primary sector comprising agriculture, forestry, mining and
quarrying.
2 Secondary sector comprising manufacturing and construction.
3 Tertiary sector comprising:
(a) Electricity, gas and water
(b) Wholesale and retail trade, accommodation and restaurants
(c) Transport, storage and communication
(d) Finance, insurance, real estate and business services
(e) Government services
(f) Other services
In the product or output approach, the gross domestic product
(GDP) is calculated by adding up all the final outputs from these
sectors as follows:
Formula:
GDP at market price = Value of final products in the economy
OUTPUT APPROACH
In the output approach, the gross do1nestic product at market price
(GDPmp) is the sum of value of all final products in the economy. The
term market price is used because the GDP is valued at purchasers'
prices. Table 10.5 shows the calculation of national income using the
output approach. (1)
ll>
The following are the formulas for calculating national income,
-·
rn
C
personal income and disposable personal income: ..,
::3
I GDPmp = Value of Pinal Products in the Economy
2 GNPn1p = GDPmp + Net Factor Income Abroad
zll>
3 GNPfc = GNPmp + Subsidies - Indirect Taxes
-·
0
4 National Income (NI) = GNPfc - Depreciation
::3
ll>
5 Personal Income (PI) = National Income + Transfer Payments
- Corporate Income Taxes - Retained/ 0
0
Undistributed Earnings - Employees
Provident Fund (EPF) - Social Security (1)

Contributions (SOCSO) - Insurance

Sl)
::3
Premium
-
C.
6 Disposable Personal Income (DPI) = Personal Income - Personal
0

-
C
Income Tax
C
Table 10.5
Item USD (Million) Calculation of national income
using the output approach
Agriculture (+) 1,450
Government services (+) 1,100
Mining and quarrying (+) 1,200
Manufacturing (+) 1,600
Electricity, gas and water (+) 800
Finance, insurance, real estate and business 3,100
services (+)
Construction (+) 750
Wholesale and retail trade, accommodation 2,100
and restaurants (+)
Transport, storage and communication (+) 1,100
Other services (+) 450
Gross domestic product at market price 13,650
Net factor income received from abroad (+)
(Factor income received - Factor income paid)
350
Factor income received from abroad 800
Factor income paid abroad 450
Gross national product at market price 14,000
Subsidies (+) 620
-100
Indirect taxes (-) 720
Gross national product at factor cost 13,900
Depreciation (-) 100
National income 13,800
Transfer payments (+) 250
Corporate income taxes (-) 1,600
Retained earnings (-) 1,500
Employees Provident Fund (-) 1,250
Social contribution (-) 1,100
Personal income 8,600
Personal income taxes (-) 2,430
Disposable personal income 6,170
SAMPLE QUESTION 10.3

USD (Million)

Finance, insurance, real estate and business services 4,750

Private expenditure 10,000
Rent 20,000
Government expenditure 6,000
Agriculture 11,400
Mining and quarrying 4,000
Transport, storage and communication 3,700
Dividends received by individual 650
Wholesale and retail trade, accommodation and restaurants 6,300
Manufacturing 12,500
Profit 23,100
Capital consumption allowances 1,000
Corporate income taxes 6,250
Taxes on expenditure 7,500
Net factor income received from abroad 3,450
Subsidies 445
Personal income taxes 125
Social contribution so
Employees Provident Fund 170
Transfer payment 700

Calculate the:
(a) Gross domestic product at market price
(b) Gross domestic product at factor cost
(c) Gross national product at factor cost
(d) National income
(e) Personal income
(f) Disposable personal income

Solution:
(a) Gross domestic product at market price
GDPmp = Value of Final Products in the Economy
= 4,750 + 11,400 + 4,000 + 3,700 + 6,300 + 12,500
= USD42,650 (million)
(b) Gross domestic product at factor cost
GDPfc = GDPmp + Subsidies - Indirect taxes
= 42,650 + 445 - 7,500
= USD35,595 (million)
 (1)
ll>
(c) Gross national product at factor cost rn
GNPfc = GDPfc + Net Factor Income Abroad (NFYA)
= 35,595 + 3,450
-·::3
..,
C

= USD39,045 (million)
zll>
(d) National income
NI = GNPfc - Depreciation -·
0
= 39,045 - 1,000 ::3
ll>
= USD38,045 (million)
(e) Personal income 0
Pl = NI + Transfer Payments - Corporate Income Taxes - Retained Earnings - EPF - 0
Social Security Contributions - Insurance Premium
= 38,045 + 700 - 6,250 - so - 170
(1)
ll>
= USD32,275 (million) ::3

-
C.
(f) Disposable personal income 0

-
DI = Pl - Personal Income Taxes C
= 39,330 - 125 C
= USD32, 150 (million)

10.5 NOMINAL INCOME VERSUS REAL

INCOME, PER CAPITA INCOME AND
GROWTH RATE
The unit of account in 1neasuring national income is in currency
because the national income measures price values. Therefore, it
is unrealistic to compare the value of national income between two
periods as long as prices keep fluctuating over a period of time. Hence,
the best yardstick to compare the national inco1ne is to re1nove the
n1arginal price factor. This factor can be solved by converting the value
of nominal income into real income.
Real income refers to the national income that is measured at a Real Income
constant price or in a base year. By comparing the value of production National income that is
in the two years at the same prices, the changes in real incon1e reflects measured at a constant price
only the changes in real output.
or in a base year.

On the other hand, nominal income is the national income that is

measured at the current price level. Any change in nominal income Nominal Income
National income that is
reflects the combined effects of change in quantity and change in price measured at current prices .
level.
 For1nula:
Nominal GDP
Real GDP =
GDP deflator
Current year price index
GDP Deflator =- - - � � � - - -
Base year price index

Base year price index

Real GDP = Nominal GDP x
Current year price index

Example:
Based on the table, calculate the real GDP in the year 2015.

Nominal GDP Consumer Price Index

Year
(USO Million) (CPI)

2010 180 100

2013 210 105
2015 240 110

Note: The base year is a year corresponding to the value of CPI = 100.
100
Real GDP(2015) = 240x-
110
= USD218.18 million
Per Capita Income
GDP per capita is often used as an indicator of living standards.
Average income per head of Per capita income refers to the average income per head of population.
Formula:
populati on.

National income
. 1ncome = -----­
P er Cap1ta
Total population

Growth Rate
Gro"vth rate is the percentage change in quantity of goods and
Percentage change in services produced from one to another.
Formula:
quantity of goods and
services produced from one
Real GNP this year -Real GNP last year x OO%
Growth Rate (% ) = 1
to another.
Real GNP last year
SAMPLE QUESTION 10.4 (1)
ll>
rn
The following table shows the value of nominal GNP and price index for a country. The
corresponding base year is 2010 (CPI= 100).
-·::3
..,
C

zll>
-·
0
Consumer Price Index 105 110 ::3
ll>
NominalGNP (USO million) 43,000 48,000
0
Population (million) 30 32 0
Real GNP (USO million) (1)
ll>
::3

-
(a) Complete the table above. C.
(b) Calculate the real income per capita for 2015. 0

-
C
(c) Between 2012 and 2015, the real GNP has (increased/decreased) by _ _%.
C
Solution:
(a)

Consumer Price Index 105 110

Nominal GNP (USO million) 43,000 48,000
Population (million) 30 32
Real GNP (USO million) 40,952.38 43,636.36

(b) Real income per capita for 2015

RealGNP2015
RealGNPpercapita(201s)=- - - - - - ­
Total population 2015
43, 636.36 (uso million)
RealGNP per capita( 2015)=
32 (million )
Real GNP per capita (2015) = USDl,363.64
(c) Between 2012 and 2015, the real GNP has (increased/decreased) by 6.55%.
The Malaysian Economy in 2014
The Malaysian economy recorded a stronger growth of 6.0% in 2014 (2013:
4.7%), driven primarily by the continued strength of domestic demand and
supported by an improvement in external trade performance. Net exports
turned around to contribute positively to growth after seven years of negative
contribution, as Malaysia benefitted fro1n the recovery in the advanced
economies and the sustained demand from the regional economies. While
the growth in private domestic demand remained strong, public sector
expenditure registered slower growth, consistent with the government's fiscal
consolidation efforts.
Private consumption grew by 7.1% in 2014, supported by favourable
income grov.rth and stable labour market conditions. Private consumption
growth \.Vas also supported by the targeted government transfers to low and
middle-inco1ne households. These partially mitigated some of the dampening
effects on household spending growth from the higher cost of living, follo\.ving
adjustments to administered prices. Public consumption recorded a slo,ver
growth rate of 4.4% given the more moderate increase in government
expenditure on supplies and services, which was in line with expenditure
rationalization initiatives announced towards the end of 2013.
Although the growth of overall gross fixed capital formation (GFCF)
moderated to 4.7%, private investment grew by 11.0% during the year.
Consequently, the share of private investment in GFCF increased to 64%
(2013: 60%). Growth in private investment occurred in both export-oriented
and domestic-oriented industries and was 1nainly driven by the services and
manufacturing sectors. Public investment contracted by 4.9%, following the
decline in Federal government development expenditure and lower capital
spending by public enterprises. TI1e latter mainly reflected the completion and
near-con1pletion of several major projects.
On the supply side, all economic sectors recorded higher growth rates in
2014, driven by domestic and external factors. In particular, the recovery in
the advanced economies and the continued demand from regional economies
resulted in the manufacturing sector recording a strong growth of 6.2%. The
services sector re1nained the largest contributor to growth, expanding by 6.3%
(2013: 5.9%).

Source: Adapted from BNM Annual Report 2014, Central Bank of Malaysia.
 (1)
ll>
Case questions rn
(a) What is the Malaysian economic growth in 2014?
-·::3
..,
C

(b) From the article, what are the two main factors that contribute to the zll>
stronger economic growth in 2014?
(c) List the three factors that support growth in household consumption.
-·
0
::3
ll>
(d) Why did the public consumption expenditure record a slower growth rate?
(e) Briefly explain any two uses of the national inco1ne statistics. 0
0
(1)
ll>
::3

-
C.
0
10.6 USES OF NATIONAL INCOME
-
C
STATISTICS C
National income statistics is one of the significant indicators that is
used to gauge the economic health of a country. It represents the total
currency value of all goods and services produced over a specific time
period. Besides, economists use the national incon1e to describe the
size of the economy of a nation. The uses of national incon1e statistics
include:
I Standard of living indicators
Standard of living reflects the individuals' welfare because it shows
how much goods and services can be consumed by each individual
in a country. It can be measured by GDP per capita. The rationale
is the more goods and services that households benefit from (from
their nation's increased econo1nic production), the higher the
increase in consumption opportunities, which in turn increases
the standard of living.
The standard of living can be compared based on two different
perspectives: (a) to co1npare the standard of living over time, and
(b) to compare the standard of living across countries.
2 Government planning and policies
National income statistics is a very useful tool for the government
to formulate their economic planning. The available statistics of
national income can guide the policymakers in planning for the
future. From the national income data, the government can view
the historical trends and performances of the economic sectors.
In addition, with the national income data, the government
can take necessary measures to improve the current level of
the economy or take the right corrective actions. For exan1ple,
when the national income statistics sho,,vs that the economy is in
recession, the policymakers will suggest the implementation of an
expansionary fiscal policy.
3 Sectoral contributions
An economy is made up of various economic activities. These
activities can be grouped according to the specific sectors, such as
the primary sector (agriculture, forestry, mining and quarrying),
secondary sector (manufacturing and construction) and tertiary
sector or services sector (electricity, gas and water; wholesale and
retail trade, accommodation and restaurants; transport, storage
and comn1unication; finance, insurance, real estate and business
services; government services and other services).
Given the availability of national income statistics, the
policymakers can recognize which economic sectors are more
or less likely contributing to the national inco1ne. A ti1ne series
analysis can also show the revolutionary changes of each sector
with time in general. For instance, in developed countries, the
services sector is the key driver contributing to the national
income. Mean,.,vhile, the primary sector is the key contributor in
less developed countries.
4 International comparisons
One of the purposes of measuring national income is to make
international comparisons of people's living standards or real
inco1ne. With the n.ational income statistics, we can co1npare the
absolute size of one economy relative to another and how well off
the average individual is in each country.

10.7 PROBLEMS OF MEASURING

NATIONAL INCOME
Theoretically, measuring national income entails a large amount of
data-collection and calculation because it involves the measurement
of the total product and services over a large region. As such,
the computation of the national income is a highly complex and
complicated task.
I Problems of non-monetized sector
Problems of a non-monetized sector usually arise in n1ost of
the third world countries. The existence of a large number of
non-monetized activities in these countries, especially in the
agricultural sector, makes computation of the national income
more challenging. This is due to the fact that a large quantity of
agricultural output in these countries do not reach the market. The
outputs are either consumed directly by farmers or exchanged for
other goods and services. This makes it more difficult to measure
the national income.
2 Underground economy
Official GDP estimates may not take into account the underground
economy, in ,vhich transactions contributing to production such
as illegal trade and tax-avoiding activities, are not reported, thus
 causing the GDP to be underestimated. Those who do not disclose :s:
their incomes or underestimate their incomes to avoid paying (1)
ll>
higher taxes may cause a loss in government income revenues and rn
sales, ,-vhich are not reflected in the GDP. -·::3
..,
C

3 Non-market transactions
A number of productive work is carried out in the economy which zll>
do not involve payment. For example, food grown in backyard -·
0
plots, home repairs, clothes sewn at home, and any other instances ::3
of do-it-yourself goods and services that people make or perform
ll>

for themselves, their families or friends are not calculated in the 0

GDP. During these transactions, no money changes hands and 0
subsequently no payments are recorded. (1)

4 Problems of expertise and modern machinery ll>

::3
The lack of professionals, such as statisticia11s, researchers,
-
C.
programmers and analysts, is a major proble1n in third world 0

-
C
countries. The services of these professionals are very important
in estimating the national income data accurately with minimum C

errors. Another important challenge faced is the non-availability

of modern 1nachinery such as advanced co1nputers or progran1s
to compute national incon1e data. Data collected on national
income, regardless of the method used, has to be analyzed using
sophisticated machinery.
5 Problems of double counting
Double counting in the national income will appear when both Double Counting
values of final goods and intermediate goods are included. As In the national income, double
most products go through a series of production stages before counting will appear when
they reach the market, some of their components are bought and both values offinal goods
and intermediate goods are
sold over a number of times. To avoid this problen1, the GDP included.
includes only the value of final goods and ignores intermediate
goods altogether. Inclusion of the value of intermediate goods will
amount to multiple counting which ,-vill distort the value of the
GDP.

The concept of national income is n1ost significant in n1acro-accounting and

it is basically used to n1easure the economic performance of an economy
because it serves as a better yardstick of the economy's overall performance.
It represents the total currency value of all goods and services that are produced
over a specific ti1ne period. Besides, economists use the national inco1ne to
describe the size of the economy of a nation.
Theoretically, to measure national income would entail a large amount of
data-collection and calculation because it involves the measurement of the total
product and services carried out over a large region. Computation of a national
income is a highly complex and complicated task. As such, it is important to
understand the concepts and mechanisms that are being used.
• National income is one of the main scopes of macroeconomics study and
the concept of national income is most significant in macro-accounting.
• Components of macroeconomics can be divided into four broad groups:
households, firms, the government and the foreign sector.
• Circular flow of income is an economic 1nodel depicting how 1noney flows
through the economy.
• Gross domestic product (GDP) is the total market value of all final
goods and services produced within a given period of time by factors of
production located within a country. Gross national product (GNP) is
defined as the total market value of all final goods and services produced
by the residents of a country during a given period of time.
• Net factor income from abroad is the difference between the income
received from abroad and the income paid abroad.
• Market price refers to the current price in the market through the forces of
demand and supply.
• Factor cost is the price of output that is valued based on the cost of factors
of production.
• Net national income means that the value of national income has been
adjusted by the value of depreciation or net national income is gross
national income minus depreciation.
• Personal income is the real income earned by households before they pay
their personal income taxes.
• Disposable personal income is the income available for personal
consumption expenditure and personal savings.
• Three approaches to measure national income: income approach,
expenditure approach, and product or output approach.
• Compensation of employees includes ,-vages and salaries paid to
households by firms and by the government, as well as various supplement
to wages and salaries, such as the contributions that employers make to
social insurance and the employees' pension funds.
• Proprietor's income is the in.come of unincorporated businesses, either of
sole proprietorship or partnership.
• Rental consists of the income received by households and businesses that
supply property resources.
• Corporate profits are the earnings of owners of corporations.
• Net interest is the interest households receive on savings deposits and
corporate bonds minus the interest households pay on their borrowings.
It also consists of money paid by private businesses to the financial
institutions.
• Personal consumption expenditures can be referred to as all expenditures
by households on durable consumer goods, non-durable consumer goods
and consumer expenditures for services.
• Gross private domestic investment refers to the purchase of new capital
by firms-housing, plants, equipment and inventory.
• Government expenditure or public consumption is the expenditure 3:
(1)
incurred by federal, state and local governments for final goods and Q)

-·::3
rn
services. C
..,

• Transfer payment is the transfer v.1hich is made ,.vithout any exchange

of goods or services. Government transfer payments include welfare z
expenditures (financial aid), social security benefits, pensions and
scholarships.
-·
Q)

0
::3
• Net export is the difference between the value of exports and the value of Q)

imports.
• Nominal income is the national income measured in current prices. 0
0
• Real income refers to the national income measured at a constant price or
in a base year.
(1)

--
Q)
::3
C.

+
0
C
C
Key concepts

• Gross domestic product • Compensation of • Government expenditure

(GDP)
• Gross national product
(GNP)
• Net factor incon1e fro1n
abroad
• Net national income
• Personal income
• Disposable personal
income
employees (G)
• Proprietor's income • Net export (X - M)
• Rental income • Transfer payment
• Corporate profits • Real income
• Net interest • Nominal income
• Personal consumption • Per capita income
expenditure (C) • Growth rate
• Gross private domestic
investment (I)

+ Exercises

Multiple-choice Questions
Answer the following questions.

1 The circular flow of income for a two-sector
economy refers to one of the following
propositions.
A Entrepreneurs pay wages to workers in
return for their labour services.
B Consumers spend money on
consumption goods, thus paying to the
producers; producers pay to factors
of production for their services, thus
generating inco1ne.
C Governn1ent pays to the public as
government expenditures and receives
from the public in taxes.
D Exports pay for imports.
- 2 The circular flow of income for a two-sector
-
0
model shows
A the flo\.v of income bet\.veen the
household, firms and government
.c:: B the flow of income for the government
u
C the flow of income from the government
to household and firms
D the flow of income between firms and
households
3 A four-sector economy is also known as a
A closed economy
B simple economy
C open economy
D modern economy
4 Gross domestic product (GDP) measures
A the market value of intermediate
products produced during the year
B the sum of the market value of both final
and intermediate products produced
during the year
C the sum of the market value of final
products produced and imported during
the year
D the market value of final products
produced in the nation during the year
5 The total market value of all final goods
and services produced by the residents of a
country during a given period of time is the
A gross national product
B gross domestic product
C net national income
D net national product
6 The difference bet,veen gross don1estic
product and gross national product is
A subsidy
B indirect tax
C depreciation
D net property income from abroad
7 The concept of value added solves the double
counting problems in the calculation of the
national income by using the
A income approach
B aggregate approach
C product approach
D product and income approach
8 To obtain the value of gross national product
at factor cost (GNPfc) from gross national
product at market price (GNPmp), we need
to
A add depreciation and minus subsidies
B add indirect taxes and minus subsidies
C add transfer payment and minus
depreciation
D add subsidies and minus indirect
taxes
9 If net factor income from abroad is positive,
A gross national product is greater than
gross domestic product
B national income is less than personal
mcome
C gross national product is less than
personal income
D gross national product is less than gross
domestic product
10 The 1nain factor that differentiates gross
national product from net national product
lS
A net investment
B gross investment
C capital consumption
D net factor income abroad
11 When there is inflation,
A real GDP increases faster than GDP
B GDP increases faster than real GDP
C GDP and real GDP increase at the same
rate
D there is no way of telling whether GDP or
real GDP increases faster
12 Gross domestic product (GDP) that is 17 The proble1n of double counting in :s:
measured in terms of the price of the base measuring GDP can be avoided by_ __
(1)
ll>
. rn
year1s ___
A nominal GDP
A including the values of the intermediate
and final goods produced -·::3
..,
C

B current GDP B deducting indirect taxes and including

C real GDP subsidies to the value of output zll>
D base GDP C deducting the value of goods imported -·
0
from the value of goods exported ::3
13 Which of the following items is included in D i11cluding the value of final goods and
ll>

the calculation of personal income, but not excluding the value of intermediate goods
in national income? produced
0
0
A Net factor income abroad
B Subsidies 18 Gross domestic product (GDP) does not
(1)
ll>
C Govern1nent expenditure include which of the follo"ving? ::3

-
C.
D Transfer payment I Intermediate goods 0
II Second-hand goods sold in the current

-
C
14 An improvement in the standard of living is time period
best indicated by an increase in_ __ III Foreign-produced goods
C

A real personal income A I only

B real income per capita B II and III only
C nominal national income C I and III only
D nominal disposable income D All of the above

15 Gross domestic product (GDP) that is
measured using current prices is called
A nominal GDP
B real GDP
C constant GDP
D deflated GDP
16 The uses of national income data include the
following, except
A to assist the government in national
planning
B to avoid the problem of double-counting
C to determine the distribution of income
in the economy
D to measure the economic growth over time
19 The largest component of the GDP is
A government purchases
B personal consumption expenditures
C net factor income abroad
D gross private domestic investment
20 Net export is a negative value when_ __
A a nation's exports of goods and services
exceed its imports
B a nation's imports of goods and services
exceed its exports
C a nation's exports of goods and services
are equal to its imports
D None of the above
Short-answer Questions
Answer the following questions.
1 The table contains a random selection ofitems from the national account of a country.

Compensation of employees 500

Corporate profit 250
Rental income 200
Net interest 150
Proprietor's income 95
Transfer payment 100
Corporate tax 80
Depreciation so
Private investment 1,000
Personal income tax 20
Employees Provident Fund so
Net factor income abroad 400

Calculate the:
(a) Net domestic product at factor cost
(b) Gross domestic product at factor cost
(c) National income
(d) Personal income
(e) Disposable personal income
2 The table contains a random selection of items from the national account of a country.

Exports 600
Personal consumption expenditure 1,500
Public investment 1,300
Changes in stock -300
Indirect business taxes 130
Government expenditure 1,090
Tax on companies profit 1,100
Personal income taxes 180
Subsidies 150
Imports 500
Factors income paid abroad 180
Depreciation 140
Factors income received from abroad 190
 Calculate the:
(a) Gross domestic product at 1narket price (1)
ll>
(b) Gross domestic product at factor cost rn
(c) Gross national product at factor cost -·::3
..,
C

(d) National income

3 The table contains a random selection of items from the national account of a country. zll>
Item ! USO (Million)
-·
0
::3
ll>

Finance, insurance, real estate and business services 5,750

0
Private expenditure 11,000 0

Rent 21,000 (1)

ll>
Government expenditure 7,000 ::3

-
C.
Agriculture 12,400 0

-
C
Mining and quarrying 5,000
C
Transport, storage and communication 4,700
Dividends received by individual 1,650
Wholesale and retail trade, accommodation and restaurants 7,300
Manufacturing 13,500
Profit 24,100
Capital consumption allowances 2,000
Business taxes 7,250
Taxes on expenditure 8,500
Net factor income received from abroad 4,450
Subsidies 1,445
Personal income taxes 1,125
Social contribution 1,050
Employees Provident Fund 1,170
Transfer payment 1,700

Calculate the:
(a) Gross domestic product at market price
(b) Gross domestic product at factor cost
(c) Gross national product at factor cost
(d) National income
(e) Personal income
(f) Disposable income
4 The table contains a random selection of iten1s from the national account of a country.
Item USO (Million)

Consumption expenditure 13,000

Investment spending 10,200
Government expenditure 11,700
Export 10,000
Import 10,500
Subsidies 4,600
Taxes on expenditure 4,020
Property income from abroad 7,950
Property income to abroad 9,030
Undistributed profits 2,400
Corporate income tax 2,750
Social security contributions 3,900
Transfer payment 2,350
Insurance premium 1,700
Capital consumption 2,680
Personal income tax 3,950

Calculate the:
(a) Net domestic product at factor cost
(b) Gross national product at factor cost
(c) Net national income at factor cost
(d) Disposable income
(e) Real GNP, given current year index is 110
5 The table shows the value of nominal GNP and the price index for a country.

Consumer Price Index 100 105 110

Nominal GNP (USO million) 38,000 41,000 42,100

Population (million) 30 32 35

Real GNP (USO million)

Real GNP per capita

(a) Complete the given table.

(b) Between 2010 and 2015, the real GNP has (increased/decreased) by_ %.
_
Essay Questions :s:
(1)
Answer the following questions. ll>
rn
I Using an appropriate diagram, explain the circular flow of income in a three-sector
econon1y.
-·::3
..,
C

--·
(Q
2 Differentiate between gross domestic product (GDP) and gross national product zll>
(GNP), with examples.
3 What are the components of measuring national income usiJ1g the income approach?
--
0
::3
Explain briefly. ll>

4 Explain the difference between real and nominal GDP, ,.vith examples. ::3
0
5 What are the four uses of national income statistics? Explain. 0
3
6 What are the four problems encountered in calculating the national income? Explain. (1)
ll>
::3

-
C.
0

-
C
'C
C
 Determination of
National Income
Equilibrium
Ul At the end of this chapter, you should be able to:
Discuss the two different approaches in the determination of

�-
�
0 national income equilibrium.
Define autonomous and induced consumptions from the
0 conventional perspectives.

·-
tn • Discuss the Islamic consumption theory according to Fahim
C: Khan Islamic consumption.
Describe the investment theory from the conventional
� perspective, autonomous and induced investments, from the
.! Islamic perspective.
• Calculate income equilibrium in two-, three- and four-sector
.
economies.
• Define and calculate the expenditure multiplier.
• Illustrate inflationary gap and deflationary gap.

Aggregate demand is the total
value of spending made by all
sectors in the economy.
Aggregate supply is the total
value of output produced.
I t is essential to learn and understand the determination of national
income equilibrium because the equilibrium level will affect the
level of employment in the economy. It is also used to identify the
rate of unemployment that occurs in the economy. An increase in the
production of goods and services in the economy is the result of a high
equilibrium level of national income. This indicates that an excessive
amount of resources are being employed in the economy. A low rate
of unemployment is achieved when the level of employment is high.
The national income is in equilibrium when the total value of spending
made by all sectors in the economy is equal to the total value of output
produced. The total value of spending made by all sectors is known
as the aggregate demand, while the total output is the aggregate
supply. The equilibrium indicates a position of balance between the
aggregate demand and the aggregate supply in the economy.
In this chapter, we will first discuss the different approaches in the
determination of national income equilibrium, followed by the Islamic
consumption theory and the calculation of income equilibrium 1n
two-, three- and four-sector economies.
11.1 APPROACHES IN DETERMINING
NATIONAL INCOME EQUILIBRIUM
According to the Keynesian theory, there are two approaches to
determine national income equilibriun1, namely the aggregate
demand = aggregate supply approach (AD = AS) and the leakages
= injections approach. We will briefly explore these two approaches,
then discuss them in greater detail in Section 11.5.
11.1.1 Aggregate Demand = Aggregate
Supply Approach
The aggregate demand = aggregate supply approach is achieved
when the total expenditures made by all sectors in the economy is
equal to the total output produced. The total expenditure is kno,,vn
as aggregate demand ,,vhile total output or national output is labeled
as aggregate supply. An aggregate demand consists of components
which are consumption, invest1nent, government sector and foreign
sector (export n1inus in1port). The equilibriun1 occurs when aggregate
demand is equal to aggregate supply.
Aggregate demand = Aggregate supply approach
Y=C+I+G+X-M
11.1.2 Leakages = Injections Approach
National income is likened to a balloon. When the balloon is being -
0
(I)

-·
(I)
filled with air, it puffs up, gets fuller and fuller. This is called 'injection� Injection is an income that can
be ra ised within the c ircular
Injection is an expansion of the economy. Injection is an income that
-·
flow.
can be raised within the circular flow. Injections include investments, D>
government expenditures and exports. 0
::s
The national income balloon will shrink when there is an air leak in 0
the balloon. This is called the 'withdrawal' or 'leakage'. Withdravval or
--·
zD>
Aleakageisan income
received by all sectors in
leakages ,vill do,vnsize the economy. A leakage is an income received the economy which is not
by all sectors in the economy which is not distributed ,vithin the
-::s
distributed within the circular 0
circular flow. Leakages include savings, taxes and imports. A leakage
flow. ::s
D>
will reduce our national income. Equilibrium occurs when leakages
are equal to injections. As shown in Figure 11.1, the balloon of national 0
0
income is stable when injections are equal to leakages. 3
(I)

-·--·
rr:I
Injections: I + G + X Figure 11.1 ,Q
C
Equilibrium in national income

-·
C"

Total Income=Total Expenditure

y

Withdrawals/Leakages: S + T + M

11.2 AUTONOMOUS AND INDUCED

CONSUMPTION

11.2.1 Consumption Theory

Consumption can be defined as the spending by all the households Consumption can be
in the econon1y on goods and services produced within the defined as the spending by
all the households in the
economy. Consumption refers to the 'planned: 'intended' or ex ante economy on goods and
consumption. It is the main component of aggregate expenditure. The services produced w ithin the
most important factor ,vhich influences consumption is disposable
economy.

income. Disposable incon1e is also

Yd = Y + Transfer payment -Taxes
known as net inco1ne after
deducti on of tax.
Yd =Y-T

APC measures the proportion
of income which is used
by households for their
consumption expenditures
at various levels of disposable
income.
MPC measures the rate of
change in consumption
expenditure when disposable
income changes.
Autonomous consumpt ion is
the expenditure incurred by
the consumer if there is no
income.
Induced consumption is the
expenditure incurred by the
consumer ;f there is an income.
11.2.2 Concepts of Consumption
I Average propensity to consume
Average propensity to consume (APC) measures the proportion
of income which is used by households for their consumption
expenditures at various levels of disposable income. It also reflects
the average inco1ne spent on household expenditures and can be
measured as:
C
APC=
yd
2 Marginal propensity to consume
Marginal propensity to consume (MPC) measures the rate of
change in consumption expenditure when disposable income
changes. It is a change in planned consumption (�C), as a ratio of
change in the disposable incon1e (�Yd):
MPC =
�c
11.2.3 Consumption Function
A consumption function sho,-vs the amount of households spending
on goods and services at different levels of disposable income. There
are two types of consumption, according to Keynes: autonomous
consumption and induced consumption.
Let us imagine a simple closed economy, with no exports or
imports, government expenditure and taxation. Assume that
households consume and save from disposable income:
Yd = C+S
C = Yd -S
The income that households do not consume is called saving.
S = Yd -C
The general form of the consumption function equation is:
C=a+bYd
where,
C = Total consumption
a = Autonomous consumption, ,-vhich is independent of the Yd
b = Marginal propensity to consume (MPC) or the slope of the
consumption function
Y,, = Disposable income
Graphical analysis:
Consumption, C
-
0
(I)

-·
Figure 11.2 (I)

Consumption function 3
C = f(Y)
-·
D>
0
::s
0

a
--·
zD>

-::s
0
,_ _ Disposable income, Yd
_________ ::s
D>
Figure 11.2 sho,-vs the consumption function, which is the total
planned consumption by households at various levels of disposable
0
0
income. The C function must be greater than zero since there is an 3
autonomous consumption. Note that "vhen disposable income is equal
(I)

-·--·
rr:I
to zero, consumption is equal to autonomous consumption. This is ,Q
C
because even though people have no income, they still need money to
buy food or other necessities. -·
C"

When Yd= 0,
C =a+ bYd
C =a+ b(O)
C =a
Thus, C cannot start from the origin.
The consumption function also sho,-vs an up,vards sloping curve
since there is a positive relationship between planned consumption
and income received. When income increases, people tend to consume
more. Table 11.l shows the an1ount of consumption by households at
various levels of disposable income.

Table 11.1
Consumption schedule

350 400 -so 1.14

450 475 -25 1.05 0.75
550 550 0 1 0.75
650 625 25 0.96 0.75
750 700 so 0.93 0.75
850 775 75 0.91 0.75
950 850 100 0.89 0.75

APC MPC
=C/Yd =6(/6Yd
= 850/950 _ (85 0 - 775)
= 0.89 (950- 850)
= 0.75
11.2.4 Factors Influencing Consumption
Change in income and non-income factors will cause the consumption
function to shift. A change in real disposable income is the sole cause
of a moven1ent along the consun1ption function. Whereas a shift or
relocation in the consumption function occurs when a factor other
than real disposable income which is known as non-income factor
changes, such as a change in expectations, price levels, interest rates,
wealth and stocks of durable goods.

Non-income determinants of consumption

1 Expectation
Consumer views of the future will affect current constunption
spending. Expectations may involve future inflation rate,
likelihood of becoming unemployed, and likelihood of receiving
higher income. Expectations of an increase in future prices will
increase current consumptions. This will shift the consumption
function upwards. In addition, the expectations of recession and
fear of job losses will also cause current consumption to decrease.
Hence, autonomous consumption decreases and the consumption
function ,..,ill shift downward.
2 Wealth
Wealth owned by households includes both real assets such as
houses, and financial assets such as cash, saving accounts, stocks,
bonds, insurance policies and pensions. When the accumulation
of wealth increases, spending will also increase, leading to an
increase in consumption. Therefore, changes in stock 1narket
prices, real estate prices and prices of other assets will affect the
value of wealth and shift in the consumption function.
3 Price level
Change in price levels tends to shift the consumption function
by reducing or enlarging the purchasing power of financial assets
(wealth) with fixed nominal values. When the price level is high,
the real value of financial assets will decrease. This ,..,ill result
in less spending among the lower inco1ne group at any level of
current disposable income. As such, the consumption function
will shift down,..,ards.
4 Interest rate
A decrease in interest rates on loans will encourages consu1ners
to borrow more credit to finance their expenses. Hence, the
consumption function will shift up,..,ards. When interest rate
increases, it discourages consumption.
5 Stock of durable goods
During the World War II, automobiles, washing n1achines and
other durable goods were not produced. After the ,..,ar, people
rushed to purchase durable goods and this caused an upward shift
in the consumption function.
 Consumption
Y=C
Figure 11.3
Consumption and saving -
0
(I)

-·
function (I)

-·0
D>
::s
0

--·
zD>

-::s
0
::s
D>
'-- -
� -
� -
� - + Disposable income
-
Saving
0
0
3
(I)

-·--·
rr:I
,Q
C

-·
C"

11.2.5 Saving Theory

Keynes argues that saving is divided into autonomous saving and Autonomous saving
induced saving. Autonomous saving (or dissaving) is the part (dissaving) is the part of
of savings that is not related to income. It occurs when there is savings that is not related to

autonomous consumption. It is the expenditure incurred by the

income. It occurs when there
is autonomous consumption.
consun1er if there is no income.
Saving is considered the part of income received by households that
is not used for consumption or expenditure.
S=Yd -C
Given that Y = C + S, saving is thus also a function of income.
This is because the amount of savings by households depends on the
levels of income received. Table 11.2 shows the amount of savings by
households at various levels of income.

Table 11.2
Saving
Income Consumption Saving schedule
(USO Billion) (USO Billion) (USD Billion)
S=Y-C

100 175 -75

200 250 -50
300 325 -25
400 400 0
500 475 25
600 550 so
700 625 75

Dissaving occurs when
consumption is more than
disposable income (C > Y.).
APS measures the proportion
of disposable income that
households save.
MPS shows the relationship
bet,neen a change in total
disposable income and a
change in total savings.
Based on Table 11.2, we can see that the amount of savings increases
when income increases. At a lower level of income (USD400), savings
is zero. Ho,.vever, when income is less than USD400, the amount of
savings is a negative value since the total consumption by households
exceeds the levels ofincome. When the households plan to spend more
than their income, they have to take extra n1oney fron1 their savings.
This is known as dissaving. Dissaving occurs when consumption
is n1ore than disposable income (C > Yd). Dissaving is financed by
previous savings, wealth, stocks, bonds or borrowings.
11.2.6 Concepts of Saving
I Average propensity to save
Average propensity to save (APS) measures the proportion of
disposable income that households save. It shows the relationship
between total income and total savings. The proportion of income
that is saved will differ at different levels ofincome and the value is
not constant. APS can be measured as:
APS= s
2 Marginal propensity to save
Marginal propensity to save (MPS) shows the relationship between
a change in total disposable income and a change in total savings.
It measures the rate of change in saving when disposable income
changes. MPS can be n1easured as:
11.2.7 Saving Function
A saving function shows the relationship between the amount of
savings and different levels of income. As we know, savi11gs is the part
of income that is not spent.
S=Y-C ................. (l)
C=a+bY ............... (2)
Substitute equation (2) into equation (1)
We get, S=Y - (a+ bY)
S = -a + ( 1 - b) Y- - - •
- Saving function equation
where,
-a =Autonomous saving
b = Marginal propensity to consume (MPC)
Thus, ( 1 - b) = 1 - MPC = MPS
The saving function has a positive relationship with income since
saving increases if income increases.
Graphical analysis:
-
0
(I)

-·
(I)
Saving, S Figure 11.4
Saving function

-·
S = f(Y)
D>
0
::s
L-
- Disposable income, Yd
1---- --;;r - - - - - 0
-a

The linear function of Figure 11.4 is the saving function, which

--·
zD>

-::s
0
shows the total planned savings by households at various levels of
::s
D>
income. At a low level of disposable income, the saving function can
be zero and negative. Saving is considered as the residual incon1e of 0
0
households that is left after consumption. 3
(I)

-·--·
Table 11.3
rr:I
,Q
Consumption and saving C

-·
schedule
C"
350 400 -50 -0.14
450 475 -25 -0.05 0.25
550 550 0 0 0.25
650 625 25 0.04 0.25
750 700 so 0.06 0.25
850 775 75 0.09 0.25
950 850 100 0.11 0.25

APS MPS
=S/Yd = t:,.S/t:,.Yd
= 100/950 - 100- 75
= 0.11 950-850
= 0.25

The sum of APC and APS must be equal to l.

APC+ AP$= 1
The sum ofMPC and MPS must be equal to 1.
MPC+MPS= 1

11.2.8 Break-even Income

Break-even point refers to the point at which consumption is equal
to national income. At this point, saving is equal to zero. Figure
11.5 sho,-vs how the break-even point can be achieved. Note that at
higher levels beyond the break-even income, a portion of income
is savings, ,vhile at lower levels below the break-even income,
dissaving occurs.
 At Yd > C : Saving
At Yd < C : Dissaving

Figure 11.5 Consumption, C

Break-even point
C=Y
Saving C =
Break-even 100 + 0.8Y
income
'\.

a
{"'-- ---;.--- - - - --+
- - National income
•'500
••
•

Saving, 5

•
Break-even: S = -100 + 0.2Y
income :
\.:' _____
1-- -=-...:::;_
- _ National income
-a

Based on Figure 11.5, the break-even incon1e is USDSOO where

incon1e intersects the consumption function at a 45-degree line. At
this point, the saving function is equal to zero.
At all income levels less than USDSOO, the consumption function
is above the 45-degree line. This indicates that the consumption
by households exceeds the income received. Moreover, the saving
function sho,-vs negative values v,rhen income level is less than USDSOO.
Thus, at income levels below break-even income, the consumption by
households is more thai1 the disposable income received and dissaving
occurs.
On the contrary, at all income levels more than USDSOO, the
consumption function is lo,-ver than the 45-degree line. This indicates
that the consumption made by households is less than the income
received. Note that the saving function shows positive values at all
incon1e levels more than USDSOO. Thus, at income beyond break-even
income, the consumption of households is less than the disposable
income received and saving occurs.
 SAMPLE QUESTION 11.1 -
0
(I)

-·
(I)

The table shows various levels of income in a country. (All fi gures are in RM million.) The 3
saving function of this economy is given as S = -80 + 0.2Yd.

Income Consumption
-·
D>
0
I ::s
0

--·
200
400
zD>

-::s
600 0
::s
D>
800

(a) Complete the table. 0

0
(b) Define and calculate autonomous consumption and state the relationship between 3
income and consumption. (I)

-·--·
(c) Find the value of average propensity to consume (APC) and average propensity to rr:I
,Q
save (APS) at income level RM400 million. C

Solution:
(a)
-·
C"

Income Consumption
I
200 240
400 400
600 560
800 720

(b) Autonomous consumption is the consumption that is independent of income.

a= 80
Positive relationship between Y and C.
(c) APC = 400/400 = 1
APS = 1 - APC = 0

11.3 ISLAMIC CONSUMPTION THI EORY

ACCORDING TO FAHIM KHAN
ISLAMIC CONSUMPTION
According to M. Fahim Khan, the consumption pattern of a Muslim
is obviously different from the conventional consumption pattern.
This is because Islam has its own distinct ethical standards, Islamic
sociological and framework. Spending in Islam includes consumption
as ,,vell as investment, lending and savings in the form of hoarding.
Islamic consumption is divided into two types:
• Consumption expenditure for self and fa1nily (El)
• Consumption expenditures for others (E2)
 A Muslim consumer is free to decide how much of his income will
be spent on these two expenditures. However, Islam gives guidelines
on the spending pattern. They are rational spending on wealth, price
level and degree of fear in God. A rational Muslim never hoards his
savings because with zakat, his savings will be slowly reduced. Thus, all
savings will be invested, resulting in an Islamic econon1y that will have
a higher rate of savings and a higher rate of investment as compared
to the conventional economy. The objective of consumption from an
Islamic perspective includes to consume enough economic goods for
an efficient life and not to consu1ne prohibited goods; consumption
also cannot be extravagant and Islam discourages luxurious living.
Consumption for satisfaction is not a vital objective, but it is more
towards achieving the higher end of life in this \.Vorld and in the
hereafter.

11.3.1 Factors Affecting Muslim's Consumer

Behaviour
According to Monzer Khaf, the behaviour of a Muslim is influenced
by several factors:
I The belief in the hereafter life
The consumption of goods and services by Muslims should comply
with the Shari'ah and obey the rules predetermined by Allah
S.WT. Consu1nption should not only focus on the satisfaction of
this world, but also the rewards in the hereafter.
2 The Al-Falah principle
Based on the Islamic framework, it is vital to receive blessings
from Allah S.WT. during spending to achieve A lFalah
- (success).
A lFalah
- is the Arabic word which means co1nplete happiness in
this world and in the hereafter.
3 The principle of wealth
A Muslim needs to believe the principle that all that exist in the
universe belongs to Allah S.WT. As such, men are mere custodians
over their properties, and are not the real masters. Therefore,
Muslims should manage their ,-vealth according to the guidelines
of Allah S.WT. for the benefit of mankind.
4 The principle of consumption of goods and services
The consumption o f goods and services according to the Islamic
framework must be clean and pure. Consumer goods in Islam
must be tied up with ethical values such as goodness, purity and
nourishment. Goods which are bad, harmful and ,.vorthless are not
considered as goods in Islam. For example, alcoholic drinks which
are harmful to the mind and health of man are not considered as
goods.
5 The ethics of consumption
The ethics of consumption according to the Islan1ic fran1ework
includes interest-free loans, prioritizing the poor and needy,
 caring for animals, spending for the ,,velfare of the future
generations and other consumption of good things is considered
a virtue in Islan1. Furthermore, excesses in consumption are
-
0
(I)

-·
(I)

also prohibited in Islam. In addition, spending on briberies and

3
illegal goods are not in compliance with Islamic rules. Muslims
are encouraged to practise a n1oderate and balanced pattern of
-·
D>
0
consumption and spending.
::s
0

11.4 AUTONOMOUS AND INDUCED

--·
zD>

-::s
0
INVESTMENT ::s
D>
In the macroeconomic analysis, investment comprises the
acquirement of new capital equipment, i.e. when firms purchase
0
0
new machines, equipment and other capital goods. A set-up of new 3
buildings or factories can be considered as investment or capital
(I)

-·--·
rr:I
formation. Investments also include a change in stocks, which is ,Q
C
meant for future consumption. In addition, an expenditure to replace
obsolete equipment can also be reflected as an i11vestment because
it can increase the productive capacity to produce output. There are
-·
C"

two major types of investment, namely autonomous investment and

induced investment.

11.4.1 Autonomous Investment

Autonomous investment is an investment which is fixed and does not
depend on national income. This type of investment depends on other
Autonomous investment is an
investment which is fixed and
factors, such as interest rate, government spending and the level of does not depend on national
technology. Figure 11.6 shows that there is no relationship between income.

national income and autonomous investment.

Investment Figure 11.6

Autonomous investment

11.4.2 Induced Investment

Induced investment is investment which depends on national income.
There is a direct relationship between investment and national income.
Induced invest1nent is
investment which depends on
Induced investment will increase as national income increases, since national income.
investors are attracted by higher national income. This is shown in
Figure 11.7.
 Figure 11.7 Investment
Induced investment

11.4.3 Factors Influencing Investment

I Price and productivity of capital goods
The investment depends on the capital goods itself. For example,
buying a machine; if the machine is productive and can yield more
output, then the investn1ent in that 1nachine will be higher. As
another example, if a store offering binding services is less profitable
compared to a store that offers photocopy services, then a producer
will be more likely to invest more in a new photocopy machine.
2 Expectations of the future
If a firm has favourable or good expectations about the future
prices of its new product, the firm will be more interested to invest
in new capital equipment. For example, a firm which is involved in
manufacturing a new car; if the firm assumes that the introduction
of new hybrid cars ,viii appeal to its potential custo1ners and,
hence, increases its sales, the firm will enlarge its investment in
the production of hybrid cars accordingly.
3 Innovations
Through innovation, new ways of producing existing products
are usually embodied in new equipment. Thus, ne,., investment
is required to set up processes such as robotization or
computerization. As such, investment expenditure is required to
modify the existing equipment or to create new equipment.
4 Profits
Profits gained from the previous year will influence investment.
Some investments are financed through borro,.,ed funds, although
much of the investment is financed by the firm from the previous
year's profit. A higher profit \.Vill provide a larger an1ount of
investment for the firm. Thus, the firm ,.,ill need to increase its
investment if its profit is high.
5 Rate of interest
The opportunity cost of capital to firm is the interest rate. The
lower the interest rate, the greater the number of investments.
When the interest rate is lower, cost of borrowing will also reduce
and, thus, the number of investment projects will increase.
6 Government policies
The government will allow tax redemption/incentives or a lower
corporate tax to promote investment; for example, to encourage
foreign direct investment (FDI) in Malaysia.
7 Rate of return
An investn1ent is undertaken if it is profitable. If the cost of
investment is higher than the rate of return, then the investment
-
0
(I)

-·
(I)

is said to be unprofitable because a higher rate of return will boost

3
investment. -·
D>
0
::s
11.4.4 Islamic Investment Theory 0
With respect to production, all resources created by Allah S.WT. must
be managed and fully exploited. Shari'ah demands that resources and
wealth should not be left idle and unexploited. Furthermore, in Islam,
--·
zD>

-::s
0
capital is not just wealth. There are four institutions that can boost ::s
D>
capital formation or investment, namely family, ummah, mosque and
government. Thus, the need to invest lies not only in government, 0
0
but also each individual in the economy. The boundaries of investment 3
in Islam are: (I)

-·--·
rr:I
1 Only permissible activities are allowed. ,Q
2 Investment is based on the desires of human, i.e. Al-maslahah
C

ummah and also the needs of dharuriyyat, hajiyyat, and kamaliyyat.

3 lnvest1nent should highlight on well-being besides profitability.
-·
C"

4 Its implementation should not against Shari'ah.

5 Does not involve any forms of riba.
The factors that influence investment is similar to the conventional
except that it must be within the boundaries mentioned above. Islam
provides choices to avoid riba in investments. Providers of capital
together with entrepreneurs can join forces and perform mudharabah
or interested entrepreneurs ,vith capital can come together and
perform musyarakah.

SAMPLE QUESTION 11.2

With the aid of diagrams, explain the differences between an autonomous investment and
an induced investment.

Solution:
An autonomous investment is the investment which is independent of income. The amount
of investment can be influenced by interest rates, business expectations and technology
development.

Investment

1- -----
- Autonomous investment

�--------+ Income
 Induced investment depends on the national income. As national income increases, induced
investment also increases. Higher national income will attract more investments from
investors.

Investment

Induced investment

-+Income
""-- - - - - - -

11.5 INCOME EQUILIBRIUM IN TWO-,

THREE- AND FOUR-SECTOR
ECONOMIES
11.5.1 Equilibrium National Income in a
Two-sector Economy

Figure 11.8 (Wages, Rent, Interest and Profits)

Circular flow of income in a __.-- Factor Payments
two-sector economy (Y)

. -- --- -- .-- ·-·----.........

-·· Factor Inputs .
,,,.,
·-
� <-- - ,.,.-·
- ---<. - - -◄
Households -------------➔ Financial r'- ---''--�
-

►_. _
Savings
(SJ
Market --j�;;��t;;,��t► �,�-Firms
-�
(I)

.-·
✓
' ·

' ,.'·
•
_,
� •-

· '· ,. ,_ Goods and _ ____.,

•

-·--- .. Services (0) -- -- -·

--_..._ Consumption ----

Households are the economic
agents who own all factors
of prod uction and spend a11
income by buyi ng all final
goods and serv ices.
Expenditure
(C)
In the equilibrium Y E 0 = =
This simple economy consists of just two kinds of economic
agents. The first economic agent is the households, who o\.vn all
factors of production and spend all income by buying all final goods
and services. The second economic agent is the firms \.vhich hire the
factors of production from households and sells goods and services to

households, and also pay any profits made to households.

 Toe flo,v of factors of production from households to firms, and the
flow of goods and services from firms to households, are matched by
the equivalent flov.r of money-firms paying income to household (Y),
-
0
(I)

-·
(I)

and households paying firms for consuming the goods and services
3
(C). \tve assume that households do not spend all their income. In other
words, households do keep so1ne money aside as savings. Thus, savings
-·
D>
0
are the difference between the households' inco1ne and expenditure.
::s
0

--·
To be in equilibrium, receipts must equal payn1ents. Thus, income
(Y) from fi.r1ns to households is equal to consumer spending ( C) plus
zD>
savings (S).
-::s
0
::s
Y=C+S D>
However, the savings do not go to the firms. This is a withdrawal 0
or a leakage. A leakage is a flow from the circular flow of income and 0
expenditure. It represents 1noney going out. A leakage is an amount
3
(I)
of income received, which is not passed on ,.vithin the circular flow.
-·--·
rr:I
,Q
Leakages will reduce the flo,.v of income. Leakages include savings, C
taxes and imports. An injection is an expenditure that raises the
income in the circular flow and is not derived from the household -·
C"

expenditure. Injections include investment, government expenditures

and exports. The component of an aggregate demand in a two-sector
economy consists of expenditures from households, kno,.vn as the
'consumption' and is denoted by (C), and the expenditure made by
fir1ns, i.e. investn1ent is denoted by (I). Therefore,
AD=C + I
Aggregate supply or aggregate output is the total quantity of goods
and services produced in an econo1ny in any given period of time.
AS=Y
The equilibrium in a two-sector economy is ,.vhen:
AD=AS approach
Y=C+ I
or
Leakages=Injections
S=I
1 Algebra analysis
Assuming a two-sector economy whereby there is no governn1ent,
no imports and no taxes. This is also called the simple economy.
Households can buy goods and services or households can save.
Toe portion of income saved will depend on the inco1ne and the
an1ount of taxes to be paid. As such, savings are portions of the
household income that are not consumed in a given period.
 In the case of a two-sector economy, the following is given:
C = RM70 million + 0.75Yd
I = RM500 million
Calculate the equilibrium level of income faced by this economy
using the AS-AD approach and leakages-injections approach.
AD = AS approach
Y = C+ I
Y = 70 + 0.75Yd + 500
Y = 570 + 0.75Yd
Y - 0.75Y = 570
0.25Yd = 570
Yd = RM2,280 million (Equilibrium income)
Leakages = Injections approach
S=I
-70 + 0.25Yd = 500
570 = 0.25Yd
Yd = RM2,280 million (Equilibrium income)

2 Graphical analysis

Figure 11 .9 AD= AS approach

AD= AS and AD (C, I)
leakages= Injections Y=AD
approaches for a
two-sector economy C +I= 570 + 0.75Yd

C = 70 +0.75Yd
570
70
IL.__,__�- - -
�- -
- - - ➔ National income
2,280
'' RM million
'
Leakages= Injections
'
approach
'
S= I :

Saving

O 1------:::,,-,..:C - - -'-
-- - - -
- National income
2,280
-70 (RM million)

Figure 11.10 Households & Firms

Summary of a two-sector
economy
/
Consumption (C)
�
Investment (I)
Saving (S)
 SAMPLE QUESTION 11.3 -
0
(I)

-·::s
(I)
"'1
3
--·
The diagram shows the saving and investment functions in an economy.

Saving, Investment (RM million) D>

-z
0
S = -400 + 0.3Y
::s
0

I= RM250 D>--·
--::s
0
D>
::s
I-----?"'-::._----'�--...!...------+ NI (RM million)
Yo Yr Y.
0
0
3
(I)

-·--·
where, rr:I
Yr = Full employment national income ,Q
C
v.= Equilibrium national income
(a) Determine the values of the MPC and MPS.
(bl Write the consumption function.
-·
C"
"'1
C
(c) Calculate the equilibrium income for this economy by using the leakages = injections 3
approach.

Solution:
(a) MPC = 0.7 and MPS= 0.3
(b) C = 400 + 0.7Y
(c) Saving = Investment
S =I
- 400 + 0.3Y = 250
0.3Y = 250 + 400
Y = 650/0.3
v.
= RM2, 167 million (Equilibrium income)

11.5.2 Equilibrium National Income in a

Three-sector Economy
Figure 11.11
Wages, Fees, Dividend and Interest Circular flow of income in a
three-sector economy
'
Firms Government Government Households
iture Expenditur
' " (G) (G)
-
-.,.
� �
- Tax
I I
Taxes (T) ,,,<
V>

'°-
-.,.
C: :,
a, Government
E V>
�
a,

->
C: Consumption (C)

,.
Financial
Investors Institutions
 A three-sector economy comprises households, firms and
the government sector. A third sector includes the intervention
of government. The government undertakes three in1portant
macroeconomic activities in the economy: purchase of goods and
services, collection of taxes, and payments of benefits and subsidies.
The purchase of goods and services as well as payment of expenditure
is part of the government expenditure (G). G is another injection into
the circular flow of income in a three-sector economy. Benefits and
subsidies are knov.rn as the government flow of income. Collection of
taxes by the government (T) is a withdrawal or a leakage as money
goes out of the circular flow. Therefore, in a three-sector economy, the
equilibrium is obtained from the following equation:
Y =C+I+G
This is an aggregate den1and equals aggregate supply approach or:
I+G=S+T
This is known as leakages-injections approach.
I Algebra analysis
The equilibrium in a three-sector economy (closed economy)
consists of households, firms and the government. Equilibrium
occurs when the aggregate demand equals to aggregate supply.
In this economy, we need to focus on two types of taxes, namely
autonon1ous taxes, which refer to taxes that are independent of
income. For example, tax=RM150. Another one is induced taxes,
which refer to taxes that depend on income. For example: tax=0.2Y.

In the case of a three-sector economy, the following is given:

C =RMlOO million+ 0.75Yd
I =RM50 million
G=RMlOO million
T=RM40 million (autonomous tax)
Calculate the equilibrium level of income faced by this economy
by using AS-AD approach and leakages-injections approach.
AS=AD approach
Y=C+I+G
Y = 100+ 0.75Yd + 50 +100
Y =100+0.75(Y - T) +50+ 100
Y =100+0.75(Y - 40) + 50+ 100
Y =100+0.75Y - 30+ 50+ 100
Y =220+ 0.75Y
 Y - 0.75Y = 220 -
0
(I)

-·::s
(I)
0.25Y = 220 "'1

--·
Y = RM880 million (Equilibrium income)
3
D>
Leakages = Injections approach

-z
0
S+T=I+G ::s
0

--·
-100 + 0.25Yd + 40 = 50 + 100
-100 + 0.25(Y -T) + 40 = 150 D>
-100 + 0.25(Y - 40) + 40 =150

--::s
0
-100 + 0.25Y - 10 + 40 = 150
D>
::s
-70 + 0.25Y = 150
0.25Y = 220 0
Y = RM880 million (Equilibrium income) 0
3
(I)

-·--·
rr:I
2 Graphical analysis ,Q
C

AD= AS approach
Figure 11.12
AD =AS and
-·
C"
"'1
C
AD (C, I)
Leakages= Injections 3
Y=AD approaches for a
C+I+ G = 220 + 0.75Yd (after tax) three-sector economy

C = 100 + 0.75Yd

220•----

100
45°
""--'---�-----,,-------. National income (RM million)
880

'
Leakages= lnjecJions approach

5+ T = -70+ 0.25Yd (after tax)

150 I---- +-- - -=----

-=- Investment+Government (I+ G)
0
880
National income (RM million)
-70

Households, Firms & the Government Figure 11.13

Consumption (C)
� t
Investment (I)
�
Government Expenditure (G)
Summary of a three-sector
economy
Saving (S) Tax (T)
 11.5.3 Equilibrium National Income in a
Four-sector Economy
A four-sector economy is also known as an open economy because
it involves international trade. This makes the econo1ny complete as
it constitutes households, firms, government sector and international
trade. The international trade will affect the equilibrium level of
national income (NI) in two ways, namely export (X) and import (M).
An export is an injection since it is the expenditure that makes the NI
level increases. On the other hand, in1port indicates the expenditure
that is made by our country on other's country national output. This
makes the money flow out of our economy. Hence, import is said to
be a leakage in the four-sector econo1ny. Now, the aggregate demand
consists of consumption (C), investn1ent by firn1s (I), government
expenditure (G), export (X) and import (M).

Figure 11.14
Circular flow of income in a
four-sector economy

Households

The components of the four sectors are as follo,-vs:

Households Firms Government External Sector

!
Consumption (C)
i
Investment (I)
!
Government Expenditure (G)
!
Export (X)
Saving (S) Saving (5) Tax (T) Import (M)

AD = AS approach
Y = C + I + G + (X - M)
Leakages-Injections approach
Leakages = S + T + M
Injections = I + G + X
I Algebra analysis
Equilibrium in a four-sector economy (open econon1y) consists of
household, firms, government and international trade or foreign
-
0
(I)

-·
(I)

sectors. Equilibrium occurs when aggregate demand is equal to

3
aggregate supply. -·
D>
0
::s
0

--·
In the case of a four-sector economy, the following is given:
zD>
C =RM150 million+ 0.80Yd
I =RMlOO million
-::s
0
::s
G =RM200 million D>
T = RMlOO million
X =RM450 million 0
0
M =RM200 million 3
(I)

-·--·
Calculate the equilibrium level of income faced by this economy rr:I
,Q
by using AS-AD approach and leakages-injections approach. C

AS =AD approach
Y=C+I+G
-·
C"

Y = 150 + 0.80Yd + 100 + 200 + (450 - 200)

Y = 150 + 0.80Yd + 550
Y=150+0.80(Y - T) + 550
Y =150 + 0.80(Y - 100) + 550
Y = 700+0.80Y - 80
Y = 620 + 0.8Y
0.2Y=620
Y = RM3,100 (Equilibrium income)
Leakages =Injections approach
S =I
-150 +0.20Yd + 100 + 200 =100 + 200 + 450
-150 + 0.20(Y - T) + 300 =750
-150+0.20(Y - 100) + 300 =750
-150 + 0.20Y - 20 + 300 = 750
130 + 0.2Y=750
0.2Y=620
Y = RM3,100 (Equilibrium income)
 2 Graphical analysis

Figure 11.15 AD= AS approach

AD=AS and
Leakages= Injections AD (C, I)
approaches for a Y=AD
four-sector economy
C +I+G+ (X -M) =620+o.sov. (after tax)
(=150+0.SOYd
620
150
45°
"°---'-'.::.._ ___ _,;...
_ _ _
_ National income (RM million)
:3, 100

' '
Leakages = Injections
'' approach
''
'
S+T + M = 130+0.20Yd (after tax)

750 Investment+Government+ Export

130
� - + National income (RM million)
-- - - - - --
3,100

Figure 11.16
Households, Firms, the Government & External Sector
/ t t �
Summary of a four-sector
economy
Consumption (C) Investment (I) Government Expenditure (G) Export (X)
Saving (SJ Saving (SJ Tax (T) Import (M)

Table 11.4 shovvs a summary of the national income equilibriutn

in two-, three- and four-sector economies by using t,-vo different
approaches.

Table 11.4 '

National income equilibrium
Sector (1) AS= AD (2) Leakages= Injections
j

in two-, three- and four-sector

economies Two-sector Y=C+I 5=1

Three-sector Y=C+l+G S+T=l+G

Four-sector Y=C+l+G+X-M S+T+M=l+G+X
 SAMPLE QUESTION 11.4 -
0
(I)

-·
(I)

The data of a country is given below. 3

C = 300 + 0.6Y
I= 50 -·
D>
0
G=200
T=10
::s
0

--·
zD>
where,
C = Consumption

-::s
I=Investment 0
G =Government expenditures ::s
D>
T=Tax
Y=Income
0
All values are in USD million. 0
(a) Calculate the national income equilibrium?
3
(I)

-·--·
(b) What is the value of savings at equilibrium level? rr:I
,Q
C
Solution:
(a) Y= C +I+ G
Y=300 +0.6Y+ SO+200
-·
C"

Y = 550 + 0.6(Y - T )
Y=550 +0.6(Y - 10)
Y= 550 +0.6Y - 6
Y= 544 +0.6Y
Y -0.6Y=544
0.4Y=544
Y=USD1,360 million (Equilibrium income)
(bl s = -a +(1 - b)Y
d
=-300 +0.4(Y - T)
=-300 + 0.4(1,360 - 1 O)
=-300 + 0.4(1,350)
=-300+ 540
--..• • • = USD240 million

11.6 DEFINITION AND CALCULATIONS OF

THE EXPENDITURE MULTIPLIER
The expenditure multiplier can be defined as the ratio of the change
in income to the change in aggregate demand. This aggregate demand The expenditure multiplier
can be defined as the ratio of
can be referred to investments, government spending, taxes and the change in income to the
balance budget and import. The size of the expenditure multiplier change in aggregate demand.
which depends on household marginal decisions to spend, is called
the n1arginal propensity to consume (MPC) or marginal propensity to
save (MPS). The multiplier sho,.,s that an initial change in aggregate
demand can have a much greater impact on the equilibrium level of
 national income. The expenditure 1nultiplier denoted by K can be
measured by:

K=- - -Change
- -�-
� in -
income
- -(��Y)- -
� -
Change in aggregate demand (�AD)
Since the size of K depends on MPC and MPS, therefore K can be
measured using the formula:

K=- -1- -
1-MPC

11.6.1 Investment Multiplier

Investment multiplier is
the ratio of an increment in
national income to an initial
increment in investment.
Investment multiplier is the ratio of an increment in national income
to an initial increment in investment. It shows that any increase in
public or private investment spending has a more than proportionate
positive influence on aggregate income and the overall economy.

The investment multiplier can be measured as:

= Change in inco1ne (� Y)
K;
Change in investn1ent (�I)
Alternatively, it can be expressed as:

or
1 1
K; =
1 -MPC MPS
Using the earlier two-sector economy as an example C = 70 + 0.75Y
and I= 500, if investment is increased by RMlOO million, ,-vhat is the
new equilibrium income for this sector?
Change in income (�Y)
K. = .............( 1)
Change in investment (�I)

=- -1- -
K . ............. (2)
1
1 - MPC
Substitute equation (2) into equation (1)
The formula is as follows:
1 - �y
1-MPC �I
1 - 6.Y
1 -0.75 100
1 �y
0.25 100
�y
This means that vrhen the
invest1nent is increased by 4=- -
1 unit, the aggregate income 100
,vill increase by 4 tin1es. �y = 400
 New equilibrium income level = Y + b.Y
= 2,280 + 400
= RM2,680 million
-
0
(I)

-·::s
(I)
"'1

--·
3
11.6.2 Government Spending Multiplier D>
The government spending multiplier is a ratio of an increment in
-z
0
The government spending ::s
national income to an initial increase in governn1ent spending. It multip'ier is a ratio of an 0
shows that any increase in government spending has a n1ore than
--·
increment in nat ional income
proportionate positive influence on aggregate income and the overall to an initial increase in
government spending.
D>
economy.
--::s
0
The government spending multiplier can be n1easured as: D>
::s
Change in income (b.Y)
Kg = 0
Change in government spending (�G) 0
3
Alternatively, it can be written as: (I)

-·--·
rr:I
1 1 ,Q
Kg = or C
1-MPC MPS
Using the earlier three-sector econo1ny as an example, C = 100 + -·
C"
"'1
C
0.75Y, I= 50 and G = 100. 3
If there is an increase in government spending by RM 100 million,
what is the new equilibrium income for this sector?

=__ _C_h_a_n�g�e i__

n in_co_ m
_ _ e_ (�b._Y__
�) _
K ............. (3)
s Change in government spending (b.G)

= - -1- - ............. (4)

Kg
1 -MPC

Substitute equation (3) into equation (4)

The formula is as follows:
1 - b.Y
1-MPC b.G
1 - b.Y
1 -0.75 100
1 - b.Y
0.25 100
This n1eans that ,vhen the
governn1ent spending JS
4=
b.Y
increased by 1 unit, the
aggregate income will 100
increase b , 4 times. b.Y = 400
Ne,-v equilibrium income level = Y + b.Y
= 880 + 400
= RMI,280 million

The tax mu ltiplier is a rati o of a
decrease in national income to
an initial increase in tax.
11.6.3 Tax Multiplier
The tax multiplier is a ratio of a decrease in national income to an
initial increase in tax. [t shows that any increase in tax will have a
negative influence on aggregate income and the overall economy.
The tax multiplier can be measured as:
Change in income (flY)
�= Change in tax (flT)
Thus, it can be expressed as:
-MPC -MPC
=
Kt 1- MPC or
MPS
Using the earlier three-sector econon1y as an example, C = 100 +
0.75Y, I= 50 and G = 100.
If there is a decrease in tax by RM50 million, what is the ne,v
equilibritun income for this sector?
Change in income (fl Y)
t=
K Change in tax (flT)
.............(5)

-MPC
Kt = - - - .............(6)
1- MPC
Substitute equation (6) into equation (5)
The formula is as follows:
-MPC - flY
1- MPC flT
-0.75 - flY
1 - 0.75 -50
-0.75
------flY
0.25 -50
_ flY
This ,neans that ,-.,hen the
tax is decreased by 1 unit, 3=
the aggregate incon1e ,-.,ill -50
increase by 3 til11es.
flY = RM150 million
New equilibrium income level = Y + flY
= 880 + 150
= RMI,030 million

11.6.4 Balanced Budget Multiplier

The balanced budget multipl ier
occurs when there is an
equal change in government
spending (G) and taxes (T).
The balanced budget multiplier occurs when there is an equal change
in government spending (G) and taxes (T). An equal increase in
autonomous government expenditure and autonomous taxes will
lead to an increase in the equilibrium level of national income while
an equal decrease in autonomous government expenditure and
autonomous truces will lead to a decrease in the equilibrium level of
national income.
-
0
(I)

-·
(I)

3
The balanced budget multiplier can be measured as.:
Kb= Kg +� -·
D>
0
Using the earlier three-sector economy as an example, C = 100 +
::s
0

--·
0.75Y, I= 50 and G = 100 and T= 40.
If there is an increase in government spending and tax by RMSO
zD>
million, what is the new equilibrium income for this sector?
-::s
0
The governn1ent spending multiplier: ::s
D>
1 - t:, y
0
1-MPC t:,G 0
3
1 - t:,y (I)

-·--·
1 - 0.75 50 rr:I
,Q
1 t:,Y
C
-
This means that v1hen the
0.25
t:,Y
so -·
C"

4=
government spending is
increased by 1 unit, the
aggregate incon1e ,viii 50
increase by 4 tunes. aY = RM200 million
The tax multiplier:
-MPC - t:,Y
1-MPC t:,T
-0.75 - 6.Y
1 - 0.75 50
- 0.75 - t:,Y
0.25 50
t:,Y
This n1eans that ,vhen the
tax i s increased by 1 unit, -3 =
the aggregate income 'Nill 50
increase by 3 times.
aY = RMI SO million
Net increase in income, 6.Y = Kg+K t
= 200 + (-150)
= RMSO million (net increase
in income is equal to the
simultaneous increase in
government spending and taxes)
Ne,.v equilibriun1 income level = Y + t:,Y
= 880 + 50
= RM930 million
 11.7 INFLATIONARY GAP AND
DEFLATIONARY GAP

11.7.1 Inflationary Gap

An in flationary gap can be
defined as a situation where
national i ncome exceeds the
full employment level.
An inflationary gap can be defined as a situation "vhere national income
exceeds the full employment level. The increase is only the increase in
the nominal income, but there is no real increase in goods and services.
When aggregate demand exceeds full employment level, inflation will

occur. An inflationary gap may be due to an increase in aggregate

expenditure. To reduce the inflationary gap, a contractionary policy
can be implemented. The government can practise contractionary
fiscal policy by reducing government expenditure and raising taxes.

Figure 11.17 AS=Y

Inflationary gap

°
45
0 Y, Y' Output/Income

11.7.2 Deflationary Gap

A defla tionary gap is a situation
where the nati onal income is
below the full employment
level.
A deflationary gap occurs when national income is not at full
employ1nent. In other words, the deflationary gap is a situation where
the national income is below the full employment level. This sho,"/'s
that resources are not fully utilized. To reduce the deflationary gap,

expansionary policies can be implemented. The government can

reduce taxes and increase the government spending.

Figure 11.18
Deflationary gap QJ
:,
.'.:!
narf
oeflatio
"O
C:
QJ �:}
. c,ap AD, = C, + 1, + G, + (X - Ml,
0.
X '
''
w
QJ
-
"'
,A
Ol
QJ
Ol
Ol
<(

45°
0 y Y, Income
It is important to learn and understand the determination of national income
equilibrium because the equilibrium level ,.,ill affect the level of employment
in the economy. It is also used to identify the rate of unemployment that occur
in the economy. An increase in the productive capacity in the economy reflects
an increase in national inco1ne for the nation. This specifies that various
amount of resources are being engaged in the economy. There are two main
approaches in measuring national income equilibrium, namely aggregate
de1nand = aggregate supply approach (AD = AS) and leakages = injections
approach. At the equilibrium income, there is no tendency for the income or
product to increase or decrease. In a two-sector economy, there are only two
economic agents involved: households and firms. This sector is also known as
the simple economy. In a three-sector economy, an additional third economic
agent known as government is involved. The four-sector economy includes
households, firms, government and international trade, which is also known as
the open economy. Fron1 an Islamic perspective, Muslims must note that the
objective in Islamic economics is not to achieve full employment at the expense
of economic efficiency.

• Equilibrium national income is satisfied when the total value of spending

made by all sectors in the economy is equal to the total value of output
produced.
• The equilibrium indicates a position ofbalance between aggregate demand
and aggregate supply in the economy.
• According to the Keynesian theory, there are two approaches to determine
national income equilibrium, namely the aggregate demand = aggregate
supply approach (AD= AS) and leakages= injections approach.
• Aggregate demand = aggregate supply approach is achieved v.1hen the total
expenditure made by all sectors in the economy is equal to the total output
produced.
• A leakage is an income received by all sectors in the economy which is not
distributed within the circular flo\.v.
• An injection is an income that can be raised within the circular flow.
• Consumption can be defined as spending by al1 the households in the
economy on goods and services produced within the economy.
• According to Keynes, there are two types of consumption: autonomous
consumption and induced consumption.
• Break-even point refers to the point at which consumption is equal to
national income.
• Islam has its o,.,n distinct ethical standards, Islamic sociological and
framework
- • Islam gives t,-vo guidelines on the spending pattern which are rational
spending on wealth, price level and degree of fear in God.
• There are two major types of investment: autonomous investment and
induced investment.
• Autonomous investment is a fixed investment and does not depend on
national inco1ne.
• Induced investment depends on national income. There is a direct
relationship between investment and national income.
• Factors influencing investment are price and the productivity of capital
goods, expectations of the future, innovations, profits, the rate of interest,
government policies and rate of return.
• The two-sector economy consists of just two kinds of economic agents:
households and firms. The former owns all factors of production and
spends all income by buying all final goods and services, while the latter
hires factors of production from households and sells goods and services
to households, and also pays any profits made to households.
• A three-sector economy constitutes of households, firms and the
govern1nent sector. The third sector includes the intervention of
government.
• A four-sector economy is also known as an open economy because it
involves international trade.
• The expenditure multiplier is defined as the ratio of change in income to
the change in aggregate demand.
• The size of the expenditure multiplier depends on the household marginal
decisions to spend, called the marginal propensity to consume (MPC) or
the marginal propensity to save (MPS).
• An inflationary gap can be defined as a situation where national income
exceeds the full employment level.
• A deflationary gap is a situation in v.1hich the national income is below the
full employment level.

+ Key concepts

• National income • Average propensity to • Closed economy

• Equilibrium consume • \,Vealth
• Aggregate demand • Marginal propensity to • Autonomous saving
• consume •
Aggregate supply Average propensity to
•
• Ethics save
Leakages
• Autonomous • Marginal propensity to
• Injections
consumption save
• Consumption
• Induced consumption • Break-even point
• Disposal income
 • Islamic consumption • Open economy • Government spending
--·
0
(I)
(I)

3
multiplier
• A lF
- alah
• Autonomous
•
•
Economic growth
Firn1s • Tax multiplier -·
D>

--·
0
investment • Balanced budget
::s
• Households 0
• Induced investment multiplier
• Expenditure multiplier
• Inflationary gap
zD>
• Simple economy • Investment mt1ltiplier
• Deflationary gap 0
::s
D>
::s

+
0
0
3
(I)
rr:I
Exercises
-·-·
C
,Q

Multiple-choice Questions -·
Answer thefollowing questions.

1 A combination of a decrease in income tax C a new technological improvement

with an increase in government expenditure
will
A increase aggregate demand
B decrease aggregate demand
C leave aggregate demand unchanged
D have an ambiguous effect on aggregate
demand
2 The most important determinant of
consumption is
A future income
B disposable income
C household wealth
D dividend
3 The average propensity to save is calculated
by dividing
A saving by income
B total income by saving
C change in saving income by change in
consumption
D change in income by change in saving
4 An investment may decrease due to
A an increase in interest rate
B an increase in business confidence
D a decrease in tax percentage
5 Keynes believed that savings depend on
A interest rate because at low interest rates,
people will spend more.
B interest rate because if interest rate is low,
people "vill save n1ore for their retirement.
C the size of the people's income because
at higher income levels, people can save
more.
D the total consumption.
6 An upwards shift of the consumption
function will
A increase the equilibrium national income.
B increase the demand for transaction
balances.
C be the result of decisions by people to
spend more at each level of national
income.
D decrease the proportion of saving.
7 In Islam, the owner of liquid capital uses this
capital for investment through the mode of
A Al-Mudharabah
 B Al-Ijarah
C Al-Musyarakah
D Al-Araf
8 The investment demand curve will shift to
the left, as the result of
A a business doubt about future economic
conditions.
B an expansion of technology.
C a decrease in business taxes.
D an increase in dividends.
9 National income equilibrium occurs 1,vhen
A de1nand equals supply in the economy.
B aggregate supply equals the real value of
national income.
C aggregate expenditure equals aggregate
supply in tl1e economy.
D total injections exceed total leakages.
10 The relationship between the spending
multiplier and the marginal propensity to
save 1s_ __
A positive
B negative
C unchanged
D uncertain
11 The follo1,ving are boundaries of investment
in Islam, except
A interest based on investment.
B investment based on Shari'ah principles.
C investn1ent emphasizing well-being.
D investment based on al-maslahah.
12 At the break-even point,_ _ _ D 1-MPC
A income equals consumption
B saving is positive
C income is bigger than consumption
D saving is greater than zero
13 If the autono1nous consumption increases,
the size of the expenditure multiplier will
A increase
B be uncertain
C remain constant
D either increase or decrease, depending
on the size of the change in autonomous
consumption
14 Multiplier effects means that
A consumption is usually several times as
large as saving.
B a small change in consumption demand
can lead to a much greater increase in
investment.
C a small increase in investment can cause
the national income to change by a larger
amount.
D a small decline in the MPC can cause the
equilibrium national income to rise by
several times that amount.
15 The accelerator principle relates to
A the ratio between the change in the rate
of growth of output and the change in
investment.
B the ratio between tl1e change in
investment and the change in the rate of
consumption.
C the ratio between consumption and
saving.
D the ratio between exports and i1nports .
16 If income is zero, consumption_ _
_
A must be zero
B is less than zero
C is greater than zero
D cannot be determined
17 Without the government and foreign sectors,
the formula of multiplier is_ __
A 1/MPS
B 1/MPC
C 1/(1 + MPC)
18 When aggregate expenditure equals
aggregate output, the economy is
experiencing ___
A a budget deficit
B a surplus budget
C a deflationary gap
D national income equilibrium
19 A recessionary gap may be caused by
A a decline in aggregate expenditure.
B an increase in planned investment.
C an increase in consumption.
D an excess in government spending.
20 A tax multiplier is
A the ratio of a change in the national
income to the change in taxes.
C the differences in taxes multiplied by
the change in the national income.
D the change in taxes by the change in
-
0
(I)

-·
(I)

B the ratio of a change in taxes to the national income. 3

change in national income.
-·
D>
0
::s
0

Short-answer Questions --·

zD>

-::s
0
Answer the following questions. ::s
D>
I The table shows the spending in a hypothetical country. (All values are in USD million.)
0
Consumption Function 300 + 0.65Yd 0
3
(I)

-·--·
Investment (I) 200 rr:I
,Q
Government expenditure (G) 350 C
Tax (T)
Net exports (X - M)
20
120
-·
C"

(a) Compute the equilibrium level of national in.come for the above economy.
(b) Assuming that full e1nploy1nent would be experienced at an inco1ne level of
USD3,000 million, state the problem this economy is facing. Illustrate your
answer with a well-labeled diagram.
(c) Using the spending multiplier, compute the change in the amount of government
spending that is required to achieve the full employ1nent inco1ne level.
(d) Derive the saving function and calculate the marginal propensity to save.
2 The table shows the data on national income and savings of a country.

GNP Saving Consumption

(USO Billion) (USO Billion) (USO Billion)

250 -40
350 -20
450 0
550 20
650 40
750 60
850 80

(a) Calculate the amount of consumption at each level of GNP.

(b) Find the value of marginal propensity to consume (MPC) and marginal
propensity to save (MPS).
(c) Define autonomous consumption and calculate its value.
 (d) Assuming that government expenditure is equal to USD80 billion and investment
is USD80 billion, calculate the national income equilibrium for the above
country.
(e) Based on the answer in (b), ,.vhat problem will this country face if the full
employment output is USDl,400 billion? Draw a diagram to sho,.v this situation.
3 Answer the following questions based 011 the diagram. (All values are in USD million.)
S, I
S = -100 + 0.2SYd
t-- - - - - -----:;,.,:;.---- 12

600 t-- - - - - +-- - 1

---,,,,C-- - - -,

0 t-- -
-;;,L--- - -
...C..,- L.,_- - - -
➔ Income
Yo Y,- - -
7,500
-100

(a) Find the break-even income at Y0.

(b) Find the equilibrium income when investment (1 1 ) is at USD600 n1illion.
(c) How much is the new investment (12 ) to achieve the equilibrium income of
USD7,500 million?
(d) If the equilibrium income is USD7,500 million, how much is the amount of
saving and consun1ption?
(e) At the income level of USD7,500 million, calculate the average propensity to save
and the average propensity to consume.
4 Answer the following questions, based on the information given on a hypothetical
econo1ny. (All values are in USD n1illion.)

Consumption Function C = 350 + 0.75Yd

Investment (I) 170

Government spending (G) 100
Net exports (X -M) 75
Tax (T) 0.1 SY

(a) Calculate the national income equilibrium using the AD-AS approach.
(b) Calculate the government expenditure 1nultiplier.
(c) Assun1ing that the income level (Yr) is USD2,000 million at full employment:
(i) Sketch a diagram to illustrate the prevailing problem given the value of
equilibrium income obtained in (a).
(ii) Calculate how much the government will have to increase for expenditure,
in order to increase the income of the economy to an efficient level.
(d) Briefly explain two methods to solve the problem in (c)(i).
5 The following information refers to the spending in Laddacity country. (All values are
in USD million.) -
0
(I)

-·::s
(I)
"'1

--·
Consumption Function 350 + 0.65Yd 3
D>
150

-z
Investment expenditure 0
Public expenditure 250 ::s
0
Tax
Net exports
20
120 D>--·
--::s
0
::s
(a) Compute the equilibrium level of national income for the above economy. D>
(b) Assuming that full employment ,,vould be experienced at an income level of
USD3,000 1nillion, state the problem this econo1ny is facing. Illustrate your 0
0
answer with a well-labeled diagram. 3
(c) Using the spending multiplier, compute the change in the amount of government (I)

-·--·
rr:I
spending that is required to achieve the full employment income level. ,Q
(d) What is marginal propensity to save (MPS), and the relationship between MPS
C

and marginal propensity to consume (MPC)?

-·
C"
"'1
C
Essay Questions 3
Answer the following questions.
1 (a) Explain consumption from an Islamic perspective.
(b) Describe the three factors which can influence consumption expenditure 1n
conventional economics.
2 (a) Explain the Keynesian consumption function.
(b) From an Islamic perspective, investment must be based on certain elements.
Identify and explain two of them.
3 (a) Discuss the four boundaries in Islamic investments.
(b) Elaborate on four factors that will affect investment.
4 With the aid of diagrams, explain the differences between autonomous investment and
induced investment.
5 Using an appropriate diagram, explain the circular flow of income and expenditure in
a t�vo-sector economy.
Money, Banking and
the Financial
System
• Discuss the definition, characteristics and functions of money.
• Differentiate between transaction, precautionary and speculative
motives of demand for money.
• Explain the concept of money supply, and define Ml, M2 and
M3.
• Discuss money market equilibrium.
• Discuss functions of central banks and the types and tools of
monetary policy.
• Discuss functions of commercial banks and calculation of credit
creation.
• Describe Islamic banking products.

Money
Anything that acts as a
medium of exchange.
System of Barter
Directly exchanging goods
and services for other goods
and services, without using a
medium of exchange such as
money.
E verybody needs to use money; even little children know how
to get money from their parents to buy candy. How much do
we understand about money? In this chapter, we will discuss the
definition, characteristics and functions of money. We will learn about
money demand and money supply and its measures of Ml, M2 and
M3, as well as how the money market stays in equilibrium.
Although most people use banking facilities, a majority of them do
not understand the actual banking system, especially in the function of
credit creation of commercial banks. Thus, in this chapter, we will also
discuss the banking system and how the central bank uses monetary
policy to influence the entire economy. The chapter ends with an
overview of the Islamic banking system and its products.
12.1 MONEY
12.1.1 Definition of Money
Money is defined as anything that acts as a medium of exchange;
any commodity that is generally acceptable as a payn1ent for goods
and services can serve as money. Money is valuable merely because
everybody accepts it as a form of payment to trade goods and services
indirectly.
Before the evolution of money, a system of barter was used. A
system of barter is an old method of exchange to directly exchange
goods and services for other goods and services without using a
medium of exchange, such as money. For example, the exchange of
a chicken with a duck. However, the exchange process faced a lot of
problen1s due to the limitations of a barter system.
The following is a description of the limitations of a barter system,
due to its inefficiencies:
(a) There must be a double coincidence of wants for a syste1n of
barter, which 1neans that both parties need to have ,.vhat the other
,.vants. For example, if Joseph wants to exchange his chicken ,.vith
Alex's fish and by coincidence, Alex also ""ishes to exchange his
fish for Joseph's chicken, then the deal is on. The need to buy
and sell at the same time is a cumbersome and time-consuming
process.
(b) There is no common measure of value . How 1nuch of Alex's :s:
fish can be exchanged for a chicken fron1 Joseplh? It is difficult 0
::s
to decide the terms of exchange for the amount of fish against a (1)

chicken or fish against beef.

�

l:XJ
(c) Indivisibility of certain goods. Some goods cannot be divided ll>

into smaller units as it will destroy the goods. For exan1ple, half -·
::s
�

of an egg or half of an apple.

(d) Lack of standards for deferred payments and difficulty in ll>
::s
storing wealth. As some goods such as fish, vegetables, fruits and Q,
1neats are easily perishable, in the process of looking for potential ::r
buyers to n1ake exchanges, these goods will perish and lose their
-·::s
(1)
"'lj
future value as deferred payments or wealth.
(e) Problem of portability. The seller is faced with the problem of ll>

carrying bulky and heavy or fragile goods such as bags of beef, -·-
::s
n
firewood or eggs.
ll>

<rn
....
Barter: The direct exchange of one good for another good. (1)

• Coincidence of wants; time-consuming process :3

• No con1mon measure of value; hard to decide terms of
exchange
• Indivisibility of certain goods
• Lack of standards for deferred payn1ents
• Difficulty i n storing wealth
• Problem of portability

Money: Anything which is readily acceptable as payn1ent for

goods and services and for settling debts.
• Use of money simplifies and increases market transactions,
prevents time wastage and promotes economic growth.
Evolution of Money
• Commodity money
Due to the mentioned limitations of a barter system, money was • Metallic money
created to play the role of the barter system. The evolution of money • Paper rnoney
started from comn1odity n1oney to 1netallic money; paper money,
• Token money
• Fiat money
token money, fiat money, bank money and plastic money. • Bank money
• Plastic money
 • A wide variety of items or commodities which are used as money,
such as cowrie shells, cattle, tea, sheep, tobacco and others as a
means of payment.

• Metals used as money were iron, tin, copper, silver and gold.
• Problems arose as most metals were too scarce to serve the
needs of a medium of exchange.

• Originated from receipts issued by goldsmiths to customers for

safekeeping of their valuables.
• Today, paper money refers to a legal tender approved by the
government for circulation as a means of payment, such as dollar
bills.

• Money which has a lower metallic value than its face value.
• Example: Coins in denominations of 5, 10, 20 and SO cents issued
by the Central Bank of Malaysia.

• Any item issued by the central bank and declared by the

government as money.
• Fiat money includes coins and paper money, i.e. currency.

• Bank money is also known as a bank deposit, demand deposit or

current account.
• Money deposited in a current account or demand deposit is
transferable through cheques.
• A cheque is not money; it only instructs the bank to transfer
money from one account to another.

• Refers to credit cards such as MasterCard and Visa or debit cards,

which are used for cashless transactions.
• This is the most modern form of banking facility.
• Credit cards are not money; it is only an agreement to pay for
goods when the card company bills the customer.

SAMPLE QUESTION 12.1

Provide an explanation on the four types of money.

Solution:
Explain the following four types of money:
(a) Commodity money-commodities which are used as money as a means of payment, e.g.
shells
(b) Fiat money-coins and paper money
••• (c) Bank money-bank deposit, demand deposit or current account
••• (d) Metallic money-metal used as money, e.g. iron, silver and gold
12.1.2 Characteristics of Money :s:
0
As discussed earlier, there have been many forms of money in history, Characteristics of Money ::s
but so1ne forms have worked better than others because they possess
(1)
• Acceptability �

characteristics that make then1 function well as money. A material • Durability l:XJ
must possess these six primary characteristics in order to function
ll>

-·
::s
• Divisibility
• Portability or
well as money:
�
transportability
I Acceptability
• Scarcity, but not too scarce,
and non-counterfeitability
Money n1ust be widely accepted not only for its intrinsic value, but
ll>
• Uniformity or ::s
also as a medium of exchange for goods and services. Almost any homogeneity Q,

item or any asset such as gold, silver, copper, nickel, animal skins or ::r
-·::s
(1)
precious gems have been used as money over the centuries because "'lj
these items can function as money and are generally accepted ll>
as payment. In the n1odern econon1y, people are confident that
money is tradable for goods and services. -·-
::s
n
ll>
2 Durability
Money 1nust be able to keep for a long period of tiJne and withstand
<rn
....
the wear and tear of many people using it. Durability also means (1)

that money cannot easily decompose, deteriorate, degrade or

:3
change its form, and it must be able to store its value from one
transaction to the next.
Gold, silver, copper and nickel have historically functioned
as money because they are extremely durable materials. This is
because an ounce of gold or silver today will remain as an ounce
of gold or silver tomorrow and even a thousand years later, unlike
perishable agricultural goods such as vegetables or raw meat
which will rot in a few days.
3 Divisibility
Money must be easily divisible into small units so that people can
purchase goods and services at any price. For example, a USDlOO
bill can be exchanged for s1naller deno1ninations of USDSO,
USD20, USDlO, USDS, USDl and further to even smaller units.
In fact, the smaller the division, the better it serves as money.
4 Portability or transportability
Money n1ust be easy to carry around. When people purchase
goods, they need to bring along their money. Hence, money must
be portable or transportable. Carrying around gold or silver in the
olden days was troublesome compared to paper currency in the
20th century because paper is lighter and easier to carry. Likewise,
paper cheques used to access current account balances are more
convenient compared to USDl,000,000 cash.
5 Relative scarcity
Money must be relatively scarce and hard for people to obtain
and the supply of money is controlled by the central bank. Money
also cannot be easily duplicated or 'printed up'. The government's

Functions of Money
• Medium of exchange
• Measure of value and a un it
of account
, Store of value
, Standard for deferred
payment
role is to prevent tl1e duplication of money and control the total
quantity in circulation.
6 Uniformity or homogeneity
Money must be in the same ,.veight and design. For example, in
comparing USDlO bills with cows, it is obvious that USDlO bills
are of the san1e size, shape and value as they are all uniforn1. This
is unlike cows which come in many sizes and shapes, resulting
in each having a different value. Hence, cov.rs cannot serve as a
uniform form of money.
12.1.3 Functions of Money
The six characteristics that were just discussed enable money to
perform four major functions that can overcome the problems of a
barter system:
1 Medium of exchange
l\tloney's function as a medium of exchange means that money
is widely accepted as a method of payment. Money acts as a go­
between which is accepted by people for buying and selling goods
and services. Buyers are confident that the cashier will accept their
payment of money and sellers are willing to let go of their goods
in exchange for money. Hence, money is considered as the most
liquid form of wealth as it is accepted by all buyers and sellers.
\,Vithout money, buying and selling can only take place through a
system of barter which bears the problem of double coincidence
of wants.
2 Measure of value and a unit of account
Money can be considered a yardstick to measure the value of
all goods and services, quoted in USD and cents in economic
transactions. This role is absent in a barter economy. However,
using money as a measure of value means that the value for all
goods and services can now be set in ter1ns of money, not quoted
in terms of other goods.
For instance, the price of a laptop is quoted as USDl,500 and
not as 150 bushels of corn. Society finds it convenient when money
acts as a common measure of value to set prices for all goods and
services in terms of monetary units across the economy. Through
n1oney, society is also able to compare the market value of different
goods and services.
As a unit of account, money allows people to keep accurate
financial records and calculate profit and loss.
3 Store of value or wealth
l\tloney makes it easier for people to buy and sell at different
times and at different places. This means that ,.ve can use money
 for future spending or defer our consumption until the future. :s:
Besides, n1oney also allows people to save as it is able to retain its 0
::s
value over time. For instance, we can save USDlOO in our piggy (1)

bank and the value of the money a month later will still be USDlOO.
�

l:XJ
When people hold money in their wallets, it is the most liquid ll>

or spendable of all assets. Money is the 1nost effective way to -·

::s
�

maintain value rather than holding other easily perishable items

of value, such as corn, until they ,.vant to exchange that value for ll>
::s
a good or service. To act as a store of value, money must be able Q,
to be reliably saved, stored and retrieved. However, money is not ::r
a perfect store of value because inflation will slowly erode the
-::s·
(1)

purchasing power of money over time.

4 Standard for deferred payment
ll>

Money functions as a standard benchmark for starti11g future -·

::s
n
ll>
payments for current purchases, i.e. buying now and paying later.
Using money as a standard of deferred payment is a direct result <rn
of the store of value and unit of account functions. ....
(1)
With the growth of the monetary economy and the use of
the interest contract, money has progressively functioned as a
standard for deferred payment. For instance, firms express their
debts in terms of the standard unit established by the law. Another
common example is the contract for a car loan, whereby people
can get a loan to buy a car today, and then pay off the loan with
deferred payments into the future.
However, money as a standard for deferred payment in settling
debts is applicable only if money can retain its value or maintain
its purchasing po,.ver over time. With hyperinflation, people will
lose confidence in the function of 1noney as a standard for deferred
payment.

SAMPLE QUESTION 12.2

Explain the four functions of money.

Solution:
Explain the following four functions:
(a) Medium of exchange-accepted by people for buying and selling of goods and services
(b) Measure of value and a unit of account-a yardstick for measuring the value of goods and
services
(c) Store of value or wealth-can be saved, stored and retrieved reliably for buying and selling
at different times and different places
(d) A standard for deferred payment-benchmark for starting future payments for current
purchases

•••
 12.2 KEYNESIAN DEMAND FOR MONEY
Motives of the Demand for Our demand for money is how much of our wealth ,.ve wish to hold as
Money cash in hand or cash in the bank at any moment in time. According to
• Transaction motive the Keynesian theory of demand for money, there are three important
n1otives of the demand for money: transaction 1notive, precautionary
• Precautionary motive
• Speculative motive
motive and speculative motive.
I Transaction motive
As a medium of exchange, money is used for conducting everyday
transactions such as paying for food and transport. Firms also
demand money to pay for goods, services, factors of production,
dividends, taxes, interest and other expenses. People hold money
in the form of cash, or checkable or demand deposits (current
account) to conduct daily transactions.
It is convenient for people to hold a certain average amount
of money at any given time, depending on the amount of things
they wish to purchase and the size of their income. The amount of
money held for transaction motive is directly related to the level
of income. The higher the income, the higher the transactions that
can be carried out; hence, the higher the amount of money held
for transaction motive.
2 Precautionary motive
Money is held as a precaution against some unforeseen events,
such as paying for the repair of the car, an en1ergency or medical
bills. Firms also keep precautionary balances as spare liquidity
because of uncertainties about their timing of receipt and
payments. For instance, a debtor who "''as to pay after seven days
is unable to pay or a supplier who used to give credit for a month
does not have stock to supply. Hence, firms have to keep cash to
meet contingencies.
The level of income will determine the amount held for this
purpose. The higher the level of income, the higher the amount
held for precautionary motive.
Money balances held for transaction and precautionary
purposes are called active money balances, as this money is to be
used as a 1nedium of exchange.
The interest rate has no influence on active balances because
people still have to n1ake everyday transactions or pay for an
emergency, regardless of the changes in the interest rate.
The four major determinants of active balances are aggregate
inco1ne, frequency of pay, use of credit cards and price level.
 • The higher the volume of income and output produced in :s:
0
the goods market, the larger the volume of transactions and
exchanges that occur. Therefore, the larger the volume of money
::s
(1)
that people will need to hold for transaction and precautionary �

motives. l:XJ
ll>
• The need to hold money balances depends on the frequency of
pay.
-·
::s
�

• A day labourer does not hold much cash balance. He gets paid
ll>
in small amounts on a daily basis and pays for his transaction and
precautionary purposes immediately. He has a near zero holding
::s
Q,
of money balances.

-·::s
• The need to hold money balances for people who are paid (1)
weekly or monthly will be higher. "'lj

ll>
• With the use of credit cards, people will reduce the need for
holding money. Hence, active money balances are reduced as -·-
::s
n
ll>
credit card usage increases.

l
• When prices rise, people will need to hold a l arger amount of (1)
money balances to pay for their transaction and precautionary :3
payments.
• Conversely, when prices fall, people only need a lower volume of
money balances to pay for active balances.

3 Speculative motive
Some people hold money for speculative purposes, n1eaning that
they hold money to buy financial assets such as stocks and bonds
for profitable opportunities. Money, when used for this purpose,
is a means of temporarily storing wealth.
Firms and individuals ,vho wish to purchase financial assets
such as bonds, shares and securities may prefer to wait by holding
cash if they feel that the prices of financial assets are likely to fall.
The money tl1at they hold for this purpose is called idle or passive
money balances. People buy shares after the prices drop and sell
them when their prices rise to make capital gains.
There is an inverse relationship between the quantity of money
demanded for speculative purposes and the interest rate. When
interest rates rise, the opportunity cost of holding money will
increase. It will be too costly for people to hold cash compared to
depositing the cash into banks for the high interest, hence this will
reduce the speculative balances. However, when interest rates fall,
the opportunity cost of holding money will decrease and people
will hold n1ore money for speculative purposes.
 SAMPLE QUESTION 12.3

Explain the Keynesian motives of the demand for money.

Solution:
Explain the three Keynesian motives of the demand for money:
(a) Transaction motive
(b) Precautionary motive

••• (c) Speculative motive

•••

12.2.1 Liquidity Preference Curve

From the three motives of money demand, we can derive the liquidity
preference curve or the demand for money curve.
When we add together the transaction and precautionary demands
for money, it will form the de1nand for active money balances.
This is labelled as L, and shown in Figure 12.1. It is a vertical line
plotted against the rate of interest because the demand for money as a
medium of exchange is independent of the interest rate. Interest rates
do not affect how 1nuch food or other essential goods we want to buy.
However, if other determinants such as incon1e or prices increase, L1
will shift rightward to L11, and the curve is still maintained as a vertical
line because active money balances are interest-inelastic.

Figure 12.1 Interest rate, i

Demand for transaction and
precautionary money balances

�-� - - �
-- -+Money balance
-

Money in the form of currency, checkable deposits, saving accounts

or any kind of negotiable draft are the most liquid assets as they
possess the advantage of instant spending power, but they earn little
or no interest return. Checkable deposits refer to current accounts on
which cheques can be drawn. However, Internet banking has slowly
replaced checkable deposits. On the other hand, non-money financial
assets such as treasury bills and bonds earn higher interest, but have
a lo,ver liquidity level (i.e. not easily converted into spending power)
compared to money. Hence, the cost of holding money as an asset is
the foregone interest rate, unlike bonds and treasury bills ,-vhich earn
a fixed rate of interest.
 Toe speculative demand for 1noney balances is termed as 12• Money :s:
balances held for this purpose are called idle or passive money 0
::s
balances. The speculative motive for holding money is inversely (1)

related to the rate of interest. This inverse relationship is illustrated in

�

l:XJ
Figure 12.2 as a downward sloping curve. At a higher interest rate, the ll>

opportunity cost of holding n1oney is high. Hence, people hold less -·

::s
�

of their wealth in the form of money, but more in the form of other
financial assets such as bonds that pay higher interest rates. When ll>
::s
the interest rate is low, ceteris paribus, the cost of holding money or C,,
maintaining liquidity is low. Hence, people hold more of their wealth ::r
in the form of money.
-::s·
(1)
"'lj

Interest rate, i ll>

Figure 12.2
Demand for speculative money
balances
-·-
::s
n
ll>

<rn
....
:3

'-- ---------
---+Quantity of money

Toe three motives for holdi11g money combine to create a demand

for money curve, as follows:
MD = Ll + 12,
where,
11 is interest-inelastic (see Figure 12. l ),
12 is inversely related to the interest rate (see Figure 12.2), and
MD is the total demand for money which is the horizontal summation
of 1 1 and 12, as illustrated in Figure 12.3.
At the interest rate of 10%, demand for money of L1 is at 5,000
and demand for money of L2 is at 3,000. Hence, the total demand for
money is 8,000.

Interest rate Interest rate Interest rate Figure 12.3

Horizontal summation of L, and
L1 to derive money demand
10 •••.. ••..•••..•••.. �.Q. • •••••••••••••••••• �.Q.
curve

00 0
5,000 Quantity of 3,000 Quantity of 00
0..,0
0
0
Quantity of
money money M Lfi' aj money
Active balances: Idle balances: Total money balance:
Transaction + precautionary Speculative motive Total demand for money
demand for money
 The money de1nand curve represents the quantity of money
demanded by people at different possible interest rates, ceteris paribus.
It is a down,,vard sloping curve, inversely related to the rate of interest
as shown in Figure 12.4. When the market interest rate falls, ceteris
paribus, the cost of holding money is low, so people hold more money.
Conversely, when the interest rate is high, the cost of holding money
is high, so people hold less of their wealth in the form of money and
more in the form of other financial assets that pay higher interest rates.
Movement along the money demand curve shows the impact of
changes of interest rate on the quantity of money demanded, holding
other things constant. If other determinants such as the price level and
aggregate national income increase, the demand for money curve will
shift rightward.
A liquidity trap occurs at i0• At the interest rate of i°, the opportunity
cost of holding money is insignificant. Hence, people ,-viii prefer to
hold money rather than bonds.

Interest rate, i
Figure 12.4
Demand for money curve

Liquidity trap
�-.A-�
( "\
jO ..............................:-:
••:-:-. ""· ---- D
M
'-------------. Quantity of money

12.3 SUPPLY OF MONEY

Supply of Money
Controlled by the central bank
and is perfectly inel astic to the
changes of interest rates.
The supply of money, i.e. Ml, M2 and M3, is controlled by the central
bank. The central bank issues the currency and decides the banking
policy on credit creation. The supply curve of money is independent
of interest rates; it is perfectly inelastic to the changes of interest rates
and is depicted as a vertical line in Figure 12.5.

Figure 12.S Interest rate, i

Supply of money

� - -
�- -+ Quantity of money
-

The supply of money is the sum of all the money in a particular

country. Every country has its own ways to measure money supply,
but in general, money consists of Ml, M2 and M3.
 Bank Negara Malaysia (BNM) defines and categorizes money :s:
supply into three measures, Ml, M2 and M3, according to the liquidity 0
::s
or the ease, speed and cost in converting financial assets into cash. (1)

1 Ml: Narrow money

�

l:XJ
Ml is transaction money or money which can be directly used
ll>

for transactions. Ml is the narrowest definition of the supply of

Ml
Transaction money or
-·
::s
�

money and it comprises the most liquid assets, which is either cash money which can be directly
or money readily changed to cash. The most liquid assets are coins, used for transactions. ll>
::s
notes and demand deposits (current accounts) at commercial C.
banks that are easily convertible into cash. Ml is the most liquid ::r
asset since it can be used as payments and settlements of debts
-::s·
(1)
"'lj
directly ,vithout any conversion. M 1 consists of:
(a) Currency-includes coins (token money) and paper money
ll>

issued by Bank Negara Malaysia; coins and paper money are -·-
::s
n
ll>
called fiat 1noney.
(b) Checkable deposits or demand deposits-checking account <rn
or current account balances kept in commercial banks that ....
(1)
are convertible into cash on demand by issuing cheques. :3
Ml (narrow money)= Fiat money (coins and paper money),
also known as currency in circulation +
Checkable/Demand deposit (cheques
or credit cards) in financial institutions

Fiat money is money that does not have intrinsic value, its value
comes from being declared as 'legal tender' by the government
of the issuing country as an acceptable form of payment. People
accept fiat money because the government says it has value and it
is accepted as a means for payment by all people.
2 M2: Ml+ Near mone y
M2 is a broader and less liquid definition of the money supply.
M2 functions as a store of value and part of our wealth. It can be
M2
Consists of M 1 and near
quickly converted into a medium of exchange, but the liquidity is money, and is a broader and
lesser than Ml because it needs to be turned into cash first. less liquid defin ition of the
M2 consists of M 1 and near money. Near money is also called
money supply.

quasi-money. Near or quasi-money are highly liquid financial

assets, such as savings deposits, fixed deposits, negotiable
instrument deposits (NIDs) and negotiable certificates of deposits
(NCD). M2 consists of:
(a) Ml (currency and checkable deposits)
(b) Savings and fixed deposits in commercial banks
(c) Negotiable instrument deposit (NID), which is a document
that promises payment to a specified person or the assignee.
It is a transferable, signed document that promises to pay the
bearer a sum of money at a future date or on demand.
(d) Negotiable certificates of deposit (NCD), e.g. short-term
interest bearing debt
 (e) Bank Negara Malaysia certificates
(f) Repurchase agreen1ents (repos)
(g) Foreign deposits in commercial banks or Bank Negara
Malaysia

M2 =Ml+ Narrow near money (quasi-n1oney)

M2 = M 1 + Savings and fixed deposits in commercial banks +
NCDs + BNM certificates + Repos + Foreign deposits in
commercial banks or BNM

Hence, narrow nearmoney (quasi-money)= M2- Ml

3 M3: Broadmoney
M3 is the broadest definition of the supply of n1oney ,-v-ith the
lowest liquidity. M3 is used by economists to estimate the entire
M3
Broadest definition of the
supply of money, with the supply of money within an economy.
lowest liquidity. M3 consists of
M2, savings and fixed deposits,
As a result of the gro,-v-ing importance of other financial
NCDs and repos in other institutions, such as finance companies, n1erchant banks, discount
financial institutions. houses and Islamic banking, Bank Negara Malaysia has defined
M3 as M2 plus savings, fixed deposits, negotiable certificates of
deposits and repurchase agreements in other financial institutions,
1nerchant banks and discount houses. M3 consists of:
(a) M2
(b) Savings and fixed deposits in other financial institutions
(c) Net issues of negotiable certificates of deposits in other
financial institutions
(d) Repurchase agreen1ents in other financial institutions

M3 (broad money) = M2 + Savings+ Fixed deposits + NCDs

+ Repos in other financial institutions

Hence, broad near money/broad quasi-money= M3 - Ml

SAMPLE QUESTION 12.4

The table shows the money supply of Malaysia in August 2015 (in RM million):
Deposits
Foreign Placed
,

Currency in' Demand Savings Fixed Other

NIDs Repos Currency with Other
Circulationi Deposits Deposits Deposits Deposits
Deposits j Banking
1

,Institutions

75,403.9 276,088.9 134,708.0 731,961.4 15,568.0 595.3 122,205.9 199,695.5 6,924.6

Source: Monthly Statistical Bulletin, August 2015, Bank Negara Malaysia

(a) Calculate M 1.
(b) Calculate the quasi-money.
(c) Calculate M2.
(d) Calculate M3.
 :s:
0
::s
Solution: (1)
�
(a) M 1=75,403.9 + 276,088.9=RM351,492.9 million l:XJ
(b) Quasi-money = 134,708.0+731,961.4 + 1 5,568.0 + 595.3 + 122,205.9 +199,695.5 ll>
= RMl ,204,734.2 million
(c) M2 = Ml + Quasi-money
-·
::s
�

= 351,492.9+ 1,204,734.2
ll>
= RMl,556,227.1 million ::s
(d) M3 = M2 + Deposits placed with other ba1nking institutions Q,
= 1,556,227.10 + 6,924.6 ::r
-·::s
(1)
= RMl,563,151.7 million
•••
ll>

-·
::s
n
ll>

<rn
SAMPLE QUESTION 12.S ....
(1)

The table shows the monetary aggregates released by Country X for December 2015.

Monetary Aggregates USD (Million)

Coins 25,000
Currency in circulation 78,000
Demand/Current deposits of the private sector 92,000
Savings and deposits in commercial banks 185,000
NCO, repo and BNM certificates 170,000
Deposits placed with other banking institutions 16,500

Based on the given data, calculate the value of:

(a) Paper money
(b) Ml
(c) M2
(d) M 3
(e) Narrow near money
(fl Broad quasi-money

Solution:
(a) Paper money = Currency in circulation - Coins
= 78,000 - 25,000
=USD53,000 million
(b) Ml = Currency in circulation+ Demand/Current deposits of the private sector
= 78,000 + 92,000
= USDl 70,000 million
(c) M2 = Ml + Savings and deposits in commercial banks+ NCO, repo and BNM certificates
= 170,000 + 185,000 +170,000
= USD525,000 million
 (d) M3 = M2 + Deposits placed with other banking institutions
= 525,000 + 16,500
= USD690,000 million
(e) Narrow near money= M2 - Ml
= 525,000 - 170,000
= USD355,000
(f} Broad quasi-money = M3 - Ml
= 690,000 - 170,000
= USD520,000
•••

12.4 MONEY MARKET EQUILIBRIUM

At the market equ librium
interest rate, the quantity of
money demanded is equal
to the quantity of money
supplied.
The intersection of the demand for 1noney, M0 from Figure 12.4 and
the supply of money, M s from Figure 12.5, determine the equilibrium
interest rate as sho,.vn in Figure 12.6. At the equilibrium interest rate
of i°, the quantity of money demanded and the quantity of money
supplied are equal at M0.

If interest rate is at i: above the equilibriun1 level, the opportunity

cost of holding money is higher, hence the quantity of money people
want to hold would be lesser than the quantity of money supplied.
People would buy more bonds and bid up bond prices, whereby the
interest rate would fall until it reaches equilibrium. If the interest rate
is at i", below the equilibrium level, the opportunity cost of holding
money is lower, hence the quantity of money people would want to
hold exceeds the quantity of money supplied. People vvould sell bonds
and bid down bond prices, whereby the interest rate would rise until
equilibrium is reached.

Figure 12.6 Interest rate, i

Money market equilibrium

i, Excess supply of money; people

buy bonds and interest rate falls

·O
I
Excess demand for money; people
i,, sell bonds and interest rate rises

'- -- -'----------------+ Quantity of money

M0

If the central bank increases money supply, the money supply

curve shifts rightward to M\, and there is increased supply of money
compared to demand for money at the interest rate i0, as depicted
in Figure 12.7. People demand for more bonds now, hence bond :s:
sellers will pay less interest rate. The equilibrium interest rate falls 0
::s
until the quantity of money demanded and the quantity of money (1)

supplied is equal at i1 . The equilibrium moves from point a to point

�

l:XJ
b. In conclusion, for a given money demand curve, an increase in the ll>

money supply will drive down the equilibriu1n interest rate, and vice -·
::s
�

versa.
ll>
::s
Interest rate, i Figure 12.7 Q,
Shift of money supply curve ::r
-·::s
(1)
"'lj

ll>

-·-
::s
n
ll>

<rn
....
(1)
il ------------ b :3
Liquidity trap
--A-�
r
'Mo
�-�-�-----------
--+ Quantity of money
0 1
M M

12.5 THE CENTRAL BANK AND ITS

MONETARY POLICY

12.5.1 Financial System in Malaysia

The financial system can be categorized into three groups, i.e. banking
institutions, non-bank financial institutions and non-bank financial
intermediaries, as presented in Figure 12.8.

Figure 12.8
The Financial System Financial system in Malaysia

I I
Non-bank Non-bank
Banking
Financial Financial
Institutions
Institutions Intermediaries

Development Employees
Central Commercial
Financial Provident
Bank Banks
Institutions Fund

Finance Islamic Merchant [)iscount

Companies Banks Banks Houses
 Banking institutions consist of the central bank and commercial
banks. The central bank is owned and controlled by the government.
Commercial banks are owned by the private sector, and are profit­
making institutions with a charter from the government to engage in
the business of banking by accepting deposits and providing loans.
Non-bank financial institutions consist of finance con1panies,
Islamic banks, merchant banks and discount houses. Finance
companies provide loans for the purchase of vehicles and properties.
Finance companies provide the same services as banking institutions
except that they do not jssue cheques.
Islan1ic banking is conducted based on the principles of Shari'ah.
As Islam prohibits riba or charged interest, Islamic banks only use
the profit-sharing concept which does not involve the paying and
receiving of interest.
Merchant banks do not accept deposits fron1 the public as they only
provide support services and advice to commercial banks, in terms of
financial management and portfolio management.
Discount houses provide short-term loans in the financial
market. They receive loans with lower rates of interest from financial
institutions and supply loans to the public at a higher rate of interest
to obtain profits.
Non-bank financial intermediaries consist of development financial
institutions and the Employees Provident Fund. The government sets
up development financial institutions to provide loans and financial
assistance to firms and farmers, enhancing investment in the industrial
and agricultural sectors. The Employees Provident Fund provides
retirement benefits to employees. Each month, the employees and
employers have to contribute a certain percentage of income to the
Employees Provident Fund for their retirement.

12.5.2 The Central Bank and Its Functions

The central bank is an important financial institution. It is a semi­
independent government authority that provides financial and banking
services for its country's government and commercial banking system.
The central bank also conducts monetary policy, regulates banks and
issues currency to ensure the financial stability of a country.
The central banking system in the US is known as the Federal
Reserve System, or more commonly known as 'the Fed'. In Malaysia,
the central bank is called Bank Negara Malaysia. Bank Negara
Malaysia was established in January 1959 under the Central Bank
of Malaya Ordinance and the Banking Ordinance 1958. It is owned
and controlled by the Malaysian government to manage the country's
financial activities and financial bodies, in order to maintain economic
stability in the country.
Toe central bank generally performs the followi11g functions: :s:
0
Issuing and managing the country's currency to ensure currency stability ::s
(1)
�
• Printing of paper currency is one of the most important functions of a central
bank.
l:XJ
ll>
• A central bank is the only financial institution with the authority to issue and
manage currency to ensure currency uniformity and stability. -·
::s
�

Acting as a banker and financial adviser to the government ll>

::s
• A central bank acts a s the banker and financial adviser to the government on all C.
important financial matters of the country.
::r
-·::s
• The central bank keeps the government's principal bank accounts, receives taxes (1)
and other revenues, and makes payments in respect of government expenditure. "'lj
• The central bank makes short-term advances to the government, manages the
national debt, sells bonds and redeems matured treasury bills. ll>

Overseeing monetary policy -·-

::s
n
ll>
• A central bank supervises money market operations to ensure low inflation
and full employment through managing interest rates and setting the reserve <rn
requirement. Low inflation creates greater economic stability and preserves the ....
(1)
value of money and savings.
:3
Holder of the country's stock of gold and foreign currency reserv es
• A central bank manages the country's foreign exchange reserves, and
implements the exchange rate system and the balance of payments policy.

Being a banker to the banks

• As the bankers'bank, the central bank keeps cash reserves of commercial banks,
and acts as the custodian of the cash reserves to support cr,edit and banking
systems.
• Banks also keep their deposits with the central bank.

Lender of last resort to commercial banks and the government

• A central bank acts as a lender of last resort to the banking sector if banks get
into liquidity shortages during a financial crisis. The central bank will lend the
commercial bank sufficient funds to maintain public confidence in the banking
system.
• The central bank also acts as lender of last resort to the government.
Government borrowing is financed by selling bonds in the open market. If the
government fails to sell sufficient bonds and has a shortfall, the central bank
will buy some government bonds to avoid liquidity shortages and public panic.

SAMPLE QUESTION 12.6

Discuss four functions of the central bank.

Solution:
Discuss the following four functions of central banks:
(a) Issuing currency and keeping reserves
(b) Acting as banker and financial adviser to the government
(c) Acting as banker to other banks
• • • (d)
...--
.... Promoting monetary stability

Monetary Policy
The policy used by the central
bank to control the supply
of money as an instrument
for achieving the ultimate
objectives of the economic
policy, such as price stabi'ity or
low unemployment.
Monetary Policy: Types and Tools
Monetary policy refers to a policy used by the central bank to control
the supply of money as an instrument for achieving the ultimate
objectives of the economic policy, such as price stability or lo,v
unemployment. The central bank directly influences economic growth
by controlling the amount of liquidity in the financial system through
guiding interest rates on loans, mortgages and bonds.
The follo,ving are the principal objectives of monetary policy:

Achieve full employment

• Achieving full employment is among the foremost objectives of monetary
policy. It is an important goal because unemployment leads to wastage of
potential output, and loss of social standing and self-respect.

Maintain pric e stability

• One of the objectives of monetary policy is to stabilize the price level because
fluctuations in prices bring uncertainty and instability to the economy.

Achieve higher ra tes of economic growth

• To achieve higher rates of economic growth is to increase the real per capita
income of a country over a long period of time. This will increase the standard
of living for its population.

Achieve balance of payments equilibrium

• Sustaining a balance of payments with the rest of the world is a macroeconomic
objective because an increase of deficit in the balance of payments reduces the
ability of an economy to achieve other object ives.

Types of Monetary Policy Expansionary and Contractionary Monetary Policies

• Expansionary monetary
There are two types of monetary policy implemented by the central
bank to solve economic problems:
policy
• Contractionary monetary
policy
Expansionary Monetary Policy
• Expansionary monetary policy aims
to increase money supply.
• It is used to control unemployment
during recession.
• The instruments used a re: buying
government securities and bonds
through open market operations,
decreasing the required reserve ratio
and decreasing the bank rate.
• It will cause the money supply
curve to shift rightward, leading to
an increase in real gross domestic
product (GDP) and, hence, lowering
the unemployment level.
Contractionary Monetary Policy
• Contractionary monetary policy
aims to decrease money supply.
• It is used to control inflation.
• The instruments used are: selling
government bonds through open
market operations, increasing the
required reserve ratio and increasing
the bank rate.
• It will cause the money supply
curve to shift leftward, leading to
a decrease in real gross domestic
product (GDP) and, hence, lowering
the inflation rate.

The instruments ofmonetary policy are tools used by the monetary

authority to affect the level of aggregate demand through the supply of
money, cost of money and availability of credit. These instruments can :s:
be categorized into quantitative and qualitative tools. 0
::s
(1)
�
Quantitative Monetary Policy Tool l:XJ
The quantitative instruments are also known as the general tools or ll>
indirect tools of monetary policy, and include open market operations,
changing reserve requirements and bank rate variations. These tools
Quantitative Monetary
Policy Tools
• Open market operations
-·
::s
�

are designed to control the total quantity of credit through commercial

• Changing reserve ratio
ll>
banks.
requirements
• Bank rate variations
::s
Q,
I Open market operations ::r
This is the most effective tool used by the central bank. Toe central
-::s·
(1)
"'lj
bank buys or sells government securities and treasury bills in the
open market to influence the size of bank deposits. ll>

When prices are rising and there is a need to control them, -·-
::s
n
contractionary open market operations is used. The central bank
ll>

sells securities and treasury bills to the public. Individuals, firms <rn
and commercial banks will purchase these securities, hence it ....
reduces bank deposits, the reserves and the credit creation of :3
com1nercial banks. Commercial banks lend less to the business
community. Money supply will drop, interest rates will rise and
investment will decrease, leading to a decrease in aggregated
demand, hence price levels will decrease.
h1 recession, expansionary open market operations is used. Toe
central bank buys securities from the public, paying them with
cheques. Cheques are paid into the general public's deposits in the
clearing banks. The reserves of commercial banks are raised and
banks can lend more, resulting in an increase in credit creation
and 1noney supply, which leads to the fall of interest rates. This
will then results in an increase in investment, aggregate demand
and employment.
2 Variation in the required reserve ratio upon the bank
The reserve requirement is also called cash reserve ratio or
statutory liquidity ratio. It is a central bank regulation employed
by most of the world's central banks in controlling money supply.
Required reserve ratio is the minimum amount of cash that the
central bank requires all commercial banks to keep in the central
bank. It is to lin1it the amount of loans that banks can make to the
don1estic economy, thus limiting the supply of money. Western
central banks prefer to use open market operations compared to
altering the reserve requirements, as it would cause immediate
liquidity problems for banks ,vith low excess reserves.
The People's Bank of China uses changes in reserve requiren1ents
as an inflation-fighting tool. In 2007, it raised the reserve
requirement by 10 times. This is because the higher the central
bank sets the reserve requirement, the more funds the commercial
banks are required to keep with the central bank. This reduces
the funds the commercial banks can loan out, and leads to lower

Qualitative Monetary Policy
Tools
• Fixing margin requirements
Direct credit controls on bank
lending
money creation and lower aggregate demand. Hence, price levels
will decrease.
In recession, the authorities reduce the required reserve
ratio to encourage an expansion in lending and deposits. This
will stimulate economic activity, hence investment, output and
en1ployment levels ,..vill increase.
3 Bank rate policy or discount rate
The bank rate policy (BRP) is an important monetary tool to
influence the quantity of the credit in a country. The bank rate or
discount rate is the rate of interest which a central bank charges
on the loans and advances to a commercial bank. Based on the
monetary policy of the country, whenever commercial banks have
a shortage of funds, they can borrow from the central bank via the
bank rate or discount rate. Changes in the bank rate or discount
rate will cause changes in the market rate of interest and this can
affect the cost of loan borrowing.
When inflationary pressures start emerging, the central bank
will force the interest rate up by raising its own lending rate, hence
loans become costly to borrow and public spending reduces. This
will reduce investment and aggregate demand, thus prices are
checked from rising further.
On the other hand, during recession, the central bank will
reduce the bank rate. Borrowing loans from commercial banks will
be easier and cheaper, and this will boost up the credit creation,
aggregate den1and and employment.
Qualitative Monetary Policy Tool
The qualitative instruments are also known as the selective or direct
tools of monetary policy. Qualitative instruments are used by the
central bank to control specific types of credit, and these instruments
affect the composition rather than the size of the loan portfolio of
commercial banks. The qualitative tools comprise the following
instruments:
I Fixing margin requirements
Margin requirements refer to the proportion of the loan amount
"vhich is not fi11anced by the bank, i.e the borrower has to raise
the funds of the margin an1ount in order to get financing for his
purpose. If the margin requirement is reduced, the loan size will
be increased, and vice versa. A reduced margin requirement will
encourage loan borrowing, and this will increase credit supply for
the needy sector. However, an increased margin require1nent will
discourage loans for other non-necessary sectors.
If the central bank feels that more credit supply should be
allocated to needy sectors such as the manufacturing sector, then
it will reduce the margin requirement to as low as 10% to obtain
loans for manufacturing sectors. Hence, borrowers only need to
self-finance 10% to obtain the loan, and this encourages more
loans to be borrowed.
 During inflation, the central bank should increase the 1nargin :s:
requirement to discourage public borrowing. This will lead to a 0
::s
decrease in aggregate demand and price levels. �
(1)

2 Direct credit controls on bank lending l:XJ

Direct credit controls are used to restrict the unhealthy expansion
ll>

of s01ne selective credit to control speculative and hoarding -·

::s
�

activities within the economy.

During inflation, the central bank restricts unhealthy expansion ll>
::s
of credit through regulations such as: Q,
(a) Imposing maximum limits upon the amount banks can lend, ::r
or upon the rate at which banks can expand total deposits.
-::s·
(1)
"'lj
(b) Persuading banks to lend only to certain types of customers
or business. For instance, investment or exports are given a
ll>

high priority. This is to avoid non-performing loans. -·-

::s
n
ll>
(c) Fixing regulations for n1inimum down payment and
maximum repayment periods for hire purchase agreements <rn
or restricting the lending policy by implementing a collateral ....
(1)
such as a security or guarantors to discourage borrowings. :3

SAMPLE QUESTION 12.7

Discuss four monetary policy tools that can be used to overcome the problem of inflation.

Solution:
Refer to the statement above and discuss the following monetary policy tools:
(a) Contractionary open market operations by selling government securities and bonds
(b) Raising the reserve ratio
(c) Raising the discount rate/bank rate
(d) Increasing margin requirements to reduce the demand for loans
•••

Lima, 9 October 2015: Top financiers have told the International Monetary
Fund's meeting that with a slowing China growth, central banks in a low­
growth world with over-leveraged and commodity-dependent economies
have little room for error.
Since the global financial crisis, although banks in industrial nations have
USD7 trillion (RM29.3 trillion) through quantitative easing, the world is in a
'ne,-v mediocre' growth pattern. Quantitative easing is the introduction of ne,-v
money into the money supply by a central bank.
 Governments aim to improve tax collection via punishing companies
that arbitrage tax regimes. Moreover, the Bank of Japan extended its money
printing progran1 (i.e. quantitative easing) as it stares down the barrel of a
fifth year of recession. The European Central Bank is also expected to extend
quantitative easing while the US Federal Reserve and the Bank of England are
closest to raising rates this year, despite inflation targets being far out of reach.
In viev,r of these, the Fed, the Japanese and the European central banks ,vere
urged by the IMF to ,vait for more signs of recovery before tightening.
Source: Adapted from lvfalay Mail Online, 2015.

Case questions
(a) Define monetary policy. Should the central bank implement expansionary
or contractionary monetary policy to control recession?
(b) Based on the article, state the instrument used by the central bank to
control recession. Suggest three other instruments of monetary policy
which could be used to reduce recession.

Solution
(a) Monetary policy is a policy implemented by the central bank to control the
inoney supply in the market for achieving the economic policy objective.
The central bank implements expansionary monetary policy to control
recession.
(b) Instrument taken by Japan's central bank is extending its money printing
program. Three other instruments under monetary policy to control
recession:
(i) Expansionary open market operations-central bank buying
securities
(ii) Decrease cash reserve requireinent ratio
(iii) Reduce discount rate

12.6 COMMERCIAL BANKS AND CREDIT

Commercial Bank
Financial institution that
performs the functi ons of
accepting deposits from the
general public and giving loans
for investment, \'Vith the aim of
earning profit.
CREATION
A commercial bank is defined as a financial institution which performs
the functions of accepting deposits from the general public and giving
loans for investment with the aim of earning profit. Commercial
banks are owned by the private sector and monitored through the
central bank and the Federal Reserve System. Cominercial banks are
profit-seeking institutions; they make their profits by taking small,
short-term, relatively liquid deposits to transform them into larger
and longer-maturity loans.
 In Malaysia, there are local banks such as CIMB Bank Berhad, Affin :s:
Bank Berhad, Hong Leong Bank, AmBank and Malayan Banking 0
::s
Berhad, which are owned locally, and foreign banks such as Citibank (1)

Berhad, Standard Chartered Bank Berhad and HSBC Bank.

�

l:XJ
ll>

12.6.1 Commercial Banks and Their -·

::s
�

Functions Functions of Commercial

The two most distinctive features of a commercial bank are borrowing Banks
ll>
::s
and lending, i.e. they borrow to lend. Commercial banks accept • Acceptng deposits Q,

deposits and lend money to earn profit. The rate of interest offered
• Providing loans and ::r
-·::s
advances
by commercial banks to depositors is called the borrowing rate, while
(1)
• Providing other banking "'lj
the rate at which they lend out is called lending rate. Functions of services and facilities
commercial banks are classified as follows:
ll>

-·-
::s
• Credit creation
n
ll>
Accepting deposits
<rn
• A commercial bank accepts deposits in the form of current, :savings and fixed ....
deposits. This is the most important function of commerical banks. (1)
• Current deposits are payable on cheques and therefore called demand :3
deposits. The bank provides facilities and does not pay any interest for current
deposits. Individual households deposit their savings into savings accounts to
earn some interest while enjoying the high liquidity. Interest paid on savings
account deposi ts is lesser than fixed deposits. Fixed deposits are referred to as
time deposits since they have a fixed period of maturity. Fixed deposits are paid
a higher rate of interest as they can only be withdrawn after the maturity of the
specified fixed period.

Providing loans and advances

• The second major function of a commercial bank is to give loans and advances,
such as housing loans, car loans, business loans or personal loans, to the public
by charging an interest rate to earn profit. This is the main source of income for
commercial banks.
• The loans are given to the lender in the form of direct loans, overdrafts facility,
cash credits, discounting bills of exchange, money at call, and so on.

Providing other banking services and facilities

• Commercial banks also provide other banking services and facilities such as
facilitating foreign exchange transactions, issuing bank drafts, cheques and
traveller's cheques, purchasing and selling stock exchange securities, providing
safe deposit boxes, providing credit card facilities and ins1.1rance coverage,
providing fund transfers from one place to another, providing advice on
financial matters, providing AutomatedTeller Machines (ATMs), and others.

Credit creation
• Credit creation is a unique function of commercial banks. Firom the deposits
received from depositors, commercial banks provide loans and investment to
its customers. In the process of granting loans, commercial banks manage to
earn profit and increase the money supply.
 SAMPLE QUESTION 12.8

Discuss four functions of commercial banks.

Solution:
Discuss the following four functions:
(a) Accepting deposits
(b) Providing loans
(c) Providing other banking services and facilitiies
••• (d) Credit creation
•••

12.6.2 The Credit Creation Process

Credit Creation
A process where a small given
deposit w illlead to a greater
increase in the money supply
ofthe economy.
Credit creation is a process where a small given deposit ,viii lead to a
greater increase in the money supply of the economy. Credit creation
is a unique function of commercial banks. From the deposits received
from depositors, commercial banks provide loans and investment to
its customers. In the process of granting loans, commercial banks

not only earn profit, but also increase the money supply via credit
creation.
This section explains the process of credit creation by assuming the
following:
(a) Cash reserve ratio is fixed by the central bank, e.g. at 10%.
(b) There are many banks in the banking system and each customer
deposits money in different banks.
(c) Banks only have two types of assets-cash and loans.
(d) Co1nmercial banks do not keep excess cash reserves; all excess
reserves are 'loaned out' (e.g. 90%).
(e) All transactions are made by cheques.
(f) The public must keep their money in the banks and all deposits
are only kept in the form of current accounts using only cheques.
(g) Leakages do not exist as there are no withdrawals fron1 the
banking system.
(h) Banks have only one liability, i.e. in the form of deposits.
The following example will show the process of credit creation.
Suppose Mr. A deposits USDl,000 in Bank A. The balance sheet of
Bank A will be as follo,vs:

Bank A: Balance Sheet

. Asset Liability
Cash USDl,000 Deposits USDl,000
 Bank Xs asset is cash of sum USD 1,000 from Mr. A and the :s:
0
liabilities is Mr. Xs deposit of USD 1,000. Bank Xs legal cash reserve is ::s
10%, hence Bank A will keep USD100 (USD 1,000 x 10%) as cash, and �
(1)

the balance of USD900 (USDl,000 x 90%) ,-vill be loaned out to the l:XJ
ll>

-·
::s
public. The balance sheet of Bank A is as follows:
�

Bank A: Balance Sheet

Asset Liability
-

ll>
::s
Cash (10%) USDIOO Deposits USDl,000 Q,
Loan (90%) USD900 ::r
-·::s
(1)
Total USDI,000 Total USDl,000
ll>
Suppose Bank A loans USD900 to Mr. B, and Mr. B pays someone
USD900 who then makes a deposit in Bank B. Assuming there is no -·
::s
n
ll>
leakage, all of the USD900 is deposited in Bank B. The balance sheet
of Bank B is as follows: <rn
....
Bank B: Balance Sheet
Asset Liability
'

Cash USD900 Deposits USD900

Bank B: 10% deposits as cash reserve

90% deposits as loan

Bank B: Balance Sheet

Asset Liability
Cash (10%) USD90 Deposits USD900
Loan (90%) USD810
Total USD900 Total USD900

Bank B loans USD8 lO to Mr. C, and Mr. C pays someone USD8 l0

who then makes a deposit in Bank C. Bank C keeps 10% of reserves
as cash and 90% will be loaned out. The balance sheet of Bank C is as
follows:

Bank C: Balance Sheet

Asset Liability
---
-- ------------ ---- ---- ----- ------- -- - - - --- ---- -----

Cash (10%) USD81 Deposits USD810

Loan (90%) USD729
Total USD810 Total USD810

The process continues until excess reserves equals to zero. We can

sumn1arize the whole process as per Table 12.l.
382

-
-
N Table 12.1 Required Excess Reserves
Expansion of money supply by Bank New Deposits
i.. Reserves (10%) (90%)
4) commercial banks
A 1,000 100 900
B 900 90 810
C 810 81 729
D 729 72.90 656.10
E
F
•

• 0
Total 10,000 1,000 9,000

From Table 12.1, we can formulate an important formula for credit

creation.

Cash reserve
Cash reserve ratio = 100%
Initial deposits
X

1
Money multiplier =
Cash reserve ratio
Total money supply = Money multiplier x Initial deposits
Total reserves = Money multiplier x Initial reserves
Total credit creation = Money n1ultiplier x Initial loan
Or
The amount of money created = Money supply - Initial deposit

SAMPLE QUESTION 12.9

1 If initial deposit= USDl ,000 and cash reserve ratio= 10°/4, find the:
(a) Money multiplier
(b) Total money supply
(c) Total reserves
(d) Amount of money created or total credit creation
2 If initial deposit= USDl ,000 and cash reserve ratio= 5%, find the:
(a) Total money supply
(b) Total credit creation
3 If initial deposit= USDl ,000 and cash reserve ratio= 20%, find the:
(a) Total money supply
(b) Total credit creation
4 Based on 1, 2 and 3, create the relationship between required cash reserve ratio and
total money supply and total creation.
 :s:
0
::s
Solution: (1)

1 (a) Money multiplier=

1
Cash ratio
= ....!...
0.1
=1O
�

l:XJ
ll>
(b) Total money supply (Total money created) -
1
Cash ratio
x Initial deposit
-·
::s
�

= ....!_ x 1,000 = USDl 0,000

0.1 ll>
(c) Total reserves = Money multiplier x Initial reserves ::s
1 C.
=- -x lOO=USDl '000
0.1 ::r
(d) The amount of money created = Money supply - Initial deposit
-·::s
(1)

= USDl 0,000 - USDl,000

= USD9,000 ll>
2 Cash reserve ratio = 5%
(a) Money supply - 1
x Initial deposit
-·
::s
n
ll>
Cash reserve
l x 1,000 = USD20,000 <rn
=
0.05 ....
(1)
(b) Money created = Money supply - Initial deposit
=20,000 - 1,000=USDl 9,000
3 Cash reserve ratio = 20%
1 x Initial deposit
(a) Money supply -
Cash reserve
1
=- - x 1,000=USDS,000
0.2
(b) Money created = Money supply - Initial deposit
= 5,000 - 1,000 = USD4,000
4 If, Cash reserve ratio ,J,, Money supply i and Money created i

---• • • Cash reserve ratio i, Money supply ,J, and Money created ,J,

Limitations of Credit Creation

Although commercial banks have the power to create credit, their
powers are not unlimited. Their power to create credit is liinited by
the factors sum1narized in Figure 12.9:
Figure 12.9
Limitations of Credit Creation Process Limitations of credit creation
process
I
I I I I
Banking Availability
Amount Business
Habits of of
of Cash Conditions
the People Borrowers

Cash Availability Central Bank

Excess
Reserve of Collatera I Monetary
Reserves
Ratio Securities Control
 The factors limiting credit creation as shown in Figure 12.9 1s
further explained here:
I Amount of cash
The power of credit creation depends upon the a1nount of cash
con1mercial banks possess. It depends on the amount of deposits
made by the depositors with the bank. The larger the cash amount
of commercial banks in the form of public deposits, the larger the
amount of credit that can be created by banks, and vice versa.
2 Cash reserve ratio/Legal reserve requirement
All deposits cannot be used for credit creation as banks have to
keep a certain percentage of deposits in cash as reserves. If the
central bank requires co1nmercial banks to increase the cash
reserve ratio or legal reserve requirement, it will reduce credit
creation of banks, and vice versa. Referring to Sample Question
12.9, if cash ratio increases from 5% to 10% and 20%, we notice
that money supply and money created will drop.
Cash ratio ,J, Money supply t and Money created t
Cash ratio t Money supply ,J, and Money created ,J,
3 Banking habits of the people
The banking habits of the people must be well developed to ensure
multiple expansion of credit creation. The loan advanced to a
customer should again come back into banks as deposits by using
cheques for the settlement of transactions.
4 Supply of collateral securities
Collateral securities is a borrower's pledge of specific property
such as land titles or government securities to a lender to secure
repayment of a loan. In lending agreements, collateral serves as
protection for a len,der against a borrower's default. If borrowers
cannot supply collateral security, it can reduce credit creation
since loans are not sanctioned if these securities are not provided.
5 Availability of borrowers
Commercial banks may have enough money to lend, but lending
is limited by the availability of borrowers. If there are no borrowers
to borrow money, there will be no credit creation. If people are
willing to borrow fron1 the banks, then the credit created by banks
will be more.
6 Excess reserves
The banks n1ay decide to 1naintain excess reserves ifthey anticipate
that there will be a significant rise in future interest rates or ,<\'hen
the economy is heading towards a recession. If banks keep more
cash in reserves than the legal reserve requirements, the power to
create credit is lower. The greater the excess reserves, the s1naller
the credit multiplier and credit creation.
7 Currency drain :s:
Currency drain n1eans son1eone who receives cheques, but does 0
::s
not deposit it in their bank account. Instead, they ,.vithdraw the (1)

money in cash for spending or for hoarding a t home. This is

�

l:XJ
viewed as leakages or the outflow of cash in the credit creation ll>

stream of the banking systen1. This cash withdrawal or currency -·

::s
�

drain reduces the capacity of banks to create credit.

8 Business conditions ll>
::s
Credit creation is affected by the cyclical nature of an economy. Q,
During the depression phase, businessmen reduce loans borrowed ::r
fron1 banks due to low profit expectations or lack of new projects,
-·::s
(1)

thus credit creation will be lower. On the other hand, when the
economy is booming, there will be more projects with higher
ll>

profitability. Hence, businessmen will approach the banks for -·

::s
n
ll>
loans and there will be higher credit creation.
9 Central bank monetary control <rn
The central bank monetary policy uses quantitative and qualitative
....
tools such as open market operations, discount rate policy and
varying margin requiren1ents to control the amount of cash
reserves of commercial banks. This will affect the amount of loans
given out and can limit credit creation.

SAMPLE QUESTION 12.9

The data shows the balance sheet of Bank A for the year ended 2015.
I - -- - - - - - - -- -- - -- - -- - - -- - - --- -
Asset Liability I
Cash USD20,000 Deposits USDl00,000
Loans USDS0,000

Total USDl00,000 Total USDl00,000

(a) Define cash reserve ratio and calculate its value.

(b) Based on the cash ratio calculated above, calculate the money multiplier and interpret
your answer. Then, calculate the:
(i) Total money supply
(ii) Total credit created
(c) List two limitations of credit creation.

Solution:
(a) Cash reserve ratio is the percentage of total deposits kept in the bank in the form of cash.

Cash reserve ratio = ( 100,000

2o ooo
, ) x 100
= 0.2 X 100
=20%
 (b) Money multiplier = ....!....
0.2
=5
For every USDl deposit, it will multiply 5 times.
(i) Total money supply = ( 1-) - x 100,000
0.2
= USDS00,000
(ii) Total money created = USDS00,000 - USDl 00,000
= USD400,000
(c) Limitations of credit creation:
• Cash ratio/Legal reserve requirement
• Collateral security
• Central bank monetary control

12.7 ISLAMIC BANKING PRODUCTS

Islamic banking is a banking systen1 based on the principles laid down
Islamic Banking
by Islamic Shari'ah to achieve the goals and objectives of an Islamic
economy. In the late 20th century, there were a number of Islamic
Banki ng system based on the
principles laid down by lsl�mic
Shari'ah to achieve the goals banks formed to apply these principles to private or semi-private
and objectives of an Islamic
comn1ercial institutions within the Muslim com1nunity.
The first Islamic bank in Malaysia, Bank Islam Malaysia Berhad,
economy.

was established in 1983 under the Islamic Banking Act 1983. In

1993, commercial banks, merchant banks and finance companies
were allo"ved to offer Isla1nic banking products and services, but
were required to separate the funds and activities of Islan1ic banking
transactions from the conventional banking business.
In Islamic Shari'ah, the requirements to conduct business affairs
are as follows:
(a) Free from interest-based transactions or fees for loans of money
which is known as riba, or usury.
(b) Free from speculation or gharar. Gharar sale involves speculative
risk such as sales of goods and services which are not yet produced.
Speculation in the forn1 of risk-taking in Islam is still allowed if
the objective of risk-taking is to attain profit and welfare of the
society. However, speculation must not have any elements of riba,
gharar and deceit. Besides, Muslims must not borrow money or
capital for speculation and expose all their assets to an unlimited
interest and risk-taking.
(c) Production relationships are based on the principle of trust,
mutual benefit and cooperation.
 In this section, we will discuss five types of Islainic bai1king :s:
products: 0
::s
I Al-Wadiah (custody and guarantee)
(1)

Islamic banks, for example Bank Islam in Malaysia, mostly use the
�

l:XJ
A l -Wadiah concept to accept deposits from customers. Al-Wadiah
AI-Wadiah ll>

refers to a trust agreement between the owner of the goods or

Goods or deposits which have
been deposited with another -·
::s
�

depositor of the money with the bank as custodian for safekeeping. person or the bank who acts
as custodian for safekeeping.
Al-Wadiah uses the Islamic banking principle of 'Al-Wadiah Yad ll>
::s
Dhamanah' as guaranteed custody. The depositor grants the Q,
bank their permission to utilize the money for "vhatever purpose ::r
permitted by Shari'ah principals. In return, the bank guarantees
-·::s
(1)
"'lj
the return of the whole amount of the deposits without being
damaged, destroyed or stolen when demanded by the depositors.
ll>

Basically, the contract is entered into between lboth parties to -·-

::s
n
ll>
ensure safe custody, thus creating an Al-Wadiah Yad Dhamanah
contract. <rn
Al-Wadiah does not provide the depositors with the right to ....
(1)
receive a share of the profits. Al-Wadiah is based on an interest­ :3
free concept, different fro1n conventional banks. The bank, as
trustee under this guaranteed custody contract, is not allowed
to mention or promise any rewards in the form of profits or
gifts (hibah) on the deposits it receives. Likewise, the depositors
too cannot demand any reward or return from the bank on their
savings placement.
For Al-Wadiah deposits in current accounts, the bank can
mobilize its customers' deposits in current accounts according
to the contract of Al-Wadiah Yad Dhamanah. This is neither
equity financing nor strictly debt financing, but js based on the
combination of two Islamic commercial contracts ,.,hich are Al­
Wadiah (custody or trust) and Al-Dhamanah (guarantee).
For A l -Wadiah deposits in savings accounts, the bank uses
the same contract as the Al-Wadiah current account, with
modification on the payn1ent of profits to be at the absolute
discretion of the bank. This means that the depositors are not
entitled to any share of the profits, but the bank may provide
returns to the depositors as a token of appreciation.
2 A lMudharabah
- (profit-sharing)
Al-Mudharabah savings account is another popular savings
AI-Mudharabah
account offered by Islamic banks. Al-Mudharabah is a profit­ Contract between two parties
sharing contract under the Shari'ah guidelines made bet\.\reen to finance a business venture,
the depositors and the bank, whereby both parties agree to share where the investor solely
provides the capital and the
the profits from investn1ent or business ventures according to a bank alts as an entrepreneur
mutually agreed ratio. Depositors or investors solely provide who solely manages the
the capital and the bank or an entrepreneur solely manages the
project.
project. If the venture is profitable, the profit will be distributed
based on a pre-agreed profit-sharing ratio. However, if there is a

3 Al-Bai Bithaman Ajil (deferred payment sale)
Al-BaiBithaman Ajil
Contract on sa le and purchase
transaction forthe financing
of assets on a defer red and
an instalment basis at a pre­
agreed payment period. The
sale p rice includes a profit
margin.
loss in business, the loss shall be borne solely by the provider of
the capital.
Under the Al-Mudharabah concept, the depositors shall entrust
the bank to utilize the deposits for its financing and investment
activities without any interference. The bank will pay the agreed
profit-sharing ratio from the bank's investinent to the depositors.
However, in certain cases, this profit-sharing ratio may only be
valid for sometime and it will automatically be renewed to another
profit-sharing ratio with the consent of the depositors under an
automatic profit-sharing rene,val arrangement. Multi-tier
profit-sharing ratios are also used for different amounts of capital;
the higher the capital, the higher the profit-sharing ratio. As the
depositors are exposed to risks or losses, the profit rates payable
to Al-Mudharabah savings account are normally higher than
conventional savings deposit rates. For example, the profit-sharing
ratio can be as high as 60:40, meaning 60% for the depositor and
40% for the bank. Ho,-vever, the actual profit ,-vill be known on the
maturity date based! on the prevailing gross rate of return for the
contracted profit-sh.aring ratio.
Al-Bai Bithaman Ajil, a widely adopted Shari'ah principle, is
also kno,-vn as Bay' al Muajjal in Pakistan or Bay' Muazzal in
Bangladesh. A l -Bai Bithaman Ajil means a 'deferred payment sale'.
It is a contract that refers to the sale and purchase transaction for
the financing of assets such as vehicle, land, building, machinery
and equipment or other consumer goods on a deferred and
an instalment basis \>Vith a pre-agreed payment period. A l ­
Bai Bithaman Ajil delivers the co1nmodity i1n1nediately to the
purchaser ,-vhile the payment is postponed until a specified date in
the future or through installn1ents.
Al-Bai Bithaman Ajil is one of the most popular Islamic
financing techniques used in Malaysia that is a substitute to
leasing. The Al-Bai Bithaman Ajil scheme involves the bank
entering into a property purchase agreement ,-vith the customer
to purchase the property from the customer at the purchase
price. This purchasing price is usually the amount of the facility
required by the custon1er. The bank will sell the property back
to the customer according to the property sale agreen1ent at an
agreed selling price, hence the customer gets the asset first and is
required to make payments later, payable in a series of fixed and
predetermined instahnents over the tenure of the facility. The
selling price or the fixed monthly instalments are determined by
the selling price, repayment period and the bank's desired profit
margin. This profit margin is justified under Islamic principles
and does not involve any element of riba or interest, there is no
adjustment n1ade if interest rates fluctuate.
4 A lM- usyarakah (partnership arrangement of profit and loss :s:
sharing) 0
::s
Al-Musyarakah means sharing; it is a partnership arrangement (1)

between tl-vo parties or more to finance a business venture,

�
AI-Musyarakah
Partnership arrangement l:XJ
whereby all parties contribute capital either in the form of cash ll>

or in kind. Any profit derived fro1n the venture will be distributed

between two parties or more
to finance a business venture, -·
::s
�

based on a pre-agreed profit-sharing ratio, while the loss is shared whereby all parties contribute
capital either in the form of
according to the ratio of the contribution. ll>
cash or in kind. ::s
A lM- usyarakah allows each party involved in a business to share Q,
in the profits and risks, and is an ideal alternative to interest-based ::r
financing. The co1nmon features of Al-Musyarakah financing are
-::s·
(1)

as follows:
"'lj

(a) Both partners together raise the joint venture \.Vorking ll>

capital and decide on the working capital contribution ratio

they need prior to com1nencement of business.
-·-
::s
n
ll>

(b) Both partners shall manage the business, but they have the <rn
option to allow the other partner to run or lead the venture ....
by defining the roles and responsibilities of each partner in
(1)
:3
the shareholders' agree1nent.
(c) The profit-sharing ratio has to be decided by both partners
prior to signing the joint venture agreement. However, losses
from this business venture shall be based on actual capital
contributed by each partner.
5 A lIjarah
- (lease or rental)
Al-Ijarah means 'providing services and goods temporarily for a
wage'. This involves providing products or services on a lease or Al-ljarah
Leasing contract, whereby a
rental basis. The A l -Ijarah contract is similar to a conventional
lessor or an ovvner leases out
lease in which the owner rents or leases his property or goods an asset or equipment to his
to a lessee and the lessee is given the right to use the object (the client at an agreed rental fee
for a pre-determined lease
usufruct) for a specified period of time for a fee. The lessee is period.
responsible for normal maintenance ,-vhile the lessor is responsible
for major maintenance.
At the end of the A l Ij - arah agreen1ent, generally the owner
retains the ownership of the assets. However, there are options for
the lessee to return the leased asset to the lessor, to renew the lease
contract for another term or to purchase the leased asset for a pre­
determined price.
Al-Ijarah is different from a conventional lease due to the
follo,-ving features:
(a) The lessor must o,-vn the assets for the full lease period, and
(b) If the lessee delays pay1nents or even defaults on payments,
the lessor cannot charge compound interest.
There are three types of Al-Ijarah according to Shari'ah
principles:
(a) Lease-ending ownership or lease with O\.vnership (ijara wa
iqtina!ijara muntahia bitamleek): The lessee can own the
leased asset at the end of the lease period as the bank may
 offer verbal or unilateral promise of transfer of ownership at
market value of the asset or a negotiated price.
(b) Operating lease (operating ijarah): This type of contract is
a hire arrangement ,-vith the lessor that does not include the
promise to purchase the asset at the end of the contract.
(c) Forward lease (ijarah mawsoofa bil thimma): This is called a
forward leasing contract. It is a con1bination of construction
finance (istisna) and a redeemable leasing agreement. This
lease is executed for a future date as it buys out the whole
project or portions of the project. It is generally used for
construction projects.
The five popular Islamic banking products are summarized in
Table 12.2.

Table 12.2 Product Description

Islamic banking products i
AI-Wadiah (custody Wadiah is a trust. AI-Wadiah means goods or deposits
and guarantee) which have been deposited with another person or
banlk as the custodian for safekeeping. The bank is the
guarantor who guarantees repayment of the whole
amount of the deposit or any outstanding amount into
the account of depositors, when demanded. Depositors
are not entitled to any share of the profits, but the bank
may provide returns to the depositors as a token of
appreciation.

A/-Mudharabah Contract made between two parties to finance a

(profit-sharing) business venture, in which the investor solely provides
the capital and the bank acts as an entrepreneur who
solely manages the project. Profit will be distributed
based on a pre-agreed ratio if the venture is profitable.
However, the loss shall be borne solely by the provider of
the capital.

Al-Bai Bithaman Ajil Contract on sale and purchase transaction for the
(deferred payment financing of assets on deferred and instalment basis at
sale) a pre-agreed payment period. The sale price includes a
profit margin.

AI-Musyarakah Partnership arrangement between two parties or more

(partnership to finance a business venture. All parties contribute
arrangement of capital in the form of cash or in kind for the purpose of
profit-and loss­ financing the business venture. Profit will be distributed
sharing) based on a pre-agreed profit -sharing ratio and loss will
be shared on the basis of equity participation.

A l l- jarah (lease or Leasing contract whereby a lessor or owner leases out an

rental) asset or equipment to his client at an agreed rental fee
for a pre-determined lease period. Lessor is the owner of
the leased equipment.
This chapter started by describing the evolution of n1oney, explaining how
limitations of a barter systen1 had made the role of money prominent. It
examined the characteristics and functions of money. The Keynesian theory
of the demand for money was discussed by differentiating between the
transaction, precautionary and speculative 1notives, ,vhereby creating the
liquidity preference curve. The supply of money is determined by the central
bank and monetary authorities. Money supply can be classified as Ml, M2
and M3. From the demand and supply curve of money, we obtain the market
equilibrium interest rate.
This chapter also shows that the central bank relies on quantitative and
qualitative monetary policy tools to control the money supply for achieving
economic objectives such as price stability or reduction of unemployment
level. Commercial banks play a unique role in the economy because they can
transform a depositor's checkable deposit into money supply through the
credit creation process. Ho,.vever, the ability to create credit depends on excess
reserves and some other factors. This chapter ends by examining the five types
of Islamic products which are popular among the Islamic banking institutions.

• Money is anything that acts as a medium of exchange.

• System of barter refers to the direct exchange of goods and services for
other goods and services without using a medium of exchange, such as
money.
• Commodity money is any item such as cowrie shells, cattle, tea, sheep,
tobacco, etc., which can be used as money.
• Metallic money refers to metals used as money, such as iron, tin, copper,
silver and gold.
• Paper money is a legal tender approved by the government to circulate as
a means of payment such as dollar bills.
• Token money is money which has a lower metallic value than its face value
such as a 50 cent coin.
• Fiat money refers to any item issued by the central bank and declared by
the government as money. It consists of paper money and coins.
• Bank money is money deposited in current accounts or demand deposits.
• Plastic money refers to credit cards or debit cards, which are not money.
• Important characteristics of money: acceptability, durability, divisibility,
portability or transportability, scarcity but not too scarce, and uniformity
or homogeneity.
• Money as a medium of exchange means money is widely accepted as a
1nethod of payn1ent.
• Money as a measure of value and a unit of account means to set prices for
all goods and services in terms of monetary units across the economy.
• Money as a store of value means money enables people to buy and sell at
different tin1es and at different places.
• Money as a standard for deferred payment means money acts as a
standard benchmark for stating future payments for current purchases.
• According to the Keynesian theory of the demand for money, people
de1nand money for transaction motive, precautionary motive and
speculative motive.
• Transaction motive is to demand money as a medium of exchange for
conducting everyday transactions.
• Precautionary motive is to hold money as a precaution against so1ne
unforeseen event, such as paying medical bills, accidents or en1ergencies.
• Speculative motive is to hold money to buy financial assets, such as stocks
and bonds for profitable opportunities.
• Ml is narro"v money and consists of transaction 1noney or 1noney "vhich
can be directly used for transactions.
• M2 is a broader and less liquid definition of the money supply which
consists of Ml and near money.
• Near money is also called quasi-money. Near money is highly liquid
financial assets, such as savings accounts, fixed deposits and negotiable
certificates of deposits in commercial banks.
• M3 is the broadest definition of the supply of money with the lowest
liquidity. M3 consists of M2, savings and fixed deposits, negotiable
certificates of deposits and repurchase agreements in other financial
institutions.
• Money market equilibrium occurs at the intersection of the demand for
money curve and the supply of money curve. At the equilibrium interest
rate, the quantity of 1noney .demanded is equal to the quantity of money
supplied.
• Banking institutions consist of the central bank and commercial banks.
• Non-bank financial institutions consist of finance companies, Islamic
banks, merchant banks and discount houses.
• Non-bank financial intermediaries consist of development financial
institutions and the Employees Provident Fund.
• The central bank is a semi-independent government authority that
provides financial and banking services for governments and the
commercial banking system. It also conducts 1nonetary policy.
• Monetary policy is used to control the supply of money for achieving the :s:
ulti1nate objectives of the econon1ic policy such as price stability or low 0
::s
unemployment. (1)

• Expansionary monetary policy is aimed at increasing money supply for

�

l:XJ
controlling une1nployment during recession.
ll>

• Contractionary monetary policy is ai1ned at decreasing money supply for -·

::s
�

controlling inflation.
• Open market operations mean the central bank buys or sells government
ll>
::s
securities and treasury bills in the open market to influence the size of bank Q,

deposits. ::r
-·::s
(1)
• Reserve ratio requirements is the minimum amount of cash that the "'lj
central bank requires all commercial banks to keep in the central bank. ll>
• The bank rate is the interest rate that the central bank charges on loans of
reserves to com1nercial banks.
-·-
::s
n
ll>
• Fixing margin requirements n1eans varying the proportion of the loan
<rn
amount which is not financed by the bank. ....
• Direct credit controls on bank lending are used to restrict unhealthy :3
expansion of some selective credit.
• Commercial banks are financial institutions which perforn1 the functions
of accepting deposits from the general public and giving loans for
investment with the aim of earning profit.
• Credit creation is a process where a small given deposit will lead to a
greater increase in the n1oney supply of the economy.
• Islamic banking is a banking system based on the principles laid down by
Islamic Shari'ah to achieve the goals and objectives of an Islamic economy.
• Al-Wadiah means goods or deposits which have been deposited with
another person or bank as the custodian for safekeeping.
• Al-Mudharabah is a contract made between tvvo parties to finance a
business venture in which the investor solely provides the capital and the
bank acts as an entrepreneur who solely manages the project.
• A lB- ai Bithaman Ajil is a contract on a sale and purchase transaction for
the financing of assets on deferred and installment basis at a pre-agreed
payment period. The sale price includes a profit margin.
• A lM- usyarakah is a partnership arrangement between two parties or more
to finance a business venture.
• Al-Ijarah is a leasing contract, whereby a lessor or owner leases out an asset
or equipment to his client at an agreed rental fee for a pre-determined lease
period.
 • Money • Precautionary motive • Contractionary monetary
• System of barter • Speculative motive policy
• Commodity money • Ml • Open market operations
• Metallic money • M2 • Reserve ratio
requirements
• Paper money • Near 1noney
• M3 • Bank rate
• Token money
• • Fixing margin
• Fiat money Money market
requirements
• Bank money equilibrium
• Direct credit controls
• Plastic money • Banking institutions
• Commercial banks
• Medium of exchange • Non-bank financial
institutions • Credit creation
• Measure of value
• Non-bank financial • Islan1ic banking
• Store of value
intermediaries • Al-Wadiah
• Standard for deferred
• Central bank • Al-Mudharabah
pay1nent
• Monetary policy • Al-Bai Bithaman Ajil
• Demand for money
• Transaction 1notive • Expansionary monetary • A lM- usyarakah
policy • Al-Ijarah

� Exercises

Multiple-choice Questions
Answer the following questions.

I When money is held as an asset, it functions 3 When the number of goods and services
as a increases, a system of barter becomes
A standard of deferred payment. A easier because chances for double
B medium of exchange. coincidence of wants increases.
C n1easure of value. B harder because chances for double
D store of value. coincidence of wants increases.
C easier because chances for double
2 The use of a dollar bill to buy a burger coincidence of wants decreases.
represents the function of money as D harder because chances for double
A a store of value coincidence of wants decreases.
B a unit of account
C a medium of exchange 4 One reason for people to hold money is
D All of the above to pay for unexpected accidents and other
 emergency expenses. This motive of holding B Ml will fall by USDl,000, while M2 will :s:
1noney is called_ _ _ be unchanged. 0
::s
A transaction motive C Ml will be unchanged and M2 will rise (1)

B emergency motive by USDl,000.

�

l:XJ
C precautionary motive D Both Ml and M2 will increase by ll>
D speculative motive USDl,000. -·
::s
�

5 Which of the following statements is correct? 10 Money used for transactions is known as ll>
A There is a transaction demand for money, ::s
Q,
due to uncertainty about the receipt of A quasi-money
future income. B broad n1oney
::r
-·::s
(1)
B The transaction demand for money is not C Ml "'lj
related to income. D M2 ll>
C Speculative demand for money varies
inversely with interest rate. 11 The central bank should i1nplement -·-
::s
n
ll>
D The precautionary den1and for money contractionary monetary policy to reduce
is affected by the opportunity cost of inflation by <rn
holding Ml balances. A increasing the discount rate. ....
(1)
B decreasing the discount rate. :3
6 Which of the following will lead to an C decreasing the required reserve ratio.
increase in the demand for money? D buying government securities in open
A An increase in the level of national market operations.
income.
B A decrease in the price level. 12 The table shows the balance sheet of Bank
C A decrease in n1oney supply. Welfare. How n1uch is the reserve ratio of the
D An increase in the interest rate. bank?
' Asset Liabilit
7 Which of the following is not part of money Reserves USD1 ,ooo Deposits USD10,000
supply Ml? Loans USD9,000
A Demand deposits A 5%
B Debit cards B 10%
C Fiat money C 20%
D Traveller's cheques D 40%

8 According to the Keynesian theory, a 1 3 Acting to establish an effective monetary

contraction in money supply tends to policy and acting as a banker to the
_ _ _ the interest rate, and_ _ _ commercial bank are two basic functions of
investment, aggregate dema11d, prices, real
GDP and en1ployment. A commercial banks
A decrease;decrease B central banks
B decrease;increase C clearing houses
C increase; decrease D merchant banks
D increase; increase
14 The goal of expansionary monetary policy is
9 Suppose Phillip transfers USDl,000 from A to have an equal distribution of income.
his checking account to his savings account. B to decrease interest rates.
How does this action affect the Ml and M2 C to decrease price levels.
money supplies? D to increase the level of aggregate output.
A Both Ml and M2 v.1ill fall by USDl,000.
15 When bond prices rise, which of the 18 Bank Islam Malaysia (BIMB) provides the
follo"ving falls? following services, except
A Stock price A Al-Mudharabah
B Money demand B Al-Ijarah
C Interest rate C Al-Tahsiniyah
D Money supply D Al-Bai Bithaman Ajil

16 Which of the following can be considered as 19 Which of the follov.ring represents goods or
the component of near money? deposits which have been deposited with the
A Coins and notes bank as custodian for safekeeping?
B Current account deposits with A Al-Wadiah
commercial banks B Al-Murabahah
C Negotiable certificate of deposits in other C A l -Mudharabah
financial institutes D Al-Musyarakah
D All of the above
20 A contract on a sale and purchase
17 A partnership arrangement to finance transaction for the financing of assets on
a business venture, v.rhereby the lender deferred and installment basis at a pre­
does not only provide the capital, but also agreed payment period is represented by
participates in the management, is known as
A Al-Wadiah
A Al-Wadiah B Al-Bai Bithaman Ajil
B Al-Murabahah C Al-Ijarah
C Al-Mudharabah D Al-Musyarakah
D Al-Musyarakah

Short-answer Questions
Answer thefolloiving questions.
1 The table shows the balance sheet of Bank Lakeview for the year ended 2016.
---- - --- -------- - - -- ---

Asset (USD) Liability ( USD)

Cash 850 Initial deposits 5,000
Loans 4,150
Total 5,000 Total 5,000

(a) Define cash ratio and calculate its value.

(b) Calculate the total money supply and total credit created.
(c) Assuming Bank Lakeview v.rishes to hold 3% of the excess reserves, how would this affect
the total money change in money supply? Why?
(d) List two limitations of credit creation.
2 The table shows the money supply for Country Yin the year 2016. :s:
0
::s
(1)
Item USO (Million)
�

l:XJ
Paper money 3,100 ll>

Negotiable certificates of deposits of commercial banks 1,500 -·

::s
�

Bank Negara certificates 2,850

ll>
Fixed deposits and savings deposits at commercial banks 6,750 ::s
Q,
Current deposits in commercial banks 6,850
::r
-::s·
(1)
Fixed deposits and savings deposits in other financial 7,100
institutions
ll>
(a) Assuming that the a1nount of fiat money is USDS,500, calculate the amount of
coins.
-·
::s
n
(b) Calculate Ml, M2 and M3 based on (a).
<rn
3 The table shows the monetary aggregates released by the central bank of Country A for ....
December 2016. (1)

Monetary Aggregate USO (Million)

Currency in circulation 85,000

Coins 32,000
Demand/Current deposits of the private sector 105,000
Savings and deposits in commercial banks 210,000
NCD, repo and BNM cert ificates 198,000
Deposits placed with other banking institutions 18,300

Calculate the value of:

(a) Paper money
(b) Ml
(c) M2
(d) M3
(e) Narrow near money
4 The table shows the money supply in Country ABC for the year 2016.

Item USD (Million)

Current deposits in commercial banks 3,500

Statutory reserves at Bank Negara Malaysia 1,000
Savings deposits in other financial institutions 1,500
Paper money 3,200
New negotiable certificates by other financial institutions 1,800
Fixed deposits in commercial banks 5,500
New negotiable certificates by commercial banks 7,200
Savings deposits in commercial banks 5,000
Fixed deposits in other financial institutions 2,000
Coins 2,500

Calculate the follo,.ving:

(a) Fiat money
(b) Ml, M2 and M3
(c) Broad quasi-money
5 Assuming Bank X receives a deposit of USDS,000 from a customer and faces a required
reserve of 10%:
(a) Show ho"v much Bank X \.vi II lend out on Bank X's balance sheet.
(b) Assun1ing that the loan shown in Bank X's balance sheet is deposited back into
Bank Y, show the changes in Bank Y's balance sheet if it lends out the n1aximum
loan.
(c) Calculate the money created from the USD5,000 initial deposit by using a money
multiplier.
(d) Assuming Bank X and Bank Y wish to hold 3% of the excess reserves, how would
this affect the total change i n money supply?

Essay Questions
Answer the following questions.
I Explain the four functions of money, using appropriate examples.
2 Using appropriate diagrams, discuss three motives for holding money.
3 Define monetary policy, and discuss four instruments of monetary policy that are used
to promote a sustainable economic growth with higher employment.
4 What are four functions of a central bank? Explain.
5 What are four functions of commercial banks? Discuss.
 Public Finance

U2 At the end of this chapter, you should be able to:

• Discuss the concepts of public finance.
� • Discuss the sources of conventional government revenue and
o
'S expenditure.

·e .
• Differentiate between the two types of government expenditures:
g, operating and development expenditures.
Distinguish between the three types of tax structures:
«s progressive, proportional and regressive taxes.
� • Differentiate between the types of government budgets: deficit,
surplus and balanced budgets.
• Discuss the types and roles of fiscal policy.
• Discuss public finance in Islam.
• Describe the sources of Islamic government revenue and
expenditure.
 P ublic finance is the field of economics that studies government
actions and the various ways of financing government
expenditure. In this chapter, we shall first discuss the sources
of government revenue and government expenditures from
conventional perspectives as well as Islamic perspectives. Finally,
we will analyze the policy used by the government to curb the
problems of inflation and unemployment.

13.1 CONCEPTS OF PUBLIC FINANCE

Public finance is the branch of econon1ics that studies the government
activities and the alternative means of financing government
expenditures. The national budget generally reflects the economic
policy of a government, and it is partly through the budget that the
government exercises its three principal methods of establishing
control: the allocation function, the stabilization function, and the
distribution function. In public finance, we will study the government
finances and how the government increases its resources to counter its
increasing expenditure. Thus, to deal ,.,ith the role of the government
in macroeconomics, two concepts of public finance-government
revenue and government expenditure as shown in Figure 13.1-will
be discussed.

Figure 13.1
Public finance
(I) Government revenue Government expenditure
C is money collected by a is often divided into
>
-
(I)
government from various two categories, namely
� Cl
sources. Revenues earned by operating expenditure and 0
C
(I) the government are received development expenditure. 11)
�
from sources such as taxes Operating expenditure ::,
3
-
C
�
>
(I)
levied on the incomes and focuses on the operations 11)
::,
0
\.'.) wealth accumulation of and administration of the 11)
individuals, non-tax revenues government department.
11)
such as fees and penalties,
a.
and n o n -revenue receipts. ;:;:
C
�

13.1.1 Major Functions of Public Finance

Public finance is the branch of economics that studies the roles of the
government in the econo1ny, which involve government revenue and
government expenditure. The three functions of public finance are the
allocation function, distribution function and stabilization function.
I Allocation function "ti
It is the responsibility of the governn1ent to provide for public
-·
C
er
goods. Public goods, such as national defence, government
administration, judiciary law enforcement, public healthcare and
public infrastructures ( e.g. roads), are different from private goods.
-·:s
Public goods are not provided through the n1arket 1nechanism, :s
0
but are essential for consumers and are, therefore, provided by the CD
government. As such, the government has to allocate its resources
between private goods and public goods. Private goods are limited
to an individual or individuals who can afford to purchase them,
whereas public goods are n1ade available for everyone.
2 Distribution function
Through its tax and expenditure policy, the government affects
distribution of personal income of households in a manner which
is just and fair. As such, it taxes the rich and spends on schemes
which will greatly benefit the poor.
3 Stabilization function
The economy of a country is affected by economic fluctuations
such as conditions of boom and depression. Such changes will
benefit some and harm others. In such a situation, appropriate
policy measures are required by the government to affect the
levels of aggregate demand. These measures are called stabilization
1neasures and are aimed at countering situations of inflation and
unen1ployment.

13.2 CONVENTIONAL GOVERNMENT

REVENUES
A main source of government revenue is taxes. However, the
government also receives revenue from other sources besides tax.
The three types of conventional government revenue are tax revenue,
non-tax revenue and non-revenue receipts.

13.2.1 Tax Revenue, Non-tax Revenue and

Non-revenue Receipts
Let us look at the three types of conventional governrn1ent revenue in
detail.
I Tax revenue Direct taxes are taxes where
This revenue source is a compulsory contribution that is imposed the burden or incidence of
by the govern1nent on private individuals and organizations, ,ax falls on the taxpayer and
in order to raise revenue to finance the expenditure on public cannot be shifted to someone
else.
goods and services. Tax revenue is the most important source of
government revenue. It is further divided into two types of taxes,
i.e. direct tax and indirect tax, as explained in Figure 13.2
Indirect taxes are taxes where
'.he burden or incidence of
tax can be shifted to another
person.
-
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Figure 13.2
Government revenue
• Taxes where the burden of the tax falls on the
taxpayer and cannot be shifted to someone else.
co Direct Tax • E.g. individual income tax, company income tax,
.c: petroleum income tax, stamp duty, real property
0 gains tax and road tax.
I
• Taxes where the burden of tax can be shifted to
another person.
Indirect Tax • E.g. export duties, import duties, excise duties,
sales tax and service tax.

2 Non-tax revenue
Non-tax revenues are revenues ,.vhich arise from other sources
besides tax. It includes receipts from licences, regulation fees
and per1nits, services fees, sales of goods, interest and returns on
investment as well as fines.
3 Non-revenue receipts
This category of revenue includes refunds of expenditure,
interdepartmental credit, refunds of overpayment, erroneous
payment, and reimbursement as well as contribution from
governn1ent departments, statutory bodies and government­
o,.vned enterprises.

SAMPLE QUESTION 13.1

What are the components of government revenue?

Solution:
Two main components of government revenue are:
(a) Tax revenue
Tax is a major source of revenue in developed countries. Tax is also the most important
source of revenue for the government and it is a compulsory contribution imposed by the
government on private individuals and organizations. Taxes can be divided into direct tax
and indirect tax.
(i) Direct taxes are taxes where the burden or incidence of tax falls on the taxpayer and
cannot be shihed to someone else. Examples are individual income tax, company
income tax, petroleum income tax, stamp duty, real property gains tax and road
tax.
(ii) Indirect taxes are taxes where the burden or incidence of tax can be shihed to another
person. Examples are export duties, import duties, excise duties, sales tax, service tax
and entertainment tax.
(bl Non-tax revenue
(i) Treasury bills, bonds and loans (iv) Fines and forfeitures
(ii) Income from investment (v) Petroleum and gas royalties
••• (iii) Sales of goods and services
•••
13.3 TYPES OF GOVERNMENT "ti

-·
C
EXPENDITURES er
Government expenditures can be divided into two basic
categories, namely operating expenditure and development
-·:s
expenditure. Figure 13.3 shows a basic distinction between these :s
0,)

0
two expenditures. CD

_, Emo uments Figure 13.3

Government expenditure
- Service charges
Operating
Expenditure: - Debts

- Expenses of operating
and administering
a government
Pensions and gratuities

department - Grants and transfers

- Asset acquisitions
Government
Expenditure
- -I Supplies and services I
Development -I Economic services I
Expenditure:
- Social services
- Expenditure for
investment purposes -
to improve facilities
in the basic physical
- Defence and security
infrastructure
-I General administration
I
I Operating expenditure
Operating expenditure refers to the expenditure of various
government departments necessary to maintain their services.
Examples include emoluments which refers to salaries for civil
servants, service charges, debts, pensions and gratuities, grants
and transfers, asset acquisitions, and supplies and services.
2 Development expenditure Operating expenditure refers
to the expenditure of vari ous
Development expenditure refers to an expenditure related to government departments to
projects that boost economic growth or strengthen the productive maintain ,heir services, while
capacity of the economy. This expenditure is allocated to the development expend,ture
refers to the expenditure
security sector (such as armed forces), social services (such as related to projects that
education), health, and housing and the economic sector (such boost economic growth or
as agriculture and rural development, public utilities, trade and
suengthen the productive
capacity of the economy.
industry, transport and infrastructural facilities).
-
t')
loo
co
.c:
0
A progressive tax is a tax that
increases as income increases.
The higher the taxable income,
the higher the tax rate.
A regressive tax is a tax whose
rate decreases as income ri ses.
A propor tional tax is also
called a flat -tax rate. It is a
tax whose rate is constant by
changes in income. In other
words, the tax rate remains the
same regardless of the level of
income.
Figure 13.4
Progressive t a x
Figure 13.5
Proportional tax
13.4 TYPES OF TAX STRUCTURES
The tax rate structure describes the relationship between the tax
collected during a given accounting period and income.
13.4.1 Progressive, Proportional and
Regressive Taxes
The tax rate structure can be further divided into three, namely
progressive, proportional and regressive taxes. This tax structure
explains the relationship between tax collected and tax base. Tax base,
on the other hand, can be further classified into three main categories,
namely income, consumption and wealth.
I Progressive tax
Tax is imposed, so that the effective tax rate increases as the amount
to which the rate is applied increases. This is where the rate of
tax increases as income increases. It imposes a greater portion
of tax on the higher income group than the lower income group.
This is the most effective ,,vay of redistributing income among the
population. This structure is practised in personal income tax.
Tax rate
2 Proportional tax
The rate of tax remains constant as income changes. An example
is the corporation tax.
Tax rate
3 Regressive tax
In this tax structure, the lower incon1e group �vill bear a higher
proportion of tax than the higher income group. This is where the
rate of tax decreases as the income increases.
 Tax rate Figure 13.6 "ti

-·
Regressive tax C
er

-·:s
:s
0
CD

Calculation of tax rate:

Tax Rate= Total tax x 100%
Income
Table 13.1 Types of tax structure

1,000 6 60 6 60 6 60
2,000 9 180 6 120 5 100
3,000 12 360 6 180 4 120
4,000 15 600 6 240 3 120

SAMPLE QUESTION 13.2

Which of the following countries is implementing regressive tax?

I ,
Income I Country A Country B Country C Country D
I

1,000 200 100 100 100

2,000 200 200 300 160
3,000 200 300 600 180

Solution:
'Country 1Tax Rate Country Tax Rate Country Tax Rate Country Tax Rate
Income
A (%) ; 8 (%) C (%) D (%)

1,000 200 20 100 10 100 10 100 10

2,000 200 10 200 10 300 15 160 8
3,000 200 6.67 300 10 600 20 180 6

Country A= Regressive tax

Country B = Proportional tax
Country C = Progressive tax
Country D = Regressive tax
-
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13.5 TYPES OF GOVERNMENT BUDGETS
A national budget is the budget of a country, ,-vhich is a written
co estimate of anticipated revenues and expenditures during a specific
.c:
0 period of time. Budgeting is the process of estimating the revenue the
government anticipates it will generate and the expenses it will incur.

13.5.1 Budget Deficits, Budget Surpluses and

Balanced Budgets
A government budget is a government paper that indicates the
government's planned revenues and expenditures for a financial year,
and is usually presented! by the Finance Minister of the country.
Government budgets are made up of three types, namely balanced
budget: when government revenue and e.J(penditure are equal, deficit
budget: when anticipated expenditure is greater than revenues, and
surplus budget: ,-vhen anticipated revenues exceed expenditure.
I Budget deficit
Budget deficit is where the government expenditure exceeds its
revenue, (G > T).
Budget deficit is where
government expenditure
exceeds its revenues.
A deficit budget is where the government plans to spend more
than it receives. It can be done by raising government expenditure
or reducing tax. The government ,,vill use this budget when the
economy is in recession. A decrease in tax enables individuals to
have more money in their hands and to spend more.
2 Budget surplus
Budget surplus is where tax revenue exceeds government
expenditure, (G < T).
Budget surplus is where tax
revenues exceed government
expenditure.
The surplus budget "\>Vill be adopted by the government to
overcome inflation. It can be done by raising the tax or reducing
the government expenditure.
3 Balanced budget
A balanced budget policy is where the government expenditure is
equal to its revenue, (G = T).
A balanced budget pol icy
is where government
expenditure equals its
The government will adopt a balanced budget when it does not
want to change the ]evel of econon1ic activities. In other ,vords, the
revenues.

economy is near or has reached full employment. The balanced

budget policy ,-vas advocated by classical economists, such as Adam
Smith, Alfred Marshall and David Ricardo, to stabilize the economy.
However, the balanced budget failed to stabilize the economy; for
instance, during the Great Depression of the 1930s when there was
mass unemployment. Lord John Maynard Keynes refuted the idea of
a balanced budget. A budget should be used to influence economic
activities.
 "ti

-·
SAMPLE QUESTION 13.3 C
er
Differentiate between a surplus budget and a deficit budget.
-·:s
Solution:
:s
0
Surplus Budget (G < T)
CD
A surplus budget is also known as a contractionary fiscal policy. It occurs when government
revenue (T) is greater than government spending (G}. This can be achieved by increasing taxes
and/or decreasing government expenditure.
Deficit Budget (G > T)
A budget deficit or an expansionary fiscal policy occurs when government spending (G) is
greater than government revenue (T). The ways of having a deficit budget are by decreasing
taxes and/or increasing government expenditure, or both.

13.6 FISCAL POLICY

Fiscal policy refers to a policy which affects the aggregate demand by
altering the balance bet\,veen government expenditure and taxation.
Fiscal policy also deals with the govern1nent managen1ent of the
economy by varying the size and type of economy, the type of taxation,
public debt, government expenditure and government revenue.

13.6.1 Types of Fiscal Policy

There are two main types of fiscal policy, namely contractionary
and expansionary. Contractionary fiscal policy aims to reduce
money supply during inflation. This policy requires the government
to delay all govern1nent spending for develop1nent purposes and
to increase taxes. Expansionary fiscal policy, on the other hand, is
aimed at boosting the economy and is often used during an economic Expansionary Fiscal Policy
A policy designed to
downturn, situations of high unemployment rate or other truncated overcome depression and
phases of the business cycle. This policy requires the government to unemployment.
either spend more n1oney or reduce taxes, or both.
I Contractionary fiscal policy
Contractionary fiscal policy is a policy that is used as a
macroeconomic instrument by the country's central bank or
finance ministry to slow down the economy. Contractionary
policies are authorized by a government to decrease the money
supply and eventually, the spending in a country.
Contractionary fiscal policy is the use of government spending,
taxation and transfer payments to shrink the economic output.
When an economy is in a situation where its growth is at a rate that
rampantly causes inflation, contractionary fiscal policy may be used
to bring it to a more sustainable level.
408

-
t')
loo
Contractionary fiscal policy
is impl emented when there
is an inflationary gap; the
co government will decrease
.c: government expenditure and
0 increase taxes to reduce the
aggregate demand.
2 Expansionary fiscal policy
Expansionary fiscal policy is
implemented when there is a
deflationary or recessionary
gap; the government w ill
increase government
expenditure and decrease
taxes to increase aggregate
demand.
If an economy is grovving excessively fast or, for exainple, if
unemployment is too low, an inflationary gap vvill form. It occurs
'\>\Then the actual gross domestic product (GDP) is above its long-run
level. In order to remove this inflationary gap, the government may
need to reduce government spending and increase taxes. A decrease
in government spending will directly decrease the aggregate demand
curve by reducing government demand for goods and services.
Increases in tax levels will also retard growth, as consumers will
have less money to spend and invest, thereby indirectly reducing
the aggregate de1nand curve. In addition, reduction in wages of
government officials will also lead to a decrease in the aggregate
den1and, thus decreasing the price of goods and services, ceteris
paribus.
When an econon1y is in recession or depression, the expansionary
fiscal policy,..,,ill be used to stimulate economic activities. Naturally,
this type of fiscal JPOlicy results in an increase in government
spending and lower taxes. A recessionary or deflationary gap
occurs when the actual GDP is below its long-run level. It shows
that aggregate demand at which the GDP is lower than it would
be in a full employment situation. A government will usually
increase their spending which will directly increase the aggregate
demand in order to close this gap, since government spending
creates den1and for goods and services. The national income will
increase through the multiplier effect.
Simultaneously, the government may decide to lower taxes, which
vvill indirectly increase the aggregate demand curve by allo,<\Ting
consu1ners to have irnore money at hand to spend and invest. This
may result in an increase in production and an expansion in the
economy. The use of this expansionary fiscal policy ,..,,ill result in a
shift of the aggregate demand curve to the right, thus closing the
recessionary gap and pro1noting economic growth.

13.6.2 Roles of Fiscal Policy

Fiscal policy is implemented to counter the effects of booms and
slumps, and to maintain economic stability. It is used to prevent an
economy experiencing a prolonged recession, such as during the
financial crisis in 1997 and 1998 and the debt crisis in 2008. Fiscal
policy can raise the general level of real income and aggregate demand.
In addition, the fiscal policy is also used t o curb inflation, such as
during the oil crisis in the 1970s.
Fiscal policy is in1plemented to smoothen the fluctuations in the
economy associated with the business cycle. This involves reducing
government expenditure or raising taxes ,..,,hen the economy is on the
verge of overheating. Conversely, at the onset of recession, as problems
of unemployment and declining output worsen, the government shall cut
taxes or raise government expenditure to boost its economic activities.
13.7 PUBLIC FINANCE IN ISLAM "ti

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C
er
There is no doubt that an Islamic state has a series of obligations
to perform not only to sustain the state, but also to ensure that the
welfare of its citizens is not compromised. An Islamic state consists of
-·:s
Muslim and non-Muslim citizens and, as such, different kinds of taxes :s
0
are levied on them. The purpose of the imposition of taxes in Islam is CD
for human ,-velfare and for the development of the country, and not to
serve the interest of a particular individual.

13.8 ISLAMIC GOVERNMENT REVENUES

Sources of revenue for an Islamic government includes zakat, al­
fai, jizyah, kharaj, taxation, waqaf, sadaqah and ushur. These will be
discussed further as follows.
1 Zakat
It is the prime source of revenue for an Islamic economy.
Payment of zakat is a religious duty and forms one of the pillars
in Islam. Zakat is collected from a full one-year possession of
wealth ,-vhich reaches to the Nisab. The zakat institution has
a wide-ranging coverage, from sheep and cattle to bonds and
equity shares. The government should establish a proper body
to enable a centralized collection of zakat. In Malaysia, the
Zakat Collection Centre (Pusat Pungutan Zakat or PPZ) under
the Islamic Religious Department (Jabatan Agama Islam) is
responsible for the collection of zakat, with close supervision by
the central fund of the state (Baitulmal).
2 Al-fai
This source of revenue refers to the property or ,-vealth that is
surrendered by non-believers at war, but done so without fighting.
Such property will go to the Baitulmal.
3 Jizyah
The tax imposed on non-Muslims in lieu of the guarantee given
to them by an Islamic state for the protection of their lives and
properties. It is the responsibility of an Islamic government to
protect the lives and properties of the non-Muslims in the san1e
manner as they would protect their Muslim citizens.
4 Kharaj
The tax on land or agricultural land owned by a non-Muslim
in the Islamic state. The tax rate will largely depend on certain
factors, such as the quality of the land, fertility and irrigation
requirements. It should be fixed on the basis of equity to prevent
any injustice towards the farmers. Kharaj was first introduced by
Caliph Umar ibn al-Khatab after he conquered the rich agricultural
countries, such as Iraq and Egypt.
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5 Taxation
The Islamic state has a right to impose taxes, as the Isla1nic
government is responsible for ensuring that the basic needs
co of its citizens are met in accordance ,-vith the socio-economic
.c:
0 status of the country. Taxation is a major source of revenue for
the govern1nent. However, the government needs to ensure that
it does not demotivate the taxpayers from working harder. In
order to be fair and just, the government should minimize the tax
burden on the poor.
6 Waqaf
A property donation by an individual for the use of less fortunate
Muslims, such as orphans and the poor. This usually entails a
donation of a building or a plot of land, or an amount of money,
to Muslims, religious purposes or charitable purposes ""ith no
intention of reclaiming the asset.
7 Sadaqah
Sadaqah (voluntary charity) is derived from the word sidq which
means sincerity of faith from the person who gives it. Thus,
according to the Shari'ah, sadaqah is not compulsory. Instead, it
represents the worshipping of Allah S.W.T. by donating money.
Sadaqah is also not subject to any conditions, or ,-vhere, or how
much (to donate).
8 Ushur
The revenue collected from trade and businesses carried out by all
citizens of the Islamic state, regardless of their religion and beliefs.
Similar to a lfai,
- this revenue will also go to Baitulmal.

13.9 ISLAMIC GOVERNMENT

EXPENDITURES
The public expenditure from an Isla1nic economy can be divided into
three categories. The three expenditures refer to the expenditures on
tasks that are ordained by the Shari'ah, necessary expenditures in the
light of Shari'ah, and expenditures necessitated by the tasks assigned
to the state by the people.
1 Expenditures on tasks ordained by the Shari'ah
The first category of public expenditure in an Islamic economy
encompasses the expenditure on responsibilities, in line with
the Shari'ah. These include defence, law and order, justice,
need fulfilhnent, da'wah and civil administration. Da'wah
is communicating the message of Allah S.WT. to mankind,
enjoining right conduct and forbidding wrong (al amr bi'l ma'ruf
 wa'l nahi 'an al munkar). Resources for the funding of these "ti
expenditures include the income derived from tlhe privatization
-·
C
er
of public property (e.g. oil, gas and electricity), revenue beyond
zakat, and other forms of revenue apart from additional taxes. -·:s
2 Expenditures necessary in the light of the Shari'ah
The second category covers expenditures that are essential for
:s
0
permissible activities in achieving the necessary Islamic objectives.
CD
This is established by ijtihad, i.e. the effort of a jurist to develop a
rule or to reach a judgement, based on the evidence found in the
Islamic sources of law, predo1ninantly the Quran and the Sunnah.
This expenditure includes the protection of the environment,
scientific research, capital formation and expenditures that are
necessitated by the stabilization objective. Additionally, the
government is responsible for assigning public expenditure
towards the medical treatn1ent of illnesses that are caused by
tobacco smoking and for designing educational programmes to
create awareness of the harm of entertainment \"lith non-ethical
values. Islamic expenditure also include the financing of medical
centres that offer free treatn1ent to those suffering from pollution,
as well as research centres that target the development of cleaner,
environmentally-friendly methods of production.
3 Expenditures necessitated by tasks assigned to the state by the
people
The third category of expenditure is for tasks allocated to the state
by the people. It is presumed that the people are willing to pay
for the goods and services involved. A distinctive characteristic of
these tasks is the supply of private goods. The reason why people
so1netin1es assign provision of private goods to the public sector
is because of the economies of large-scale production. There are,
however, other factors to consider before a decision is made.
In the Islamic conception of welfare, the state is responsible for
establishing, maintaining and operating the required public
utilities.
Public utilities, such as clean water supply, electricity and postal
services, are some of the best examples. The Islamic state also spends
on public ,vorks and infrastructure, such as bridges, irrigation canals
and road construction. Public expenditure under this category also
includes building houses for the poor, assisting homeless widows,
helping young men to get married, giving financial support to
scholars and students, funding translation works and establishing
public libraries.
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SAMPLE QUESTION 13.4

Discuss the main sources of government revenue in an Islamic economy.

co
.c:
0 Solution:
Sources of government revenue in an Islamic economy:
• Zakat
, A lfai
-
• Jizyah
• Kharaj
• Taxation
• Waqaf
• Sadaqah
••• • Ushur
•••

Public finance is the study of the government's role in the economy. It is the
branch of economics which assesses government revenue and government
expenditure of public authorities, and the adjustment of one or the other to
achieve the desired objectives and to avoid the undesirable ones. T,,vo main
components that need to be addressed in this chapter are government revenue
and expenditure fro1n the conventional and the Islamic perspectives.
Government revenue comes from taxes (direct and indirect taxes) and non-tax
such as government receipts from sources other than taxes, sale of goods and/
or services, interest and return on investment, licences and permits, service fees,
fines and forfeitures, rental and petroleum royalties. Government expenditure
is divided into operating expenditure which consists of emolu1nents paid
to government servants, debt service charges, pensions and gratuities, and
maintenance, repair works and supplies to improve the provision of public
services and facilities. Development expenditure is allocated to the security sector,
i.e. the replacement of equipment and development of ar1ned forces, the social
services which include education, health and housing, and the econon1ic sector
comprising trade and industry, agriculture and rural development infrastructure.
• The main components of the government budget are government revenue
and government expenditure.
• Government revenue comes from taxes (direct and indirect) and non-tax •
such as government receipts from sources other than taxes.
• Direct taxes are taxes where the burden or incidence of tax falls on the
taxpayers and cannot be shifted to someone else.
• Indirect taxes are taxes where the burden or incidence of the tax can be
shifted to another person.
• Government expenditure is divided into operating expenditure and
development expenditure.
• Development expenditure refers to an expenditure related to projects
that boosts economic growth or strengthens the productive capacity of the
econon1y.
• Operating expenditure refers to the expenditure of various government
departments to maintain their services.
• Three types of budgets: balanced budget, surplus budget and deficit
budget.
• Three types of tax rate structures: progressive, regressive and proportional.
• Government revenue from the Islamic perspectives include zakat, a lfai, -
jizyah, kharaj, taxation, waqaf sadaqah and ushur.

� Key concepts

• Public finance • Fiscal policy • Operating expenditure

• Government • Contractionary fiscal • Progressive tax
• Direct tax policy • Proportional tax
• Indirect tax • Expansionary fiscal • Regressive tax
• Budget deficit policy • Tax revenue
• Budget surplus • Development • Non-tax revenue
expenditure
• Balanced budget • Non-revenue receipt
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Exercises

O Multiple-choice Questions
Answer the following questions.

1 Which of the follov.1ing statements is correct 6 The government controls the problem of
about government budget policy? inflation by imposing a surplus budget. This
A Budget surplus is expansionary in nature is done by_ _ _
and leads to an increase in aggregate A reducing sales tax and increasing
demand. expenditure
B Budget deficit means government B reducing expenditure and income tax
expenditure is less than government simultaneously
revenue. C reducing expenditure and increasing
C A balanced budget is suitable to correct services tax
inflation. D None of the above
D None of the above
7 \,Vhich of the following examples is an
2 A surplus budget occurs when government indirect tax in Malaysia?
expenditures are_ _ _ A Petroleum revenue
A equal to revenues B Corporate or business tax
B less than revenues C Capital gain tax
C greater than revenues D Excise duties tax
D None of the above
8 A budget surplus can be achieved by_ _ _
3 Zahra pays a tax of RM400 on her income of A increasing government development
RM7,000, while Iris pays a tax of RM220 on expenditures
her income of RMS,000. This tax structure is B increasing income taxation
C increasing govern1nent expenditure and
A constant decreasing taxation by the same an1ount
B regressive D open market operation
C progressive
D proportional 9 Based on the following data, we can
conclude that the tax structure is- -
-
4 Fiscal policy includes all of the follov.1ing, Taxable Income ' Total Tax
except (RM) (RM)
A changes in sales tax
B changes in discount rate
1,000 0
C changes in government expenditure 2,000 100
D changes in income tax 3,000 300

5 Which of the following terms is not a source 4,000 600

of revenue for an Isla1nic government? 5,000 1,000
A Hisbah
A horizontal
B Jizyah
B proportional
C A lfai
-
C progressive
D Kharaj
D regressive
10 All of the following sources are non-tax A there is a deflation "ti
revenues, except
A royalties from petroleum and natural
B there is an inflation
C the federal government purchases -·
gas
B receipts from licences, fees and per1nits
exceed net taxes
D aggregate de1nand is greater than
-·:s
C reimbursements and contributions aggregate supply :s
from government departments, CD
statutory bodies or government-owned 16 A constant rate of income tax structure is
enterprises called a
D import duties and excise duties A regressive tax
B progressive tax
11 The two categories of government C proportional tax
expenditure are D rate tax
A economic expenditure and non-
econo1nic expenditure 17 If the government wants to reduce
B operating expenditure and development unemployment, government spending
expenditure should be
C public expenditure and private A decreased
expenditure B increased
D transaction expenditure and C constant
precautionary expenditure D None of the above

12 The tax structure, whereby the wealthy pay 18 When government expenditure is greater
a smaller percentage of their income as tax than revenue, the budget is considered a
compared to the poor, is known as
A proportional tax A maximum budget
B progressive tax B minimum budget
C regressive tax C deficit budget
D flat tax D surplus budget

13 All of the following are sources of 19 \i\'hich of the following revenues is not a
government revenue, except source of government revenue from an
A corporate income tax Islamic perspective?
B transfer payments A Donation
C loans from the World Bank B Property gained from non-Muslims
D court fines C Property gained during wars
D Fees
14 Which of the follo,-ving products is not an
Islamic financial product? 20 The government reduced the personal
A Al-Mudharabah income tax rates to encourage
B Al-Musyarakah household spending. This is an example
C Al-Ijarah of _ __
D Al-Falah A a monetary policy
B an income policy
15 A federal budget deficit occurs when C a fiscal policy
D an inflationary policy
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Short-answer Questions
Answer thefollowing questions.
1 Determine the tax structure adopted by each country below.
co
.c:
0 Income Level 10,000 12,000 14,000

Tax Rate 1,250 1,500 1,750

Income Level 8,000 10,000 12,000

Tax Rate 720 1,440 2,400

2 The table shows the government spending and tax revenue for a hypothetical economy
over a five-year period. All figures are in billion.

Year Government Spending (RM) Tax Revenues (RM)

I
2012 800 825
2013 850 850
2014 900 875
2015 950 900
2016 1,000 925

(a) In which years were there budget deficits and what ,-vere the amounts?
(b) In which year was there a budget surplus and what was the amount?
(c) What is the total amount of public debt in this economy over the five-year
period?
3 The table shows the total taxes paid by individuals in Austria and Uganda at different
income levels.
Income Level (USD) 2,000 3,000 4,000 5,000

Tax Paid (USD) 80 210 360 500

Tax Rate

Income Level (USD) 8,000 11,000 12,000 15,000

Tax Paid (USD) 480 660 720 900

Tax Rate

(a) Calculate the tax rate for each country at every income level.
(b) Determine the tax rate structure adopted by each country.
4 The table shows the total taxes paid by three individuals at different income levels. "ti

-·
C
er
-·:s
6,000 300 300 360 :s
0
8,000 560 400 400
CD
10,000 800 500 400
12,000 1,080 600 360

(a) Calculate the tax rate ,-vhen the total income ils RM8,000 for the three individuals.
(b) Identify and explain the type of tax rate structure for each individual.
(c) State three examples of direct tax.
5 The table shows the total taxes paid by individuals from three countries at different
income levels.

7,000 140 210 210

8,000 160 320 160
9,000 180 540 90

(a) Calculate the tax rate for each country.

(b) Deter1nine the tax structure with the help of diagrams.

Essay Questions
Answer thefollowing questions.
1 What are the n1ain sources of government expenditure? Discuss.
2 Distinguish between a surplus budget and a deficit budget.
3 What are the differences between jizyah and kharaj? Explain.
4 With the aid of diagran1s, explain the three types of tax structure.
5 What are three main expenditures fron1 an Islamic econon1ic perspective? Discuss.
Macroeconomic
Problems
U2 At the end of this chapter, you should be able to:
• Define and measure inflation.
0 • Differentiate the three types of inflation.
u
::s • Explain the effects of and measures available to control inflation.
0
0'> • Define and measure unemployment.
.5 • Differentiate the types of unemployment and measures available
� to control unen1ployment.
• Discuss the effects of unemployment.
�
• Interpret the relationship between inflation and unemployment.

Inflation
A persistent and sustained
increase in the aggregate or
average pri ce level of goods
and services in an economy.
Inflation is measured by the
consumer pric e index (CPI)
data over a period of months
or years.
Four Stages of Calculating
CPI
1 Selecting a base year that
everything gets compared to
2 Selecting the CPI basket of
goods and services
3 Conducting the monthly
prices of selected goods
4 Giving weightage of relative
importance for each category
of goods and services
I nflation and unemployment are the two major macroeconomic
problems in the economy. These two issues are closely related in
the short run.
In this chapter, we will first discuss inflation, followed by
unemployment. Finally, we will analyze the trade-off between
inflation and unemployment.
14.1 INFLATION
Inflation is defined as a persistent and sustained increase in the
aggregate or average price level of goods and services in an economy.
An inflation implies that there is an increase in the cost of living
that causes lower purchasing power. It is a situation where there is
'too much money chasing too fev,r goods'. There is, thus, an inverse
relationship between inflation and the value of money. When inflation
is high, the value of money "''ill be lower, and vice versa. With inflation,
there is a loss ofthe value of a currency because the consumers' money
now ,.vill not buy as much today as it could yesterday.
14.1.1 Measuring Inflation
Inflation is measured by the consumer price index (CPI) data over a
period of months or years. The CPI is also known as the cost of living
index because it measures changes in the average price of consumer
goods and services. An increase in this cost is called inflation and a
decrease in this cost is called deflation. Hence, CPI will tell you what
has happened to the value of money that you hold.
Calculating the Consumer Price Index
Calculating the CPI involves four stages of a huge operation, as
explained below:
I Selecting a base year that everything gets compared to
Assuming that the base year is 2010, whereby this is the reference
base year as the benchmark against which other years are
compared. The CPI for base year is defined to equal to 100 (i.e.
2010 = 100). The base year must be a normal year where the
economy and prices are stable.
Table 14.1 shows that the CPI has increased to 112.3 in May 2015
and 113.0 in June 2015 co1npared to year 2010.
 Table 14.1
Year Consumer Price Index
I Base year for consumer price
index 0
..,
201 O (base year) 100.0 0
(I)
September 2014 110.7 0
0
October 2014 111.3 ::s

-·
0
November2014 111.9

.,,..,
December2014 111.8 0

Januar y 2015 110.6

0
Februar y 2015 109.9 t:r
(I)
March 2015 110.9
April2015 111.9
May2015 112.3
June2015 113.0

Source: Adapted from the Monthly Statistical Bulletin, Bank Negara Malaysia, July
2015.

2 Selecting the CPI basket of goods and services

The Bureau of Statistics will choose a representative fixed 'basket' of
typical consumption on goods and services of a general household
such as food, shelter, furniture, clothing, medical, transportation
and recreation to construct a CPI. This 'basket of goods' is viewed
every year by adding or ren1oving some items in the basket to
reflect the changes in the market and to ensure that the indices are
up to date and represent consumer spending patterns.
The Bureau ofLabour Statistics in the United States categorized
expenditure items into n1ore than 200 categories and arranged
them into eight major groups, as follows:

Major Group '

I Category
I
1 Food and beverages breakfast cereal, milk, coffee, chicken, wine, full
service meals, snacks
2 Housing rent of primary residence, owners' equivalent rent,
fuel oil, bedroom furniture
3 Apparel men's shirts and sweaters, women's dresses, jewellery
4 Transportation new vehicles, airline fares, gasoline, motor vehicle
insurance
S Medical care prescription drugs and medical supplies, physicians'
services, eyeglasses and eye care, hospital services
6 Recreation televisions, toys, pets and pet products, sports
equipment, admissions
7 Education and college tuition, postage, telephone s•ervices,
communication computer software and accessories
8 Other goods and tobacco and smoking products, haircuts and other
services personal services, funeral expenses
 3 Conducting the monthly prices of selected goods
The Bureau of Statistics will survey prices of selected goods from
reliable sources. The economic assistants will visit or call thousands
of retail stores, service establishments and rental units throughout
the country to obtain information on the prices of thousands of
selected items used! to track and measure price changes in the
CPI. They will then record the prices of each item every month
to send to the commodity specialists to check for data accuracy
and consistency. The prices recorded must record the details of
changes in quality or packaging, so that price changes can be
isolated fron1 other changes.
To illustrate the method of constructing a simple CPI, we
assume that there are only three items in the basket of goods that
consumers have purchased as shown i11 Table 14.2. The basket is
valued at the base year of 2010 and the san1e basket of goods will
be valued at the current year and current price of 2016. Notice
that only the prices in this calculation will change and quantity
purchased remains the same. The purpose is to isolate the effects
of the changes in price change from the effect of the changes in
quantity that may occur at the san1e time.
To calculate the simple CPI, let us:
(a) find the cost of the CPI basket at base period prices. The base
year is 2010.
(b) find the cost of the CPI basket at current period prices. The
current year is 2016.
(c) calculate the CPI for the base period and current period
using this formula:
Cost of CPI basket at
current year price
Simple Consumer Price Index = ----�-�--- x 100%
Cost of CPI basket at
base year price

Table 14.2
Products in
I (3) (5)
Simple consumer price index (1) (2) Market (4) I Market
Consumer
Quantity Price in Basket Cost Price in , Basket Cost
Market
Purchased 2010 in 2010 2016 in 2016
Basket
1(1) X (2)] 1(1) X (4)]

Bread so USD1 USDSO USD2 USD100

Gallons of 250 USD0.90 USD225 USD1.20 USD300
gasoline
Shirt 2 USD15 USD30 USD30 USD60
Cost of Cost of
CPI basket CPI basket
in 2010 in 2016
= US0305 =US0460
 USD305 x
CPI in 2010 = 100% = 100
USD305 0
..,
460
0
CPI in 2016 = x 100% = 150.82
(I)

305
0
0
::s
Hence, the price level has increased from 100 to 150.82 from
-·
0
the base year of 2010 to the current year of 2016. It has increased
by 50.82%. .,,..,
0

4 Giving ,veightage of relative importance for each category of 0

goods and services
t:r

Weightage is used to 1neasure the relative importance of the items

(I)

in the CPI baskets, depending on the amount of money spent by

the consumer. The highest weightage shov.rs the most important
commodity for the consumer, and vice versa.
A weighted CPI measures changes in the average prices of a
'market basket of goods and services' purchased by a typical urban
household, taking into account the importance of certain goods
and services relative to others.
In Australia, changes in the weighting pattern have been made at
about six yearly intervals to take into account changes in household
spending patter ns. Malaysia's CPI report is divided into 12 groups
,vhich consists of about 460 itemized goods and services. Table
14.3 sho,vs the CPI table released by the Depart1nent of Statistics
Malaysia with weights assigned to each of the 12 groups.

Group
'
Weightage Feb 2014 Jan 2015 Feb 2015 Table 14.3
, Consumer price index for main
groups, Malaysia (201 O = 100)
Total 100.0 109.8 110.6 109.9
Food & non-alcoholic 30.3 114.4 117.7 117.5
beverages
Alcoholic beverages & 2.2 121.7 134.6 134.6
tobacco
Clothing & footwear 3.4 98.8 98.6 98.2
Housing, water, electricity, 22.6 108.0 109.6 110.6
gas & other fuels
Furnishings, household 4.1 106.5 106.8 106.6
equipment & routine
household maintenance
Health 1.3 108.4 111.7 112.1
Transport 14.9 111.1 104.2 98.0
Communication 5.7 98.1 97.2 97.2
Recreation services & culture 4.6 104.9 105.3 105.7
Education 1.4 109.3 111.1 111.7
Restaurants & hotels 3.2 115.4 118.6 118.8
Miscellaneous goods & 6.3 105.0 106.2 106.7
services

Source: Department of Statistics Malaysia, 20 March 2015

 Let us look at the following example:
The table shows the information on a basket of goods for an
economy in years 2010 and 2015. Year 2010 is assumed to be the
base year.
For (a) to (e), calculate the:
(a) Simple consu1ner price index without weightage for year
2015.
(b) Weighted consumer price index for years 2010 and 2015.
(c) Rate of inflation between the two years.
(d) Real value of money for year 2015. What is the real value of
RMl,000 for this year?
(e) Change in the value of money from years 2010 to 2015, and
determine whether the value of money has increased or
decreased during this period.
(f) If the consumers' incon1e have increased by 10% in 2015,
what happens to the cost of living during the period? Justify
your answer.

Prices Prices I Weighted

Weightage: 201S Index
Item in 2010 in 201S Price Index
(3) (4) = :�: 100% (S) = (4) X (3)
X
(1 ) (2)
__

Housing 500 1,000 3 lS��O X 100 = 200 200 X 3 = 600

120 X
Transport 150 120 2 100 = 80 80x2=160
150
80
Food so 80 4
so
X 1 00 = 160 160 X 4 =64 0

300
Healthcare 150 3 00 1.2 X 100= 20 0 200 X 1.2 = 2 40
150
640 1,640
Total 10.2 = 160 = 160.78
4 10.2

(a) Simple consumer price index without weightage for year

2015
Current year price
Current Year Price Index = x 100
Base year price
Current year index of all items
Simple CPI=
Number of items
200 + 80 + 160 + 200
4
640
- --= 160%

Hence, the general price level has increased by 60% from the
base year of 2010 to current year of 2015. All items in the
above table show that all costs of the items have increased,
except for the cost of transport which has decreased to 80%.
(b) vVeighted consumer price index for years 2010 and 2015
Sum of all weighted price index
Weighted CPI= 0
Total weights
..,
0
Weighted consumers price index (CPI) for years 2010 (base
(I)
0
0
year)= 100 ::s
600 + 16 0 + 640 + 200
-·
0
Weighted CPI for year 2015=
10.2
.,,..,
0

1'640
- = 16 0 .78% 0
10.2 t:r

(c) Rate of inflation between the two years

(I)

We can use CPI to measure the rate of inflation, i.e. the

percentage of price change from one year to another using
this formula:
. -CPI previous year
CPI current year
Inflahon =- - - ----' - '--- - ----''---- - --'- - x 100%
CPI previous year
-A)/A) x 100%
Inflation= ((B
where, A= CPI in previous year
B= CPI in current year
160.78 - 100
The rate of inflation=- ---- x 100%= 60.78%
100
The inflation rate is extremely high, with a rapid increase
rate of 6 0.78 in general price level, indicating an extremely
high cost of living.
(d) Real value of money for year 2015
The CPI is also used to calculate real value of money and
the changes in the value of money. If the CPI has increased,
then the value of money has decreased, and vice versa.
Base year index
Real Value of Money=- - ---'-- - - - x 100%
Current year CPI
100
Real Value of Money=- - -x 100% = 62.20%
160.78
RMl,000 in year 2015= RM622 in year 2010
(e) Change in the value of money from years 2010 to 2 015
Base year index
Change in Value of Money= -[ -�--- - -1] x 100%
Current year CPI
100
-- - - -1 X 100%=-37.8%
160.78
The value of money has decreased to 37.8%.
(f) An increase in income by 10% is not enough to cover the
increase in price. Cost of living is still high because the value
of 1noney has dropped to 37.8%, a decrease of n1ore than
10% in income.
 SAMPLE QUESTION 14.1

The table shows the price index for the year 2015, with 2011 as the base year.

Good . Price Index 2011 I Price Index 201 S Weight

A 100 130 2
B 100 113.5 2
C 100 98 4
D 100 140 1
E 100 150 3

(a) Calculate the weighted consumer price index (CPI) for every good in the current year.
(bl Calculate the weighted consumer price index (CPI) for the current year.
(c) Based on (b) above, what is the problem faced by this economy? Calculate the percentage
change in the general price level of the current year.
(d) Calculate the real value of money in the current year.
(e) What will happen to the value of money in the current year? Why?

Solution:
(a) Goods A= 260, B= 227, C = 392, D = 140, E = 450
(b) Weighted Consumer Price Index (CPI) for the current year
_ (130 X 2) + (113.5 X 2) + (98 X 4) + (140 X 1) + (150 X 3) = _122_42%
12
(c) Problem of inflation
= 122·42 - 1OO x 100%
(d) Percentage Change in the General Price Level
100
= 22.42%
lOO X 100% = 81.69%
(e)
122.42
(f) Value of money has decreased due to inflation. The value of RM100 in the base year
of 2012 is only worth RM81.69 in the current year.

14.1.2 Various Degree of Inflation

Six Types ofInflation Inflation is a rise in the general level of prices of goods and services
(categorized by speed) over a period of time. lit refers to any increase, ho,-vever big or small.
1 Creeping In this section, ,-ve will discuss various degree of inflation based on
2 Walking
3 Running rising price or rate of inflation. There are six main types of inflation,
4 Galloping categorized by their speed: creeping, walking, running, galloping,
S Hyperinflation hyperinflation and stagflation (see Figure 14.1).
6 Stagflation
Creeping inflation is inflation that rises gradually, but continually
over time. Creeping inflation is still low by normal standards. When
price rises by 2% or less, it actually stimulates economic growth :1::
because this mild inflation increases demand owing to consumers' 0,)
0
tendency to buy more before prices increase. Although the rate of ..,
0
increase in prices is relatively small in the short term, but if it persists (I)
0
over time, the effect ,-vill become more significant as it increases the 0
::s
cost of living in the long run. Hence, relevant government agency has
-·
0
to keep an eye on creeping inflation to ensure that wages are increased
:3
.,,..,
0
in tandem with price increase.
Walking and running inflations are harmful to the economy as they
heat up economic growth too fast. \,Vhen people start to buy 1nore -
0
t:r

than they need to avoid ton1orrow's n1uch higher prices, it drives

(I)
:3
rn
demand and prices even higher that the supply and ,-vages cannot
keep up. This in turn, will drive demand even further as suppliers are
unable to meet the demand. More importantly, neither can wages. As
a result, co1n1non goods and services are priced out of the reach of
most people.

Stagflation/
Slumpflation
• High rates
of inflation
combined
with high
unemployment
and stagnant
economic
growth.
• This occurred in
the UK and the
US in the 1970s
to early 1980s.

Figure 14.1 Degree of inflation categorized by their speed

 Galloping inflation is a serious concern as money has lost its value
so fast that business and employees' income cannot keep up with the
costs and prices. This will discourage foreign investors from investing
in the country, leading to instability in the economy.
Hyperinflation will create absolute havoc to the economy as money
co1npletely becomes valueless. It happened in Zi1nbabwe between 2004
and 2009 because the government printed money to pay for the war in
Congo. The inflation rate was 98% a day and prices doubled up every 24
hours, causing people to accept only foreign currencies instead of the
Zimbabwe dollar. Hyperinflations are normally unsustainable and short­
lived. It occurs during a political crisis when the government has lost its
control of the economy and starts to print money to pay debts.
Stagflation is "vhen the economy experiences stagnant economic
growth, high unemployment with high inflation. It happened in the
1970s when the United States Federal government manipulated its
currency to spur economic growth, but restricted supply ,.,ith wage­
price controls.

14.1.3 Types and Causes of Inflation

The n1odern economic theory categorized three n1ain causes of
inflation as: demand-pull inflation, cost-push inflation and
monetary inflation.
I Demand-pull inflation
Demand-pull inflation occurs
The demand-pull inflation is caused by an increase in the aggregate
when the aggregate demand demand and the cost push is due to the increase in the cost of
(AD) exceeds the aggregate production while the monetary inflation is caused by increase in
the supply of money.
supply (AS).

Keynes adapted his theory of how excess demand can cause

inflation in fully employed economy at the beginning of the
World War II. He stated that the demand-pull inflation occurs
when aggregate demand (AD) exceeds the aggregate supply (AS).
As AD = C + I + G + (X - M), any increase of these variables will
cause aggregate de1nand to rise. For exan1ple, a rise in consumer
demand (C), or a rise in investment by firms (I) or an increase in
government expenditure ( G) or a rise in net exports (X - M) from
foreign countries or any combination of the four components will
shift the AD curve to the right as sho"vn by Figure 14.2. For example,
with a reduction in income tax, it \.vill cause consumption ( C) to
rise, a fall in interest rate induces investment (I) while a reduction in
exchange rate encourages more net export (X- M). Hence, all these
economic variables will also stimulate the rise of AD . Among these,
the most important factor is an increase in govern1nent expenditure
(G) as it has direct multiplier effect on AD.
According to Keynesian, there are three stages occurred in
economy. In Figure 14.2, when the economy is in a recessionary
stage, aggregate supply curve is horizontal. Assuming the initial
aggregate demand is at AD0 and aggregate supply is horizontal
supply curve. Hence, when AD increases from AD1 to AD2, AD2
 i11tersects with horizontal AS at the equilibrium price of PO and :1::
the new equilibrium output of Q2• Price still remains at PO because 0,)
0
factors of production are still available in the economy. The ..,
0
rightward shift of AD from AD1 to AD2 only results in the rise of (I)
0
output from Q 1 to Q2 ,.vithout any price increase. 0
::s
At the second phase of the economy, when there is less idle
-·
0
resource with decreased unemployment, the AS curve is shaped
.,,..,
0
as upward sloping, refers as normal AS curve. Hence, referring to
Figure 14.2, if AD2 shifts up,.vards to AD3• then the price will begin 0
to rise slowly from P0 to P1, output increases to Q2 • If AD increase
t:r

further to AD4 , the price level ,.vill increase to P2 and output increases
(I)

to Q3• Inflation at this phase is mild and creeping. It is in the normal

economy range.
At the third phase of the economy when AS is vertical and
constant at full-e1nploy1nent output, a rightward shift of AD to AD5
causes the price level to increase rapidly to P3• A further increase
of AD to AD6 again causes the price level to increase substantially
to P4• Notice here that output still remains constant at Yr because
resources are fully employed. When industries cannot respond
to changes in AD, price will begin to rise rapidly. This is called
demand-pull inflation as the excess demand will pull the prices up
causing demand-pull inflation. Hence, the demand-pull inflation
is associated with booming econo1ny. The essence of de1nand-pull
inflation is that 'too much spending chasing too few goods:
General price Figure 14.2
AS Demand-pull inflation

P3

P2
ADs
P1
Po AD4

1 If AD, ➔ AD, (in recessionary stage) ⇒ Output t, unemployment J.. There is no

effect on price.
2 If AD3 ➔ AD. (when there is less idle resources and a decrease in unemployment),
price begin to rise slowly. Inflation is mild and creeping.
3 If AD5 ➔ AD6 (in full-employment stage), industries cannot respond to changes in
AD, thus price will begin to rise rapidly. Hence, demand-pull inflation is associated
with a booming economy.
 2 Cost-push inflation
Cost-push inflation occurs
when an increase in the cost
ofproduction decreases the
aggregate supply, resul ting in
a price increase.
Causes of a Decrease in
Aggregate Supply
1 Increase in \"iages
(wage-push inflation)
2 Increase in import prices
(import-push inflation)
3 Exhaustion of natural
resources or natural disasters
4 Fall in exchange rates
5 Increase in government
regulation or taxation
6 Increase in supplier profit
(profit-push inflation)
Alternatively, inflation can also rise fro1n a decrease in aggregate
supply. This is called the cost-pull inflation. Cost-push inflation
occurs when a shortage of supply of labour, shortage of ra,.v
materials, crop failures or capital drives up the cost of production
and decreases aggregate supply, thereby raising the price level.
Aggregate demand still remains the same, but since there are fewer
goods or services, the supplier can charge more for each unit.
Price increases even before full employment is reached, results
in 'supply shock' inflation. This is because the increases in the costs
of production are passed onto the consun1ers in the form of higher
prices. Cost-push inflation can only occur if demand for the end
product or service is inelastic, such as gasoline, because people
cannot find other substitute goods to replace it. If the demand is
elastic, then people will either buy less of the product or s,vitch to
other cheaper goods.
Cost-push inflation is shown in Figure 14.3, ,.vhere a leftward
shift of the aggregate supply raises the price level. The various
factors that cause the leftward shift in the aggregate supply are as
follows:
(a) Wage costs (,vage-push inflation)
Cost-push inflation is due to wage increases that cause
businesses to raise output prices to cover higher labour costs.
Higher output prices in turn will lead to a higher demand
for even higher wages. This process is called the wage-price
spiral.
The increase in wage level may be due to the negotiation
of a strong trade union, for wage increases higher than the
current inflation rate or the firm itself has increased the
wage level to prevent their ,.vorkers from moving to other
firms. If wages increase more than productivity, the costs of
production will rise, causi11g the aggregate supply to decrease
and fueling inflation or output prices.
In view of this, the government should use prices and
incomes policies to limit the freedom of trade unions to
raise wages and employers to raise prices.
(b) Import prices (import-push inflation)
Import-push inflation is caused by an increase in the prices
of imported raw materials, intermediate goods or final
goods and services. With globalization, many firms import a
significant proportion of their raw materials or semi-finished
products. If the import prices increase, then firms will be
forced to increase prices to pay for higher raw material costs.
For example, the direct relationship betv.reen oil price
and inflation was evident in the 1970s. When the oil
 price rose fro1n USD3 before the 1973 oil crisis to USD40
during the 1979 oil crisis, it caused the cost of production 0
to rise substantially. This is because oil is a major input in ..,
0
the economy in critical activities such as transportation, (I)
0
manufacturing and heating. If oil price rises, it ,.vill cost more 0
::s
to produce end products, the firm will then pass on son1e
-·
0
or all of this cost to the consumer, which raises prices and
.,,..,
0
thus cause inflation. The extent to ,.vhich oil price increases
lead to inflation depends on ho,.v important the oil is for the 0
production of a given type of goods or services. However,
t:r

the strong relationship between oil prices and inflation that

(I)

was seen in the 1970s has weakened significantly after the

1980s. After the 1980s, despite the rapid oil price run-up, the
CPI remained relatively stable.
(c) Exhaustion of natural resources or natural disasters
If a main resource became scarce, the aggregate supply curve
will shift to the left and price will increase. For example,
overfishing has caused the price of many types of fish
and fish-based products to rise higher each year. Another
example is the erosion of land that has caused agricultural
prices to rise.
(d) Fall in exchange rates
A fall in the external value of a country's currency will
worsen inflation as lower exchange rate wil1 cause imports
to become more expensive. Hence, firms ,-vill have to pay
more for their imported ra,.v materials or machinery. This
will increase the cost of production and result in a cost-push
inflation.
(e) Government regulation or taxation (tax-push inflation)
Producers are allo,.ved to pass on the increases in indirect
taxes (taxes on expenditures) to the consumers and this
will push up the selling price of products in the shops. For
example, taxes on unhealthy products such as cigarettes and
alcohol ,.vhich were meant to lo,.ver the demand for these
goods, can also raise the prices of these products and create
inflation.
(f) Increases in supplier profit (profit-push inflation)
Cost-push inflation occurs when firms gain more power
and are able to push up prices to make larger profits. The
profit-push inflation happens when markets become more
concentrated and move towards monopoly or oligopoly
power. It occurs when firms stock up on goods and create an
artificial shortage to increase the price of goods in order to
earn higher profits.
 Figure 14.3
Cost-push inflation
3 Monetary inflation
Monetary inflation is caused
by an expansion of money
supply. Money supply increases
through the expansionary
fiscal policy or expansionary
monetary policy.
Price level LRAS
SRAS0
'
'
. -- . - . ...' - --- --
''
AD0
� �
- - - � -- - -- Real national income
- �
Y1 Y 0 Y1
Figure 14.3 shows that the econo1ny is at the normal
range of short-run aggregate supply, with the SRA$ curve
sloping upwards. It is at the second phase of the Keynesian
economy where full employment, Yf, is yet to be achieved.
The initial economy is at SRAS0 intersecting with AD0, with
the equilibritun price of P0 and real output of Y0. When
there is a cost-push inflation due to the increases of costs of
production, the short-run aggregate supply curve ,.,ill shift
leftwards from SRAS0 to SRAS 1, hence pushing the price
level up to P1 and reducing the real output to Y1•
A third cause of inflation is an over-expansion of the money
supply called the monetary inflation. Monetary inflation is a
sustained increase in the money supply of a country, resulting in
price inflation. Money supply increases through an expansionary
fiscal policy or expansionary monetary policy.
The expansionary fiscal policy is executed by the Federal
government through either deficit spending or printing of more
cash or coins to cover its deficits, inefficiency, corruption or
n1ismanagement of the economy. Expansionary fiscal policy
pumps more money into the economy, creating monetary inflation.
Meanwhile, expansionary monetary policy is executed by the
monetary authorities and central bank. By using the instruments
of monetary policy as discussed in Chapter 12, it expands the
money supply. One of the instrument is to lower the required
reserve ratio, which is the amount of reserve that the banks must
keep on hand at the end of each day. The less the required reserve
commercial banks have to keep, the n1ore they can lend. The act of
the central bank to lower the interest rates also allo,.,s borro,.,ers
to take out a bigger loan for the same overall cost. Hence, ,.,hen
loans are cheap and easy to obtain, people can borrov,r for virtually
nothing. Then there ,viii be too much money chasing too few
goods, creating inflation, even though neither demand nor supply
has changed.
 Quantity theory of money as explained by the monetarist states
that there is a direct relationship between the growth of the money 0
supply and inflation: ..,
0
(I)
MV=PT 0
0
where, ::s

-·
0
M = Money supply
V = Velocity of circulation or the average number of times each
.,,..,
0
dollar bill is spent
P = Price level
0
t:r
T = Transactions or outputs (I)

Monetarists assume that V and T are fixed and determined in

the long run by the productive capacity of the economy. Hence,
when there is an increase in the money supply (M), the price
level (P) will also increase. Over-expansion of the money supply
has a direct impact on inflation.
As such, v•1e can conclude that there is not only one particular
factor to be held responsible for a price rise; infllation is in fact
caused by the interplay of the various factors discussed above.

SAMPLE QUESTION 14.2

Using suitable diagrams, explain the differences between demand-pull inflation and cost-push
inflation.

Solution:
Demand-pull inflation

Price level
AS

P3 ---------------- ------- C

o·'-- - -
--- - - .. Real GDP
--=- - -
01 01.

Demand-pull inflation occurs when the aggregate demand (AD) exceeds the aggregate supply
(AS). It is caused by a rise in AD which may be due to a rise in consumer demand (C), or a rise in
investment by firm (1), or an increase in government expenditure (G), or an increase in demand
for the country's net exports (X - M) or a combination of the four. This means that the AD curve
will shift to the right as shown in the diagram. If AD 1 shifts upwards to AD2, then price will
increase from P, to P2• If the increase of AD happens in the stage of full employment where AS
is vertical, then inflation will rise rapidly. For example, when AD2 shifts to AD3, then the price will
increase drastically from P2 to P3_
 Cost-push inflation

Price level LRAS

p1 ........ - • - - - - - ........ • SRAS0

••
Po ------

AD0

� ---�----�
-- +
- Real national income
Y1 Yo Y1
Cost-push inflation occurs when the general price level increase is associated with the increase
in the cost of production. Cost-push inflation is the result of the seller's activities.
Factors that lead to cost-push inflation are:
(a) Wage-push inflation: due to the increase in the wage level which will lead to an increase in
the cost of production and the output price ..
(bl Profit-push inflation: when certain producers or monopolists stock up goods to create an
artificial shortage which will increase the price of these goods, thereby giving them higher
profits.
(c) Import-push inflation: occurs when prices of imported raw materials or finished goods
increase. This may be due to the fluctuation of the foreign exchange rate. This will lead to
an increase in production costs and eventually, an increase in the price of outputs.
•••
•••

14.1.4 Effects of Inflation

Anticipated inflation is inflation
that people are more or less
prepared for. Everyone will
incorporate this expected
higher level of inflation into
his/her plans.
Inflation affects an economy in various ways, both positive and
negative. The seriousness of the adverse effects depends on \.vhether
inflation is anticipated or unanticipated.
Anticipated inflatio11 is inflation that people are n1ore or less
prepared for. Everyone ,viii incorporate this expected higher level
of inflation into his/her plans; they tend to spend more and invest
because if they do not, their money will be worth less in the future.
This spending and investment can benefit the econo1ny. This mild
anticipated inflation brings about positive effects as it stin1ulates
market gro\.\1th, resulting in higher profits and increased production,
hence a reduction in unemployment. When the real value of a given
nominal wage reduces, inflation increases the demand for labour and,
therefore, reduces unemployn1ent.
Besides, inflation also reduces the real burden of debt, both public
and private. As the loan or mortgage on your house is on a fixed rate
basis, an increase in your salary over time due to inflation, will allow
you to spend less on your mortgage payment as it constitutes a smaller :1::
percentage of your earnings. 0,)
0
However, anticipated inflation also can bring negative effects: ..,
0
1 Increase 'menu cost'. Firms have to frequently adjust their printed
(I)
0
price lists.
0
::s
2 Reduce the real value of the tax burden.
-·
0

3 Reduce the standard of living. Inflation reduced real purchasing

.,,..,
0
power and real income.
4 At high anticipated inflation, people will try to avoid holding 0
onto money. They spend their income as soon as they receive
t:r

them. Ho,-vever, it is very difficult for people to fully anticipate a

(I)

hyperinflation as the actual inflation rate vary from year to year.

Unant icipated inflation is
Unanticipated inflation is inflation that comes as a surprise to the inflation that comes as a
public or comes before the people have had time to adjust fully to its surprise to the public or

presence. It causes the follo,.ving effects:

comes before the people
have had time to adjust fully
1 Redistribution of income or ,vealth to its presence.

Inflation will shift income from one group to another. There will
be gainers and losers in society. Effects of Unanticipated
The gainers fro1n continuous unanticipated inflation are:
Inflation
• Redistribution of income
(a) Businessmen who make more profits from rising prices. or wealth
(b) Debtors as the purchasing po,-ver of money is reduced by the • Discourages investments

time they repay tl1eir loans. With inflation, although debtors

and savings
• Affects the balance of
return the sa1ne amount of money, they pay less in terms of payments
goods and services as the value of money a t the time when • Breakdovvn in the

they repay the loan is less when they first borro,-ved the
functions of money

money. Hence, the burden of debt is reduced and the debtors

will gain.
(c) Property owners as the prices of property increase, often
faster than the average rate inflation on all goods.
(d) Shareholders as they receive higher dividends when firms
gain higher profits.
The losers fron1 the continuous unanticipated inflation are:
(a) Creditors because if the rate of inflation exceeds the rate
of interest charged on loan, there ,-vill be a reduction in the
purchasing po,-ver of the outstanding balance on the loans.
Although the creditors will get back the san1e amount of
money that was given as loans, they will receive less in real
terms as the value of money has fallen.
(b) vVage earners and salaried ,-vorkers as their real value of
income decrease because their wages or salaries are slow to
adjust to the rising prices of goods and services.
(c) Pensioners are the n1ost badly affected group as their income
is fixed, and with inflation their real income ,-vill fall.
(d) Savers because those with fixed or savi11g deposits ,-vill lose
as the purchasing power of their savings will decline.

Contractionary fiscal policy,
contractionary monetary
policy or direct control are used
to control inflation.
Figure 14.4
Different measures for
controlling inflation
Contractionary Fiscal Policy
Theimplementation o f budget
surplus to reduce inflati on
on an economy. Two tools of
budget surplus are reducing
government expenditure (G)
and/or increasing taxation (T)
to decrease the aggregate
demand (AD).
2 Discourages investments and savings, due to uncertainty over
future inflation
Inflation increases the opportunity cost of holding money, reduces
savings and distorts consumers' behaviour by causing them to
purchase and hoard more. Inflation also distorts the behaviour of
firms and 1nakes long-term planning difficult. Firms may divert
funds from productive investments to speculation. Trade unions
may fight for higher v.rages and go on strike, ,-vhich will affect
production.
3 Affects the balance of payments
A higher rate of inflation n1akes exports seem relatively expensive
and imports seem relatively cheaper. Hence, the balance of trade
\.vill suffer. It will also affect employment in industries involved in
exports.
4 Breakdown in the functions of money
In a severe strato-inflation or hyperinflation, money becomes less
useful as it loses its function to serve as a medium of exchange
and a store of value. In hyperinflation, the use of money may
completely breakdown and lead to a replace1nent ,vith the barter
system.
14.1.5 Measures to Control Inflation
A government can use either contractionary fiscal policy,
contractionary monetary policy or direct control to control inflation
(see Figure 14.4). The choice of the types of policies to be used for
controlling inflation depends on its causes.
I Measures of Inflation
Contractionary Contractionary Direct
fiscal policy monetary policy control
If inflation is caused by an excessive aggregate demand, it can be
controlled by decreasing the aggregate demand through contractionary
fiscal policy and contractionary monetary policy. The n1easures for
using contractionary fiscal and contractionary monetary policies to
control demand-pull inflation are:
I Contractionary fiscal policy (Budget surplus: T > G)
The govern1nent reduces the inflationary pressure on its econon1y
by implen1enting a budget surplus. The two tools of budget surplus
are reducing government expenditure (G) and/or increasing
taxation (T) to decrease the aggregate demand (AD). This is
because any decrease in the components of AD will decrease AD,
as AD = C + I + G + X - M.
 For easy recall, let us use the 'on-diet two-headed fish' to explain :1::
how the process of contractionary fiscal policy can finally solve the 0,)
0
problem of inflation. Imagine that the tools ( G and T) represent the ..,
0
two-headed fish. In Figure 14.5, this t\-vo-headed fish shared the (I)
0
same body (process) and tail (outcome). Hence, by decreasing G 0
::s
and increasing T, AD will decrease (the process) and the outcon1e
-·
0
is that this 'on-diet t,-vo-headed fish' can win over the monster of
.,,..,
0
inflation.
0
Figure 14.5 t:r
Contractionary fiscal policy (I)

''
'
G!- ---� AD-I- = C +I+ G-1- + X - M:' Price level
:' AS
➔
:' Po -- -----
T't'➔ v.!- ➔ C!- +
'
' AD-I- = C!- + I + G + X - M:' P, AD0
AD,
,I, Aggregate output
p!,

(a) Decrease in government expenditure

Government should postpone some development projects
and reduce its operational expenses in times of inflation.
A reduction in government expenditure (Gt) will bring a
direct multiplier effect on the aggregate demand causing the
AD to decrease, hence bringing down the price level:
G .J, ➔ AD .J, = C + I + G .J, + X - M ➔ P .J, ➔ Inflation .J,
(b) Increase in taxes
In times of inflation, the government tends to i1nplement
regressive tax structure or increase its indirect taxes on
goods and services to reduce the disposable income of
individuals (Yd ). This will reduce the consumption of goods
and services (C), hence causing the AD to shift down,-vards,
in turn leading to a fall in the price levels:
t
T ➔ Yd .J, ➔ C .J, ➔ AD .J, = C .J, + I + G + X - M ➔ P .J,
➔ Inflation .J,
Ho,.,vever, the rates of taxes imposed should not be too
high as to discourage savings, investments and production.
Rather, the government should design the tax system to
provide greater incentives to those who save, invest and
produce more.
2 Contractionary monetary policy
The central bank can reduce the money supply through different
monetary instruments, such as using open market operations,
raising the required reserve ratio, calling of special deposits and
increasing the rate of interest. These measures will reduce money
creation, consumption and investments, so that the aggregate
demand will fall. Hence, it will cause a decrease in prices.
(a) Open market operations
During inflation, the central bank sells government
securities, short-term bonds or treasury bills in the open
market to the public to reduce bank deposits and credit
creation of commercial banks. Money supply will reduce,
hence reducing aggregate demand and price level.
(b) Raising required reserve ratio
Required reserve ratio is the minimum amount of cash that
all commercial banks have to keep in the central bank. In
the event of inflation, the central bank will increase the
required reserve ratio of all co1nmercial banks. This will
reduce the ability of comn1ercial banks to provide loans and
hence, decrease credit creation, money supply, aggregate and
inflation rate.
(c) Call of special deposits
During inflation, commercial banks are son1etimes required
to deposit an additional percentage of their deposits in the
central bank to control their credit creation and decrease
money supply and price level.
(d) Raising the base lending rate/bank rate
The central bank acts as lender of last resort, and supplies
cash to the banking system. The central bank can force the
bank rate to increase by raising its own lending rate, hence it
raises the price of borrowing funds fro1n banks for the firms,
resulting in costly loans and firms will have to reduce their
borrowings and spending. The aggregate will reduce and the
inflation rate will drop.
(e) Raising the interest rate
The central bank will direct the commercial banks to raise
their interest rates for deposits from the public. The high
interest rates will encourage the public to save more and
increase the savings level to decrease the aggregate demand
and price level.
(f) Qualitative instruments or direct credit control
During inflation, the central bank restricts the expansion of
credit by imposing the following regulations:
(i) Reducing the total credit li1nit on the amount banks can
lend, or on rates at which banks can expand their total
deposits.
(ii) Persuade banks to lend only to certain commodities
or businesses, for example only allow lending for
investments or exports.
 (iii) Imposing strict regulations on hire-purchase agreements :1::
for higher minimum down payment and maxi1num 0,)
0
repayment period, or restrict lending policy by ..,
0
implementing collateral; security or guarantors to (I)
0
discourage borrowings. 0
::s
However, if inflation is due to an increase in the cost of production,
-·
0

the following direct control measures can be used to control cost-push

.,,..,
0
inflation:
1 Inco1ne policy
0
t:r
The government has to ensure wages do not rise faster than (I)

productivity. Trade unions are required not to demand for higher

wages. Increase in ,-vages must link to increase in productivity.
This is important to control the ,-vage-push inflation and cost of
production.
2 Price control and rationing
The government will control directly on prices of certain goods.
Price pegging, either by fixing a floor price or ceiling price, is
i1nple1nented so that the general price level can be kept low.
The authority also must enforce price tagging for all goods and
services. All prices must be labeled to prevent overcharging.
Anti-hoarding campaigns should be used to prevent producers
or consumers from storing goods as such storing can cause an
artificial shortage of goods that pushes the prices of goods upwards.
Rationing is the last resort used in some countries if the above
measures failed to control the prices of some essential goods.
Rationing is applied to essential consumer goods such as wheat,
rice, sugar, kerosene oil, etc. to stabilize the prices of scarce goods
so as to make them available to a large number of consumers.
In rationing, consumers are given coupons to buy goods and
services in certain amounts to avoid hoarding. Rationing is
very inconvenient for consumers as it leads to queues, artificial
shortages, corruption and black markets.
3 Supply side policies to increase productivity
The government can undertake supply side policies to increase
long-term competitiveness and productivity. Supply side policies
can reduce inflationary pressures but these policies will take a long
time to have an effect and are unable to reduce the sudden increase
in the inflation rate.
The government should adopt the following measures to
increase production:
(a) To increase the production of essential consu1ner goods
such as food, clothing, kerosene, sugar, vegetable oils, etc.
(b) The government should give tax incentives, grants and
encourage research and development to increase productivity.
(c) Provide assistance to different consun1er goods sectors in
the form of latest technology, raw materials, financial help,
subsidies, etc., to increase production.
 4 Exchange rate policies to control import cost-push inflation
The government should reduce quantities or prices of imports.
This involves increasing the value of currency to reduce the prices
of imports and hence, reduce imported inflation.
5 Increase in savings
Another 1neasure is to increase savings to reduce disposable
income and hence, personal consumption expenditure. However,
people are not in a position to save voluntarily due to the rising
cost of living. Hence, Keynes suggested compulsory savings or
'deferred payment'. The government should introduce compulsory
provident fund or provident fund cum-pension schemes to
increase savings in controlling inflation.
To control monetary inflation, the money supply must be
regulated. It is the responsibilities of the government and the
central bank to ensure that money supply does not gro\.v faster
than the real output of the economy.
As there are a number of causes affecting inflation at the same
time, there is no single policy measure that ,-vill be effective
in controlling inflation. Therefore, to control inflation, the
government should adopt all measures of the above policies
simultaneously.

Kuala Lun1pur, 7 November 2014: Despite cutting fuel subsidies that threaten
private consumption and cause inflationary pressures, Malaysia still manages
to keep its benchmark interest rate steady to support growth. Bank Negara
Malaysia held overnight policy rate is at 3.25%.
The central bank governor, Tan Sri Zeti Akhtar Aziz, says monetary policy
has to remain accommodative to support expansion due to the uncertainties
of global recovery. Last quarter demand for Southeast Asian nation's exports
weakened and rising costs are hurting companies and consumers.
Ho Woei Chen, an economist at the United Overseas Bank Ltd. in Singapore
said the impact of the fuel price hike is going to affect consumption. Thus, they
will not be in a rush to raise interest rates further.
Gross domestic product growth is forecasted as much as 6% this year and
next by the government.
The central bank said that while domestic demand still remains the key
driver of growth, private consumption and exports have shown signs of
moderation. However, investment activity is projected to remain robust.
Hence, the Monetary Policy Co1n1nittee will continue to assess the balance
of risks surrounding the outlook for domestic growth and inflation carefully.
 :1::
0,)

In September, Malaysia's inflation rate was 2.6% compared to 3.3% in

0
..,
0
August. The government forecast consumer prices to climb from 4% to 5% (I)
next year, the fastest since 2008.
0
0
::s
In October, the government raised fuel prices by about I 0% and will increase
-·
0
some gas tariffs this month. Moreover, with a goods and services tax of 6%
that will start in April next year, it will increase the burden on businesses and .,,..,
0

households after food and fuel subsidy cuts. 0

Source: Adapted from The Star Online, 2014.
t:r
(I)

Case questions
(a) State the two different types of inflation.
(b) What is monetary policy? Should the central bank implement expansionary
or contractionary monetary policy to control inflation?
(c) Based on the article, state the instrun1ent used by the central bank of
Malaysia to control inflation. Suggest other two instruments of monetary
policy that can be used to reduce inflation.
(d) What are the hvo factors that can lower Malaysia economic growth in the
above article?
(e) Briefly explain the t,-vo types of direct controls that can be used to solve
inflation.

Solution
(a) Demand-pull inflation and cost-push inflation
(b) Monetary policy is enforced by the central bank and monetary authorities
to control the supply of money. Different monetary instruments which
aim at controlling the supply of money are used to overcome the problem
of inflation or une1nployment.
The central bank should imple1nent contractionary monetary policy to
control inflation.
(c) Interest rate
• Open market operations: the central bank sells securities
• Reduce cash reserve requirement ratio
(d) Do1nestic factor: Cuts in fuel subsidies
• Goods and services tax of 6%
(e) Price control: The government could implement floor price or ceiling
price to control prices of goods. Rationing may be used as a last resort if
all 1neasures fail.
• Income policy: The government has to ensure wages do not rise faster
than productivity. Trade unions are required not to den1and for higher
wages. Increase in wages must link to increase in productivity.

Unemployment occurs when
people who are in the working
age group are able and willing
to work, but are unable to
obtain jobs.
Figure 14.6
Total population of
economically active and
inactive groups
14.2 UNEMPLOYMENT
14.2.1 Definition
Unemployment occurs when people who are in the working age
group are able and willii.1g to work, but are unable to find suitable jobs.
Unemployment represents the number of people in the workforce
who want to work, but are unable to get jobs. Unemployment is often
used as a measure to gauge the health of the economy in a country.
Figure 14.6 helps in fully understanding the concept of unemployment.
Total Population
Aged 1 S and Above
Economically Active
Labour is within the age group of 15 Economically
to 64, excluding housewives, full-time Inactive
students and people who are ill
I
I
Not in Labour Force
Unemployed - Armed forces
Employed - New entrants
- Housewives
- Employees - Re-entrants
- Full-time students
- Self-employed - Lost last job
- Persons with disabilities
workers - Quit last job
- Retirees
- Laid o ff
- Discouraged workers
The labour force of a country is the actual number of people
(15 to 64 years old) who are available to work. They are called the
economically active population, comprising those who are employed
and unemployed. According to the Department of Statistics, the
'employed' are those who during the reference week, ,vork for at least
one hour for pay, profit or family gain as an employee, employer,
own-account worker or unpaid family worker. The employed includes
those who:
1 Cannot ,vork, due to illness, injury, bad weather, leave or labour
dispute, but have a job
2 Are temporarily laid-off with pay, who would definitely be recalled
to work. Temporary lay-off with pay when the employer does not
have enough work and some of the workforce are asked not to
con1e to work, but employees still have the employn1ent rights
during a lay-off, including the right to b e paid.
3 Are expected to report for work or to start operation on a farm or :1::
business enterprise ,-vithin t,-vo ,-veeks fron1 the reference week 0,)
0
4 Only work less than 30 hours, due to their nature of ,.vork or ..,
0
insufficient ,-vork (I)
0
5 Are able and willing to accept additional hours of work, but are 0
called underemployed.
::s

-·
0

The size of the labour force is determined by several factors

.,,..,
0
such as population size, population gro,Nth, sex distribution, age
distribution, levels of income, educational opportunities and 0
t:r
en1ployment opportunities. The labour force fluctuates due to a (I)
con1bination of demographic trends, social trends, seasonal trends
and macroeconomic conditions.
Unemployment may be voluntary or involuntary. Voluntary
unemployment occurs ,-vhen there is a job available, but the
unemployed person is not willing to accept it at the going wage rate.
The inactively unemployed or 'voluntary unemployed' include those
who:
I Do not look for work, as they believe they are unqualified or no
work is available. They are the discouraged workers.
2 Would have looked for work if they had not been temporarily ill
or due to bad weather
3 Awaiting results of job applications
4 Had looked for work prior to the reference week
The 'unemployed' or 'involuntary unemployment' occurs when a
person is willing to accept a job at the going wage rate, but cannot
find one. Involuntary unemployment includes ,.vorkers fired due to
an economic crisis, industrial decline, company bankruptcy, or an
organizational restructuring. Involuntary unemployment is a serious
social concern, because it causes economic waste due to lost output
and it is a source of human suffering.
Underemployment refers to people ,-vho have a job which is part­
time or temporary. They would like to work full-time, but only have a
part-time job or income.
The economically inactive population are those who are outside the
labour force. They are people residing in institutions such as hostels,
hotels, hospitals, prisons, boarding houses and n1ilitary barracks. They
also include full-time students, patients, prisoners, unpaid care-givers,
housewives and the armed forces.
There cannot be zero unemployment in any economy because some
people will be une1nployed "vhile changing jobs. According to Lord
Beveridge, full employn1ent is achieved when no n1ore than 3% of the
working population is unemployed.
 SAMPLE QUESTION 14.3

For each of the following descriptions, indicate whether the person can be classified as
'Employed; 'Unemployed' or 'Not in the labour force'.
(a) A 60-year-old woman who left her job to help her daughter with her household.
(b) A 1 9 -year-old student who is out of school for the summer break and is looking for a job.
(c) A 32-year-old man, with a PhD in Geography, who has not been able to find a teaching
position, thus has started driving a taxi, 28 hours per week.
(d) A 4 5 -year-old factory worker who is not working and has given up searching for a job.

Solution:
(a) Unemployed
(b) Not in the labour force
(c) Employed
(d) Not in the labour force
•••
•••

14.2.2 Measuring Unemployment

Labour Force Participation
Rate
The proportion ofthe labour
force to the working age
population.
The labour force participation rate is the proportion of the labour
force to the working age population (15 to 64 years old). The formula
for the labour force participation rate is:
. . . Economically active
Labour Force Part1c1pat1on Rate=- - - - - �- - - - x 100%
Working age population

Unemployment Rate The unemployment rate is the proportion of unemployed persons

The proportion of unempl oyed
persons to the total l abour
force.
to the total labour force. It measures the percentage of the unemployed
population in the labour force, as sho,-vn by this formula:
Number of unemployed
Unemp1oyment Rate= x 10007c0,
Labour force (Economically active)

SAMPLE QUESTION 14.4

The table shows the total labour force and total employment in Malaysia in November 2014
and June 2015. What is the unemployment rate for Malaysia between November 2014 and
June 2015?

Item November 2014 II June 201 S Changes(%)

Labour force ('000) 14,082.9 14,287.5 1.5

Employed ('000) 13,707.8 13,837.6 0.9
Unemployed ('000) 375.1 449.9 3.2
Outside labour force ('000) 6,777.1 6,783.9
Labour force participation rate(%) 67.5 67.8

Unemployment rat@(%) 2.7 3.2

Source: Department of Statistics Malaysia.
 :1::
0,)
Solution: 0
..,
Number of unemployed 0
Unemployment Rate=- - - - - - - - � �- - x 100% (I)
Labour force (Economically active) 0
0
375.1 ::s

-·
Nov 2014= X 100%= 2.7% 0
14,082.9

.,,..,
0
449.9
June 2015 = X 100%=3.2%
14,287.5 0
There was positive growth of 1.5% in the labour market (November 2014) in Malaysia, from t:r
(I)
14.08 million in November 2014 to 14.29 million in June 2015. However, the number of
unemployed people also increased from 375,100 to 449,900 people, contributing 3.2% to
total unemployment in June 2015. The unemployment rate was comparatively higher by a 0.5
percentage point, increasing from 2.7%> in November 2014 to 3.2°/4 in June 2015.

14.2.3 Types of Unemployment and

Measures to Control Them
There are several types of unemployment caused by different factors.
The appropriate policy to reduce these types of unemployment will
depend on identifying the underlying causes of unemploy1nent.
I Classical unemployment
It is also called the real wage unemployment. Arise when trade
unions drive wages in excess of the market clearing levels, resulting
in a fall in demand for labour. Trade unions usually negotiate to
increase real wages causing classical unen1ployment. Classical
unemployment is also caused by government minimum wage.

Real wages Figure 14.7

Classical unemployment

W1 I--- __;:,..,..._____-:,('Minimum wage

Wo - - - - - --- -- _,_ - - -. - -- - -

�---�--�--��--- Labour force

L,

Figure 14.7 shows the classical unemployment of L1 and L2•

Demand of labour curve is DL ,-vhile supply of labour curve is
SL. The market equilibrium is at the real wage rate of W0 with L0
quantity of labour. When the trade union manages to negotiate
 real wages to vV 1 or with the implementation of minimum wages
at WI ' the market quantity demand for labour reduces to L1 while
the quantity supplied of labour increases to L2, hence creating
classical unemployment of L1L2 •
To reduce classical unemployment, the government has to
control trade unions to prevent wage increments. If real ,vages
decline, consumer expenditure vvill reduce which in turn lowers
the quantity demand for labour. Minimum wage has to be reduced.
However, if the minimum wage is reduced, the low-skilled workers
,vill be at a disadvantage.
2 Frictional unemployment
This refers to short-term or temporary unemployment which
occurs ,vhen people enter the labour market to look for jobs or
people leave their jobs, either voluntarily or are asked to go, and
are unemployed for a period of time while they are looking for
a new job. Frictional unemployment includes new entrants such
as school-leavers, fresh graduates and re-entrants such as people
who quit their jobs for a better position or higher wages or former
homemakers. Hence, there is ti1ne lag during which a worker is
unemployed when he/she is moving from one job to another.
Frictional unemployment is caused by geographical or
occupational immobility of labour. Geographical immobility
occurs when jobs are available in big cities but unemployed
workers may not be able to move there due to difficulties in getting
housing or other reasons. Occupational immobility happens ,vhen
there may be skilled jobs available, but many workers do not have
the relevant skills.
Besides, the 1nore imperfect the labour market information,
the longer it takes for people to find new jobs. Duration of
frictional unemployment also depends on how long people are
willing to search for new jobs that are suitable for them. Frictional
unemployment is always present in an economy.
To overcome frictional unemployment, there n1ust be better
job information. The government can set up job centres, where
they match the unemployed to the job vacancies. It can also be
reduced by better flow of job information through newspapers,
radio or the Internet. Governments should seek ways to reduce
unnecessary frictional unemployment through multiple means
such as providing education, advice, training, and assistance like
day-care centres.
3 Seasonal unemployment
This occurs when certain product cannot be produced during
a certain season. Hence, many workers are temporarily laid off
on a short-term basis during certain times of the year. It results
 from regular fluctuations in ,.veather conditions, climatic changes :1::
or changes in the trend of demand. Seasonal fluctuations in 0,)
0
unemployment occurs in construction ,.vorkers who ,.vill be ..,
0
unemployed during rainy season, fishermen who are unable to fish (I)
0
during the monsoon season or in ,.vinter and tourist workers who 0
::s
are une1nployed during o ff -peak periods in some tourist areas.
-·
0
The solution is to have matching seasonal industries which
.,,..,
0
can share the labour force. More jobs can be created through
diversification and integration of economy in agricultural, 0
manufacturing, construction, transportation, finance, insurance
t:r

and the services sectors.

(I)

4 Structural unemployment
Results from structural decline of industries, unable to compete
or adapt to changing demands and new products, or changing
methods of production. A change in the pattern of den1and results
when tastes change, demographic profile change or introduction of
ne\.v products or technology may have made the existing product
obsolete, hence the skills of,.vorkers are no longer suitable with the
jobs available. The growth of international competition has been
an in1portant cause of structural unemployment. Workers who are
laid off or out of ,.vork even longer, will find difficulties in getting
jobs as their job skills may no longer match the requirements of
new jobs offers.
As major industries tend to be heavily concentrated in certain
regions, structural unemployment often leads to regional
unemployment and the impact can be quite serious. Regional
unemployment occurs when an industry, ,.vhich is concentrated
in a particular area has to close down. Structural unemployment
is made worse by the geographical or occupational in1mobility of
workers.
To overcome structural unemployment, government can:
(a) set up training centres to retrain workers in ne"v skills to
improve occupational 1nobility.
(b) encourage workers to move to regions and industries where
job are available.
(c) encourage firms to move into areas where there are high
levels of unemploy1nent by giving tax incentives.
5 Technological unemployment
Arises from labour-saving technique of prod1Uction or new
technology \.Vhich requires workers \.Vith different sets of skills.
The workers who lost their jobs will have to acquir,e new skills and
the government can help by providing retraining or re-skilling
programmes.
 6 Cyclical unemployment
Expansionary fiscal policy and/
or monetary policy, acting to
stimulate aggregate demand,
are used to solve cyclical
unemployment, in addition to
other di re ct controls used.
Figure 14.8
Expansionary fiscal policy
This is also known as the demand deficient unemployment.
Cyclical unemployment is caused by a lack of demand in the
downs-.,ving of the business cycle or recession. It exists because there
is a recessionary gap forcing businesses to lay off large numbers
of workers to cut costs. Keynes believed that deficient aggregate
demand was a major cause of persistent mass unemployment
between the 1920s and the 1930s. During the downswing of the
trade cycle, aggregate demand falls and via the multiplier effect,
national income falls further. Hence, consumption falls, production
reduces, companies may close down and workers are laid off
resulting in cyclical unemployment. Cyclical unemployment
is a serious form of une1nploy1nent as it usually creates more
unemployment. The laid-off ,.vorkers now have less n1oney to buy
the things they need, further lo,.vering demand.
To reduce this type of unemployment, the government has to
implement expansionary fiscal policy and/or monetary policy to
stimulate the aggregate den1and, thus reducing the deflationary
gap.
For easy recall, let us use the 'put-on-weight hvo-headed fish' to
explain how the process of expansionary fiscal policy can finally
solve the problem of unemployment. In1agine the tools (G and
T) represents a two-headed fish. In Figure 14.8, the two-headed
fish shares the same body (process) and tail (outcome). Hence, by
increasing G and decreasing T, AD will increase (the process) and
the outcome is this 'put-on-weight two-headed fish' can win over
the monster of unemployment.
''
- - � - ADi = C + I +Gt+ X -M:' Price level
''
' AS
''
'
T-1- ➔ Y•i ➔ Ci-;+
' A01'
= Ct+ I + G + X - M : ' AD,
AD0
o. Q, y
vt
Productiont
Unemployment.J.
 Government should implement expansionary fiscal policy in :1::
0,)
which government expenditure is higher than taxation (budget 0
..,
deficit): 0
(I)
(a) Increase government expenditure 0
Increase government expenditure (G) by creating more 0
::s

-·
development projects which will increase aggregate 0
demand (AD) via the multiplier effect. Production will

.,,..,
increase, hence reducing the cyclical unemployment. 0
(b) Decrease taxes
0
Decrease in taxes (T) such as a reduction in excise tax, t:r
service tax, sales tax, income tax or corporate tax will (I)
increase the consumption of goods and services and
also induce investment, hence aggregate demand will
increase and production will increase, reducing cyclical
unemployment.
Government should implement expansionary monetary
policy to increase money supply using the following
instruments:
(a) Open market operations
The central bank buys government securities, short-term
bonds or treasury bills in the open market from the public
to increase money supply. Hence, consumption and
investment will increase, increasing aggregate demand and
production and reducing cyclical unemployment.
(b) Lowering the required reserve ratio
In unemployment, the central bank will lower the required
reserve ratio of all commercial banks. This will increase the
ability of commercial banks to provide loans and hence,
increase money supply to stimulate economic growth and
reduce unemployment.
(c) Lowering the base lending rate/bank rate/discount rate
The central bank lowers the bank rate, and hence, it
makes loans less costly to borrow and firms will increase
investments by employing more workers.
(d) Lowering the interest rate
The central bank will direct the commercial banks to
lower their interest rates for deposits so as to encourage
the public to spend. This will increase the aggregate
demand and production and hence, decrease cyclical
unemployment.

Ho,-vever, the use of an expansionary fiscal or monetary policy to

reduce cyclical unemployment, will result in a higher rate of inflation.
This is because the expansionary fiscal or n1onetary policy will cause
the aggregate demand and national income to increase. Firms will
have to employ more workers to increase their production. When
the aggregate demand increases, the price level will also increase.
Therefore, expansionary fiscal policy or monetary policy for solving
unemployment is in conflict ,-vith that of stable prices.

High and persistent
unemployment has a negat ive
effect on individuals, the
economy and society .
In an economy where unemploy1nent is very high, the government
should undertake some direct measures such as encouraging workers
to be self-employed and to establish small business. Training, technical
education or short courses should be given to the unemployed to
upgrade their skills. Government agencies should create more jobs
through new land development, diversification of economy and the
establishment of small-medium industries, especially for the rural
residents to reduce unemployment and rural-urban migration.
14.2.4 Effects of Unemployment
High and persistent unemployment has a negative effect on subsequent
long-run economic growth. This situation poses a waste of resources
and also drives people to poverty.
I Individual effects
(a) Une1nployn1ent erodes self-esteem, pron1oting social
dislocation, unrest and conflict.
(b) Unemployed individuals are unable to earn money to pay
mortgage payments or to pay rent may lead to homelessness.
Unen1ployed !People have higher rates of medication use,
poor diet, anxiety, depression, suicide and drug use.
(c) If unemployment persists for a long period, individuals will
lose their job skills, causing a loss in human capital. It will
also lead them to radical social and political activities by
increasing crime rates.
2 Economic effects
(a) It is a waste of resources as there is a permanent loss of output
of goods and services. An economy with high unemployment
is not using all of their resources especially labour available
to it. Economy is operating below its production possibility
frontier, reducing the economy's efficiency and production.
(b) High unemployment means that the government will
receive less taxation revenue but will have to pay more on
unemployment benefits. Therefore, less money to spend on
other areas such as education and health.
(c) Unemployment affects economic growth as it decreases
consumption. Hence, the aggregate demand, production
and economic growth will reduce.
3 Social effects
(a) Unemployment results in lo,ver morale and human suffering.
The family unit will be affected if the sole bread-winner loses
his/her job.
(b) Social problems arise if the unemployed turn to drugs or
crime.
Therefore, the attainment of full e1nployment is a major economic
objective of governments in many countries.
 :1::
0,)
0
..,
0
(I)
0
Kota Bharu, 15 June 2015: From 2011 until 2014, the average annual
0
::s
unemployment rate in Malaysia was at 3%.
-·
0

Minister in the Prime Minister's Department, Datuk Seri Abdul \,Vahid

.,,..,
0
Omar, said in the first four years of the 10th Malaysia Plan (2011-2015)
Malaysia has more than 400,000 people looking for jobs. 0
t:r
Malaysia had set a target i.e. 75% of graduates would find employment within (I)

six months of graduation. In 2011, with the introduction of I Malaysia Training

Scheme (SLIM), 1nore than 53,000 graduates with dliplo1nas or degrees and
those who passed the SPM and STPM have benefited from this programme.
From this total, 19,700 were graduates ,vho had undergone training and were
directly involved in the programme, while the rest received assistance from
outreach progran1mes such as resun1e writing and intervie,v skills.
Source: Adapted from The Star Online, 2015.

Case questions
1 Define unemployment, and write the formula il:o calculate the rate of
unemployment.
2 Based on the above article, identify and briefly explain the type of
unen1ployment and suggest two direct control measures taken by the
government to overcome this problem.
3 Briefly explain hvo effects of unemployment to a country.
4 State any other two policies that can be used to reduce unemployment by
the government.

Solution
1 Unemployment occurs when people are able to work and are actively
seeking a job, but are unable to find jobs.
Total unemployed labour force
UnempIoyment Rat e = X 100%
Total labour force
2 Frictional unemployment, as there are new entrants such as school-leavers
and fresh graduates entering the labour force for the first time actively
seeking jobs and also some re-entrants such as people ,vho quit their jobs
for a better position or higher wages, or for1ner homemakers.
Direct controls:
(i) The government could set up job centres, where they can match the
unemployed and the job vacancies that are available. It can also be
reduced by better flow of job information through newspapers, radio
or the Internet.
 (ii) Governments should seek ,..,,ays to reduce unnecessary frictional
unemployment througJ11nultiple means, such as providing education,
advice, training and technical education for individuals who have
difficulties securing a job.
3 Effects of unemployment:
(i) Unemployed ,..,,orkers will face financial problems, lose theirs job
skills, and lose their self-respect if they are une1nployed for too long.
(ii) High unemployment means that the government will receive less
taxation revenue, but ihas to pay more on unemployment benefits.
Therefore, there is less money to spend on other areas such as
education and health.
4 Expansionary monetary policy and expansionary fiscal policy.

14.3 RELATIONSHIP BETWEEN INFLATION

The short-run Phillips curve
shows an inverse relationship
between inflation and
unemployment in the short
run.
A ND UNEMPLOYMENT
14.3.1 Short-run and Long-run Phillips Curve
Trade Off
Econo1nists use the short-run Phillips curve to show that there
is an inverse relationship between inflation and unen1ployment
in the short run. Figure 14.9 shows that if the inflation rate is low,
then unemployment rate will be high, and vice versa. Hence, if the
government objective is to achieve full employment, they must be

prepared to accept a certain high level of inflation.

In view of that, the government should use demand management
policies to maintain a balance bet\¥een acceptable levels of inflation
and unemployment.

Figure 14_9 Price/Inflation

Short-run Phillips curve

Short-run Phillips curve:

The lower the level of
unemployment, the higher
the rate of inflation.

<-- -----------
+ Unemployment rate(%)
o
Price/Inflation Figure 14.10 :1::
Long-run Phillips curve 0,)
0
Long-run Phillips curve: ..,
0
Unemployment is not (I)
affected by inflation. 0
0
::s

-·
0

.,,..,
0

0
t:r
(I)
-- - - � - Unemployment rate (0/4)
- -- - - - - -
0 U1

Ho,-vever, the short-run Phillips curve relationship between inflation

and unemployment broke down at the end of the 1960s when British
began to experience stagflation where economy had rising inflation
associated with rising unemploy1nent.
Figure 14.10 shows that in the long run, the rate of inflation does
not affect the natural rate of unemployment and the long-run Phillips
curve is vertical at the natural rate of unemployment. The natural rate
of unemployment amounts to OU1•
Natural rate of unemployment is a rate of unen1ployment
Natural Rate of
that occurs when the economy is at full en1ployment. It is the level Unemployment
of unemployment ,-vhen the labour market is in equilibrium. It is A rate of unemployment
composed of frictional and structural unemployment. that occurs when the

The natural rate of unen1ployment is affected by changing

economy is at full
employment, and consists
demographic structure of the labour force, government social policies of frictional and structural
and rising structural unemployment. unemployment.

In this chapter, we have examined the t,-vo most important economic problems:
une1nployment and inflation. Inflation is a persistent and sustained increase in
the average price level of goods and services, implying that there is an increase
in the cost of living that lowers the purchasing po,-ver. There is an inverse
relationship between inflation and value of money. Inflation is measured using
the consumer price index (CPI) data over a period of months or years. CPI
is the cost of living index because it measures changes in the average price
of consumer goods and services. There are three main causes of inflation:
demand-pull inflation, cost-push inflation and monetary inflation. Demand­
pull inflation is caused by an increase in the aggregate demand and cost-push
inflation is caused by an increase in the cost of production, while monetary
inflation is caused by an increase in the supply of money. Inflation causes
the redistribution of income or ,-vealth that shifts income from one group
to another. In the event of severe strato-inflation or hyp erinflation, money
loses its function to serve as a 1nedium of exchange and a store of value. A
government should select the t ype of policy, either contractionary fiscal policy,
contractionary n1onetary policy or direct control, to control the inflation
depending on its cause.
 Unemployment occurs when people are able and willing to work, but
are unable to find suitable jobs. The unemployment rate is the proportion
of unemployed persons to the total labour force. There are several types of
unemployment caused by various factors. The appropriate policy to reduce
these types of unemployment depends on identifying the underlying causes
of unemployment. Expansionary fiscal policy and/or monetary policy should
be implemented to stimulate aggregate demand, in order to reduce cyclical
unemployment. High and persistent unemployment brings negative effects on
long-run economic growth and drives people to poverty. The short-run Phillips
curve shows an inverse relationship between inflation and unemployment in
the short run. Natural rate of unemployment is the rate of unemployment that
occurs ,.vhen the economy is at full employment. It is composed of frictional
and structural unemployment.

• Inflation is defined as a persistent and sustained increase in the aggregate

or average price level of goods and services in an economy.
• Consumer price index (CPI) measures the changes in the average price of
consumer goods and services.
• Calculation of the CPI involves four stages:
(a) Selecting a base year that everything gets compared to
(b) Selecting the CPI basket of goods and services
(c) Conducting the monthly prices of selected goods
(d) Giving weightage of relative importance for each category of goods and
serVIces
• Six n1ain types of inflation, as categorized by their speed: creeping,
walking, running, galloping, hyperinflation and stagflation.
• Three causes of inflation:
(a) Demand-pull inflation is caused by an increase in the aggregate
demand. It occurs when aggregate demand (AD) exceeds aggregate
supply (AS).
(b) Cost-push inflation is caused by an increase in the cost of production.
It occurs ,.vhen the increases in the cost of production decreases
aggregate supply, resulting in price increases.
(c) Monetary inflation is caused by an increase in the supply of money.
Money supply increases through expansionary monetary policy.
• Inflation causes the redistribution of income or ,vealth and breakdo,vn in
the functions of money.
• Contractionary fiscal policy, contractionary monetary policy or direct
control are used to control inflation.
• Unemployment is a situation, whereby people in the working age group
are able and willing to work, but cannot obtain jobs.
• Labour force participation rate is the proportion of the labour force to the
working age population.
• Unemployment rate is the proportion of unemployed persons to the total
labour force.
• Classical unemployment or real wage unemployment arises when trade :1::
unions drive wages in excess of the market clearing levels, resulting in a 0,)
n
fall in the demand for labour. It can also be caused by the government ..,
0
minimum wage. (I)
n
• Frictional unemployment includes new entrants (e.g. school-leavers, 0
::s
fresh graduates) and re-entrants (e.g. people who quit their jobs for better
-·n
0
positions or higher wages).
• Seasonal unemployment results from regular fluctuations in weather .,,..,
conditions, climatic changes or changes in the trend of demand. 0
t:r
• Structural unemployment results from structural decline of industries, (I)
an inability to compete or adapt to changing demands and new products,
or changing methods of production.
• Technological unemployment arises from labour-saving techniques of
production or ne,v technology, which requires workers to have different
sets of skills.
• Cyclical unemployment is caused by a lack of demand in the downswing
of the business cycle or recession.
• Expansionary fiscal policy and/or expansionary monetary policy
stimulate aggregate demand, thus are used to solve cyclical unemployment,
while other direct controls are also used.
• High and persistent unemployment has a negative effect on individuals,
the economy and society.
• The short-run Phillips curve sho"vs an inverse relationship between
inflation and unemployment in the short run.
• Natural rate of unemployment is the rate of unemployment that occurs
,vhen the econon1y is at f1tll employ1nent. It consists of frictional and
structural unemployment.

� Key concepts

• Inflation • Unemployment • Seasonal unemployment

• Consumer price index
(CPI)
• Demand-pull inflation
• Cost-push inflation
• Monetary inflation
• Anticipated inflation
• Unanticipated inflation
• Contractionary fiscal
policy/Contractionary
monetary policy
• Underemployment
• Labour force
participation rate
• Unemployment rate
• Classical
unemployment/Real
wage une1nployn1ent
• Frictional
unemployment
• Structural unemployment
• Technological
unemployment
• Cyclical unemploy1nent
• Expansionary fiscal policy
and monetary policy
• Short-run Phillips curve
• Natural rate of
unemployment
...,.
-
i..
0 Multiple-choice Questions
Answer thefollowing questions.
1 Inflation is a situation where there is
A an increase in the value of money.
B a loss in income, due to excessive
government expenditure.
C a persistent and sustained increase in the
general price level.
D a rise in real inco1ne of consumers.
2 Inflation can be measured by the
A changes in the consumer price index.
B changes in the price of a particular
comn1odity.
C percentage change in the consumer price
index.
D percentage change in the price of a
particular commodity.
3 An increase in the world oil prices in 2013
has
A decreased aggregate demand, causing
de1nand-pull inflation.
B increased aggregate demand, causing
demand-pull inflation.
C decreased aggregate supply, causing cost­
push inflation.
D increased aggregate supply, causing cost­
pull inflation.
4 If the consumer price index is equal to 100
in 2014 and is equal to 103.2 in 2015, "ve can
conclude that
A the inflation rate from 2014 to 2015 is
3.2%.
B the inflation rate fro1n 2014 to 2015 is
103.2%.
C there ,-vas no inflation from 2014 to 2015.
D 2015 is the base year.
5 The government should_ _ _ to reduce or
close an inflationary gap.
A decrease taxes
B increase government spending
C implement budget deficit
D implement budget surplus
6 Cost-push inflation is caused by
A a decrease in the cost of production.
B an increase in the cost of production.
C lower indirect taxes imposed by the
government.
D lower aggregate demand.
7 During inflation, the central bank will
perform open market operations by_ _ _
governn1ent bonds, so that the money supply
could be ___ to stabilize the economy.
A selling; decreased
B selling; increased
C buying; decreased
D buying; increased
8 The government wants to reduce inflation,
thus it should implement
A an expansionary fiscal policy and an
expansionary monetary policy.
B a contractionary fiscal policy and a
contractionary monetary policy.
C the equilibriun1 budget.
D a contractionary fiscal policy and an
expansionary monetary policy.
9 Inflation causes the redistribution of income
or wealth. Which of the follo,ving groups
stands to gain from inflation?
A Debtors C Pensioners
B Creditors D Savers
10 Den1and-pull inflation occurs when the
- -- shifts to- -
A aggregate demand curve; the right in full
employment
B aggregate demand curve; the left in full
employment
C aggregate supply curve; the left
D aggregate supply curve; the right
11 Which of the following statements is true D Cyclical unemployment is a serious :1::
about the effects of inflation? unen1ployment, leading to a lack of 0,)
0
A Inflation causes holders of fixed deposits aggregate demand in recession. ..,
0
in banks to gain more income. (I)
0
B Inflation has more adverse impact if 16 Unemployment rate is the 0
anticipated rather than unanticipated. A proportion of unemployed persons to
::s

-·
0
C Countries earn a surplus balance of the total labour force.
trade since imports are greater than B proportion of unemployed persons to 0

exports. the total population.

C proportion of unemployment to
0
D Creditors who have loaned money at t:r
interest rates below the rate of inflation en1ployed workers. ;-
will suffer economic losses. D proportion of employed workers out of
the total population.
12 The number of people unemployed equals
A the number of people employed divided 17 Cyclical unemployment exists because
by the labour force. some workers
B the labour force plus the number of A have lost their jobs, due to technical
people employed. factors.
C the labour force minus the number of B quit their jobs to look for better jobs.
people en1ployed. C lack soft skills.
D the number of people employed minus D have lost their jobs during a downswing
the labour force. in the economy.

13 The population of Country A is 40 million, 18 The natural rate of unemployment consists

total labour force is 250,000 and total
employment is 180,500. Calculate the
unemployment rate for Country A.
A 27.8%
B 9.4%
C 72.2%
D 7.3%
14 What type of unemployment can best be
described as 'short-term unemployment
,-vhen new entrants and re-entrants enter
the labour market to look for jobs'?
A Frictional unemployment
B Seasonal unemployment
C Technological w1employment
D Structural unemployment
15 All of the following statements are true,
except
A Frictional unemployment occurs when
workers are between jobs.
B Structural unemployment occurs as a
result of changing production methods.
C Seasonal unemployment occurs because
trade unions negotiate for higher wages.
of
A frictional and cyclical unemployment.
B frictional and classical unemployment.
C frictional and structural unemployment.
D seasonal and cyclical unemployment.
19 Workers who are overqualified for their
current jobs are defined as ___.
A underemployed
B discouraged workers
C over-employed
D unemployed
20 What is the definition of a discouraged
worker?
A A person who has been sacked and is
temporarily out of job.
B A person ,vho leaves the job market and
has no success in finding a job after a
long time.
C A person who works part-time and is
looking for a full-time paid job.
D A person who is currently not working,
due to structural changes.
Short-answer Questions
Answer the following questions.
1 Answer the following questions based on the table.

Year I Consumer Price Index (CPI)

2011 100
2012 105
2013 95
2014 110
2015 115
2016 128

(a) Which year is the base year?

(b) vVhat is the rate of percentage change in the general price level from year 2011 to
year 2012 and fro1n year 2011 to 2016?
(c) Does the cost of living increase or decrease from year 2011 to year 2013? Justify.
(d) Does the cost of living increase or decrease from year 2011 to year 2016? Justify.
2 Answer the following questions based on the table.

Price
Commodity Weight (kg)
2015 (RM/Unit) 2016 (RM/Unit)

E 1 1.00 1.20
F 2 1.50 1.90
G 4 2.00 2.30
H 5 0.80 0.70

(a) Assuming that 2015 is the base year, calculate the weighted price index for each
commodity for the year 2016.
(b) Calculate the overall weighted consun1er price index for the year 2016.
(c) What is the rate of inflation or deflation in the year 2016?
(d) Calculate the change in the value of money for the year 2016. What is the real
value of RMlOO for this year?
(e) Based on your answer in (d), calculate whether standard of living increases if a
person receives RM2,000 in 2015 and RM2,500 in 2016.
3 The table shows the total labour force, the number of employed and the unemployed
in Country ABC.
Total Labour Employed Unemployed
Year
Force ('000) ('000) ('000)

2015 7,500 820

2016 8,900 1,520

(a) Fill in the blanks ,.vith appropriate answers.

 (b) Calculate the unemployment rate for 2015 and 2016.
(c) Explain briefly the two types of unemployment. 0
..,
4 Answer the following questions based on the table. 0
(I)
0
Component I Number of People (Million) 0
::s

-·
0
Under 16 45

.,,..,
0
Working full-time 80
Working part-time 40 0
t:r
Retired 30 (I)

Unemployment 5

(a) What is the total labour force?

(b) vVhat is the unemployment rate?
(c) Suggest one policy to curb une1nployment.
5 (a) Complete the following table:

Item 2014 2015

I
Total population(million) 30.2 35.9
Working age population(million) 21,780.0 22,572.0
Labour force('000) 12,352.4 12,587.5
Employed persons ('000) 12,025.2 12,589.8
Number of unemployed ('000) 672.0 770.3
Labour force participation rate(%)
Unemployment rate(%)

(b) Identify the types of unemployment, based on the information:

(i) Kate lost her job due to the changes of skills required by the market.
(ii) The tourist guide lost his income due to the off-peak travel period.
(iii) Joseph resigned from his job to look for a better position.
(iv) Many jobseekers could not find a job, due to the recession.
(v) John is jobless due to minimum wage.

Essay Questions
Answer the following questions.
I With the aid of suitable diagrams, illustrate the differences between demand-pull
inflation and cost-push inflation.
2 Explain four monetary policy tools used to overcome inflation.
3 Discuss the effects of redistribution of income or wealth by explaining who the gainers
and losers are during inflation.
4 Explain any three types of unemployment, ,-vith examples.
5 (a) Explain the three effects of unemployment.
(b) Discuss how fiscal policy helps to remedy unen1ployment.
 International
Economics
Ul At the end of this chapter, you should be able to:
� • Describe international trade.
0 • Differentiate between absolute and comparative advantages.
t)
• Discuss the advantages and disadvantages from trade.
0
tn • Discuss concepts of absolute advantage and comparative

·e
advantage.
• Describe the reason for protectionism and elaborate tools of
ctS protectionism.
�
• Calculate balance of payment (BOP), and discuss the structt1re
of the BOP as well as the effects and measures to reduce BOP
deficit.
• Discuss and differentiate between fixed and flexible exchange
rate systems.

International Trade
The exchange of goods and
services between one country
and another.
T he economic activities of a nation involves domestic and
international trade with foreign countries. When the activities of
an economy transcend international borders, the trade processes and
practices will definitely differ from those in the home country. These
include the regulations governed within the trading nations, medium
of payments, the management of external accounts and others.
In this chapter, we will examine the scope of international economics
from the perspectives of trade theory, balance of payments (BOP) and
exchange rate systems. We will begin with the classical trade theory
which covers the theory of absolute advantage and comparative
advantage. We will also discuss the balance of payments, followed by the
exchange rate systems.
15.1 INTERNATIONAL TRADE
Theoretically, international trade refers to government and individual
activities on the exchange of capital, goods and services across
international borders or territories. However, due to the immobility of
factors of production, such as capital and labour, international trade
is mostly restricted to trade in goods and services. Hence, we define
international trade as the exchange of goods and services between one
country and another.
We can find almost every kind of product in the international market,
such as food, clothes, spare parts, mobile phones, stocks and currencies.
Global trading also includes services such as insurance, tourism,
banking, consulting and transportation. In most countries, international
trade represents a significant share of gross domestic product (GDP).
A product that is sold to the global market is defined as an export
while one that is bought from the global market is called an import.
International trade takes place because of the diversity in conditions of
production an1ong countries; for example, tropical countries produce
bananas and papayas while cold countries specialize in grapes and
strawberries. Hence, international trade gives rise to a world economy.
As the world economy is growing at an accelerating pace, any global
events \.vill affect domestic prices through changes in supply and demand
of imports and exports.
15.1.1 Absolute and Comparative
Advantages
In this section, we will briefly discuss the three models of international
trade, then we ,.vill focus on the concepts of absolute advantage,
comparative advantage and specialization.
I Adam Smith model ::3
According to the Adam Smith model, trade
takes place on the basis of countries exercising ::3
absolute advantage over one another. -·
ll)

0
2 Ricardian model ::3
David Ricardo was the first to propose the
ll)

law of comparative advantage. Comparative 0

advantage arises due to differences in
0
::3
technology or natural resources. The Ricardian
-·
0
1nodel is based on the following assumptions: 0
(a) Labour is the only prin1ary input to
production
(b) The relative ratios of labour at which the
production of one goods can be traded off
for another differs between countries and
governments.
3 Heckscher-Ohlin model
Eli Heckscher and Bertil Ohlin developed theory of international
trade in the early 1900s. Their theory, known as ithe Heckscher­
Ohlin model (H-0 model) predicts that countries ,.vill utilize
their locally abundant raw materials and resources to produce
and export goods to other countries which need these goods.
In return, they will import goods which they cannot produce or
require resources which they lack in. The H-0 model is based on
the following core assumptions:
(a) Labour and capital flow freely between sectors.
(b) Amount of labour and capital in two coU1ntries differ in
endowments.
(c) Technology is the same an1ong countries in the long term.
(d) Tastes are the same.

Absolute Advantage
A country is said to have an absolute advantage in the production of An absolute advantage means
goods v.1hen it can produce more of those goods compared to another that a country can produce
country, using the same amount of resources. more of a certain type of
good than another country,
According to Adam Smith, countries will gain simultaneously if they using the same amount of
practice free trade and specialized goods which have absolute advantage. resources.
Adam Smith stated that countries should find out what they can produce
more efficiently, specialize in what they do best and then trade with other
countries who are also doing ,-vhat they are best at because the wealth
of nations depends on the goods and services available to their citizens,
rather than the gold reserves held.
To sho,.v how absolute advantage theory ,.vorks, the several underlying
assumptions are as follo,.vs:
(a) Just two countries in the world, Young Land and Happy Land
(b) Only two goods are produced, wheat and cloth
(c) Only one unit of resources is used

Reciprocal or mutual absolute
advantage means that each
country has an absolute
advantage in producing some
products.
Table 15.1
Absolute advantage before
specialization
Table 15.2
Absolute advantage after
specialization
(d) Free trade exists between these two countries
(e) No transportation costs incurred
(f) Production is under the constant cost
Table 15.1 provides a simple example of absolute advantage in the
production of wheat and cloth by using one unit of resources. Both
countries use 50% of tlheir resources to produce wheat and another
50% of resources to produce cloth initially. Young Land can produce
500 kg of wheat and 2,000 metres of cloth, while Happy Land can
produce 750 kg of wheat and 1,800 metres of cloth. This example shows
the reciprocal or n1utual absolute advantage because each country
has an absolute advantage in producing some products. Young Land
has an absolute advantage in producing cloth, while Happy Land has an
absolute advantage in producing wheat.
Country I Wheat (kg) ! Cloth (metre)
Young Land 500 2,000
Happy Land 750 1,800
Total Production 1,250 3,800
Since both countries have reciprocal or mutual absolute advantage in
the production of wheat and cloth, specialization can take place. Young
Land specializes in producing cloth, ,.vhile Happy Land specializes in
producing wheat. Table 15.2 shows the changes in production caused by
moving 50% of resources out of wheat into cloth for Young Land and
moving 50% of resources out of cloth into wheat for Happy Land. In
such situations, the total production of both countries can be increased
if each specializes in the product in which it has the absolute advantage.
Table 15.2 sho,.vs that Young Land produced 4,000 metres of cloth and
0 kg of wheat, while Happy Land produced 1,500 kg of wheat and
0 n1etre of cloth. Hence, they will both be better off and the world
production of wheat has increased fron1 1,250 kg to 1,500 kg and cloth
increased from 3,800 metres to 4,000 metres.
2,000 + 2,000 = 4,000
Young Land
Happy Land 750 + 750 = 1,500 0
Total Production 1,500 4,000
With specialization, both countries can conduct trading with other
countries. They then import the products they do not have an absolute
advantage and export the products which they have absolute advantage.
Assuming that the terms of trade is 1 kg of wheat to 1 metre of cloth.
If Young Land ,vishes to consume 500 kg of wheat, it has to export
500 metres of cloth for Happy Land. Table 15.3 shows the quantity of
wheat and cloth after international trade. Now, Young Land has 500 kg of -::3
wheat and 3,500 metres of cloth, while Happy Land has 1,000 kg of wheat
and 500 metres of cloth. Both countries are in a better position after the ::3
international trade. -·
ll)

0
::3
ll)
Country Wheat (kg) Cloth (metre) Table 15.3
Absolute advantage rr:I
0
(consumption after 0
Young land 500 4,000 - 500 = 3,500 international trade) ::3
-·
0
Happy land 1,500 - 500 = 1,000 500
Total Production 1,500 4,000 0
rn

Wheat Figure 15.1

Production possibility curve of
Young Land and Happy Land

1,500 A

1,000
'
750 ·--�·······
__ -,' _____ -- _:'____ L ______ --'L:(3,500, 500)
500 I I I I

''
I
'' ' I I I

' ''
'------''- -----"-"---..:::,..i"'--- Cloth
500 1,800 2,000 3,600 4,000

Figure 15.l shows the production possibility curve for Young Land
and Happy Land. AB is the production possibility curve for Happy Land,
producing either 1,500 kg of wheat or 3,600 1netres of cloth. CD is the
production possibility curve for Young Land, producing either 1,000 kg
of ,.vheat or 4,000 metres of cloth. They use 50% of their resources to
produce wheat and another 50% of resources to produce cloth. Both of
the1n have fixed production cost. Young Land produces at point L with
500 kg of wheat and 2,000 metres of cloth, while Happy Land produces
at point K with 750 kg o f wheat and 1,800 metres of cloth. Young Land
has an absolute advantage in producing cloth, while Happy Land has an
absolute advantage in producing wheat. After trade, both counties will
increase their consumption to point I..'. (Young Land with 3,500 kg of
wheat and 500 metres of cloth) and K' (Happy Land with 1,000 kg of
wheat and 500 metres of cloth). Both countries are in better positions
because the new points lie outside their production possibility curves.
When each country has an absolute advantage over another country
in producing a product the gain from trade is obvious. However, what if a
country possesses absolute advantage for both products or a country can
produce both products more efficiently than another? Will specialization
take place? Will international trade be possible? These were David
Ricardo's questions. Hence, he developed the theory of comparative
advantage.

Comparative advantage refers
to a country's ability to produce
a particular product wi th a
lower opportunity cost than
another country.
Comparative Advantage
Comparative advantage is measured in terms of opportunity cost; it
refers to a country's ability to produce a particular product with a lower
opportunity cost than another country. Opportunity cost is defined
as what you sacrifice in making an economic choice. In international
trade, it refers to the value of the goods you sacrifice in producing one
goods instead of another. The country with a lower opportunity cost
has the comparative advantage.
David Ricardo stated that a country should specialize in the production
of goods or services in which it has greater comparative advantage
or lower opportunity cost by exporting these goods; and import
commodities where the opportunity cost is higher or less comparative
advantage.
To illustrate this theory, let us use the exa1nple of Young Land and
Happy Land, but now assume that Young Land's efficiency has increased
two-fold from the previous example. Now, a unit of Young Land's
resource can produce either 1,000 kg of ,-vheat and 4,000 metres of
cloth. Happy Land's efficiency re1nains unchanged. Table 15.4 sho,vs
that Young Land is now better at producing both wheat and cloth than
Happy Land. It appears that Young Land has nothing to gain by trading
with Happy Land. Is it really so? In fact, Table 15.5 shows it does have
something to gain for Young Land and it is still possible to increase the
world production of wheat and cloth by calculating the opportunity costs
of both products under the comparative advantage theory.

Table 15.4 Country

I Wheat (kg) Cloth (metre)
I I!
Comparative advantage before
specialization
Young Land 500x 2 = 1,000 2,000 X 2 = 4,000
Happy Land 750 1,800
Total Production 1,750 5,800

Young Land has the absolute advantage in producing ,vhcat and cloth.
Step 1: To determine who should produce wheat and cloth, ,-ve need
to calculate the opportunity costs as follows.

Country Wheat Cloth

I I
Young Land Cloth/Wheat Wheat/Cloth
Happy Land Cloth/Wheat Wheat/Cloth

Country Wheat Cloth

I I
Young Land 4,000/1,000 l ,000/4,000
Happy Land 1,800/750 750/1,800
 Table 15.5 ::3
Country Wheat (kg) Cloth (metre)
I Comparative advantage
(opportunity cost)
::3
-·
Young Land 4 0.25
ll)
Happy Land 2.4 0.42 0
::3
ll)

Table 15.5 shows that Young Land has the comparative advantage in
producing cloth because it can produce cloth at a lo,ver opportunity cost,
0
0
i.e. only sacrifice 0.25 kg of wheat in order to produce 1 metre of cloth as ::3
-·
0
compared to Happy Land that has to sacrifice 0.42 kg of wheat to produce
1 metre of cloth. On the other hand, Happy Land has the comparative 0
advantage in producing wheat because it has a lower opportunity cost.
Happy Land only forgoes 2.4 1netres of cloth to produce 1 kg of wheat
compared to Young Land which has to forgo 4 metres of cloth to produce
1 kg of wheat. Hence, vve can conclude that:
Young Land should produce cloth and Happy Land should produce
wheat since the opportunity costs are lower.
Step 2: Now, calculate the production after specialization in wheat
and cloth respectively.

Table 15.6
Country Wheat Cloth
. Comparative advantage

0
(production after specialization)
Young Land 4,000 + (1,000/0.25)
=8,000
Happy Land 750 + (1,800/2.4) = 1,500 0
Total Production 1,500 8,000

or

Country Wheat Cloth

I
Young Land 0 =
4,000 X 2 8,000
Happy Land 750 X 2 = 1,500 0
Total Production 1,500 8,000

Table 15.6 shows that the total world output increases after
specialization. Happy Land specializes in the production of ,-vheat
by producing 1,500 kg of wheat, while Young Land specializes in the
production of cloth by producing 8,000 metres of cloth.
Step 3: The two countries must decide on the terms of trade, i.e. how Terms of trade is the rate at
which goods are exchanged;
much wheat t o exchange for cloth. Terms of trade is the rate it refers to the amount of a
at ,-vhich goods are exchanged; it refers to the amount of goods good to forgo, in order to
to forgo in order to obtain another goods. obtain another good.
 In modern economics, terms of trade refer to the relative price of
exports in terms of imports as it is defined as the ratio of export and
import prices.
Average price of exports
1erms of Trade =_ _ _._.__.__
_ _ _ _ _ x 100070L
_.__
rr
Average price of imports
Tern1s of trade is interpreted as the amount of import goods an
economy can purchase per unit of export goods. Terms of trade is said
to move in a favourable direction if the prices of a country's exports rise
relative to the prices of its imports as it no,.v receives more imports for
each unit of goods exported.
We can calculate the terms of trade ofthe two countries for both wheat
and cloth as follows:
Terms of trade for wheat: 1 ,.vheat: 2.4 - 4 cloth (see Table 15.5)
1 wheat = (2·4 + 4 )
2
= 3.2 cloth
Terms of trade for cloth: 1 cloth: 0.25 - 0.42 wheat (see Table 15.5)
(0.25 + 0.42 )
1 cloth =
2
= 0.335 wheat
Step 4: Assume that Young Land and Happy Land agreed on the
terms of trade, as follows:
1 cloth: 0.335 wheat
1 ,.vheat: 2.5 cloth
If Happy Land ,.vishes to import 2,000 metres of cloth from Young
Land, then it would have to give away 670 kg of wheat (2,000 x 0.335).
Young Land ,.vould have to give away 2,000 metres of cloth and ,.vill be
left ,.vith 6,000 metres (8,000 - 2,000) of cloth. Both countries ,.vill enjoy
more of both commodities after trade.

Table 15.7 Country Wheat

Comparative advantage I !
(consumption after
international trade)
Young Land 670 8,000-2,000=6,000
Happy Land 1,500-670=830 2,000
Total Production 1,500 8,000

Diagrammatically, we can use the production possibility curve (PPC)

to illustrate the above example (see Figure 15.2).
 Wheat Figure 15.2 -::3
Comparative advantage
gains from specialization and
::3
2,000 A international trade
-·
ll)

0
::3
1,500 C ll)

rr:I
0
1,000 ----. . ....-........ K 0
• • • • -- -- - - L'
s30
750 - --- -- - , L : ::3
-·
610 ----- -- "'- -,--- - ----- •----
' ''
- - .. K' 0
'
''
' 0
L- - '-- ;..-____:.::Dc......;
_ _ 8.--"♦
_ ;...-_ .....:,,;::. rn
-----' Cloth
1,800 3,600
2,000 4,000 6,000 8,000

Figure 15.2 shows the production possibility curve for Young Land
and Happy Land. AB is the production possibility curve for Young Land,
producing either 2,000 kg of wheat or 8,000 1netres of cloth. CD is the
production possibility curve for Happy Land, producing either 1,500 kg
of ,-vheat or 3,600 metres of cloth. They use 50% of their resources to
produce wheat and another 50% of resources to produce cloth. Both of
the1n have fixed production costs. Young Land produces at point K with
1,000 kg of wheat and 4,000 1netres of cloth, \.vhile Happy Land produces
at point L ,-vith 750 kg of wheat and 1,800 metres of cloth. Young Land
has comparative advantage in producing cloth, while Happy Land has a
comparative advantage in producing wheat. After trade, both countries
,vill increase their consumption to point K' (Young Land with 670 kg
of wheat and 6,000 metres of cloth) and L (Happy Land with 830 kg of
wheat and 2,000 metres of cloth). Both countries are better off because
their new points lie outside their production possibility curves.

SAMPLE QUESTION 15.1

The table shows the production of two countries before specialization.

Country Car ·(Unit) , Computer (Unit)

'

A 400 600
B 200 160

(a) Which country has an absolute advantage in the production of (i) cars, and (ii) computers?
Why?
(b) Calculate the comparative advantage of producing cars and computers for both countries,
and state the good that each country should specialize in.
(c) Construct a table to show the amount of goods produced after specialization.
(d) Suggest the terms of trade that will benefit both countries.
(e) Assuming that the terms of trade is 1 car: 2 computers and Country A uses 200 units of cars
domestically, show the amount of goods for both countries after trade using a table.
Solution:
(a) Country A has the absolute advantage in producing both cars and computers because it
uses the same amount of resources to produce more units of cars and computers.
(b) Calculate the opportunity cost to find the comparative advantage.

I
Country Car (Unit) Computer (Unit)
i

A 600/400=1.5 400/600=0.67

B 160/200 =0.8 200/160=1.25

Based on the calculations above, Country B will specialize in producing cars and Country A
will specialize in producing computers, since the opportunity costs are lower.
(c) Production after specialization
'
Country : Car (Unit) Computer (Unit)
I

A 0 (400/0.66) + 600= 1,200

B (160/0.8) + 200=400 0
Total Production 400 1,200

or

Country I
'
Car (Unit) ' Computer (Unit)

A 0 600X 2 =1,200
B 200 X 2 =400 0

Total Production 400 1,200

(d) TOT (Terms of trade)= 1 car: 0.8 to 1.5 computer

1 computer: 0.66 to 1.25 car
(e} Assuming that both countries agreed to exchange by the rate of 1 car: 2 computers.
Production when international trade takes place.

Country I Car (Unit) 1 Computer (Unit)

'

A 200 1,200 - 400 = 800

B 400 -200 = 200 400

Total Production 400 1,200

15.1.2 Advantages and Disadvantages of

International Trade
International trade has its advantages and disadvantages to the \.VOrld
economy as a whole or to an individual country. 'The advantages are
due to the possibility of exchange and increased specialization.
Advantages or Gains from International Trade ::3
1 Increase in world output
Different countries have different production possibilities and ::3
different demands for products across boundaries. A country -·
ll)

0
benefits fro1n free trade if specialization is possible in areas ,vhich ::3
it has absolute advantage or comparative advantage.
ll)

Specialization and division of labour enable countries to 0

0
produce more with the same resources than if they are to be ::3
self-sufficient and produce everything themselves. There is an
-·
0

increase of world output through specialization and international 0

trade as illustrated by all the examples in the previous sections.
2 Enjoy varieties of goods
Some countries have a surplus of certain goods to their needs,
while others have deficits. A country with a surplus in certain
goods should export them to exchange for goods which are scarce.
By trading globally with other countries, it gives consumers the
opportunity to be exposed to variety of goods and services not
available in their own countries. This ,vill result in a higher living
standard. It allo,.vs provision of previously unavailable products.
For instance, consumers in tropical regions enjoy temperate fruits
such as strawberries and grapes.
3 Increase in efficiency
Keen con1petition exists with international trade. In order to
survive, firms will strive for efficiency, result in lower costs and
prices. This will benefit consumers and it may also prevent the
formation of 1nonopolies in a country.
4 Enjoy economies of scale
By exporting abroad, a country is able to increase its market size.
Industries will produce at a large scale and enjoy economies of
scale, as their average costs fall and profits increase.
5 Higher income and higher rate of economic gro,vth
International trade generates higher income and brings economic
growth. When the demand for exports rises, the expansion of
production creates more e1nployment and stimulates economic
growth. A country can consume a co1nbinations of goods that lie
outside the production possibilities curve of that country.
6 Earn foreign exchange
A country ,.vill be able to earn foreign exchange ,.vhen it exports
goods. This helps the country to pay for its i1nports and settle its
debts. This reduces a deficit in the balance of payments.
7 Benefits to political, economy, social and technology links
International trade allows political links between countries to
develop. For instance, ASEAN and the European Union help
other members in economic and social cooperation. It also
promotes travel, sharing of knowledge, research and development,
information and technology among trading nations. Political

Protectionism
Barri ers that are imposed by
a country on the free flow of
goods and services, so as to
protect its domestic industries.
differences can be minimized and relationship among trading
partners can be strengthened.
Disadvantages of International Trade
I Depletions in country's reserves
The continuous export of raw materials fron1 a country, such as
oil, iron and steel, may deplete a country's reserve of the deposit
in the long run. If this happens, it will affect the gro,,vth of the
country in the long run. A country that depends on agricultural
exports is 1nore vulnerable to external influence, and therefore has
to look for new sources to preserve its natural resources and raw
materials to stabilize its economy.
2 Economics and political dependence
International trade leads to econo1nic and political dependence.
With economic specialization, a nation may have to depend on
other countries for goods or services ,-vhich makes the country
vulnerable to external forces. Fluctuation in prices will affect
employment as well as economic growth. If the political link is
,veak or has worsen, a country n1ay i1npose a quota on exports
from another country.
3 Transportation costs
International trade will not be profitable for some countries if the
transportation costs are too high, resulting in negligible gains or
profits.
15.2 PROTECTIONISM
There are limitations or restrictions to the trading activities in
international trade, although international trade helps to increase the
exchange of goods and services of a country. Restrictions implemented
by every country are kno,vn as protectionism. Protectionism can be
defined as barriers that are imposed by a country on the free flow of
goods and services, so as to protect its domestic industries.
15.2.1 Arguments or Reasons for
Protectionism
I Reduce deficit in the balance of payments
The most important purpose of protectionism is trade
protectionism. Trade protectionism is to use tariffs and quotas to
restrict imports. High imports as compared to exports will lead to
a severe deficit in the current account of the balance of payments.
As such, the IMF allows member countries to use temporary
trade restrictions to fix their balance of payments. With tariffs and
quotas, imported goods will cost more and demand for imports
will fall in relation to exports. The control on the current account
 deficit will help to manage the disequilibrium in the balance of ::3
payments.
2 Increase in government revenue ::3
The imposition of some protectionism tools will raise revenue for -·
ll)

0
the government, such as tariff and taxes. ::3
3 Protect infant industries
ll)

Infant industries need to be protected during the first few years 0

0
of their operations since they are new industries in the country. ::3
-·
0
Typically, they cannot compete with the ,,.,ell-known industries
which are operating on the economies of scale. 0
4 Prevent dumping
Dumping is a situation where goods are sold abroad at lower prices
compared to the origin market. This occurs when the overseas
Dumping
A situation where goods are
producers are given export subsidies or a monopolist practising sold abroad at lower pr ices
price discrimination. This situation may also exist when there is an compared to the origin
excess supply in the production of goods and services.
market.

5 Diversify the economy

This argument is to prevent the country from depending on one
sector only. With the in1ple1nentations of certain restrictions, the
local producers will have to diversify their goods for the domestic
market, creating a wide range of goods rather than focusing on
producing certain goods only.
6 Create more job opportunities
Through protectionism, local producers tend to produce more
goods and services. This will create more job opportunities in the
economy as the production of goods and services has increased.

15.2.2 Protectionism Tools

1 Tariff
It is the first instrument used by the government to protect local Tariff
industries. Tariff refers to taxes i1nposed on imports. When tariff Tax imposed on imports.
is imposed on imported goods, the price of these goods becomes
more expensive. This ,.vill lead to a decrease in the consumption of
imported goods by households.
2 Quota
Quota is the restriction or li1nitation on the volume of imported Quota
goods. When the government limits the import of certain goods, A restriction or limitation
it will put pressure on the price of those goods, resulting in a price on the volume of imported
increase. As such, the demand for the imported goods is expected
goods.

to decrease since they have become more expensive.

3 Subsidies on export
Local producers receive subsidies from government to produce
goods and services for export to other countries. These subsidies
encourage exports to be n1ore competitive because it helps reduce
the prices of goods and services. This is the most positive way to
implement protectionism.

Embargo
Ad rect control by the
government of a country to
control certain goods and
services from being brought
into the country.
Balance of payments is the
national account of a country
which measures all financial
transactions and flow of
currencies into and out ofthe
economy within a particular
period, usually a year.
Acurrent account measures
the inflow and outflow of
goods, services and investment
incomes, indicating the
country's income gains and
losses from trade.
4 Exchange controls
This measure occurs when the government ,vants to restrict the
supply of foreign currencies in the country. In order to import
goods and services from other countries, payments have to be
made using their currencies. Thus, controlling the availability
of foreign currencies in a country is effective in restricting the
amount of imports into the country.
5 Embargo
An embargo is considered a direct control by the government
of a country to prohibit certain goods and services entering
the country. The governn1ent n1ay ban some items fron1 other
countries, based on different ideologies.
15.3 BALANCE OF PAYMENTS
Balance of payments is the national account of a country which
measures all financial transactions and flow of currencies into and
out of the economy within a particular period, usually a year.
15.3.1 Structures and Calculations of BOP
Receipts of foreign currencies from the rest of the world are referred to
as credits and they appear in the balance of payments with a'+' sign.
Payn1ents of foreign currencies to the rest of the world are referred
to as debits and are shov.rn ,.vith '-' sign. The balance of payments
comprises three sections:
1 The current account
The current account measures the inflow and outflow of goods,
services and investment incomes, indicating the country's income
gains and losses from trade. The current account is the most
important component of the balance of payments, as it reflects the
economy's international competitiveness and the extent to which
it is living within its n1eans.
There is a current account deficit ,.vhen receipts from exports are
less than payments for imports. A surplus in the current account
occurs "vhen receipts from exports are more than payments for
i1nports.
The main components of the current account are: Trade balance
(visible trade account) and service account balance (invisible trade
account balance), e.g. insurance and services. The current account
balance is obtained by adding the balance of visible trade and the
balance of invisible trade.
(a) Trade balance (balance of visible trade) ::3
Visible balance of trade measures the value of goods exported Visible balance of trade
minus the value of goods imported. It consists of export and ::3
-·
measures the value of goods
import of physical goods such as cars and machines.
ll)
exported minus the value of
goods imported. 0
Visible Balance of Trade = Value of goods exported - Value ::3
of goods imported
ll)

Visible balance of trade is also known as the balance of 0

0
visible trade. ::3
(b) Service account balance (balance of invisible trade)
-·
0

Invisible balance of trade n1easures the value of services Invisible balance of trade 0
exported minus the value of services imported. It consists of measures the value of services
the sale and purchase of services, such as banking, insurance, exported minus the value of
brokerage, tourists spending, recipient of gifts of monies
services imported.

from overseas residents, net property income from abroad

and aid to developing countries.
Invisible Balance of Trade= Value of services exported -
Value of services imported
Invisible balance of trade is also k.i1own as the balance of
invisible trade.
(c) Net income balance (net factor payment)
Net income refers to the difference between income
receipts from abroad and income payments to residents
abroad. Incon1e receipts fron1 abroad consists of salary or
compensation received from residents working abroad
and investment income from assets abroad in the form of
interest, profit and dividend payments from bonds, stocks
etc. It is a credit items in the current account which shown
positive ( +) sign.
Income payments abroad is a debit items in the current
account which shown a negative (-) sign. It consists of
salary or compensation paid to foreign residents working
in the country and payn1ents to foreign o,-vners of assets
in the country in the form of interest, dividends and profit
remittances.
Net Income Balance = Income receipts from abroad -
Income payn1ents to residents abroad
(d) Current transfers
Current transfers are the unilateral transfer from one country Current transfers are the
to another in the form of gifts, military aid, donations and unilateral transfer from one
financial aid by the government, private organizations or country to another in the

individuals. Credit is recorded if a foreign country makes a

form of gfts, military aid,
donations and financial aid
donation to Malaysia, ""hereas a debit is recorded if Malaysia by the government, private
provides an aid to other countries. organ izations or individuals.
 2 The capital account
A capital account shows the
net change in the physical
or financial asset ownership
of a nation, which includes
foreign direct investment
(FDI), portfolio and other
investments, p lus changes in
the reserve account.
Long-term Capital Flows
Long-term capital investments,
e.g. foreign direct investment
(FDI), which involve the
purchase or construction of
machinery, buildings or whole
manufacturing plants.
Short-term Capital Flows
Also known as 'hot money'
flows as they are highly
specu l ati ve.
A capital account shows the net change in the physical or financial
asset o"vnership o f a nation, ,..,,hich includes foreign direct
investment (FDI), portfolio and other investments, plus changes
in the reserve account.
Capital inflows involve residents of other countries purchasing
capital assets within the country. Capital outflows take place
when the country's residents purchase capital assets located
in overseas countries. Capital inflows are given positive signs
vvhile capital outflows are given negative signs. Net capital flows
are the difference between inward and out,..,,ard capital flows.
Capital movements are undertaken by governments, firms and
households. We shall distinguish between long-term capital flo,vs
and short-tenn capital flows:
(a) Long-term capital flo,vs
Long-term capital flows refer to long-term direct capital
investment or portfolio investment. Real or direct
investment such as foreign direct investment (FDI) involves
the purchase or construction of machinery, buildings or
whole n1anufacturing plants, or the creation of foreign
subsidiaries. If foreigners are investing in a country, it is an
inflow of FDI and counts as a surplus item on the capital
account. However, if the citizens of the country are investing
in foreign countries, then an outflow of FDI will occur and
results in a deficit in the current account.
In contrast, portfolio investment involves the purchase
of financial assets such as shares of overseas companies or
the securities issued by foreign governments. Examples
of portfolio investinent are purchase and sale of shares in
foreign companies and public capital movements of long­
term loans between governments.
Long-term capital flovvs reflecting economic activities
and investments are located in countries which possess
comparative advantage. Long-term capital flo,..,,s tend to
be relatively stable and predictable. Visible trade, invisible
trade and long-term capital flows are sometimes known
as the autonomous or spontaneous part of the balance of
payments. They are real flo,..,,s as they result fron1 decisions
by individuals and firms to buy goods and services or to
invest in productive capital assets.
(b) Short-term capital flo,vs
Short-tern1 capital flo,..,,s are also known as 'hot n1oney' flows
as they are highly speculative. These include funds in bank
accounts or in very short-term securities such as treasury
bills. They are highly liquid and mobile i11 response to
changes in interest rates and exchange rates. The speculators
will sell the currency which is expected to fall in value and
 purchase the currency which is expected to rise in value. ::3
The short-ter1n capital flow or move1nent is influenced
by the movement of exchange rates, international differences ::3
in interest rates that attract foreign funds into countries -·
ll)

where interest rates are temporarily high. International

0
::3
crises that can cause funds to move into gold or in political ll)

stable countries. 0
Speculative movements of funds have become self­ 0
::3
fulfilling. This is because large-scale movement of funds
-·
0
out of one currency into another, creates excess supply of 0
the former currency, causing exchange rate of the former
currency to fall and excess demand of the latter currency,
causing the exchange rate of the latter currency to rise. In
this way, the movement of speculative funds produces
exactly the change in exchange rates necessary to give the
owners of capital, the speculative gain they are expecting in
the first place. Hot money movements destabilize a country's
exchange rate, balance of payments and also its domestic
economy.
(c) Errors and omissions
In theory, the capital account balance should be equal
and 'opposite' to the current account balance so that the
overall account is balanced, meaning that the credit entries
are equal to the debit entries in accounting book-keeping
concepts. However, in practice, there may be some missing
information. Hence, the BOP accountants use a balancing
item called as errors and omissions to bring the final balance
of payn1ents account to zero.
3 Official financing account
The balance in the official financing account shows the balance of The balance in the official
monetary movements in and out of a country. It reflects the total financing account shows
currency flow of the country and how the balance of pay1nents is the balance of monetary
financed. A positive sign shows a net inflow of fun.ds or surplus in movements in and out of a
country. It reflects the total
the balance of payments, ,-vhereas a net outflow or deficit in the currency flow of the country
balance of payments is sho\v. n by a negative sign. and how the balance of
A deficit in the balance of payments occurs when the central
payments is financed.

bank sells or runs down the official reserves of gold or hard

currencies. Hence, the government must finance the deficit in the
balance of payments through official financing.
The ways of financing deficit in a balance of payments include:
(a) Borrow locally
(b) Borrow fron1 international financial institutions such as the
International Monetary Fund and the World Bank
(c) Borrow from other countries central banks
(d) Draw from the official reserves of foreign exchange "vhich
have been saved over the years
(e) Sell locally or overseas an asset
 (f) Receive gifts and grants
(g) Reschedule debts
A surplus in the balance of payments occurs when there is an
excess of exports of goods and services. This surplus could be used
in the following ways:
(a) Increase its official gold and foreign currency reserves
(b) Early repayment of foreign debt either from International
Monetary Fund or foreign central bank
(c) Pay outstanding debts
(d) Lend money to other countries
(e) Purchase locally or overseas an asset
(f) Increase the official reserves of foreign exchange
(g) Invest the surplus
(h) Give gifts and grants to other countries
The balance of payments must balance exactly in the sense that all the
items included in the balance sheet must add up to zero. This is because
through official financing, the account as a whole is brought into an exact
balance as illustrated by the following exa1nple.
Let us assume that the deficit in the total balance of payments is
USDl,400 : -USDl,400 million, the calculation of official financing
account (USD million) is as follov.rs:
Foreign currency borrowing + 900
Official reserves+ 500
Total+ 1,400
Now we have balanced the balance of payments by eliminating the
deficit ofUSDl,400 n1illion.
The net official financing reflects changes in official currency reserves.
In a fixed exchange rate regime, the authorities must use official
reserves to finance a deficit or surplus in the current account to prevent
the exchange rate from falling below, or rising above, the fixed rate
determined by the authorities. In a floating exchange rate regime, the
market forces determine the exchange rate. There is no need to use
official reserves to influence the exchange rate and to finance a current
account surplus or deficit. This is because in a floating exchange rate,
when a deficit occurs, the exchange rate will fall making the country's
exports more competitive and correcting the disequilibrium in the
balance of payments. Therefore, a deficit in the balance of payments is
usually considered to be more of a problem in fixed exchange rates than
the floating exchange rates. In recent years, private sector capital flows
rather than changes in the official reserves kept by the central bank, have
financed a current account surplus or deficit.
If a country continues to have a deficit in the balance of payments
year after year, then it 1nust find ways to correct that adverse balance
of payments by increasing exports through incentives, subsidies, credit :s
facilities or improve marketing skills of local manufacturers, encourage
foreign investments, reduce government spending, devalue the local :s
currency to make exports cheaper. Imports must be reduced by increasing -·
ll)

tariffs or import duties on imported goods and services, setting quotas

0
:s
or i1nposing special licences to limit the quantity of imported goods or ll>
devaluation to make in1ports cheaper. 0
0
:s
-·
0
A. Trade BalanceNisible Trade Accounts/Merchandise Account Figure 15.3
Balance
Malaysia's balance of payments
in 2014
0
• Export
• - Import
TRADE BALANCE/TOTAL VISIBLE TRADE A
B. Service Account Balance/Invisible Trade Accounts
• Net freight and insurance
• Transport
• Travel
• Government services
• Interest payment
• Net profit and dividend
SERVICE ACCOUNT BALANCE/INVISIBLE
TRADE BALANCE B
C . BALANCE ON GOODS & SERVICES C=A +B
D. Net Investment Income
Transfer payment (net government grants) D
E. CURRENT ACCOUNT BALANCE E= C+D
F. CAPITAL ACCOUNT
(a) Long-term capital account
• Official long-term capital
• Net government debt
LONG-TERM CAPITAL BALANCE L
G. BASIC BALANCE G = E +L
(b) Short-term capital account
• + Private capital inflow
• - Private capital outflow
SHORT-TERM CAPITAL BALANCE H
CAPITAL ACCOUNT BALANCE F =L +H
Errors and Omissions I
J. OVERALL/TOTAL BALANCE OF PAYMENTS J = E + F + I
H. OFFICIAL FINANCING ACCOUNT
• Special drawing rights (SDR) from IMF
• BNM gold and currency reserves } -J
 2014
+ - Net
RM Million
Goods 679,913 566,500 113,414
Services 137,263 148,451 -11,188
Transportation 15,618 41,726 -26,108
Travel 73,951 40,478 33,472
Other services 47,404 65,620 -18,216
Government transaction 289 626 -337
Balance on goods and services 817,176 714,950 102,226
Primary Income 52,310 89,632 -37,322
Compensation of employees 5,149 10,150 -5,000
Investment income 47,160 79,482 -32,322
Secondary Income 10,308 27,894 -17,586
Balance on current account 879,794 832,476 47,317
0/oofGNI 4.4
Capital account 272
Financial account -81,597
Direct investment -18,480
Assets -53,096
Liabilities 34,616
Portfolio investment -38,536
Assets -28,111
Liabilities -10,452
Financial derivatives -975
Other investment -23,606
Official sector -2,030
Private sector -21,576
Balance on capital and financial accounts -81,325
Errors and omissions -2,500
of which:
Foreign exchange revaluation
gain(=)/ loss(-) 7,573
Overall balance (surplus+ I deficit-) -36,507
Bank Negara Malaysia
International reserves, net
RM million 405,345
USO million 115,930
Reserves as months of retained imports 8.3
Source: Adapted from Annual Report 2075, Bank Negara Malaysia
SAMPLE QUESTION 15.2
::3

::3
The data shows the balance of payments of Country Yin 2014.

Item RM (Million)
-·
ll)

0
I ::3
ll)

Transportation -1,640
0
Compensation of employees 440 0
::3
-·
0
Errors and omission -32

Merchandise export 6,739 0

Merchandise import 2,500

Direct investment 360

Other investment 300

Travelling 420
Investment income -480
Net transfer 360

Portfolio investment 420

Calculate the:
(a) Current account balance
(b) Capital and financial account balance
(c) Overall balance
(d) Does the overall balance show a situation of deficit or surplus? Why?

Solution:
(a) Current account balance
= Merchandise trade balance+ Services balance+ Net Income+ Net Transfer
= (6,739- 2,500) + (-1,640+ 420) + ( -480 + 440)+ 360
= 4,239- 1,220- 40 + 360
= RM3,339 (million)
(b) Capital and financial account balance
= Direct investment+ Other investments+ Portfolio investment
= 360 + 300 + 420
= RM1,080 (million)
(c) Overall balance
= Current account balance+ Capital and financial account balance- Errors and omissions
= 3,339 + 1,080- 32
= RM4,387 (million)
(d) A surplus, because the overall balance is positive.
Malaysia's Balance of Payments in 2015
Malaysia's external position remained resilient in 2015 despite the greater
uncertainties in the global economy. While the current account surplus
narrowed during the year, it remained supported by a sizeable trade surplus of
R.M94.6 billion (2014: RM82.5 billion).
The current account surplus narrowed amid larger deficits in the services
and secondary income accounts. The services account registered a larger
deficit due mainly to lower net receipts from the travel account and higher
net payments for other imported services for trade and investment-related
activity. Tourism receipts fell in 2015 as tourist arrivals into Malaysia were
lower, while there was an increase in outbound travel.
During the year, there was a larger deficit in the secondary income account
due to larger outward remittances by foreign workers. The deficit in the
primary income account narrowed as the decline in payments accrued to
foreign direct investors in Malaysia had more than offset the decline in income
receipts accrued to Malaysian companies investing abroad.
For the trade balance, there were two divergent trends that reflected a lower
surplus in the goods account. In the first half of the year, the external trade
performance was largely weighed down by the decline in commodity prices and
the sluggish demand for commodities and commodity-related manufactured
products. In the second half of the year, external trade improved due to a
rebound in export growth arising fron1 h.igher demand for n1anufactured
products and commodities, and the positive valuation effects from the ringgit
depreciation. For the whole year, the trade surplus was higher, supported by
both manufactured and commodity products.
The level of international reserves remained sufficient to meet short­
term external obligations, thus providing ample buffers against external
vulnerabilities.
Source: Adapted from BNM Annual Report 2015, Bank Negara Malaysia.

Case questions
(a) What are the two causes narrowed in the current account surplus?
(b) What are the factors that contribute to a larger deficit in the service
account?
(c) What caused a larger deficit i11 the secondary income?
(d) External trade performance decreased in the first half of the year. vVhy?
15.4 EXCHANGE RATE
-::3
Excha nge rates and a foreig n exchange market exist because different ::3
cou ntries use differe nt currencies to pay for trade. A currency's
exchange rate is its external price, expressed in terms of another
-·
ll)

0
::3
currency, such as US dollar or gold. ll)

Before 1914, most exchange rates ,.vere expressed in tern1s of gold. rr:I
0
After 1945, the dollar became the universally accepted standard. I n the 0
::3
UK, the Sterling Index has now replaced the US dollar as the official
-·
0
measure of the exchange rate.
0
rn
15.4.1 Definition of Exchange Rate
Excha nge rate is the price of one currency in terms of another curre ncy, Exchange Rate
which is determined by the relative price of tr aded commodities (the The pri ce of one currency in
rate of inflation). This is to ensure equality in the purchasi ng po\ver terms of another currency,

among two or more r egions.

i
which is detcrrr. ned by
the relative price of traded
If the internal value of money falls, the external value of money will commodities (the rate of
also fall: inflation) to ensure equality in

Fo reign price level

the purchasing power arnong
New Exchange Rate = Old exchange rate x two or more regions.
Local price level

Factors Influencing Exchange Rate of a Currency

The exchange rate between two countries is determi ned by:
1 The demand and supply in foreign exchange markets. Dema nd
comes fron1 individuals, firms a nd governme nts who want to
buy a curre ncy and supply comes from those who want to sell it.
Demand and supply in turn are influe nced by a variety of factors:
(a) Rate of inflation compared to the r ate of in flation in other
countries
(b) Interest rates compared to interest rates in other countries
(c) Balance of payme nts
(d) Speculation
(e) Government policy on interve ntion to influe nce exchange
rates
2 Total income and expe nditure in the domestic economy will
determine the demand for domestic, imported! and expo rted
goods.
3 Output capacity and the level of employment in the domestic
economy influe nce the balance of payments. If the economy has
achieved full employment, it will be unable to increase its volume
of production for expo rts.
4 The g ro,.vth in the money supply influe nces inter est rates a nd
domestic inflation.

Fixed Exchange Rate
A situation where the
government of a country
fixes the external value of i ts
currency, in relation to other
currenoes.
15.4.2 Exchange Rate Systems
With respect to the exchange rate systems, a nation must decide ho,-v
it will value its currency compared to other currencies. A nation can
manages its currency in the foreign exchange market through the
exchange rate regime. There are three basic types of exchange regimes:
I Fixed exchange rates: The Gold Standard and the Bretton Woods
system
2 Floating exchange rates
3 Managed floating/Managed exchange rates
Fixed Exchange Rates
I The Gold Standard
Between 1879 and 1934, the gold standard was determined as the
main exchange rate system in the world economies. In this system,
the trading countries need to fix the prices of their domestic
currencies in terms of a specified amount of gold at a fixed price.
In that respect, the various national currencies will have fixed
relationships to one another. As such, the exchange rate can easily
be determined.
For example, if the United States defines USD25 in terms of one
ounce of gold and Britain defines £5 for one ounce of gold, then
the exchange rate between dollars and pound ,-vill be USDS to £1.
Under this system, each nation must:
(a) Define its currency in terms of a quantity of gold.
(b) Maintain a fixed relationship between its stock of gold and
its money supply.
(c) Allow gold to be freely exported and imported.
The advantage of the gold standard is the ability to maintain
stable exchange rates and to correct deficits and surplus in the
balance of pay1nents automatically. On the other hand, the
gold standard has its own weaknesses. First, the country must
accept domestic adjustments in such unpleasant forms either
unemployment and falling incomes or inflation. The second
proble1n is the country cannot establish its own n1onetary policy
in its o,-vn national interest.
2 Bretton Woods system
Under the Bretton Woods system, countries have to peg their
currencies in US dollar instead of gold. The US dollar would then
be pegged directly to gold which is USD35 to an ounce of gold.
The US guaranteed that it would freely convert dollars (USD) into
gold. It was hoped that this would encourage countries to hold the
USD as their major reserve currency. After all, if the USD were
freely convertible into gold, they were as good as gold. As such,
all the other countries continued to peg their currency to the US
dollar.
 From time to time, however, they would revalue or devalue :s
their currencies against the US dollar. The Bretton Woods system
allows for different types of adjustments to the disequilibrium :s
in the balance of payment, depending on the severity of their -·
ll)

economic problems.
0
:s
Exa1nple of calculation: ll)

0
USD 1 = 0.02857 ounce of gold 0
Exchange rate : USDl = RM4
:s
-·
0
Exchange rate : USD1 = ¥50
0
If Malaysia trades with Japan and needs to import Japanese
goods worth ¥400 n1illion, the pay1nent using the exchange rate
would be:

¥400 1nillion = USD8 million = RM32 million

Revaluation
Occurs when the monetary
The government fixes the external value of its currency in relation to authorities raise the external
other currencies. Revaluation occurs when the 1nonetary authorities value of a currency to a higher
raise the external value of the currency to a higher fixed parity. fixed parity.
Devaluation occurs when the monetary authorities lower the external
value of the currency to a lower fixed parity.
Devaluation
Occurs when the n1onetary
authorities lower the external
Fixed exchange rate regime value of a currency to a lower
fixed parity.
A fixed exchange rate means the
govern1nent fixes the external
value of its currency in relation
£ Exchange rate
t o other currencies. A revaluation
happens when the monetary
authorities raise the external
value of the currency to a higher
fixed parity. Devaluation occurs
when the monetary authorities
lower the external value of the
currency to a lower fixed parity. £ Quantity

In a fixed exchange rate regime, the currency's external value remains

unchanged while the internal price level, or domestic economic activity
and output, is adjusted to eliminate the disequilibrium in the balance of
payments.
Advantages of fixed exchange rates:
(a) Ensures certainty and stability in the international financial
system and encourages the development of international trade.
(b) Discourages speculation of a country's currency as speculation
may cause fluctuations in the value of the currency.

Floating Exchange Rate
Determined by the market
forces of demand and supply of
a country's currency.
Appreciation
When demand for currency
rises relative to the supply in
the floating exchange regime,
causing the exchange rate to
nse.
Depreciation
When demand for currency
fal Is relative to the supply in
the floating exchange regime,
causing the exchange rate to
falI.
Disadvantages of fixed exchange rates:
(a) Fixed exchange rate is required to establish a level of parity
between currencies. An inappropriate parity may cause a currency
to be overvalued o r undervalued which could harm the economy.
(b) A deficit country will suffer severe deflationary costs of lost output
and unemployment whereas a surplus country will 'import'
inflation.
(c) Resources which could be used more productively else,-vhere are
tied up in official reserves, as in fixed exchange rates.
(d) By committing economic tools to the 1naintenance of a fixed
exchange rate, the government may have to sacrifice other
domestic policy objectives.
Floating Exchange Rates
A floating exchange rate or flexible exchange rate regime is determined
by market forces of demand and supply of the country's currency.
Assumptions:
(a) A country is demanded on foreign exchanges solely for the
pay1nent of trade and only trade flows will deter1nine the
exchange rates.
(b) Demand for imports is price elastic.
As British exports are priced in pound sterling, the companies ,-vhich
i1nport British goods are required to pay in pounds. The lower the
exchange rate of the pound (£), the more competitive the British exports
becomes. The increase in British exports will lead to greater overseas
demand for pounds. This will result in a dow11,vards sloping demand
curve for pounds.
On the other hand, imports generate a supply of pounds. This is because
British trading companies must pay for imports in foreign currencies.
They therefore supply or sell sterling pounds to the foreign exchange
market, in order to purchase foreign currencies to pay for inlports. If
the demand for imports js price elastic, an increase in the sterling pound
exchange rate will lo,-ver the sterling pound price of imports, enabling the
British consumers to increase their total expenditure on imports. Hence,
a greater total quantity ofsterling pounds must be supplied to the foreign
exchange market to pay for i1nports, resulting in the up,vards sloping
supply curve of pounds.
When demand for currency rises relative to the supply in the floating
exchange regime, causing the exchange rate to rise-this is referred to
as an appreciation. On the other hand, when demand for currency
falls relative to the supply in the floating exchange regime, causing the
exchange rate to fall-this is called a depreciation.
 USO exchange rate of the £ -::3
::3
USD1.50 -·
ll)

0
::3
ll)
USDl.20
rr:I
0
0
::3
-·
D, 0

0
rn
190 m 250 m

• Equilibrium exchange rate: Demand for£ = Supply of£

• Assuming:
(I) Exports and imports are the only items in the country's
balance of payn1ents.
(2) The balance of payments is also in equilibrium.
(3) Ignore capital flows, hence exchange rate equilibrium
implies balance of payments equilibrium on the current
account.
• If UK residents increase their demand for imports, the demand
for foreign exchange increases, more sterling must be supplied.
Therefore, supply curve of sterling shifts rightwards from S 1 to
S2. At an exchange rate of USDl.50, there is an excess supply
of sterling. To relieve the excess supply, the exchange rate
for pounds will depreciate or fall, hence increasing the price
competitiveness of British exports while reducing the imports.
The adjust1nent process continues until it reaches the new
equilibrium exchange rate established at USDl.20 to the pound
sterling.

Advantages of floating exchange rates:

(a) In floating exchange rates, market forces v.rill quickly adjust towards
an equilibrium exchange rate. The exchange rate should never be
overvalued or undervalued for a very long period. Overvalued
or 'too high' exchange rate causing export competitiveness and a
payment deficit.
(b) Floating exchange rate should respond and adjust to slow changes
in demand and comparative advantage.
(c) In a floating exchange rate, balance of payments surpluses
and deficits are not a 'policy problem' for the governn1ent.
Governments can simply allow market forces to look after the

Managed Exchange Rate
Used to achieve stability, as
in a fixed exchange rate, and
to avoid overvaluation and
undervaluation by responding
to market forces, as in a floating
exchange rate.
balance of payments"vhile they concentrate on domestic economic
policy. Ho\>vever, in . fixed exchange rate, overvalued exchange rate
will deteriorate competitiveness and cause unemployment.
(d) Floating exchange rate prevents the country from 'importing
inflation' from the rest of the world if inflation rates are higher in
the rest of the world. This is because the exchange rate is allowed
to rise upwards, thus the prices of imported goods will stabilize.
Ho,.vever, a fixed exchange rate causes a country to 'import'
inflation through the rising price of imported goods and services.
(e) With floating exchange rate, a country's monetary policy and fiscal
policy are independent of external conditions and influences.
There is no need to keep official reserves to increase interest rate to
attract capital flows to finance a deficit in payments. When a deficit
occurs, the exchange rate will fall to correct the disequilibrium.
The country's do1nestic money supply is unaffected by a change in
official reserves, and interest rate policy is not determined by the
need to protect the exchange rate.
Disadvantages of floating exchange rates:
(a) The volatility and instability caused by floating exchange
rates reduce the volume of international trade because of the
uncertainty over the future exchange rate.
(b) Exchange rates are vulnerable to speculative capital or 'hot
money' 1novements and fail to reflect correctly the trading
con1petitiveness of the country's industries. Hot money flo,.vs
destabilize exchange rates, balance of payments and domestic
economies and even the ,.vorld system of trade and payments.
Managed floating/Managed exchange rates
Since World War II, most of the world's principal currencies used
the managed exchange rates regime. Managed exchange rate regime
occurs when the country's central bank actively intervenes in the
foreign exchange 1narkets through buying or selling reserves and its
own currency to influence the movement of the exchange rates in a
particular direction.
The purpose of using a managed exchange rate is to achieve
stability, as in a fixed exchange rate, and to avoid overvaluation
and undervaluation by responding to market forces, as in a floating
exchange rate.
(a) Fixed pegs
This system allows a creation of a zone of flexibility around a
fixed peg. This is because market forces are free to determine the
day-to-day exchange rates of a currency between a ceiling and
floor.
If there is a surplus in the balance of payments, market forces
will push up the exchange rate, n1oving it towards a ceiling.
 Then, the central bank will increase the supply of its currency in the -::3
foreign exchange n1arket. By selling its own currency, the exchange
rate could be kept below the ceiling and within the zone of flexibility. ::3
Meanwhile, a persistent payments surplus or deficit leads to -·
ll)

a persistent tendency for the exchange rate to le.ave the zone of

0
::3
flexibility. This indicates a 'wrongly' valued exchange rate and ll)

as such, the IMF allows a country to adjust the par value of its rr:I
0
exchange rate with a formal revaluation in the case of surplus, and 0
::3
devaluation in the case of deficit.
-·
0

0
rn

International trade arises because a country may not be able to produce all
goods and services on its o,,vn. International trade refers to governmental
and individual activities i n the exchange of capital, goods, and services
across international borders or territories. However, due to the i1nmobility of
factors of production such as capital and labour, international trade is mostly
restricted to goods and services. Hence, we define international trade as the
exchange of goods and services between one country and another. A product
that is sold to the global market is defined as an export, while a product that is
purchased from the global market is called an import. International trade takes
place because of the diversity in conditions of production among countries; for
example, tropical countries produce bananas and papayas while cold countries
specialize in grapes and strawberries. Hence, international trade gives rise to
world econo1ny. As the ""orld's economy is linked at an accelerating pace, any
global events will affect domestic prices through changes in supply and demand
for imports and exports.
The balance of payments is the national account of a country and it measures
all financial transactions, flow of currencies into and out of the econo1ny within
a particular period, usually a year. Receipts of foreign currencies fron1 the rest of
the ,.vorld are referred to as credits and appear in the balance of payments with a
'+' sign. Payments of foreign currencies to the rest of the ,.vorld are referred to as
debits and are shown with a'-' sign. Balance of payment consists of three sections,
namely the current account, the capital account; investment and other capital
flo,.vs and official financing.
Exchange rates and a foreign exchange market exist because different countries
use different currencies to pay for trade. A currency's exchange rate is its external
price expressed in terms of another currency, such as US dollar or gold.
Before 1914, most exchange rates were expressed in terms of gold and only
after 1945, the dollar becomes the universally accepted standard. In the United
Kingdom, the Sterling Index has now replaced the US dollar as the official measure
of the exchange rate.
 • International trade refers to governmental and individual activities of
the exchange of capital, goods and services across international borders or
•
• territories.
• A product that is sold to the global market is defined as an export, while a
product that is purchased from the global market is called an import.
• International trade take pla,ce because of the diversity in conditions of
production an1ong countries.
• A country is said to have an absolute advantage in the production of goods
when it can produce more of certain goods than another country by using
the same amount of resources.
• Comparative advantage is measured in tern1s of opportunity cost; it refers
to a country's ability to produce certain goods with lower opportunity cost
than another country.
• Protectionism can be defined as barriers that are imposed by a country on
the free flow of goods and services, so as to protect its domestic industries.
• The balance of payments is the national account of a country and it
measures all financial transactions, flo,-v of currencies into and out of the
economy within a particular period, usually a year.
• The current account meast1res the flow of expenditure on goods and
services, indicating the country's income, gains and losses from trade.
• The capital account includes capital inflo,-vs involving residents of other
countries purchasing capital assets ,-vithin the country.
• Capital outflo,vs take place when a country's residents purchase capital
assets located in overseas countries.
• Long-term capital flo,-vs occur when residents of one country purchase or
invest in physical or productive assets.
• Short-term capital flows show short-term capital movements, which are
also kno,vn as 'hot money' flows as they are largely speculative.
• Official financing occurs when the central bank sells or runs down official
reserves of gold or hard currencies, borrowing from foreign central banks
or from the International Monetary Fund (IMF).
• Exchange rates and a foreign exchange 1narket exist because different
countries use different currencies to pay for internal trade.
• An exchange rate is determined by the relative price of traded commodities
( the rate of inflation) as to ensure equality in purchasing power between
two or more regions.
• Devaluation occurs when the monetary authorities lowered the external
value of the currency to a lower fixed parity.
• A fixed exchange rate is one where the government fixes the external value
of its currency in relation to other currencies.
• A floating exchange rate is determined by n1arket forces of den1and and
supply of the country's currency.
• An exchange rate is managed when the country's central bank actively
intervenes in the foreign exchange 1narkets, buying or selling reserves
and its own currency, to influence the moven1ent of the exchange rate in a
particular direction.
+ Key concepts
-::3
::3
-·
ll)

• International trade
• Export
• Import
• Absolute advantage
• Reciprocal or mutual
absolute advantage
• Comparative advantage
• Specialization
• Terms of trade
• Protectionism
• Dumping
0
• Tariff • Long-ter1n capital flow ::3
ll>
• Quota • Short-term capital flow rr:I
• Subsidies on export • Official financing 0
0
• Embargo • Fixed exchange rate ::3
-·
0
• Exchange controls • Revaluation
• Balance of payments • Devaluation
0
rn
• Current account • Floating exchange rate
• Visible trade • Appreciation
• Invisible trade • Depreciation
• Capital account • Managed exchange rate

+ Exercises

Multiple-choice Questions
Answer the following questions.

1 If a country can produce more of a particular
commodity compared to another country,
using the same amount of resources, that
country is said to have_ _ _
A an absolute advantage
B a comparative advantage
C a mutual advantage
D terms of trade
2 The ratio at which nations will exchange
goods and services is known as the ___
A fixed exchange rate
B interest rate
C balance on current account
D terms of trade
3 Which of the following statements is an
argun1ent for protective tariffs?
A To encourage the transfer of technology
to other countries
B To protect domestic employment
C To give local consumers 1nore choices
D To reduce the external value of domestic
currency
4 The n1ain reason why one nation trades with
another is to
A save its natural resources from rapid
exhaustion.
B achieve the gains of specialization.
C abolish the danger of retaliation from
other nations.
D develop political alliances.
5 Brazil produces more coffee than any other
country, therefore it has_ __ in coffee
production.
A an absolute advantage
B a comparative advantage
C both a comparative and an absolute
advantage
D an absolute advantage and a mutual
disadvantage
6 After Malaysia introduces a tariff in the
n1arket for pahn oil, the price of palm oil in
Malaysia will_ __
A decrease
B increase
C remain the same
D neither decrease nor increase
7 "It is suggested that an industry must be
protected at the initial stages of its growth,
so that ..."
Which of the follo,.ving completes this
infant industry argument for protectionism?
A firms can be protected from subsidized
foreign competition.
B domestic producers can attain the
economies of scale to allo,.v them to
compete in world markets.
C there will be adequate supplies of crucial
resources, in case they are needed for
national defence.
D None of the above
8 Which of the following statements is true
about quota?
A A limit on the quantity of imported
products.
B Total ban on imported goods.
C Government subsidies on exported
goods.
D Exchange controls on the sale of foreign
currencies.
9 Under a system of floating exchange rates,
an excess supply of a currency will lead to
___ of that currency.
A a depreciation
B an appreciation
C a short-term surplus
D a short-term shortage
IO An appreciation of the Malaysian ringgit
will lead to
A a decrease in the prices of Malaysia's
imports and exports.
B an increase in the prices of Malaysia's
imports and exports.
C a decrease in the prices of imported
goods, but an increase in the prices of
exported goods in Malaysia.
D an increase in the prices of imported
goods, but a decrease in the prices of
exported goods in Malaysia.
11 The infant industry argument for
protectionism is based on the concern that
A firms in a newly developing domestic
industry will have difficulty growing
if they face strong competition fro1n
established foreign firms.
B foreign buyers will absorb all of
the output of domestic producers
in a growing industry, unless trade
restrictions are imposed.
C the growth of a new industry in a nation
will be too rapid.
D firms in an economy will not grow,
unless the economy is highly diversified.
12 A tariff is
A a tax on exported goods.
B a tax on imported goods.
C an interest charged on investinent.
D an indirect business tax.
13_ _ _ is the situation where a country
exports more than it imports.
A A trade surplus
B A budget surplus
C An expansion
D A deficit
14 An excess demand for ringgit in the floating
exchange rate system will lead to ___ of
the ringgit.
A a depreciation
B an appreciation
C a long-term surplus
D a long-term shortage
15 Which of the following is not included in
the current account balance?
A Balance of goods and services
B Financial account
C Current transfer
D Net income
16 Toe floating exchange rate is the C the levels of Malaysia's exports and -:s
A total yearly amount of 1noney changed in1ports.
from one country's currency to another D All of the above :s
country's currency.
B amount of a country's currency that can 19 Protectionism can best be described as
-·
ll)

0
:s
be exchanged for one ounce of gold. A imposing tariff barrier only. ll)

C sum of net unilateral transfers. B reducing export duties to raise the price rr:I
D price of one country's currency, in terms of exports.
0
0
of another country's currency. C increasing import duties to reduce :s
-·
0
imported goods.
17 Which of the following is not a tool for D the actions and policies taken by the rn
0
restricting trade? government to restrict imports.
A Dumping
B Tariffs 20 Dumping
C Quotas A is a form of illegal price discrimination.
D Voluntary export restrictions B refers to tariff imposed on in1ports.
C is defined as selling more goods than
18 The balance of payments contains allowed by the import quota.
information, regarding D is a practice of selling goods at lower
A purchases of Malaysia's financial assets prices in foreign countries.
by foreigners.
B purchases of foreign financial assets by
Malaysian citizens.

Short-answer Questions
Answer the following questions.
1 The table shows the production possibilities schedule for books and butter of Countries
X and Y .

Country Book (Unit) Butter (g)

;'

X 400 800
y 200 600
Total 600 1,400

(a) Calculate the opportunity costs of books and butter for both countries. Interpret
the values of each opportunity cost obtained.
(b) Identify the specialization pattern, based on the principle of comparative
advantage. Briefly explain your reasons.
(c) Construct a new production possibilities schedule after specialization has taken
place.
(d) What would a mutually beneficial terms of trade for the given situation be?
2 The data shows the items in the balance of payments for Malaysia in 2014.
Item RM (Million)

Transportation 7,000
Portfolio investment 3,600
Current transfers 2,020
Capital account 5,910
Error and omission 6,000
Other services 3,200
Direct investment 3,200
Insurance 1,030
Government transaction 2,860
Income from investment 6,000
Imports 1,465
Education 1,810
Other investment 600
Exports 2,400

Calculate the:
(a) Merchandise trade balance
(b) Current account balance
(c) Capital and financial account balance
(d) Overall balance
3 The table shows the output that can be produced by two countries.

Country Rice (Tonne) Car (Unit)

I
Malaysia 600 1,500
Thailand 2,000 650

Assuming the resources are divided equally bet,,veen the production of rice and car:
(a) Define absolute advantage. State the country that has the absolute advantage in
the production of:
Rice:- - - - - -
Cars: _ _ _ __
(b) Calculate the opportunity cost of each country for producing one tonne of rice
and one unit of car.
(c) Which country has the comparative advantage of producing rice and cars?
(d) Construct a new table to show the amount of output produced after specialization.
4 The data shows the items in the balance of payme11ts for Malaysia in 2013. ::3
Item I RM (Million) ::3
Exports 679,123 -·
ll)

0
::3
Imports 570,892 ll)

Transportation -30,280 0
0
Travel 29,424 ::3
-·
0
Other business services -15,627
Compensation of employees -3,824 0

Investment income -30,302

Direct investment -34,708
Portfolio investment -10,634
Other investment 15,040
Errors and omissions (Net) 9,431

Source: Department of Statistics Malaysia

Calculate the:
(a) Balance of trade
(b) Balance on current account
(c) Balance on capital account
(d) Overall balance
5 The table shows the production possibilities schedule for computers and gasoline of
two countries, using the sa1ne amount of resources.
Country Computer I Gasoline
'

Mexico 500 200

United States 1,000 800

(a) Which country has an absolute advantage in the production of computers? Why?
(b) Calculate the comparative advantage of producing computers and gasoline for
both countries. State the good that each country should specialize in.
(c) Construct a new table to show the amount of goods produced after specialization.
(d) Assuming that the terms of trade is 1 computer : 2 gasoline and the United States
needs 400 units of computers domestically, prepare a table to show the amount
of goods for both countries after trade.
Essay Questions
Answer the following questions.
1 (a) Explain the theory of comparative advantage in international economics.
(b) Discuss three n1ain reasons ,.,hy international trade could be advantageous to
Malaysia.
2 (a) Provide two economic reasons ,vhy a country adopts a protectionism policy.
(b) Elaborate on how fiscal and 1nonetary policies can be used to correct a persistent
deficit in the balance of payments.
3 (a) Explain the current and financial accounts in the balance of payments.
(b) Suggest two ways to reduce trade deficit.
4 (a) Ho,v do countries correct a deficit in their trade balance? Explain four n1easures.
(b) Define protectionism. Using appropriate examples, discuss four trade barriers.
5 Countries continue to trade despite obstacles, due to the benefits associated with trade.
Discuss four benefits of international trade.
 3 (a)
CHAPTER 1
Air conditioner (Unit)
Multiple-choice Questions
1 A 6 C 11 D 16 A 300 t
''
2 B 7 D 12 B 17 C 250 ------:------
'
3 D 8 A 13 D 18 D ''
'
200 ''
4 A 9 B 14 C 19 B ------�------�-------
'' '' '
'
5 C 10 A 15 B 20 A 150 :' :.
'' y (d) :
'' '
' '
100 --- -•-'-: • • •- •.:.' • • • •- •-'-: • • • •-
'' ' '
'' ''
Short-answer Questions 50 I
'
'' ''
I

''I

'
1 (a) Microeconon1ics Fan (Unit)
0 5 10 15 20 25
(b) Microeconon1ics
(b) (i) 80 units of air conditioners
(c) Macroeconomics
(ii) 160 - 90 = 70 units of air
(d) Macroeconomics
conditioners
(e) Microeconomics
(iii) 25 units of fans
2 (a) (c) The PPC ,-viii shift outwards
Rice (kg) to,vards air conditioners.
(d) Any points inside the PPC
show attainable but inefficient
100 ---- ' 8 production, since the country is
, C
80
••••• J ••••
:' :' not using all its resources efficiently
----�-----:.... D (a waste of resources).
' ' '
60 ' ' '
'
''
''
'
'
'
'
4 (a) Increasing opportunity cost, due to
40 -----,----�----�--�
, , , E
I I I I
the concave shape of the PPC.
I I I I

20
I
I
'
I
I
'
I
I
'
I
I
'
(b) (i) 6,000 units of motorcycles
I I

(ii) 2,800 - 1,500 = 1,300 units of

I I
I
'F Wheat (kg)
' '

0'-----'-1---'2-�3-4---➔ cars
(b)
(c)
Car (Unit)
Rice Wheat Opportunity
Combination (Choice along PPC)
(kg) (kg) Cost
A 100 0 - 3,000
8
/ • A (Scarcity)
2,soo---------- '
B 92 1 8 kg of rice :' 8
·, (Attainable but
C 80 2 12 kg of rice •C , inefficient)
1,5 00 --·-··---•··---··-·-
D 65 3 15 kg of rice
8
E 40 4 25 kg of rice
F 0 5 40 kg of rice
B
-- .,..,,.._ Motorcycle
! - -�-....,,..,""""....,..,,
-
O 2,500 5, 00 6 , 00
(c) lOOkg ofrice 0 0
(Unit)
(d) Unattainable, due to scarcity. (d) Assumptions of the PPC:
(i) Only t\-vo goods are produced
in a country
 (ii) Limited and fixed resources 2
(iii) Fixed technology Microeconomics Macroeconomics
(iv) Full level of e1nployn1ent Studies individual and Studies economics as
5 (a) specific economic a whole
units
Durian (kg )
Analyzes the Analyzes the
6,000 economic entity in economic unit in
detail general
A
I t looks at the It looks at the entire or
5,000 8 ind ividual unit. aggregate aspects.
Examples: Examples:
4,000 ..--.. --..t -..--.... C (a) Production (a) Production
''
'
' Individual, firm Gross Domestic
''
3,000 ' and industry Product (GDP),
'' ''
(b) Prices Gross National
-------►------�-------
' ' Product (GNP),
' ' Ind ividual goods
2,000 '' '
' and services aggregate demand
'' and aggregate
'
' (c) Income
'
Distribut ion supply
1,000 L__ _:
- �--::-::-:::--7,;:E� Mang o
- among factors o f (b) Prices
0 1 00 200 300 400 (kg) production Average prices,
(b) (i) Unattainable (d) Employment Consumer Price
Index (CPI) or
(ii) Attainable and efficient Household supply
of labour inflation
(iii) Attainable but inefficient (c) Income
(c) (i) Improvement in technology Total wages and
(ii) Increase in resources salaries, total profit
(iii) Economic growth (d) Employment
(iv) Increase in population Total
employment and
unemployment
Essay Questions
3 A production possibilities curve shows
I Scarcity: Points outside the PPC are
the alternative combinations of two
known as unattainable. This happens
goods which can be produced ,vith the
due to a lack of resources to be able to
existing resources and the current level
produce outside the PPC.
of technology.
Choice: Points along the PPC are Factors that influence the PPC to
attainable and efficient points. All
shift out,¥ards (an increase in the
resources are fully utilized.
production of goods):
Opportunity cost: Movement from
(a) Increased inputs and resources/
factors of production
one point to another point. For
example, to produce n1ore of Good A,
When labour, land, capital, and
n1ore of Good B has to be sacrificed.
entrepreneurs as '"'ell as natural
Point Y: Attainable but inefficient
resources increase in an economy,
production, due to '"'aste of resources.
a country would be able to produce
Good A more goods and services.
(b) Improved level of technology
(Choice) • X(Scarcity) When there is technological
�
advancement in a country, the
• Y (Attainable but country would be able to produce
inefficient) z tow (Opportunity cost) more goods and services. This is
because the cost of production
'"'ill be reduced and the speed of
L_
_ _ _ _ _ _ _,_-+GoodB
 production for goods and services 5 )>
,.vill be fast. ::s
Capitalist Economic Socialist Economic rn
(c) Increased economic growth System System
\!\Then a country experiences an 1 Production of goods 1 Production of "1
rn
increased econon1ic gro�rth, the and services by goods and services
country would be able to produce
private sector. by public sector/
government.
more goods and services. This
2 No or minimum
government 2 No private
is because the country will have intervention. sector/central
more income to expand its factors 3 Laissez-faire planning authority
of production. 4 Price mechanism is involvement.
important. 3 Price mechanism is
4 (a) What and how much to produce less important.
Decisions on v,hat and ho,v much
5 Competition is
highly practiced. 4 No competition.
to produce is determined by the 6 Freedom of choice. 5 Less freedom of
market's demand and supply 7 Production of choice.
mechanism. Both private goods various goods and 6 Production of
and public goods are provided in services. public goods is top
the country. Society enjoys basic
pri ority.

goods at a cheaper price, and a 6

variety of goods and services are Mixed Economic
Capitalist
provided by the private sector. System: Advantages
Economic System:
Disadvantages
(b) Ho,v to produce
Producers choose the most
1 Society has 1 No public goods
economic freedom are produced.
efficient and cost-effective method and social welfare is 2 There is a pri ce
of production. Meanwhile, the fulfilled. to be paid for all
government enforces la,vs to 2 Efficient wealth goods and services
co1nbat inefficiencies that arise allocation since produced.
from negative externalities, such
public goods and 3 Inequality in
private goods are
as pollution and industry ,vastes.
distri bution of
produced at the wealth and income.
The producers ,viii choose either same time. 4 Allocation of
a labour intensive or capital 3 There is wealth depends on
intensive method that minimizes competition, purchasing power.
cost, 111axin1izes profit and achieves
leading to the
5 Existence of
production of
efficiency.
monopoly power.
quality products
6 The poor is
(c) For ,vhom to produce and the production
discri minated.
TI1e production of goods and of basic goods by
7 High social cost.
services depends on the market's
the government.
4 Both public and 8 Social welfare is
demand and society's needs. It private interests are disrupted.
is based on the society's income served.
distribution. The public sector
produces basic goods and public 7 Characteristics of Islamic economic
goods at affordable prices to serve system:
social interests, ,vhile the private (a) The production of goods and
sector produces goods and services services are based on Islamic
based on the market's demand Shari'ah.
and achieves maximu1n profit. (b) Individual entities and the private
Ho\\,ever, if there is a necessity or sector are free to make economic
if the social interest is disrupted, decisions and gain profit. The
the government will intervene and public sector ensures that social
control the prices of goods and welfare is the priority.
services.
 (c) Production of the goods and
services must be permissible
(halal), ,vhereas the production
of non-permissible (haram) goods
and services must be avoided.
(d) The production of goods and
services depends on the hierarchy
of need.
Basic philosophical foundations of
Islamic economic system:
(a) Concept of Tauhid
Believing that in !slain there is
only one God, Allah S.W.T., to be
worshipped.
(b) Concept of Rububiyyah
Believing that Allah S.\iV.T. alone
is the 1nost powerful creator,
who organizes and rev;ards man's
economic activities for genuine
interests to achieve Al-Falah in this
,vorld and the life hereafter.
(c) Concept of Tazkiyyah
The concept of purification as
Islam believes that man must
have a pure and good soul before
he indulges in any economic
activities. Individuals can purify
his wealth by giving out tithe
(zakat) and donating (sadaqah) to
the poor.
(d) Concept of Khalifah
The concept of vicegerent, which
believes that men are the servants
of Allah S.W.T.
(e) Concept of Ukhulvah
In Islam, this concept refers
to brotherhood, as all n1en are
brothers. They must love, respect
and be responsible to each other.
CHAPTER 2
Multiple-choice Questions
1 8 6 A 11 A 16 D
2 C 7 B 12 B 17 A
3 D 8 D 13 C 18 D
4 C 9 8 14 A 19 C
s D 10 D 15 C 20 D
Short-answer Questions
1 demand
2 quantity demanded
3 supply
4 do,vnwards; negative; price; quantity
demanded
5 upwards; positive; price; quantity
supplied
Essay Questions
1 (a) Number of buyers-the more the
number of buyers, the more the
demand for the goods.
(b) Tastes and preferences-changes
in buyers' taste will change their
consumption or demand for a
product.
(c) Consu1ners' income-increased
den1and for nor1nal goods if
income increases; decreased
demand for giffen goods if income
increases.
(Provide examples in the answers.)
2 (a) Dharuriyyah goods-basic need
goods, without v,hich humans
cannot survive.
(b) Hajiyyah goods-comfort goods,
,vhich provide comfort and
,vithout which humans will feel
less comfortable.
(c) Kamaliyyah goods-luxury goods,
,vhich complete the needs of
hu1nans, but 'Nithout which
hun1ans can still survive and live in
comfort.
(d) Tarafiyyah goods-non-permissible
goods, ,vhich have a negative itnpact
on society; these goods are also
extravagant and lead to 'A'astage.
(Provide examples in the answers.)
3 demanded of such commodities )>
increases, and vice versa. ::s
Real wage rate rn
(b) Luxury goods-are also normal
goods, but a norn1al good is not "1
rn
W3 ------------------------
necessarily a luxury good; when
W2 --------------- -------- - :-'---- income rises, people spend a
'
'
''
higher percentage of their income
on luxury goods.
(c) Giffen goods-are inferior goods
v,rhich people consun1e more
=
1....,: _ _ _ _
_;_ _ -'-- ....!.... --+ Hours of ,vhen its price rises because
H, H3 Hi worked
they cannot afford to buy other
The nor1nal supply curve is upward expensive goods.
sloping, showing that there is a direct (d) Necessity goods-essential to
relationship between the quantity human life; without these goods,
supplied and the price of the good. An it is i1npossible to survive.
exceptional supply curve is downv.rard (Provide examples in the answers.)
sloping, i.e. it does not follo\v the lav,
of supply. The exceptional supply
curve is used to study the relationship CHAPTER 3
bet,veen ,-vages offered and the number
of working hours. The higher the
wages offered, the higher the number
Multiple-choice Questions
of working hours would be, i.e. people 1 D 6 B 11 A 16 C
prefer to work (substitution effect). 2 C 7 D 12 D 17 A
Ho,-vever, there will come a point,
3 B 8 C 13 C 18 D
whereby people choose to relax rather
than v,ork even though the wages 4 A 9 C 14 B 19 A

offered are high, for example from W2 5 C 10 C 15 B 20 D

to Vv3• They (labour) will spend their
time on leisure activities, such as going Short-answer Questions
for holidays or being ,-vith their fan1ily
I (a) I ed I = 0.5 (inelastic demand)
members and friends. This back,-vard
(b) I ed I= 2 (elastic demand)
bending supply curve is known as the
(c) I es I= 1 (unitary supply)
exceptional supply curve.
(d) I eS I= 1 (unitary supply)
4
2 Good D
Change in Quantity
Demanded
Change in Demand EY = 6 (elastic income)
Therefore, Good D is a luxury good.
Factor: Price of the Factor: Factors other
good than the price of the GoodE
good Ey = -1.8 (negative income)
Includes movement Includes shift of the Therefore, Good E is an inferior good.
along the demand demand curve
curve Good F
Upwards movement- Shift to the right- ey = 0.9 (inelastic inco1ne)
contraction demand increases Therefore, Good F is a normal good.
Downwards Shih to the left- 3 (a) decreases
movement- demand decreases
(b) decreases
extension
(c) increases
5 (a) Normal goods-as the consumer's (d) decreases
income increases, the quantity (e) is constant
4 (a) ed = 0.75 shov;s the demand is
inelastic. Thus, the supplier has to
increase the price to increase total
revenue.
(b) ex = -1.2 denotes a negative cross
elasticity of demand. Thus, Good
M and Good N are co1nplements.
(c) ex = 2.3 denotes a positive cross
elasticity of demand. Thus, Good
Kand Good N are substitutes.
S ey = 0.7 denotes an inelastic income
elasticity of demand. Thus, the
v,ratermelon is a normal good for
Ku1nar.
Essay Questions
1 The cross-elasticity of demand
1neasures the degree of responsiveness
of the quantity demanded for a
particular good, v.•ith respect to the
change in the price of another good.
The three degrees of responsiveness to
indicate the relationship bet,veen two
goods are:
(a) Negative cross-elasticity-comple­
mentary goods.
(b) Zero cross-elasticity-both goods
are not related to each other/
independent goods.
(c) Positive cross-elasticity-the goods
are substitute goods.
2 Price elasticity of den1and n1easures
the degree of responsiveness of the
quantity demanded for a particular
good, with respect to the changes in
the price. Four deter1ninants of price
elasticity of demand are:
(a) Availability of substitutes-a good
v,ith more close substitutes will
have a higher elasticity.
(b) Habits-for consu1ners ,vho are
habituated to the consu1nption of
a particular good, such as coffee
or cigarettes, the demand for the
good will be inelastic because these
goods are essentials to them.
(c) Proportion of income spent
on a product-if only a small
proportion of income is spent on a
good, the demand will be inelastic;
for goods on which a consumer
spends a large portion of his/her
income, the demand will be elastic.
(d) Income levels-people with higher
incomes have an inelastic demand
because being richer, they are less
sensitive to price changes; those
with lower incomes have an elastic
de1nand as a slight change in price
,-viii affect their budget.

3
Perfectly Inelastic
ed =O
Vertical demand
Inelastic
o < e. < 1
Steeper slope of
e -1
Rectangular
.-
Unitary Elastic Elastic
e.> 1
Flatter slope of Horizontal
.-
Perfectly Elastic
e - "°

curve demand curve hyperbola demand curve demand curve

p p demand curve
p p
D
D
p •
D P, �
P2
"'- '
P2
P2
P, P, \. P, P, D
P,
Qd \ . Qd Qd o, Q,
Qd Qd
Q, Qi<), o, Q,
Consumers wil I The% changes in Consumers The% changes At a certain price,
buy a good or pri ce (P, increases respond to in price (P, the quantity
service regardless to P2) is larger than an equivalent increases to P) demanded is
ofthe movement the% changes % of change is smaller than infinite. If a firm
of price even when in quantity in quantity the% changes increases price by
price increases demanded (Q, demanded from in quantity 1 °A>, it would see
from P1 to P2. decreases to Q). Q1 to Q2 as the demanded (Q1 all of its quantity
price changes decreases to Q). demanded
from P, to Pi- evaporate.
4 Income elasticity of demand measures Short-answer Questions )>
the degree of responsiveness of the ::s
1 (a) rn
quantity demanded for a particular
good, v,ith respect to the changes in
P (USD)
"1
s rn
income of the consumer. The four
degrees of responsiveness in income
Surplus
500
elasticity of de1nand to determine the
Floor price/
Minimum price
particular type of good are: IP* 400
(a) Negative income elasticity-
inferior goods
(b) Zero inco1ne elasticity-essential
D
goods
(c) Inelastic incon1e elasticity- O'--- - -
2,000 --+ Q (kg)
-'-- - -

normal goods Q*

(d) Elastic income elasticity-luxury (b) Equilibrium price= USD400/kg

goods Equilibrium quantity= 2,000 kg
5 Price elasticity of supply 1neasures (c) TI1e surplus ,vill be (3,200 kg -
the degree of responsiveness of the 1,500 kg)= 1,700 kg.
quantity supplied of a particular good, Floor price/Minin1un1 price
with respect to the changes in the (d)
price. Four determinants of price P (USD)
elasticity of supply are:
(a) Perishable goods-perishable So
goods have a limited shelf life, s,
so any changes in price will not
change supply by a lot; therefore, lP
Po •• • • •• • • •• • • • : Eo
the supply is inelastic. , ••·•••••• ••• ;' •••• 'E,
' '
(b) Ease of entry into the market-the
'
� :
''
easier it is to enter into a market, '
'
' D
the greater the nu1nber of firms
'

in the market and the more price

'--
o - - -'-
-0 q--
---+
0-
,- - �
- Q (kg)

elastic the n1arket supply will be. • As technology in the production

(c) Level of technology-the higher of rubber increases, the cost of
the technology level, the more production will reduce.
price elastic the supply will be. • The supply curve of rubber will
(d) Availability of inventory-supply increase and shift rightwards.
will be more elastic if inventories • Thus, equilibrium price reduces
can be kept because supply can be from P0 to P1, equilibriu1n
added very quickly in the market. quantity increases from Q0 to Q1
and the equilibrium level moves
from E0 to Ee
CHAPTER4 2 (a) Price before tax= USDlO
Quantity before tax= 150 units
Multiple-choice Questions (b) Price after tax= USD11
Quantity after tax= 100 units
1 B 6 B 11 D 16 A
(c) Consu1ner
B
= USDlO- USDS= USDS
2 A 7 C 12 A 17
3 D 8 A 13 B 18 C Producer
4 C 9 B 14 A 19 A "' USD15 - USD 11 "' USD4
s D 10 A 15 C 20 C (d) Tax revenue collected by the
government
 = USD6 x 100 • The demand curve of cars shifts
= USD600 leftwards.
(e) Producers will pay more tax • Thus, the equilibrium price of
because the demand is elastic. cars reduces from PO to P .- The
Producers are willing to pay more equilibrium quantity reduces
because consumers are sensitive from Q0 to Q1 and the new
towards price change. equilibrium level moves from
3 (a) E0 to E1•
P (USD) 4 (a)
P (USD)

S, (after tax)

r
So (before tax) So
5, (c)
P, 2.78 • •• P, 7.40 ............. .....
p• 2.50 Po7.00 ················
P,2.28 P.6.40

-
.' '
o ----,1 37.'='s .,..
s0 -----,. Q (Litre)
' =-=,--
'- =-=-=' D
1
Q, Q*
(
Equilibrium price = USD2.50 per 0,_ 4_0_0_4_-
_ _ _ _ 3_5 -Q kg)
-
litre (b) Equilibrium price = USD7 per kg
Equilibriun1 quantity = 150 litre Equilibrium quantity = 400 kg
(b) (i) Supply curve shifts leftwards (d) Nev. equilibrium price= USD6.40
1

as shown in figure. per kg

(ii) Nev, equilibrium price New equilibriun1 quantity= 435 kg
= USD2.78 per litre (e) Consumer's benefit
Nev; equilibriun1 quantity = (USD7 - USD6.40) x 435 kg
= 137.5 litre = USD261
(iii) Consumer Producer's benefit
= (USD2.78 - USD2.SO) x 137.5 = (USD7.40 - USD7) x 435 kg
= USD38.5 = USD174
Producer
(a)
= (USD2.50 - USD2.28) x 137.5
5

= USD30.25
P (USD)

(c)
P (USD) s

s
p• 6 ... -..- .....E*
4 Ceiling price/
Shorta e Maximum price
' g
'
'
D
Q (kg)
0 70
Do Q*

- (b) Equilibrium price = USD6 per kg

D,
- Q (Litre)
Equilibrium quantity = 70 kg
'-
o ---Q
....,--'-Q-o---

• If the price of petrol increases, (c) (i) Ceiling price/Maxin1um price

the demand for cars will reduce (ii) Shortage
(iii) 90 kg - 50 kg= 40 kg
(complementary goods).
 (d) (i) (iii) )>
::s
P (USD) P (USD) rn

l
S0 (5S before subsidy) s, "1
rn
So
S, (SS after subsidy)
E,
l P, .............
Po ............. ··· : ···· o
�'
'

-
D
D
� Q (kg)
'-- ,-
o - - -
--'cQ o-----=Q-
- , - - '--
o - - -
-=-
Q , ---:,Q-
- o - Q (kg)
- +
When the government When the durian season
increases the subsidy, the cost comes to an end, the supply
of production will reduce. This of durian will reduce and the
,viii encourage production, supply curve shifts leftwards
therefore the supply 1,vill fro1n S0 to S 1• The equilibrium
increase and the supply curve price increases from P0 to P1,
shifts rightwards from S0 to S1. equilibrium quantity reduces
The equilibriun1 price reduces from Q0 to Q1 and the
from P0 to P1, equilibrium equilibrium level moves from
quantity increases from Q0 E0 to E1.
to Q1 and the equilibrium
position 1noves from E0 to E1.
Essay Questions
(ii)
I
P (USD)
p
51 (SS after tax)
s, So (SS before tax)
So
P, • Consumer
fP 2
....· ......· ...... Producer
•'
'' ''
'' D, ''
''

-
'' ''
' -'-- Do '' '
O'--- - -
� ---+ Q (kg)
Qo Q,- - - '-- -
- -'-- - - -
Q, Oo
---+Q

As the preference for durian When the govern1nent imposes

increases, the demand
for durian 1,vill increase.
The demand curve shifts
rightwards from D0 to D1• The
equilibriun1 price increases
from P0 to P1, equilibrium
quantity increases from Q0
to Q1 and the equilibriu1n
position 1noves from E0 to E1.
indirect tax on producers, the cost of
production will increase and this will
discourage production of goods and
services. The supply curve v,rill shift
to the left from S0 to S1• The price
will increase from PO to P1, while the
quantity will reduce from Q0 to Q1•
The burden of tax ,viii be shared by
both producers and consun1ers. When
 demand is inelastic, consumers will
pay more tax compared to producers.
Consumers •.vill pay (P, - P0) per unit
of tax, whereas producers ,viii only pay
(P0 - P2) per unit of tax as shown in the
shaded areas.
2 Ma.wnum price is the ceiling price
established by the government to
prevent prices from rising above the
price set by the government. The
government will impose a ceiling price
for essential goods whenever the prices
of these essential con1modities tend
to rise. Ceiling price is set below the
equilibrium price and this will cause
shortages.
p
s P1
E*
p• ............
P, t-7=======�- Ceiling pr ice/
Shqrtage D Maximum price
.�- - -
-'-- - - -
---+Q
O Q•
Two benefits of 1naximu1n price:
(a) Consumers enjoy goods and
services at a cheaper price.
(b) Increases consumers' standard of
living and reduces poverty.
Two negative i1npacts of n1aximun1
pnce:
(a) The existence of black markets
because producers are involved in
s1nuggling out the cornn1odities to
neighbouring countries, in order
to gain more profit.
(b) Producers might engage in
hoarding of commodities to force
the government to increase the
prices of the commodities.
3 Floor price is the minimum price
legally established by the government
to prevent prices from falling below
the minimun1 price set by the
government. A minimum price is
itnplemented to protect the producers'
income, especially farmers. Usually
the minimum price is imposed in the
agricultural sectors, especially in the
event that prices are too lo,v in the
market. The minimum price is set
above the equilibrium price and, thus,
surpluses ,vill be created. The concept
of 1ninimum wage is one example
of minin1u1n price or floor price.
Employers are prohibited from paying
their employees below the minimum
wage fixed by the government. For
example, if the government fixes the
minin1um price at USD!,000, then
en1ployers cannot pay their ,vorkers
less than USDl,000.
p
s
f- ___::>F==��
-
Surplus
Floor price/
Minimum price
p� .............
D
Q
0 Q*
Two advantages of minimum price:
(a) Producers' income is protected
since the price is set above the
n1arket price.
(b) The government may keep the
surplus of commodities for future
consumption.
T,vo disadvantages of minimu1n price:
(a) Consun1ers are worse offsince they
have to pay more than the market
price for the commodities.
(b) \i\Tastage of resources.
4 (a)
P (USD)
s
I D,
Do
.'----....__,_____..., Q
O Oo Q,
 A new design of skirts will (d) )>
attract teenagers v,ho love p rn
fashion to buy the skirts. s :E
Thus, the demand for skirts rn
by Asshanas \\1ill increase and
the demand curve 1,vill shift to Po
1
the right from D0 to D,. Both P,
equilibriun1 price and quantity
,,viii increase. D,

-
(b) Do
0 Q
p
Q, Oo

When the governn1ent imposes

s, GST on smartphones, the price of
So
smartphones will increase because
6% of GST will be added on to the
l PP, --
o
price of smartphones. The demand
for smartphones will reduce and
•
•
•• the demand curve shifts leftwards
•
• D
•
• from D0 to D1 • Both equilibrium
----,
O '--- o=--..,.
, _ __. o
O. o _ _ price and quantity \\'ill reduce.
When the government has 5 Market equilibrium is a situation,
banned the supply of meat whereby the quantity demanded and
from Ne1,v Zealand, the supply quantity supplied is equal and there
of n1eat will decrease and is no tendency for price and output
the supply curve 1,vill shift to change. When the goven1n1ent
to the left from S0 to S1• Both gives subsidies to producers, the
equilibrium price and quantity cost of production will reduce. This
,,viii decrease. ,,viii encourage the supply of goods
(c) and services. The supply curve shifts
rightwards from S0 to S,. The price of
goods will decrease from P0 to PI and
p

quantity increases from Q0 to Q1•

s,
p
So

l
So (SS before subsidy)
lP
P,o --------
- ---
""
-
•
•
l Po ----------------:Eo
P1 ------------ ---�---
S, (55 after subsidy)

l
•• D •
•
•
L_
_ ,;,..._...,__
_ _ _ _
_. Q
O
Q, Oo Do
As the price of chicken feed O
,'--
- - - -=-
- ....;..- - __.
- Q
Oo Q,
has increased, the cost of
production will increase. The 6 Islam allows the determination of
supply of chicken will reduce equilibrium price and quantity by
and the supply curve shifts market forces. It depends on the
left,,vards fron1 S0 to S1• Both producers and consun1ers to practice
equilibriun1 price and quantity justice and fairness, based on Shari'ah.
will reduce. When the market is not in equilibrium,
 it is not necessarily due to injustice. The (b)
existence of shortages is due to lack of Total utility
production, a reduction in in1ported
goods or the availability of goods
being less than the demand. On the
other hand, surpluses occur because
there is 1nore availability of goods
in the market, but lesser den1and.
However, Islam rejects the practice '---------cups of
of price control in the market. This
ice cream

is because it will lead to injustice to Marginal utility

either the producer or consumer. For

example, the implen1entation of ceiling
price will harm producers because the
price is lower than the market price,
whereas floor price ,vill have a negative
impact on consumers since the price
'------�-.::::-----+ Cups of
of con11nodities is higher than the ice cream
n1arket price. However, if it is necessary (c) Fifth cup of ice cream
and social welfare is disrupted, then (d) Total utility diminishes
the government may intervene and fix
the price. 3 (a)
Quantity Marginal Utility
(Unit) Sandwich Tropical Juice

CHAPTERS 1 20 25
2 20 15
Multiple-choice Questions 3 15 10

1 C 6 B 11 B 16 B 4 5 6

2 A 7 D 12 D 17 C 5 4 2

3 C 8 C 13 D 18 B 6 1 1

4 D 9 C 14 C 19 D (b) 60 - 55 = 5 utils
s B 10 A 15 D 20 B PX
(c) MRSxv = ­
pv
Short-answer Questions - 15 utils
15 utils
I (a) satisfaction or utility
(b) higher USD2
USD2
(c) budget line
= 3 units of sandv.riches
(d) diminished
and 2 units of tropical
(e) tangent
juices
2 (a) (d) 4 units of sandwiches and 3 units
Ice Cream Marginal
of tropical juices
Total Utility
(Cup) Utility 4 (a)
1 8 8 Quantity
MU/P MU/P
2 14 6 (Unit)

3 18
4 20
5 20
6 18
22 = 3. 7
4 1 6 � = 5.3
6 3
2
0 2 .!2.. = 3.2 ...!i_ = 4.67
6 3
-2
 Quantity 3 )>
MU/P MU/P ::s
(Unit) Cardinal Utility Ordinal Utility rn
3 �=3 ..!Q_ =3.33 Cardinal utility states Ordinal utility states
6 3 that utility can be that utility is not "1
rn
measured by attaching measurable, but it can
4 Jl.=2 -
8
=2.67 specific values or be ranked.
6 3 numbers of utils to
the consumption of
..!Q_ =1.67 7 =2.33
- a good or a basket of
5
6 3 goods.

-
8 =1.33 6 =2
-
6 4 Lavv of diminishing 1narginal utility
6 3
states that the utility gains for the
6 =1
- -
5 =1.67 consun1er fro1n successive units of a
7
6 3 particular product diminishes as total
consu1nption of the product increases,
(b) 4 units of Good X and 6 units of
,-vhile the consumption of all other
Good Y
products remains constant.
5 (a) 20
5 A budget line indicates the various
(b) USD2
combinations of two goods that a
(c) 40
consumer can purchase with a given
(d) 12
amount of income. In other vvords,
(e) Price of Good Y increases or the
the budget line represents the budget
consun1er's income falls.
constraints faced by the consumers.
Let us assume that Px is the price of
Essay Questions Good X, Qx is the quantity of Good
I An indifference curve shows the X, Pv is the price of Good Y, Qv is
various combinations of tvvo goods the quantity of Good Y and I is the
that give the same level of satisfaction. consumer's monetary income.
Four assumptions of the indifference GoodY
curve are:
(a) Ability to rank preferences 25 A
(b) Tastes of consumer which are Budget line
transitive
(c) Non-satiation
(d) Diminishing marginal rate of
substitution 8 Good X
L- 2-"0�
- - - - - --"
2 (a) Indifference curves do not
intersect. Suppose that Px = USDS, Pv = USD4
(b) Higher indifference curves are and I = USDlOO. By spending all
preferred to lower indifference income on Good Y, the consumer
curves. ,-vould purchase 25Y and OX. TI1is is
(c) Indifference curves are negatively denoted by endpoint A on the vertical
sloped. axis of the figure. Alternatively, by
(d) Indifference curves are convex to spending all income on Good X, the
the origin. consumer vvould purchase 20X and OY.
(e) Indifference curves do not touch This is denoted by endpoint B on the
the Y-axis and X-axis. horizontal axis. By joining endpoints
 A and B with a straight line, we will CHAPTER6
get the consumer's budget line. By
assun1ing that a consumer spends Multiple-choice Questions
all of his/her income on Good X and
Good Y, we can express the budget 1 C 6 C 11 A 16 A
constraints as: 2 B 7 C 12 D 17 D

PX QX + PY QY = I
3 C 8 A 13 C 18 A
4 D 9 C 14 B 19 D
6 Consumer equilibriu1n 1s attained
v,rhen a consun1er chooses a
5 B 10 A 15 A 20 A

con1bination of goods that n1aximizes

his/her utility at a given level of Short-answer Questions
income. This can be explained when 1 (a) declines
a consumer's budget line is tangent to (b) fixed
the indifference curve. (c) variables
GoodY (d) total product
(e) zero
p 2
A Output TVC TC AFC AVC
(Q) (USO) (USO) (USO) (USO)
Ye 0 0 200 0 0
1 60 260 200 60
2 80 280 100 40
_ _ _ _ _ _..:,,.
_ _ Good X
_
OL_ ___,x_E Q 3 90 290 66.67 30
4 100 300 so 25
A rationale consumer will choose a
5 140 340 40 28
combination on the highest indifference
curves possible, given by his/her budget
6 210 410 33.33 35

line. In the figure, point C which is at 3 (a)

the indifference curve I) denotes the
highest level of utility compared to 1 1
Total Average Marginal
Capital Labour
Product Product Product
and 12" Ho,-vever, point C is unattainable 100 0 0 0 -
because of the budget constraint, i.e.
1
it lies outside the budget line, P Q . The
100 10 10 10

only possible combinations will be 100 2 26 13 16

points A, B and E which converge ,-vith 100 3 40 13.33 14
the budget line, P Q. Since points A and 100 4 51 12.75 11
B lie on the lower indifference curve 11, 100 5 59 11.8 8
the consumerv.rill maximize the utility 100 6 64 10.67 5
at point E, \Vhere the indifference curve 100 7 66 9.43 2
12 is tangent to the budget line, PQ.
Thus, the consumer is said to be in
100 8 66 8.25 0

equilibrium at point E ,-vith XE and YE 100 9 62 6.89 -4

quantity. (b) Tv.ro

(c) Stage 2, as it is the most efficient
stage.
4 (a) Essay Questions )>
::s
Total Total
Total
Average Average
Average 1 rn
Output Fixed Variable Fixed Variable
Cost Cost Production
(Unit) Cost Cost Cost Cost
(USO) (USO) "1
(USO) (USO) (USO) (USO) (TP, AP, MP)
Stage Stage Stage
rn
0 20 0 20 0 0 0 1 2 .,,..,..d,.,_ 3
TP
1 20 30 so 20 30 so
2 20 so 70 10 25 35
3 20 66 86 6.67 22 28.67
a
•. C
4 20 90 110 5 22.S 27.5 .•
5 20 130 150 4 26 30 The law o ·:.•
diminishi g AP
6 20 186 206 3.33 31 34.33 t£....- ----'-'"""-'-"'---L-�
c.::.._
----+ (QL)

7 20 250 270 2.86 35.7 38.57 MP

(b) Stage 1: Increasing returns

Cost (USO) Stage 2: Diminishing returns
MC Stage 3: Negative returns
ATC 2 An implicit cost is not an accounting
AVC cost and is only viewed as an econo1nic
cost It is the opportunity cost of using
resources o,vned by a firm and is not
shown or reported. An example of
in1plicit cost is a business firm owning
o'--
---------
---+ Output a warehouse and using the warehouse
for its operations. Hence, the implicit
(c) Sho1t run, because the firn1 has cost for this firm is the rental inco1ne
fixed costs. received if the ,varehouse is rented out
5 to other firn1s.
Production Explicit cost is the real payment for
(TP, AP, MP)
Stage Stage Stage
any transactions which are purchased
1 2 /'T"d-,.,, 3 for production purposes and this
TP cost ,vill be documented accordingly.
Son1e exan1ples of explicit costs are
the payments for wages, fuel and
electricity, and the expenditure 111
purchasing ra,v materials.
3 (a) Supply of skilled ,vorkers
e law The pool of labour will search for
diminishi AP jobs in the location. The industry
""-- - '"'e...,
--'tu,.,_rn""s'-- .,__-� -- (QL)
will be able to obtain skilled
MP workers ,vithout advertising in the
ne,vspapers.
 (b) Managerial economies
Large firms can set up different
departn1ents according to
their needs, for example a sales
department, personnel department,
quality control departrnent,
marketing department and others.
En1ployment of professionals, e.g.
accountants, economists, business
administrators and lav.ryers, is made
possible. Therefore, these will ensure
higher productivity and greater
efficiency, leading to reduced cost
and higher returns.
(c) Technical economies
Large-scale firms can afford to use
the most modern, sophisticated
and efficient productive machinery
and equipment compared to the
small firms. They can also afford to
purchase and employ highly skilled
,vorkers to operate the n1achinery.
Additionally, they could utilize the
equipment effectively, such as in a
non-stop assembly-line operation,
as they produce a high volume of
production.
(d) Economies of concentration
Economies of concentration refers
to the concentration of firms or a
particular industry in one area.
v\Tith concentration, firms will be
able to save on transportation cost
and advertising costs to advertise
their location and products. This
,viii result i n increasing returns
to scale and decreasing cost to
industry.

4
Internal Diseconomies of Scale
(a) Technological problems
Technological problems arise when firms run
a large-scale production and over-utilize a
certain machine with a certain capacity of
production. The machine may break down
due to extensive use and may incur high
maintenance costs.
(bl Low morale
With the specialization of labour, work
becomes monotonous and dull, causing
workers to lose interest in work and
product ivity to decrease.
External Diseconomies of Scale
(a) Social problems
If soc ial problems such as pollution and traffic
congestion arise, the government will impose
taxes, fines and strict regulations on firms.
Hence, the firms will incur additional costs to
resolve the social problems in compliance with
government requirements.
(b) Wage differential within the industry
To obtain experienced and skilled workers,
firms have to pay higher wages to attract new
workers and prevent their existing workers
from moving on to other firms. Hence, the
cost of production of firms will increase
tremendously. This will result in decreasing
returns to scale.

5
Cost (USD)

LRAC

Increasing cost
Decreasing: industry
B
ost industr� (decreasing
(increasing: returns to
returns ' Constant:cost
' industry scale)
to scale) : (constant rl'?turns to scale)

Econon;ies of scale Diseconomies o.f scale

o�- - �
-------�-------�--
+ Output
o, 02 03
CHAPTER 7 (b) Perfect competition, since the )>
::s
average revenue and marginal rn
revenue are equal and fixed or
Multiple-choice Questions constant at USD40. In perfect "1
1 B 6 A 11 A 16 D
rn
competition, P= AR = MR.
2 D 7 D 12 D 17 D (c) Profit-maximizing price= USD40
3 B 8 B 13 A 18 A Profit-maximizing quantity = 5
4 B 9 D 14 A 19 D units
5 A 10 A 15 C 20 B
(d)Trr =TR-TC
=200-140
= USD60
Short-answer Questions
(e) The finn is earning supernormal
I (a) Perfect competition, because the profit as the total profit is positive,
demand curve is horizontal/ v,rhere TR > TC.
perfectly elastic.
(b) Profit-maximizing price= USD20 3 (a )
Profit-maximizing output = 100 Quantity
p TR MR TC MC
(USD) (Unit) (USD) (USD) (USD) (USD)
units
250 100 25,000 250 5,000 50
(c) TR = 20 x 100 = USD2,000
230 200 46,000 210 20,000 150
TC=25 x 100 =USD2,500
Trr = TR-TC 210 300 63,000 170 37,000 170
= 2,000-2,500 180 400 72,000 90 57,000 200
= -USD500 160 500 80,000 80 79,000 220
The fu1n is experiencing 140 600 84,000 40 104,000 250
subnormal profit.
(b) Profit-maximizing price= USD2lO
(d) Short run, because the firm is
Profit-maximizing output = 300
experiencing subnormal profit.
units
In the long run, the perfectly
(c) Trr = TR-TC
con1petitive firm will only earn
= 63,000-37,000
normal profit, due to free entry
= USD26,000
and exit of firms.
(d)The firm is earning supernormal
(e) AFC= AC -AVC = 25-15
profit as the total profit is positive,
= USDlO
v.1here TR > TC.
TFC =AFC x Q = (25 -15)x 100
= USDl,000 4 (a) A: Marginal cost (MC)
(f) The firm should continue its B: Average cost (AC)
operations since P or AR > AVC. C: Average revenue= Demand
(AR= D)
2 (a)
D: Marginal revenue (MR)
Output TR AR MR TC MC
(Unit) (USD) (USD) (USD) (USD) (USD)
(b) Profit-maximizing price=USD9
- - Profit-maxin1izing quantity = 40
0 0 0 10
units
1 40 40 40 20 10
(c) TR = 9 x 40= USD360
2 80 40 40 35 15 TC = 5 x 40 = USD200
3 120 40 40 65 30 Trc =TR-TC
4 160 40 40 100 35 = 360-200
5 200 40 40 140 40 = USD160
6 240 40 40 205 65 (d)Long run, because the firm is
7 280 40 40 283 78 experiencing supernormal profit.
8 320 40 40 365 82 In the long run, the monopoly will
only earn supernormal profit, due
9 360 40 40 461 96
to barriers to entry.
 (e) (i) One/Single seller
(ii) Price maker
(iii) Produce unique product/No
close substitutes
(iv) Barrier to entry
5 (a) Equilibrium price=USD25
Equilibrium quantity= 100 units
(b) TR =25 x 100=USD2,500
TC =25 x 100 =USD2,500
Trr =TR-TC
=2,500-2,500
=USDO
(c) The furn is realizing norn1al profit
as AR = AC and TR = TC at
MR=.tvIC.
(d) Long run, because
is relatively elastic due to product
differentiation and the availability
of close substitutes in the 1narket.
(c) Equilibrium price=USD11
Equilibrium output= 15 units
TR= 11 x 15= USD165
TC =9 x 15= USD135
(d) Trr = TR - TC
=165-135
= USD30
The firm attained supernormal
profit.
(e)
P (USD)
the
LRMC

n1onopolistically con1petitive firm LRAC

will only earn norn1al profit in the P = AC •••

long run, due to freedom of entry LRAR= D
and exit.
(e) (i) Relatively large number of
LRMR
Q (Unit)
0'--- - 0- -
-- - - -
-+
sellers
Monopolistic competition is 7 (a) Oligopoly, because the demand
characterized by a relatively curve is kinked.
large number of firms, but (b) Q
the nu1nber of firms 111 (c) B
monopolistic con1petition is (d) OBKQ; ODMQ
not as large as perfect (e) Supernonnal profit
competition. No single firm P (USD)
can influence the 1narket price
of the product.
(ii) Differentiated products A ••••.• MC
Firms 1n monopolistic B ••••.••.••••••• • .•.• '(\J
,.••••••.•• , K
'' ' ''
competition produce Profit i'
''
AC

differentiated products \\ ith

'
!
C .................. .l:H
1
............' L
close substitutes available D - --------------------�' ------- iM
in the market. There are a ' AR=D
E . . .....................:J............;',
variety of goods and services
Q (Unit)
'
available in the market and
L-
o , - - ---=
--p .,;,
-0�.,--- +
-
consumers have many choices
MR

of products. The products 8 (a) Oligopoly, due to the kinked

are differentiated in terms of
packaging, labelling, brand
names, benefits of usage,
advertising, etc.
6 (a) Y : Marginal revenue (MR)
Z: Average revenue=Demand
(AR=D)
(b) TI1e de1nand curve for a
monopolistically con1petitive firm
den1and curve.
(b) Equilibrium price=USDlOO
Equilibrium output= 100 units
(c) TR =100 x 100=USDl0,000
TC = 100 x 100=USDl0,000
(d) Trr = TR - TC
=10,000- 10,000
=USDO
Normal profit, because AR = AC
and TR= TC at MR=MC.
 (e) (i) If an oligopolistic firm reduces firms in the whole industry are )>
the price, the rivals will follo,,v making profit, it will attract ne1,v ::s
rn
by reducing their prices as well firn1s to enter the industry and the
to avoid losing customers. number of perfectly competitive rn
"1

(ii) If an oligopolistic firm increases firms will grow larger. On the

the price, the rivals will not other hand, whenever firms in
follow, but will instead 1naintain the industry are facing significant
the san1e price in order to gain losses, it 1,vill influence the existing
customers from the firm v;hich firms to exit from the industry.
increases the price. Therefore, the number of purely
(f) S1,veezy competitive fir1ns in the industry
v,rill reduce.
Essay Questions 2
I (a) Large number of sellers Perfect Competition Monopoly
There are a large number of Characteristics Characteristics
sellers and buyers in the market. • Large number of • Single seller
Ho•Never, the size of each firm is sellers • Price maker
sn,aU. The firms cannot influence • Price taker • Produces unique
or determine the prices of goods • Produces products without
that they produce. The price of standardized or substitutes
homogeneous • Barrier to entry and
co1nmodities is determined by products exit
market forces, •Nhich are n1arket • Free entry and exit
demand and market supply.
(b) Homogeneous/Standardized/
Long run equilibrium Long run equilibrium
Normal profit due to Supernormal profit
Identical products free entry and exit. due to barri er to entry
The firms produce standardized and exit.
products (homogeneous or Price and quantity Price discrimination
identical). The products are Lower price charged, Higher price charged,
identical in terms of packaging, but the equilibri um but the equilibrium
quality, design, colour, etc. Thus, output is more than output is less than
monopoly. perfect competition.
the producers cannot control price
Efficiency Efficiency
and they cannot charge different
More efficient Less efficient than
prices for the same product. For allocat ion of resources perfect competition
example, the 1,vheat produced at than monopoly since since monopoly needs
Brian's Farm would be identical to P=MC. more resources to
the wheat produced at John's Farin. produce less output,
(c) Price taker
and P > MC.

The firms have no significant 3 The condition of shutting down or not

control over the market price of
the commodities produced, due
to the sn1all size of each firn1. The
perfectly competitive firm is a price
taker, whereby the price of goods
is determined by market demand
and supply. Once the price has
been detern1ined by the 111arket,
the price would be constant.
(d) Veryeasyentry and exit
New firms can easily enter the
industry. This sho,.vs that if many
depends on the average variable cost.
A firm can still continue its operations
,.vhen the average revenue (or price)
is higher than the average variable
cost, even though it is experiencing
losses. The firm can still pay ,.vages to
,.vorkers, buy raw 1naterials and pay
for other operating expenses. On the
other hand, the firm should shut down
when the average revenue (or price) is
less than the average variable cost. 1l1is
means that the fir1n cannot cover its
 variable cost; for example, it is unable P (USD)
to pay its ,vorkers' ,,vages, buy raw LRMC
1naterials or pay for other operating
expenses. Thus, the shutdown point is
the point v,rhere the average variable LRAC
cost equals the average revenue ( or
price).
P (USD) LRAR= D
MC .L
0
-- - � ---- - Q (Unit)
- - - -+
AC Q
LRMR
AVC
MR=AR=D 5
Monopolistic
Monopoly
Competition
Characteristics Characteristics
L---
---- Q (Unit) • One/Single seller in • Large number of
1-
O- - - -0 -----..
the whole industry smal I sellers in the
4 In the long run, the monopolist ,vill • Produces unique industry
earn supernonnal profit, due to the products without • Produces
close subst itutes differentiated
characteristic of a monopoly n1arket available products
v.•hich faces barriers to entry of new • Full power to • Less power to
firtns into the industry. When there control price, o r control price
is a restriction on entry of ne,,v firms, price maker • Free entry and exit
the 111onopolist does not have any • Barrier to entry and

competitors. Due to this reason, the exit

monopolist can increase or decrease Long run equilibrium Long run equilibrium
the price, depending on the cost The Iirm earns The firm earns normal
supernormal profit in profit in the long run,
that it incurs. For instance, if the the long run, due t o due t o freedom of
cost increases, the monopolist may barrier to entry and entry and exit.
increase its price in order to avoid exit.
minimum profits or losses. This means Example Example
that the monopolist can make all the Local utilities, such Retail products, such
necessary changes to cost, due to as water supply, as shoes, clothes,
restriction on entry of new firms into electri city supply, shampoo, detergents,
entertainment, etc. etc.
the industry. The long run equilibrium
of a monopolist is achieved when long­ 6 The firm is 1naking supernormal
run marginal revenue equates long­ profit ,vhen AR exceeds AC at the
run 1narginal cost (LRMR = LRMC). equilibrium point MR = MC. The
This is shov.•n at point E. The profit­ profit-maximizing price is determined
maximizing price is obtained at point at A and the profi t -maximizing output
A and the profit-maximizing output is is achieved at Q. The shaded area,
achieved at point Q. The shaded area of ACDB, represents the supernormal
ACDB represents supernonnal profit profit earned 1n n1onopolistic
that is earned by the monopolist in the competition.
long run, due to barriers to entry.
 Supernormal profit/Economic profit Normal profit/Zero profit/Breakeven )>
P (USO) P (USO)
::s
rn
AC
MC
MC "1
rn
AC C
A (10) A (10) ----
AR=O

B (5) AR=O

- - '- ______ Q (Unit

)
_. Q (Unit
_ _ _ ) o ---Q�(-15 )
o� -Q-(1- -5)___,,_M_R
Monopolisti c competit
ion makes normal profit
Monopolistic competition earns supernormal profit when AR< AC and TR< TC at MR= MC.
when AR > AC and TR > TC at MR = MC. TR=10x15 TC=10x15 Tn=TR-TC
TR = 10 x 15 TC= 5x15 Tn = TR -TC = USD150 = USD150 = 150 -150
= USD150 = USD75 =150 - 75 =-USDO
= USD75 (Normal
(Supernormal profit)
profit)
7 In the long run, a perfectly competitive
The firm is experiencing subnormal
firm ,viii only earn normal profit due
profit because AR is less than AC at
to the freedo1n of entry and exit.
the equilibrium position MR = MC.
(a) Effect of entry
The equilibriun1 price and equilibrium
In the short run, when the
output are obtained at points A and Q
perfectly competitive fir1n achieves
respectively. The firm incurs losses as
supernormal profit, it will attract
reflected in the shaded area, ABDC.
1nany nev; firms in tlle 111arket
Subnormal profit/Negative profit/Loss to enter into the same market,
in order to maximize profit. As
P (USO)
many firms enter the market, the
MC AC nu1nber of sellers or suppliers
the market will increase.
B (15) --------�--"'0
111
•,;:.._-i--�
s• Therefore, the equilibrium market
A (10
) price will reduce and the perfectly
competitive firm will also reduce
AR=O its prices. This condition ,viii
MR cause the price to fall until profit
O'-
- - - Q U
---'- - - - - - ( n it) becomes zero. Thus, in the long
Q (15)
run, perfect competition will only
Monopolistic competition makes subnormal profit earn normal profit due to the free
when AR < ACand TR< TCat MR=MC.
TR= 10 x 15 TC= 15 x 15 Tn = TR - TC entry effect.
= USDl 50 = USD225 = 150 - 225
= -USD75 P (USO)
(Subnormal
profit)

TI1e firm is making normal profit

because AR and AC are equal at the 20
equilibrium point MR = MC. The 1 0 ............ ...........

equilibrium price is determined at

0
point A and the equilibrium quantity o '-- - � �
- - - -+ - Q (Unit
)
10 15
at point Q. The revenue obtained by
(a) Marketequilibrium
the firn1 is just enough to cover its cost.
 P (USD) increase or decrease the market price
LRMC of the products in the industry. There
are two assun1ptions that reflect the
LRAC theory of a kinked demand curve:
20 1--"s:::-
- - -+
----,,- LRAR = LRMR = D (a) If an oligopolistic firm reduces the
10 1-- =---r--
---=
=-
--LRAR, =LRMR, = D, price of its product, the rivals will
react by reducing the price of their
- Q (Unit) products as ,vell to avoid losing
0'-- -------
custo1ners.
(b) Perfect competition
(b) If an oligopolistic firm increases
(b) Effect of exit the price of its product, the rivals
The effect of exit occurs v,hen the ,viii react by not increasing the
perfectly competitive firn1 faces price of their product, but instead
subnonnal profit or loss. vVhen maintaining the same price. In
the market experiences subnorn1al doing so, the rivals ,viii gain
profit, existing firms will exit fro1n customers from the oligopolistic
the market to avoid making losses. firm that increases the price.
Thus, the equilibriun1 1narket price Due to these two assumptions,
will increase and the perfectly each oligopolistic firm faces a
competitive firm v,rill also increase kinked demand curve. A kinked
its price. Thus, perfect competition demand curve can be defined
earns normal or zero profit in the as a den1and curve faced by an
long run due to the effect of exit. oligopoly, assuming that rivals ,viii
match the price cut, but ignore the
P (USD)

'
s, price increase.
P (USD)

20 ........... ....
A Elastic demand, (Ed > 1)
10

pO •••••••••••••••••••••••••••••••••

D Inelastic demand,
o '-- -
--1 �-
0 -
51� - - -
� Q (Unit) (Ed < 1)

(a) Market equilibrium , ------::---='-+

O'-- Q (Unit)
D Qo

P (USD) The given figure explains the

LRMC behaviour of the kinked demand
LRAC
curve of a n oligopoly. AED
201-
--- represents the kinked demand
---===,-..f-..:::::- LRAR, =LRMR, = D,
curve. The den1and curve faced
10 LRAR = LRMR = D
by an oligopoly depends on the
price elasticity of demand. The
price above PO represents elastic
'-- den1and, \vhereas the price below
0 ---------- � Q (Unit)
PO corresponds with inelastic
(bl Perfect competition
demand. Whenever price increases
8 An oligopolistic firm faces a kinked above P0, which is at the kink
demand curve due to price rigidity. point, it will lead to a large drop
The concept of price rigidity explains in the quantity den1anded (based
the behaviour of an oligopolistic on the second assun1ption). As
firm v.1hich has no incentive either to price reduces below P0, there will
 be a small increase in the quantity (c) MPPxP=MRP )>
demanded since all firms will also 50 X p= 100 ::s
rn
reduce the prices of their products 100
below P0 (belov; the kink point). 50 "1
rn
Therefore, consumers will face the =USD2
same price for products from all (d) 4 workers
oligopolistic firms (based on the (e) 5 workers
second assu1nption). (f)
Wage rate

CHAPTERS
241-- - - 51
---"-- - - - -
Multiple-choice Questions
1 B 6 C 11 A 16 A 181-
-- - -
.--- - -
-",,,--
- - So
2 C 7 C 12 C 17 B
3 D 8 D 13 C 18 B MRP=D
4 A 9 D 14 A 19 C 0.__ 4 _ _ _
_ _ _ 5 _ _
_L
s C 10 B 15 D 20 A 3 (a)
Marginal Average
Total
Short-answer Questions Labour
Product
Product of Product of
(Unit) Labour Labour
I (a) the marginal revenue productivity (Unit)
(Unit) (Unit)
(MRP) curve 0 - - -
(b) perfectly elastic/horizontal 1 8 8 8
(c) marginal revenue product (MRP)
2 21 13 10.5
= marginal \,vage cost (MWC)
3 39 18 13
(d) 10 units; USDlOO
4 53 14 13.25
(e) lower; higher
5 62 9 12.4
(f) transaction 1notives; precautionary
motives; speculative n1otives 6 68 6 11.33
(g) Transfer earnings 7 68 0 9.7
(h) Rent; economic rent 8 64 -4 8
(i) Quasi-rent
(b) 4th \VOrker
(j) entrepreneur; risks; profit (c) MPL x P = 4 x 9
2 (a) = 36
MRP=MWC
Total Marginal
Product Product Total
Marginal 36 = 36
Labour Revenue
(Unit)
(Unit of Revenue
Product Therefore, 5 workers would be
per Labour (USD)
Day) (Unit)
(USD) employed.
(d)
0 0 0 0 0
Wage rate
1 so so 100 100
2 70 20 140 40
3 86 16 172 32
4 98 12 196 24
5 107 214 18
361----�,------s
9
6 112 5 224 10
MRP=D
(b) Law of diminishing marginal
returns �- - �
- - - - - -+
- L
0 5
4 (a) (b) 7 v,orkers
Marginal
Total Marginal Total Wage rate
Labour Revenue
Product Product Revenue
(Unit) Product
(Unit) (Unit) (USO)
(USO)
0 0 - - -
1 60 60 30 30
2 110 so 55 25 270 I- - - - ---".,.__ _ So
_____

3 150 40 75 20
4 180 30 90 15
5 200 20 100 10 MRP=D
o·'--- - - -'-
-7 - L
- - - - - - -+
6 210 10 105 5

(b) 4 \VOrkers (c) 9 v.rorkers

(c) MRP = MPP x P
30 = 60 X p Wage rate

p = 30
60
= USD0.50
(d) 2 workers
(e) 270 I- - - - --'.,.__ _ 5,
_____

Wage rate

MRP=D
o'-------'---------+ L
9
25 I---�-------- S1

15 1- --+- ---",.___ _ _ _ S0 Essay Questions

I The marginal productivity theory
MRP=D explains how the rewards or payments
.._- - - - - �
-- - - - -
-+L for four factors of production are
2 4
detern1ined. This1narginal productivity
5 (a) theory of distribution ,vas developed
Marginal by J . B. Clark, an American economist
Total Marginal
Labour
Product Product
Revenue in the late 19th century. The marginal
(Unit) Product
(Unit) (Unit)
(USO)
productivity theory explains that
- - - in equilibriun1, each productive
0
labour will be rewarded according
1 300 300 1,500 to their marginal productivity. The
2 535 235 1,175 equilibriu1n ,;,rage rate is determined
3 712 177 885 by the market demand and market
4 847 135 675 supply of labour. When market
5 946 99 495 demand and market supply of labour
are equal, the market equilibrium wage
6 1,020 74 370
will be attained. The market demand
7 1,074 54 270
curve of labour is downward sloping,
8 1,110 36 180 representing that the higher the wage
9 1,137 27 135 rate, the lower would be the demand
10 1,161 24 120 of labour, and vice versa. On the other
 hand, the market supply of labour
is upward sloping, showing that the
higher the wage rate, the higher ,vould
be the supply of labour, and vice versa.
This indicates that there are negative
relationships bet,veen market demand
of labour and wage rate, ,vhereas there
are positive relationships bet1,veen
market supply of labour and wage rate.
Wage rate
s of interest to n1ake an investment.
E*
w• ....................
D
�- - - - --
� - - - - -+
- L
L*
The intersection point bet,veen
n1arket demand and supply of labour is
represented by point E*, and is used to
determine the ,vage rate and quantity
of labour that will be employed. The
wage rate is obtained at OW* and L*
is the quantity o f labour that ,vill be
employed.
2 Loanable funds can be defined as the
total money that people or entities
have decided to save or lend out to
borro\vers to be used as an investment
rather than personal consumption.
According to the theory of loanable
funds, interest rate is the price
determined by the de1nand for and
supply of loanable funds.
The demand for loanable funds
comes from the borrower's side. When
the interest rate is higher, the de1nand
for investment (consun1ption) would
be lower and thus, there would be fe,ver
investors, and the reverse is also true.
This indicates there is an inverse or
negative relationship bet\veen interest
rate and investments (consu1nption).
Therefore, the demand curve for )>
loanable funds slopes do,vn,vards ::s
rn
to represent an inverse relationship
bet-A•een the volume of investn1ent and "1
rn
the interest rate, and vice versa.
Supply of loanable funds comes
from people and organizations such
as businesses and the governn1ent who
decide not to spend their money, but
instead use their savings money for
investment purposes. They ,vill lend
their money to borrowers at a rate
Savings constitute the n1ost important
source of the supply of loanable
funds. The higher the interest rate, the
higher the savings ,vill be. A higher
interest rate will encourage people
and businesses to save more since
the return on savings will be more as
,veil. Thus, there is a direct or positive
relationship between interest rate and
savings. This indicates that the supply
of loanable funds slopes upwards
to reflect the positive relationship
between the volume of savings and the
interest rate, and vice versa.
The liquidity preference theory
was propounded by John Maynard
Keynes. According to Keynes liquidity
preference theory of interest, the
interest rate is payn1ent assets in the
most liquid form. This means that
people would v;ant to hold money
,vhich is the most liquid asset rather
than less liquid assets, such as bonds
and shares. In short, liquidity refers
to the convenience of holding cash.
Therefore, this contributes towards
the demand of holding money by
people. TI1e demand for money is
downward sloping since the interest
rate is the opportunity cost of holding
money. Conversely, the supply of
money is controlled or determined
by govern1nent policies and central
banks of nations. The supply of
money consists of coins, bank notes
and demand deposits ,vith banks.
 The supply of money depends on Rent
the currency as well as the policy on
credit creation i1nplen1ented by the
s
central bank. The supply of money
is independent of the rate of interest.
Therefore, the supply curve for money E
R -•••••••••••••••••••
is perfectly inelastic or a vertical
straight line.
3 The modern theory of rent states that
land is scarce and it is not in perfect D
elastic supply. The various rates of rent
are influenced by the scarcity of the 0 Q Land
products that land can yield, not by
the differences in fertility of the land. 4 'fransfer earnings is the an1ount of
Rent is paid because the produce of the money which any particular unit
land is scarce in relation to its demand, could earn in its best paid alternative
thus land earns scarcity rent. .tvlodern use. Additionally, transfer payment
economists apply rent to all the factors can be defined as the minilnum
of production; rent is not paid for the price which n1ust be paid to keep a
use of land alone, but also for labour, factor of production in its present
capital and entrepreneurship. use or employment. Economic rent is
1he general concept of land states considered as a payment in excess of
that rent is determined by the n1arket transfer earnings.
forces of den1and and supply of factors Economic Rent = Actual earnings
of production. Demand for factors of (Total income) - Transfer earnings
production is derived demand, as it is Each factor of production has its
demanded indirectly to produce final alternative uses. For example, land can
goods. There is a negative relationship be used for planting crop or building
behveen rent and demand for a factor apartments. When we transfer a factor
of production because ,-vhen rent is from one use to another, we have to
high, the den1and for a factor ,-vill be sacrifice the earlier income earned by
low, and vice versa. Thus, the de1nand it. This sacrifice of earnings is defined
curve for a factor of production is as transfer earnings.
downward sloping from left to right.
The supply curve for a factor of Rent
production is upward sloping because 55
as rent increases, the supply of a factor
v,rill increase, and vice versa.
This is because there are alternative
E
uses for a particular factor, such as R
land. The equilibriun1 rent happens
when the demand and supply of a ER
factor intersect. DD is the demand
TE DD
for a factor of production, while SS is
the supply of a factor of production. 0
___,..Land
Q
1<..... ..__
_ _ _ _ _ _ _ _ _ _

The equilibriun1 point is at E witl1 OR

as the equilibrium rent and OQ as the DD is the demand curve for factor
equilibrium quantity. of production ,-vhile SS is the supply
 curve for factor of production. The and abnormal profit, and is earned )>
equilibrium point occurs at point ,-vhen total revenue is greater than ::s
rn
E \Vith equilibrium price at OR and the total cost. Total cost includes a
equilibrium quantity at OQ. Econon1ic re,vard to all the factors, including "1
rn
rent is the area of OREO, which is normal profit. This means that when
above the supply curve and below the total revenue equals total cost, the
equilibriu1n factor price (OR). Transfer entrepreneur is earning normal profit,
earnings is the area of OEQO, v1hich ,vhich is the 1ninin1un1 re,vard that
is below the supply curve. The actual keeps the entrepreneur providing their
earnings or total income received skills, and taking risks.
by the factor of production is ER +
TE, the area of OREQ, \vhere price x
quantity= OR x OQ. CHAPTER 9
5 The concept of quasi-rent was
developed by Alfred Marshall. He Multiple-choice Questions
defined quasi-rent as surplus earnings
generated by the factors of production,
1 C 6 D 11 C 16 B
except land. Quasi-rent refers to short­ 2 D 7 B 12 D 17 A
run economic profit or temporary 3 A 8 D 13 D 18 D
economic rent which is enjoyed by 4 D 9 C 14 B 19 B
the owner of a particular kind of s B 10 A 15 D 20 C
skill, n1achinery or barriers to entry
in the short run because the increase
in demand for it will disappear in the Essay Questions
long run. Skills, capital equipment or I (a) To achieve full en1ployment
other factors of production are elastic (b) To achieve price stability
if enough time is given because this (c) To achieve economic growth
temporary scarcity in supply can be (d) To achieve an equitable distribution
increased in the long run. Thus, quasi­ of income
rent ,-vill disappear in the long run. (e) To achieve equilibrium in the
Quasi-rent is only a temporary surplus foreign sector
that is earned in the short run because 2 (a) Social justice
the supply of capital equipment cannot (b) Equitable distribution of income
be increased in the short run. Ho,vever, (c) Universal education
the supply of capital equipment can be (d) Optimal rate of econo1nic grov.rth
increased in the long run to meet the (e) Maximization of employment
increased den,and for it, resulting in generation
the loss of excessive earnings in the
3
long run.
6 Norina} profit: In 1narkets ,-vhich
Aggregate
output
are perfectly con1petitive, the profit
available to a single firm in the long
Peak

run is called normal profit. This exists

when total revenue, TR, equals total
cost, TC. Normal profit is defined
as the n1inimu1n reward that is just
sufficient to keep the entrepreneur Trough
� ------- -
-+Time
supplying their enterprise.
A business cycle portrays a series
Supernormal profit: Supernor1nal of cycles of economic expansion and
profit is also called econon1ic profit, contraction. There are four phases in a
 business cycle: the trough, expansion,
peak and recession. An expansion
is a period during v,rhich aggregate
output grows, v,hile a recession is a
period during which aggregate output
declines. The peak is the highest
point of a business cycle, where the
business is producing at aln1ost full
capacity and the econon1y is at almost
full employment. A trough refers to
the lo,vest point of a business cycle,
v,rhere the business is operating belo,v
capacity and une1nployn1ent reaches
high levels.
4 (a) Social justice and equitable
distribution of income
Social justice is to achieve spiritual
salvation to human happiness. It
is based on the principle that all
existence in the universe belong to
Allah S.W.T. Man, God's vicegerent
on earth, has been granted the
ownership of these bounties. He
5
Scope of Economics Production Price
Microeconomics Production output Price of
in individual individual
industries and goodsand
businesses services
Macroeconomics National Aggregate
production or price level
output
must therefore use whatever is
given to him as a trustee, not as an
absolute ov.,ner.
Islatn also insists on a powerful
built-in income redistribution
mechanism. Inco1ne redistribution,
voluntary or compulsory, is not
only an econon1ic necessity, but
also a means to spiritual salvation.
(b) Universal education
Acquisition of knowledge 1s
obligatory in !slain. Thus, every
child, irrespective of his birth,
must receive an equal opportunity
for education. Man's claim to
superiority over all creations is
based on this superior kno,vledge.
In an Islamic economy, the
government must subsidize or
provide free education, so that
education is available to equalize
everyone ,vho are endov.red
differently in terms of wealth and
property.
Income Employment
Wages or income Employment
of labour and by individual
distribution of businesses and
income and wealth industries
National income Employment and
unemployment in
the economy

CHAPTER 10 = 500 + 250 + 200 + 150 + 95

= USDl,195 (million)
(b) GDPfc = NDPfc + Depreciation
Multiple-choice Questions = 1,195 + 50
1 8 6 D 11 8 16 8 = USDl,245 (n1illion)
2 C 7 C 12 C 17 D (c) NI = NDPfc + Net factor income
3 C 8 D 13 D 18 D abroad
4 D 9 A 14 B 19 B = 1,195 + 400
= USD1,595 (111illion)
s A 10 C 15 A 20 B
(d) PI = NI + Transfer payment -
Corporate tax - Employees
Short-answer Questions Provident Fund
I (a) NDPfc = 1,595 + 100 - 80 - 50
= Con1pensation of employees + = USD1,565 (million)
Net interest + Rental income + (e) DPI = PI - Personal income tax
Corporate profit + Proprietor's - 1,565 - 20
1nco1ne = USDl,545 (million)
2 (a) GDPmp = C + I + G + (X - M)
= 1,500 + I1,300 +
(-300) l + 1,090 +
(600 - 500)
= USD3,690 (million)
(b) GDPfc = GDPmp + Subsidies -
Indirect business taxes
= 3,690 + 150 - 130
= USD3,710 (million)
(c) GNPfc = GDPfc + Net factor
income abroad (NFYA)
= 3,710 + (190 - 180)
= USD3,720 (1nillion)
(d) NI = GNPfc - Depreciation
= 3,720 - 140
= USD3,580 (million)
3 (a) GDP111p = Value of final products
in the economy
= 4,750 + 11,400 + 4,000
+ 3,700 + 6,300 +
12,500
= USD48,650 (million)
(b) GDPfc = GDPfc + Subsidies -
Indirect taxes
= 48,650 + 1,445 - 8,500
= USD41,595 (n1illion)
(c) GNPfc = GDPfc + Net factor
income abroad (NFYA)
= 41,595 + 4,450
= USD46,045 (million)
( d) NNPfc/NI = GNPfc -
Depreciation
= 46,045 - 2,000
= USD44,045
5 (a)
(million)
(e) Pl = NI + Transfer payn1ents -
l�r
Corporate incon1e taxes -
Retained earnings - EPF - Consumer Price
Social security contributions Index
4 (a) NDPfc = GDPmp + (Subsidies )>
::s
- Indirect taxes) rn
Depreciation
= (13,000 + 10,200 "1
rn
+ 11,700 + 10,000
- 10,500) + (4,600 -
4,020) - 2,680
= USD32,300 (111illion)
(b) GNPfc = GDPmp + (Subsidies
- Indirect taxes) +
(Property income fro1n
abroad - Property
income to abroad)
= (13,000 + 10,200
+ 11,700 + 10,000
- 10,500) + (4,600 -
4,020) + (7,950 - 9,030)
= USD33,900 (million)
(c) NNifc = GNPfc - Depreciation
= 33,900 - 2,680
= USD31,220 (million)
(d) DI = Personal inco111e - Personal
incon1e taxes
- (31,220 + 2,350 - 2,400
- 2,750 - 3,900 - 1,700)
- 3,950
- USD18,870 (million)
(e) Real GNP = Nominal GNP x
Base year price index
Current year price index
lOO
= 33'900 X
110
= USD30,8 l 8. l 8
(n1illion)
2005 2010 2015
100 105 110

38,000 41,000 42,100

- Insurance premium Nominal GNP
(USD million)
= 44,045 + 1,700 - 7,250 -
30 32 35
1,050 - 1,170 Population
(million)
= USD36,275 (1nillion)
Real GNP (USD million) 39,047.62 38,272.73
(f) DI = Pl - Personal income taxes
= 36,275 - 1,125 Real GNP per capita 1,220.24 1,093.51
= RM35,150 (million)
(b) decreased; 1.98
Essay Questions
I The largest component in the
F
actors of Production/
Payments
• A
/ServGoods&
Labour/
Taxes /
A ' Government
Household
/ Wages/
Services
Factor Pa yments/
Goods & Services
The three-sector economy is also
called a closed economy. The difference
between the t,vo-sector and three­
sector econon1y is the involvement
of an additional sector, known as the
government sector. The principal
roles played by the government in the
circular flow are:
• Purchase goods and services from
fir1ns
• Collect taxes from households and
fir1ns
• Pay benefits and subsidies to
households and firms
If the government revenue is less
than its payments, the government is
dissaving.
2 GDP is the n1arket value of all final
goods and services produced by factors
of production located in a country,
e.g. Malaysia. It excludes intermediate
goods as ,,veil as output produced
by Malaysians abroad. This .vould
therefore include output produced
by non-residents (foreign v,rorkers)
residing or ,,vorking in the country.
GNP, on the other hand, refers to all
final goods and services produced by
Malaysians, regardless of where they
are. This automatically excludes all
output produced by foreign workers
and includes the output of Malaysians
,vorking overseas.
GNPn1p = GDPmp + (Factor income
received from abroad
Factor income paid abroad)
or
GNPn1p = GDPn1p + Net factor
income from abroad
3 (a) Compensation of employees
national incon1e. Co1npensation
of employees includes ,,vages and
salaries paid to households by
firms and by the government,
ces/Taxes
' i
•
as well as various supplement to
Firm
Payment/ \
,,vages and salaries such as the
Services
'
contributions that employers
make to social insurance and the
employees' pension fund.
(b) Proprietor's income
The income of unincorporated
businesses, either of sole
proprietorship or partnership.
(c) Rental income
Rental consists of incon1e received
by households and businesses
that supply property resources. It
includes the monthly payments
tenants make to landlords and
lease pay1nent corporations pay for
the use of office space. The figure
used in the national accounts is net
rent-gross rental income minus
depreciation of the rental property.
(d) Corporate profits
The earnings of the owners of
corporations. Earnings can be
subdivided into three categories:
• Distributed profits (Dividends)
-these are parts of corporate
profits that are paid to the
shareholders.
• Undistributed profits (Retained
earnings)-these are parts of
corporate profits that are not
distributed to the shareholders.
• Corporate income taxes-these
taxes are levied on corporations'
net earnings.
(e) Net interest
The interest households receive
on savings deposits and
corporate bonds minus the
interest households pay on their
borrowings. It also consists of the
money paid by private businesses
to the financial institutions.
4 Nominal income 1s the national
income measured at current prices.
Any change in nominal incon1e
reflects the combined effects of change
in quantity and change in price level.
On the other hand, real income refers
to the national income 1neasured at
a constant price or in a base year. By
comparing the value of production in
the two years at the same prices, the
changes in real income reflects only
the changes in real output.
5 (a) Standard ofliving indicators
Standard of living reflects the
individuals' welfare because it
shows ho,v much goods and
services can be consumed by each
individual in a country. It can
be measured by GDP per capita.
The rationale is the more goods
and services that households
benefit fron1 (fron1 their nation's
increased economic production),
the higher the increase in
consumption opportunities, which
in turn increases the standard of
living. Standard of living can be
compared based on two different
perspectives: (i) the standard
of living over time, and (ii) the
standard of living across countries.
(b) Govern1nent planning and
policies
National income statistics is a very
useful tool for the government
to forn1ulate their economic
planning. The available statistics
of national income can guide the
policymakers in planning for the
future. From the national income
data, the gover1m1ent can vie\\' the
historical trends and perfonnances
of the economic sectors. Besides,
,vith the national income data, the
government can take necessary
measures to in1prove the current
level of the economy or take
the right corrective actions. For
example, ,vhen the national income
statistics shows that the econo1ny
1s 111 recession, the policymakers )>
\\rill suggest the implementation of ::s
rn
an expansionary fiscal policy.
(c) Sectoral contributions "1
rn
An economy is made up of various
economic activities that can be
grouped according to specific
sectors, such as the primary
sector (agriculture, forestry,
mining and quarrying), secondary
sector (manufacturing and
construction) and tertiary sector
or services sector (electricity,
gas and water; v,holesale and
retail trade, accommodation and
restaurants; transport, storage
and co1nmunication; finance,
insurance, real estate and
business services; government
services and other services).
Given the availability of national
income statistics, the study of
the economic sectors shows the
relative in1portance of various
parts of the economy and the
changes ,vith ti1ne. It is also useful
for the analysis of special proble1ns
1n an econon1y.
(d) International comparisons
One of the purposes of measuring
national income is to make
international con1parisons of living
standards or real income. With the
national income statistics, we can
compare the absolute size of one
economy relative to another and
how well off the average individual
is in each country.
6 (a) Problems of non-monetized
sector
Problems of a non-n1onetized
sector usually arise in most of
the third world countries. The
existence of a large number of
non-monetized activities 111
these countries, especially 111
the agricultural sector, n1akes
the computation of the national
income more difficult. This is due
to the fact that a large quantity
 of agricultural output in these faced is the non-availability
countries d o not reach the market. of modern machinery such as
TI1e outputs are either consu1ned advanced co1nputers or progran1s
directly by farn1ers or exchanged to co1npute national incon1e
for other goods and services. data. Data collected on national
This ,vill lead to difficulties in income, regardless of the method
measuring the national income. used, needs to be analyzed using
(b) Underground economy sophisticated machinery.
Official GDP estimates may not (e) Problems of double counting
take into account the underground Double counting in the national
economy, in which transactions income will appear when
contributing to production such both values of final goods and
as illegal trade and tax-avoiding intern1ediate goods are included.
activities are not reported, As most products go through a
therefore causing the GDP to be series of production stages before
underesti1nated. So1ne people they reach the market, some of
do not disclose their inco1ne or their components are bought
underesti1nate their incon1e to and sold 1nany tin1es. To avoid
avoid paying higher taxes. Hence, this problem, GDP includes
the government losses its income only the value of final goods
revenues and sales which are not and ignores intermediate goods
reflected in the GDP. altogether. Inclusion of the value
(c) Non-market transactions of intermediate goods will amount
A number of productive work is to multiple counting which will
carried out in the economy which distort the value of the GDP.
do not involve payment. For
exa1nple, food gro,vn in backyard
plots, home repairs, clothes sewn CHAPTER 11
at home, and any other instances of
do-it-yourself goods and services Multiple-choice Questions
that people n1ake or perform for
then1selves, their fan1ilies or their 1 A 6 C 11 A 16 C
friends are not calculated in the 2 B 7 A 12 A 17 A
GDP. During these transactions, 3 A 8 A 13 C 18 D
no money changes hands and 4 A 9 C 14 C 19 A
subsequently no pay1nents are s C 10 A 15 A 20 A
recorded.
(d) Problems of expertise and
modern machinery Short-answer Questions
The lack of professionals, for 1 (a) Y - C +I+ G + X - M
exa1nple statisticians, researchers, - (300 + 0.65Yd) + 200 + 350 +
programmers and analysts, is a 120
major problem in third world - [300 + 0.65(Y - 20)] + 670
- 300 + 0.65Y - 13 + 670
countries. The services of these
professionals are very i1nportant Y - 0.65Y = 957
in estimating national income data 0.35Y = 957
accurately with minimal errors. = 957
y
0.35
Another important challenge
Y = USD2,734.29 million
 (b) (d) Y = C+I+ G )>
= 90 + 0.8Y+ 80 + 80 ::s
rn
= USDl,250 billion

(e) Deflationary gap, because NI< full "1

rn
employment output.

C, I, G, X, M

45° : Deflationary AD= AS

gap C + I + G + (X - M,,)
2,734.29 3,000

Y, < Yr denotes a deflationary gap. C + I + G + (X - M)

1
(c) =K
(1-MPC)
=K
1
0.35 0"----1-,2:_50
- 1,4-
-' 0-0 -National
..... income
(USO)
K=2.89 y Y,,
/1Y
K= 3 (a) Y0 ➔ (break-even point) ➔ S = O
11G
2,734.29) or Y= C
2.89 = (3,000-
11G -100 + 0.25Yd = 0
l1G= 265.71 -100 + 0.25Y=0
2.89 0.25Y = 100
= 92.91

(d) S = -a+ (1- b)Yd y 100

=
0.25
=-300 + (1 - 0.65)Y d Y = USD400 (million)
=-300 +0.35Yd
(b) U sing the injections = leakages
MPS = 0.35
approach
2 (a) S= I
GNP Saving Consumption -100 + 0.25Yd = 600
(USD Billion) (USD Billion) (USO Billion)
-40
-100 + 0.25Y=600
250 290
0.25Y=600 + 100
0.25 = 700
350 -20 370
450 0 450 700
Y=
550 20 530 0.25
650 40 610 Y = USD2,800 (million)
750 60 690 (c) S = 12
850 80 770 -100 + 0.25Yd = 12
-100 + 0.25(7,500) = 12
(b) MPC (370 - 290) + (350 - 250)
=
-100 + 1,875 = I2
= 0.8 I2 =USD1,775 (million)
MPS = ((-20) - (-40)] + (350 -
(d)S =-100+0.25Yd
250)
= -100 + 0.25(7,500)
= 0.2
= -100 + 1,875
or
= USD1,775 (n1illion)
MPS = 1-MPC
C=Y-S
= l - 0.8
= 0.2 = 7,500 - 1,775
= USD5,725 (million)
(c) Consumption that is influenced
by non-income factors, such as (e) APC = �
borrov-•ing or v,ealth. _ 5,725
C=a+bYd 7,500
290 = a + 0.8(250) = 0.76
a = 90
r/l APS s
-- 5 (a) Y = C +I+ G + X-M
y
y = 350+ 0.65(Y-20) + 150 + 250
; - 1,775
7,500 + 120
= 0.24 0.35Y = 857
or Y = USD2,448.57 (million)
�

APS = 1-APC (b) A deflationary gap

= 1-0.78 AD
= 0.24
4 (a) Y = 350 + 0.75Yd+ 170 + 100+ 75 AD,
= 350 + 0.75(Y-T) + 170 + 100
+ 75 AD,
= 350+ 0.75(Y - 0.15Y) + 170 +
100 + 75
= 350 + 0.75(0.85Y) + 170 + 100
+ 75
Y -0.6375Y = 695 _ - --==::---- - -
IL.._ -::-'--=-
2,228.57 3,000 - y
0.3625Y= 695 1 1
Y = 1,917.24 (c) k = = = 2·86
MPS 0.35
National income equilibrium is Change in Y = 3,000-2,448.57
USDl,917.24 (million). = 551.43
. Y
(b) KG -
1 Cl1ange m G= Change in
1 - b + bt k
551.43
= 1 -0.75 + 0.75(0.15) 2.86
= 2.7586 = USD192.81
(c) (i) (n1illion)
AD (d) MPS is the change in savings
AD=AS brought about by a change in
[C + I + G + (X - M)],
:_.;!�:;;:;:_, [C + I + G + (X - M)],
national income.
-=--=::7'�- Deflationary gap MPS and MPC are related because
MPS+ MPC= 1.
0 ""-- �--..,..,.......,,.=-�N
- 1,917.24 a t on al income
Y,= Y,= 2,000 i
(USD million)

(ii) 16 = KG
Essay Questions
1 (a) According to M. Fahim Khan,
6.Y = 6.G the consumption pattern of a
KG Muslim is obviously different from
6.G = 2,000 - 1,917.24/2.759 the conventional consumption
= 30 pattern. TI1is is because Islam has
The increment in govern1nent
its own distinct ethical standards,
expenditure required to Islamic sociology and fran1ework.
achieve a full en1ployment Spending 1n Islam includes
level of income is USD30 consumption and investment,
million. lending as well as savings in
(d) (i) Increase govern1nent expendi­ the form of hoarding. lslan1ic
ture, G-,vhen the income consun1ption is divided into two
increases, it closes the types:
deflationary gap.
• Consumption expenditure for
(ii) Reduce taxes-vvhen self and family (El)
consumption, C, increases, it
• Consumption expenditure for
closes the deflationary gap. others (E2)
 A Muslim consumer is free to
decide ho,v much of his income
,vill be spent on these l\vo
expenditures. However, Islam
gives guidelines on the spending
pattern. They are rational spending
on wealth, price level and degree
of fear in God. A rational Muslim
never hoards his savings because
with zakat, his savings will be
slo,vly reduced. Thus, all savings
,vill be invested, resulting in an
Islan1ic econo1ny that will have a
higher rate of savings and a higher
rate of investment compared to
the conventional economy. The
objective of consumption from
an Isla1nic perspective includes
to consume enough economic
goods for an efficient life and not
to consume prohibited goods;
consun1ption also cannot be
extravagant and Isla1n discourages
luxurious living. Furthermore,
consumption for satisfaction is
not the ultimate objective, but it is
more to,vards achieving the higher
end of life in this world and in the
hereafter.
(b) I Disposable income, Yd
At a higher Yd, consumption
is also higher. This is called
induced consumption.
II Non-income determinants
(i) Wealth
This includes real assets
(houses and other
durables) and financial
assets (stocks). Greater
v.•ealth leads to higher
consun1ption.
(ii) Interest rate, r
The lower the interest
rate, the lo,ver the cost of
borrowing will be;
thus, the higher the
consumption.
(iii) Expectation of house­
holds about the future
Consumption increases
when there is an expec­ )>
tation of higher prices, ::s
rn
higher inco1ne and lower
product availability. "1
rn
2 (a) C=a+bYd
a is autonomous consumption,
v.•hich is defined as the portion
of consumption when national
income is zero. Autonomous
consumption is not influenced by
income level, but by other factors
(e.g. wealth, consumers' tastes and
preferences, etc.).
bYd is included consumption,
which 1s the portion of
consumption that is influenced
by incon1e level. The higher the
income level, the higher the
induced consumption ,vill be. The
slope of the consumption function
is c, i.e. the MPC, which is the
change in consu1nption as a result
of a percentage change in national
income.
(b) (i) Halal l\lal haram
Isla1n forbids economic
activities that are against the
rules of syarak, such as trading
of haram goods (i.e. liquor
and pork) and activities which
involve unce1tainties (gharar),
such as gambling.
(ii) Benefits of investment
Investment must be beneficial
to the investors (profitable)
and also to the society (e.g.
providing e1nployment to
the people). Investment must
be prioritized based on the
hierarchy of consumption:
dharuriyyah, hajiyyah and
kamaliyyah. Investors must
ensure there is enough supply
of dharuriyyah and hajiyyah
goods, before investing in
producing kamaliyyah goods.
Investment in tarafiyyah goods
must not be done as they are
forbidden in Islam.
3 (a) (i) Only permissible activities are
allov.red.
(ii) lnvestn1ent is based on the
desires of humans and also the
needs of dharuriyyah, hajiyyah
or kamaliyyah.
(iii) Investment should e1nphasize
on welfare, besides profitability.
(iv) Its implementation should not
go against Shari'ah.
(v) Does not involve any for1n of
gharar and riba.
(b) (i) Price and productivity of
capital goods
The investment depends on
the capital goods itself. For
example, buying a machine;
if the machine is productive
and can yield more output,
then the investment in that
machine will be higher. As
another example, if a store
offering binding services is less
profitable compared to a store
that offers photocopy services,
then a producer ,,vill be more
likely to invest more in a new
photocopy machine.
(ii) Expectations of the future
If a firm has favourable or
good expectations about
the future prices of its new
product, the firn, ,,viii be
more interested to invest in
new capital equipment. For
example, a firm v.•hich is
involved in manufacturing a
new car; if the firm assumes
that the introduction of new
hybrid cars will appeal to
its potential custo1ners and,
hence, increases its sales, the
firm ,viii enlarge its investment
in the production of hybrid
cars accordingly.
(iii) Innovations
Through innovation, new
ways of producing existing
products are usually embodied
in new equipment. Thus, new
invest1nent is needed to set up
processes such as robotization
or computerization. As such,
investment expenditure is
required to n1odify the existing
equipment or to create new
equipment.
(iv) Profits
Profits gained fro1n the
previous year will influence
investment. Some investments
are financed through borrowed
funds, although much of the
investn1ent is financed by the
firm from the previous year's
profit. A higher profit will
provide a larger amount of
investment for the firm. Thus,
the fun, will need to increase its
investment if its profit is high.
(v) Rate of interest
The opportunity cost of capital
to firm is the interest rate.
The lower the interest rate,
the greater the nun1ber of
investments. When the interest
rate is lower, cost of borrowing
will also reduce and, thus, the
nun1ber of investment projects
will increase.
(vi) Government policies
The government will allo,,v tax
redemption/incentives or a
lower corporate tax to promote
investment; for example,
to encourage foreign direct
investment (FDI) in Malaysia.
( vii) Rate of return
An investment is undertaken
if it is profitable. If the cost
of investment is higher than
the rate of return, then the
investn1ent is said to be
unprofitable because a higher
rate of return will boost
investment.
4 An autonon1ous invest1nent is the
investn1ent which is independent
of national income. The amount of
invest1nent can be influenced by
interest rate, business expectations and
technology development.
Investment increases. Higher national income ,¥ill )>
attract more investment by investors. ::s
rn
- - - - Autonomous investment
Investment "1
1- -
Induced investment rn
L-- - - - - -
-lncome
Induced investment depends on
national income. As national income
i.::.... ➔
_______ Income
increases, induced investn1ent also

5 Revenue Spending

Revenue Spending
/ Market for Goods '\
and Services
Goodsand • Firms sell Goods and
services sold • Households buy services bought

Firms Households
• Produce and sell • Buy and consume
goods and services goods and services
• Hire and use factors of • Own and selI factors of
production production
.

Factors of Labour, land and

production Market for Factors capital
of Production
• Households sell
' • Firms buy J
Wages, rent and profit Income

---,�► =Flow of inputs and outputs

--� = Flow of dollars

The circular-flow diagram is a visual the market for factors of production.

model of the economy that shows ho,v The inner loop represents the flows
money flo,vs through markets an1ong of inputs and outputs betv.reen
households and firms. This diagran1 is households and firms. The outer loop
a very simple model of the economy. represents the flows of money between
Note that it ignores the roles of the households and firms.
government and international trade.
There are two decision-n1akers in the
model: households and firms. There CHAPTER 12
are two markets: the market for goods
and services, as well as the market for Multiple-choice Questions
factors of production. Firms are the
sellers in the n1arket for goods and 1 D 6 A 11 A 16 B
services and the buyers in the market 2 C 7 B 12 B 17 D
for factors of production. Households 3 D 8 C 13 B 18 C
are the buyers in the 1narket for 4 C 9 B 14 D 19 A
goods and services and the sellers in s C 10 C 15 C 20 B
Short-answer Questions
I (a) Cash ratio is fixed by the central
bank.
Cash ratio
_ Cash reserve x 1OO%
Initial deposits
= SSO X 100= 17%
5,000
(b) Money multiplier= 1 deposits at con1mercial
Cash ratio
Total money supply
= Money n1ultiplier x Initial
deposits
l X 5,000
- M3= M2 + Fixed deposits in other
17%
= USD29,41l.76
Total credit created
= Money supply - Initial deposit
= 29,411.76 - 5,000
= USD52,l 16.95
(c) Money supply ,viii decrease to
l x 5,000= USD25,000
20%
(d) (i) Amount of cash
1l1e power of credit creation
depends upon the a1nount
of cash comn,ercial banks
possess. It depends on the
amount of deposits made by
the depositors ,vith the bank.
The larger the cash an1ount of
comn,ercial banks in the form
of public deposits, the larger
the amount of credit that can
be created by banks, and vice
versa.
(ii) Supply of collateral securities
Collateral securities are a
borrower's pledge of specific
property such as land titles
or governn1ent securities to a
lender to secure repayment of
a loan. In lending agreements,
collateral serves as protection
for a lender against a default
by a borrower. If borrowers
cannot supply collateral
security, it can reduce credit
creation since loans are not
sanctioned if these securities
are not provided.
2 (a) Amount of coins= 5,500 - 3,100=
USD2,400 (million)
(b) Ml = Fiat n1oney + Current
deposits
= 5,500 + 6,850
= USD12,350 (million)
M2 = Ml + Negotiable certificates
+ BNM certificates + Fixed
banks
= 12,350 + 1,500 + 2,850 +
6,750
= USD23,450 (n1illion)
financial institutions
= 23,450 + 7,100
= USD30,550 (n1illion)
3 (a) Paper money= Currency in
circulation - Coins
= 85,000 - 32,000
= USD53,000 (n1illion)
(b) Ml= Currency in circulation +
Demand/Current deposits of
the private sector
= 85,000 + 105,000
= USD190,000 (million)
(c) M2= Ml + Savings and deposits
in commercial banks+ NCD
+ Repo + BNM certificates
= 190,000 + 210,000 + 198,000
= USD598,000 (n1illion)
(d) M3= M2 + Deposits placed v,rith
other banking institutions
= 598,000 + 18,300
= USD616,300 (million)
(e) Narro,v near money= M2 - Ml
= 598,000 - 190,000
= USD408,000 (million)
4 (a) Fiat 1noney
= Coins + Paper 1noney
= 2,500 + 3,200
= USDS,700 (million)
(b) Ml= Fiat money + Current
deposits at co1nn1ercial
banks
= 5,700 + 3,500
= USD9,200 (million)
M2 = Ml + Fixed deposits at
con1mercial banks + New
 negotiable certificates by = USDS0,000 )>
::s
commercial banks + Savings Total money created rn
deposits m comn1ercial = Money supply - Initial deposit
banks "1
= 50,000 - 5,000 rn
= 9,200 + 5,500 + 7,200 + 5,000 = USD45,000
= USD26,900 (million)
(d) Holding 3% excess reserves
M3 = N12 + Savings deposits in reduces the money supply because
other financial institutions each bank would lend less, thus
+ New negotiable certificates creating fewer checkable deposits.
by other financial institutions
+ Fixed deposits in other
financial institutions Essay Questions
= 26,900 + 1,500 + 1,800 + I (i) Medium of exchange
2,000 Money acts as a medium of
= USD32,200 (million) exchange because it is accepted by
(c) Broad quasi-money= M3 - Ml people in exchange for goods and
= 32,200 - 9,200 services. For instance, a person
= USD23,000 (million) may use USDlOO to buy a handbag
5 (a) Balance sheet: Bank X directly v,rithout exchanging goods
for other goods. With the use
Asset Liability
of 1noney, the need for a double
Cash USDS,000 Deposits USDS,000
coincidence of wants and the
Bank: 10% deposits as cash inefficiency of the barter systen,
reserves; 90% deposits as loan are eliminated.
reserves (ii) Measure of value/Unit of account
Balance sheet: Bank X Money is used for 1neasuring the
Asset Liability 'value' of goods and services in the
Cash (10%) USDSOO economy. In Malaysia, the ringgit is
Deposits USDS,000 used to measure the value of goods
Loan (90%) USD4,500
and services. Money also provides
Total USDS,000 Total USDS,000
the basis for keeping accounts and
(b) Balance sheet: Bank Y calculating profit and loss.
Asset Liability (iii) Store of value or ,vealth
Cash USD4,500 Deposits USD4,500 Any commodity that can be used
Bank: 10% deposits as cash to enable people to buy and sell
reserves; 90% deposits as loan at different tin1es and at different
reserves places is able to function as a store
of value. For instance, v.re save
Balance sheet: Bank Y
USDl,500 for future spending on
Asset Liability
a laptop as its value does not fall as
Cash (10%) USD450 fast compared to perishable goods.
Deposits USD4,500
Loan (90%) USD4,050
(iv)A standard of deferred payment
Total USD4,500 Total USD4,500 Money can be used as a payment
(c) The change in the money supply at a later date and not necessarily
depends on the initial changes in v.•hen the goods and services are
excess reserves. purchased, i.e. v,e can buy no,v and
Total money supply pay later. In view of the fact that
= Money multiplier x Initial money is stable in value, durable
deposits and acceptable by all, it can be used
1 5,000 as a payn1ent at future dates.
=-x
0.1
2 According to Keynes theory:
(i) Transaction motive
As a n1ediu1n of exchange, money
is used for conducting everyday
transactions. For example, we
use money to pay for food and
transport. People hold money in
the form of cash or checkable/
demand deposits (current deposit).
The amount held is directly related
to the level of inco1ne.
(ii) Precautionary motive
Money is held as a precaution
against some unforeseen events;
for example, to pay for tlte repair
of a car. Firms keep precautionary
balances as spare liquidity because
of uncertainties about their timing
of receipts and payments. The
level of income will determine the
amount held for this purpose.
(iii) Speculative 111otive
Firms and individuals \vho \,vish
to purchase financial assets, such
as bonds, shares and securities,
may prefer to wait if they feel
that the price is likely to fall. They
will hold idle n1oney balances. By
buying shares at a low price and
selling them when their prices rise,
capital gains can be n1ade. Money
used for this purpose is a means of
temporarily storing wealth. There
is an inverse relationship between
the quantity of money de1nanded
and the interest rate. When the
interest rate is increased, the
opportunity cost of holding money
increases and the speculative
balances ,,vill decrease.
3 Monetary policy refers to a policy
which is employed by the central
bank to control money supply as an
instrument to stabilize the economic
condition.
(i) Open market operations
This involves the buying and
selling of government securities.
Purchase of government securities
from the public can increase the
n1oney supply by adding reserves
into the banking system and
increasing loans, money supply,
investn1ent, en1ployn1ent and
aggregate demand.
(ii) Statutory reserve requirement
(SRR)
Banking institutions are required
to keep a certain percentage of
their reserves with the central
bank in the form of cash reserves.
The central bank influences a
bank's lending ability by changing
the required reserve ratio. To
promote a sustainable economic
growth, the central bank should
decrease the required reserve ratio
to increase money supply. Hence,
investment, e1nployn1ent and
aggregate demand will increase.
(iii) Bank rate policy or discount rate
By varying the discount rate (or
bank rate), the interest that the
central bank charges on loans of
reserves to commercial banks will
vary. If the central bank decreases
the discount rate, it will decrease
the cost of borrowing reserves
and encourage the borrowing
of reserves and taking loans.
This \,viii increase money supply,
investment, employment and
aggregate demand.
(iv) Fixing margin requirements
l\ilargin requirements refer to tlte
proportion of the loan amount
\-vhich is not financed by the bank,
i.e. the borrower has to raise tlte
funds of the margin amount in
order to get financing for his
purpose. A reduced margm
requirement \¥ill encourage loan
borrowing, tltus increasing money
supply, investment, employment
and aggregate demand.
4 (i) Issuing currency and keeping
reserves
The central bank is the only
financial institution ,-vith the
authority to issue currency. It
has to safeguard the value of the
currency issued.
 (ii) Acting as banker and financial facilities, such as issuing bank )>
adviser to the government drafts, cheques and traveller's ::s
rn
Central banks in all countries act cheques, facilitating foreign
as the banker and financial adviser exchange transactions, and others. "1
rn
for their respective governments. (iv) Credit creation
In Malaysia, the central bank keeps Credit creation is a process,
the goverment's principal bank v.1here a small given deposit in a
accounts, receives taxes and other commercial bank ,vill lead to an
revenue, and makes payments in increase in the supply of money.
respect of goverment expenditure, Commercial banks earn most
manages the national debts, sells of their profit from the interest
bonds and redeems 1natured generated through loans. Through
treasury bills. the process of grantmg loans,
(iii) Acting as banker to other banks commercial banks ,viii increase
The central bank performs the money supply via credit
functions as the banker to other creation.
banks. lt controls cash reserves of
con11nercial banks in the econon1y
and acts as the lender for other CHAPTER 13
banks as a last resort.
(iv) Pro1noting monetary stability Multiple-choice Questions
and a financial structure 1 D 6 C 11 B 16 C
It is the responsibility of the central 2 B 7 D 12 C 17 B
bank to employ quantitative and
3 C 8 B 13 B 18 C
qualitative monetary policies to
4 B 9 B 14 D 19 D
achieve a highlevel of employment
and maintain price stability, as 5 A 10 D 15 C 20 C
well as a reasonable balance, ,vith
regard to the country's Short-answer Questions
international payments. I
5 (i) Accepting deposits Country Income Level 10,000 12,000 14,000
This is the n1ost m1portant IRIS Tax Rate(%) 0.125 0.125 0.125
function because banks depend
Country Income Level 8,000 10,000 12,000
on such deposits from customers IMAN Tax Rate(%) 0.09 0.144 0.2
in the form of current or demand
deposits, savings deposits and Country IRIS: Proportional tax
fixed deposits. Country IMAN: Progressive tax
(ii) Providing loans and advances 2
Commercial banks give loans, Year Surplus/Deficit
such as housing loans, car loans 2012 25
or business loans, to the public 2013 0
and earn profits by itnposing an -25
2014
interest rate which is higher than
2015 -50
the discount rate. The loans are
given in the form of direct loans, 2016 -75
overdrafts and discounting bills of (a) There ,vere budget deficits in:
exchange. • Year 3 (RM25 billion)
(iii) Providing other banking services • Year 4 (RMSO billion)
and facilities • Year 5 (RM75 billion)
Co1nn1ercial banks also provide (b) There was a budget surplus 1n
other bank.mg services and Year 1 (RM25 billion).
 (c) The public debt over the five years (b) Country J
was RM125 billion. Tax rate
(RM25 billion + RMO - R..tv125
billion - RMSO billion - RM75
billion)
3 (a)
Income Level
2,000 3,000 4,000 5,000
"'
·;:
(USD) '--------+ Income
Proportional tax
Tax Paid
80 210 360 500
ct (USD) CountryK
Tax Rate(%) 4 7 9 10 Tax rate
Income Level
8,000 11,000 12,000 15,000
"' (USD)
"'1:11 Tax Paid 480 660 720 900
::, (USD)
Tax Rate(%) 6 6 6 6

(b) Austria: Progressive tax

Uganda: Proportional tax
4 CountryL
Total Taxes (RM) Tax rate
Total
Income Tax Tax Tax
(RM) Farisha Rate Farish Rate Faiz Rate
(%) (%) (%)
6,000 300 s 300 s 360 6
8,000 560 7 400 s 400 s
10,000 800 8 500 s 400 4 '--------+
Regressive tax
Income
12,000 1,080 9 600 s 360 3

(a) Farisha = 560 x 100 = 7% Essay Questions

8,000
1 (a) Operating expenditure
Farish = 4oo x 100 = 5%
8,000 Operating expenditure refers to the
expenditure of various government
Paiz = 4000 x 100 = 5%
8,000 departments to n1aintain their
(b) Farisha = Progressive tax services. For example, pension and
Farish = Proportional tax gratuities, debt service charges,
Paiz = Regressive tax expenditures for maintenance and
(c) Income tax, corporate tax and poll repair works.
tax (b) Development expenditure
5
Development expenditure refers to
(a)
an expenditure related to projects
Total Total Taxes (RM)
that boosts economic grov.rth
Taxable Tax Tax Tax
Income Country Country
Rate K Rate L
Country
Rate or strengthens the productive
(RM) J capacity of the economy. This
(%) (%) (•/4)
7,000 140 2 210 3 210 3 expenditure is allocated for the
8,000 160 2 320 4 160 2
security sector, such as armed
forces, social services such as
9,000 180 2 540 6 90 1
education, health and housing,
 and the economic sector such as increases as income increases. It )>
agriculture and rural develop1nent, ilnposes a greater portion of tax ::s
rn
public utilities, trade and industry, on the higher incon1e group than
transport and infrastructural the lower income group. This is the "1
rn
facilities. n1ost effective 1,vay of redistributing
2 (a) Surplus budget (G < T) the income among the population.
A budget surplus is also kno,vn This form is practiced in personal
as contractionary fiscal policy. income tax.
It occurs when government Tax rate
revenue (T) 1s greater than
government spending (G). TI1is
can be achieved by increasing taxes
and/or decreasing government
expenditure.
(b) Deficit budget (G > T)
A budget deficit or expansionary
fiscal policy occurs ,vhen (b) Proportional tax
govern1nent spending (G) is The rate of tax remains constant
greater than government revenue as income changes. An example is
(T). The ways to have a deficit corporation tax.
budget are by decreasing taxes Tax rate
and/or increasing governn1ent
expenditure or by both.
3 (a) Jizyah
It is a tax ilnposed on the 11011-
Muslin1s in lieu of the guarantee
(c) Regressive tax
given to then1 by an Islan1ic state
for the protection of their lives and
This structure ,viii make the
properties. Indeed, it is the duty of
lower inco111e group bear a higher
the Islamic government to protect
proportion of tax than the higher
the lives and properties of non­
income group does. This is where
Muslims like of any other Muslim
the rate of tax decreases as income
citizen.
increases.
(b) Kharaj
Tax rate
It is a tax on land or agricultural
land o•,,_rned by non-Muslims in the
Islamic state. The rate viii! n1ainly
depend on the quality of the land,
fertility, irrigation requirements
and other factors. It should be
fixed on the basis of equity, so that
no injustice is done to farmers. 5 (a) Expenditures on tasks ordained by
4 (a) Progressive tax the Shari'ah.
Tax imposed so that the effective (b) Expenditures necessary in the light
tax rate increases as the amount to of the Shari'ah.
which the rate is applied increases. (c) Expenditures necessitated by tasks
This 1s where the rate of tax assigned to the state by the people.
CHAPTER 14 RM2,500 - (RM2,500 x 5.57%)
= RM2,360.7 5 in the year 2016,
,vhich is still n1ore than RM2, 000
Multiple-choice Questions in the year 2015. Hence, the
1 C 6 B 11 D 16 A standard of living has risen.
2 C 7 A 12 C 17 D 3 (a) 201 5:
3 C 8 A 13 A 18 C E1nployed= 7, 500 -8 20= 5,860
4 A 9 A 14 A 19 A 2 016:
5 D 10 A 15 C 20 B
Total labour force= 8 ,900 + 1,520
=10,420
(b) Unemployment Rate
Short-answer Questions
I (a) Year 2011 = Nu1nber of unemployed x lOO%
Total labour force
(b) Fron, year 2011 to 2012
= (105 -100) = 5% 2015: 820 X 100% =1.06%
7 , 500
100%
2016: 1, 520 X 1 00%= 14%
Fron1 year 2011 to 2016 10,420
(c) Frictional unemployment refers
= (1 28 - 100) = 28%
100% to short-tern1 or temporary
(c) Cost of living decreases, because unemploy1nent ,vhich occurs when
the general price level (CPI) people enter the labour 1narket to
decreases from 100 to 9 5. look for jobs, or leave their jobs
(d) Cost of living increases, because either voluntarily or were asked
the general price level (CPI) to go, and are unemployed for a
increases from 100 to 128. period of time while they look for a
ne1,v job. Frictional unemployment
2 (a) Com1nodity E: 1. 2o x 100% x 1
1.00 includes new entrants, such as
= 120.0 school-leavers, fresh graduates
Commodity F: 1 ·90 x 100% x 2 and re-entrants such as those
1.50
= 253.3 ,vho quit their jobs for a better
position or higher ,vages. Seasonal
Commodity G: 2· 30 x 100% x 4
2.00 unen1ployment results fron1
= 460.0 regular fluctuations in weather
Commodity H: 0.70 x 100% x 5 conditions, climatic changes or
0.80 changes in the trend of demand.
=437.5
1 20 + 253.3 + 460 + 4 37.5 = 105_9 4 (a) An1ount of labour force
(b ) = 80 + 40 + 5 = 125 (million)
12
(c) Inflation Rate= 105.9 -100.0 (b) Unemployment Rate
=5.9% = Unemployment x lOO%
(d) Change in the value of money Labour force
= lOO%-{ CPI base year x = 5 X 1 00%
lOO%
CPI current year} 125
=4%
= 100% -( lOO X 100%) (c) Expansionary fiscal policy or
105.9
=100 -94.43 expansionary n1onetary policy
= 5 .57% 5 (a) Labour force participation rate
The real value of RMlOO = RMlOO Labour force x lOO%
- (RMlOO x 5.57%) = 94.43 \i\Torking age population
(e) In the year 2016, the change in the 2014: 1 2• 352·4 X 1 00%= 56.71%
value of money= 5. 57%. 21,780.0
 100% = 55.77% 770. 3
= 6.12%
12 •587 ·5 )>
2015: X 2015: X 100% ::s
22,572.0 12,587.5 rn
Unemployment rate (b) (i) Structural unemployment
= Total unemployed x (ii) Seasonal unemployment "1
1OO% rn
Labour force (iii) Frictional unemployment
(iv) Cyclical unemployment
100% = 5.44%
672 ·0
2014: X
12,352.4 (v) Classical unemployment

Essay Questions
I
Demand-pull Inflation Cost-push Inflation
Price
AD. Price
AD3
P. --·····-··········

P3 ····--------------------- AD AS,

P2 -----------
t
P , ······-·

� --�-�---+-Output
- -- - Output Q 2 Q,
�Q-
0 -=-Q-, Q�2 -Q- �Q
3 --
4 - -
+

• Occurs when AS shifts upwards causing price

• Occurs when AD exceeds AS; associated with a
level to increase.
booming economy at full employment level.
• When cost of production increases, AS, shifts to
• From AD to AD,, price remains the same at P ;
0 0 AS2• This causes output to decrease from 0, to
producers have not produced at the maximum
O,and prices to increase from P, to P,.
capacity. Price will increase from PO to P2 to P3
• Factors of influence: Higher product on cost due
when AD, shifts to AD, and AD,. i
• Factors of influence: Any increase in the to higher wages, higher profit, higher import
prices and higher tax rates. This higher cost
components of AD, such as C, I, G and X - M wi ll
is passed on to the consumers and cost-push
induce demand-pull inflation.
inflation is developed.

2 Monetary policy is the central bank's to reduce money creation of

instrument which is used to control
money supply to stabilize the econo,nic
condition. Contractionary ,nonetary
instrun1ents are used during inflation:
• Selling of government securities
in open market operation to the
public and banking sectors to
reduce money supply.
• Raising reserve requiren1ent to
reduce cash resources and lending
capability of con1mercial banks to
decrease money supply.
• Raising discount rate or bank rate
to make loans expensive; hence
there is less borrowing activities
comn1ercial banks and decrease
n1oney supply.
• Raising interest rate to encourage
savings and discourage investn1ent.
3 Inflation shifts income from one group
to another; there ,vill be gainers and
losers in society due to redistribution
of inco1ne and ,vealth.
The gainers fron1 continuous
unanticipated inflation are:
• Businessmen who make more
profits from rising prices.
• Debtors as the purchasing power of
n1oney is reduced by the time they
repay their loans.
 • Property ov,ners as the prices of looking for jobs, but have yet to
property increase faster than the secure a job.
inflation level. • Frictional unemployment does
• Shareholders as they receive higher not pose a serious problem of
dividends ,vhen companies gain une1nployment because of its
higher profit. short-term nature.
(c) Seasonal unemploy1nent
TI1e losers from continuous
• Seasonal unemploy1nent occurs
unanticipated inflation are:
in so1ne outdoor occupations,
• Creditors because if rate of inflation
for instance bad weather causes
exceeds rate of interest charged
temporary unemployment in
on loan, there \,vii] be a reduction
fishing and farming. In so1ne
1n purchasing po"A•er of the
occupations, the den1and for
outstanding balance on the loans.
labour only happens at certain
• Wage earners and salaried workers
periods of the year, for exa1nple
as their real value of income
school holidays, sales, harvest
decreases due to slow adjustment of
season and tourist peak seasons.
wages to inflation rate.
• An example of seasonal
• Pensioners are the most badly
unen1ployment 1s unskilled
affected group as their income is
labour in the construction
fixed, and with inflation their real
industry. vVhen a particular
income ,viii fall.
project is completed, the labour
• Savers because those with fixed
'A'ill lose their jobs.
or saving deposits will lose as the
purchasing power of their savings 5 (a) (i) Individual effects
decline. • Unemployed workers may
lose their job skills if
4 (a) Structural unemployment
unemployment persists.
• Changing structure of the
• Individuals will lose their
economy.
income and self-respect
• The retrenched workers may
from their family and
not be easily absorbed into
friends.
other industries as they need
(ii) Social effects
specific skills.
• Unemployed ,vorkers may
• Technological unemployment
join radical groups and
is an example of structural
cause proble1ns socially and
unemployment as capital 1s
politically.
used to substitute for labour.
• With more unemployed
(b) Frictional unemployment
workers, the crime rate
• Frictional unemploy1nent
would be higher.
occurs \vhen people change
(iii) Economic effects
their jobs from one firm to
• Society loses the capability
another or fron1 one profession
to produce 1nore output
to another or from one place
as there are resources kept
to another. They n1ay be
idle.
te1nporarily unen1ployed for a
• TI1e govern1nent \¥ill receive
few months or a short period of
less taxation revenue,
tilne.
but has to pay 1nore
• An exa1nple of frictional
unemployn1ent benefits if
unen1ployment includes new
high unen1ployment occurs
entrants, such as school-leavers
in the society.
 (b) Fiscal policy uses taxation and to directly increase aggregate )>
government expenditure to achieve demand through the multiplier ::s
rn
econo1nic stability. Expansionary effect. Hence, aggregate output
fiscal policy is used to overco1ne increases and unemployment "1
rn
unemployment. The government decreases.
practices expansionary fiscal • Decreasing in taxes (T). A
policies or budget deficit through reduction 1n excise duty,
the follo\ving: sales tax and business and
• Increasing governn1ent corporate tax will increase
expenditure (G) by undertaking the consurnption expenses of
more public works progran11nes the people. Decrease in taxes
and development projects or prornotes investment and, thus,
increase govern1nent staff salary increases employment.

Gt ➔ ADt = C + I +Gt+X - M Price level

AS

-:+
'
'
'
''
'
''
' AD,
'
''
' ADo
''
'
''
'
''
' Yt
Production t
''
'
'
'' Unemployment J,
'

CHAPTER 15 Country
Book (Grams of Butter (Units of
Butter) Books)
3 [600/200] 0.33 [200/600]
Multiple-choice Questions
CountryY CountryY
1 A 6 B 11 A 16 D y foregoes 3 grams foregoes 0.33
of butter to units of books to
2 D 7 B 12 B 17 A
produce 1 more produce 1 more
3 B 8 A 13 A 18 D unit (of books). gram (of butter).
4 B 9 B 14 A 19 D
(b) Country X specializes 111 the
s A 10 C 15 B 20 D production of books due to
the lower opportunity cost of
Short-answer Questions producing books (2 grams as
I (a) opposed to 3 grams of butter).
Country Y specializes in the
Book (Grams of Butter (Units of
Country
Butter) Books) production of butter due to
the lower opportunity cost of
2 [800/400] 0.5 [400/800]
producing butter (0.33 units as
Country X Country X
foregoes 2 grams foregoes 0.5 opposed to 0.5 units of books).
X
of butter to units of books to
produce 1 more produce 1 more
unit (of books). gram (of butter).
 (c) (c) Rice: Thailand
Country Book (Unit) Butter (Gram) Car: Malaysia
400 + 400 [800/2]
(d)
X =80 0 0 Country Rice Car

600 + 606.06 Malaysia - 3,000

y 0 [200/0.33] = Thailand 4,0 00 -
1,206.06
4 (a) Balance of trade
Total 800 1,206.06
Exports 679,123
2
(d) 1 unit of books= ( + 3) Imports 570,892
2 Balance of trade 108,231
= 2.5 grams of butter
or (b) Balance on current account
1 grain of butter= (0.5 + o.33
) Balance of trade 108,231
2 Transportation -30,280
= 0.415 units of books Travel 29,424
Other business services -15,627
2 (a) Merchandise trade balance
Con1pensation of
= Export - Import employees -3,824
= 2,400 - 1,465 Invest1nent inco1ne -30,302
= RM935 n1illion Balance on current
(b) Current account balance account 57,622
= Merchandise balance + Service (c) Balance on capital account
balance + Net income + Current Direct investment -34,708
transfer Portfolio investment -10,634
= 935 + 7,000 + 3,200 + 1,030 + Other investment 15,040
Balance on capital
2,860 + 1,810 + 6,000 + 2,020
account -30,302
= RM24,855 million
(d) Overall balance
(c) Capital and financial account
Balance on current
balance
account 57,622
= 3,600 + 5,910 + 3,200 + 600
Balance on capital
= RM13,310 million
account -30,302
(d) Overall balance Errors and omissions
= Current account + Capital and (Net) 9,431
financial account + Error and Balance on capital
om1ss1on account 36,751
= 24,855 + 13,310 + 6,000
5 (a) The United States, because it
= RM44,165 1nillion
can produce more computers
3 (a) Absolute advantage is the ability compared to Mexico by using the
of a county to produce more same amount of labour.
of a good or service than its
(b)
cotnpetitors using the same
Country Computer Gasoline
amount of resources.
Mexico 0.4 2.5
Rice: Thailand
United States 0.8 l.2S
Cars: Malaysia
(b) .tvlexico: Computer
United States: Gasoline
Country 1 Tonne of Rice 1 Unit of Car
(c)
i ,5oo =2.5 car 600 =0.4 rice
Malaysia
600 1,5 00 Country Computer Gasoline
Mexico 1,000 0
650 = 0.325 car 2,000 = 3.077 r ce
Thailand i United States 0 1,600
2,000 6 50
Total 1,000 1,600
 (d)
Country Computer Gasoline
Mexico 600 800
United States 400 800
Total 1,000 1,600
Essay Questions
I (a) A co1nparative advantage exists
when a country has a lower
opportunity cost in the production
of a good or service. It is used
to justify free trade and oppose
protectionis1n and is based on
differing opportunity costs,
reflecting the different factors
endo,vments of the countries
involved. The theory assumes free
trade, willingness to specialize
and factor mobility. Trade and
specialization benefit countries by
providing an exchange rate bet,veen
their respective opportunity cost
ratios. Countries benefit if they
specialize in the production of
goods or services in which they
have a comparative advantage, i.e. a
lov.,er internal opportunity cost.
(b) (i) Benefits of specialization
A country ,vhich is good at
producing a particular product
(at a relatively lower cost) ,viii
specialize in producing that
good and exchanging it with
other countries for goods it
can only produce at a relatively
higher cost.
(ii) Benefits of economies of scale
Economies of scale mean
lo,ver per unit cost as output
expands. Instead of each
econon1y having a lot of sn1all
producers, difef rent countries
concentrate on different things
and produce in a large scale. In
this way, everyone can benefit
from the cost reductions that
ensue.
(iii) Larger market
Through international trade,
the 1narket for a product is no
longer confined to the home )>
market, ,vhich could be too ::s
rn
s1nall for the producer to fully
exploit the advantages oflarge­ "1
rn
scale production that enable
producers to reap the benefits
of econo1nies of scale.
(iv) Increased competition
International trade increases
competition, thus promoting
efficiency in production.
To survive the co1npetition,
producers ,viii have to ensure
that they produce high quality
products at the lowest possible
production costs.
(v) More and in1proved choices
Trade provides consun1ers
with n1ore and better choices.
Malaysian consumers can
enjoy products not produced
locally, such as bake using
wheat fron1 America, drive
Japanese cars, eat Florida
oranges, drink Brazilian coffee,
and so on.
2 (a) (i) Protect infant industries
Infant industries need to be
protected during the first fe,v
years of their operations since
they are nev.r industries in the
country. Typically, they cannot
con1pete with the well-known
industries which are operating
on the economies of scale.
(ii) Diversify the economy
This argument is to prevent
the country from depending
on only one sector. With the
i1nplementation of certain
restrictions, the local producers
will have to diversify their
goods for the domestic market
rather than just focusing on
producing certain goods,
creating a \\'ide range of goods.
(b) Contractionary/tight fiscal policy
also means surplus budget. This
is v,here ta,'< collection is greater
than government expenses. For
exa1nple, by increasing taxes on
 imports, demand for imported
goods will fall due to a rise in price.
At the san1e time, the govern1nent
will spend less. This ,vill further
decrease imports.
Co n t r a c t i o n a r y/ t i g h t
monetary policy involves an
increase in bank rate, increase
in cash and liquidity ratio, and
the selling of bonds in the open
market. By doing so, importers
1nay find it difficult to obtain credit
facilities for the goods in1ported.
When imports become expensive
due to a high interest rate, total
imports will fall.
3 (a) TI1e current account records goods,
services, income and current
transfers and is used to mark the
inflow and outflow of goods and
services into a country. Goods are
n1ovable and physical in nature:
includes general 1nerchandise,
goods used for processing other
goods, and non-monetary gold.
Services are transactions that
result from an intangible action,
such as transportation, business
services, tourism, royalties or
licensing. Income is earnings
on investments, both public and
private. It is money going in or
out of a country from salaries,
portfolio investments, direct
investments or any other type of
investments. Current transfers are
unilateral transfers ,vith nothing
received in return. These include
workers' remittances, donations,
aids and grants, official assistance
and pensions.
The financial account records
assets pertaining to international
monetary flows. It consists of
foreign direct investment (FDI)
and portfolio investn1ent. FDI
refers to a company from one
country v,hich makes a physical
investment in another country,
such as investment in buildings,
n1achinery and equipment.
Portfolio investment is investment
in paper claims, such as ordinary
shares, without obtaining a voice
in management. It is the purchase
of foreign financial assets with the
purpose of deriving returns from
the security vvithout intervening
in the managen1ent of the foreign
operation.
(b) (i) Reduce the value of the ringgit
relative to other foreign
currencies (devaluation) to
simulate exports.
(ii) Reduce imports by imposing
trade barriers.
(iii) Stimulate exports by giving
subsidies to exporters.
(iv) Use contractionary policies to
reduce aggregate demand and,
hence imports.
4 (a) (i) Encourage export
(ii) Discourage import
(iii) Signing of trade agreements
(iv) Deflation
(Provide suitable explanations)
(b) Protectionis1n is a policy practiced
by a nation on other nations, in
,vhich certain barriers are imposed
on trade for economic or non­
economic reasons.
(i) Tariff
It is the first instru1nent used
by the government to protect
local industries. Tariff refers
to taxes imposed on imports.
When tariff is imposed on
imported goods, the price of
these goods becomes more
expensive. This ,,vill lead to a
decrease in the consumption
of in1ported goods by
households.
(ii) Subsidies on exports
Local producers receive
subsidies from the government
to produce goods and
services to be exported to
other countries. This subsidy
can make the exports more
con1petitive because it can
 reduce the prices of goods
and services. This is the most
positive v,ray to in1plen1ent
protectionis1n.
(iii) Quota
Quota 1s the restriction or
limitation on the volume of
imported goods. When the
governn1ent limits the in1port
of certain goods, it will put
pressure on the price of those
goods, resulting 1n a price
increase. As such, the den1and
for the imported goods 1s
expected to decrease since
the goods have beco1ne more
expensive.
(iv) Embargo
An embargo 1s considered
a direct control by the
government to prohibit certain
goods and services fron1
entering into the country. The
governn1ent can ban some
ite1ns from other countries
\',ith different ideologies.
5 (a) Increase in world output
Different countries have different
production possibilities and
different demands for products
across boundaries. A country
benefits from free trade if
specialization 1s possible 1n
areas which it has absolute
or comparative advantage.
Specialization and division of
labour allo".r countries to produce
more with the same resources than
if they ,vere to be self-sufficient and
produce everything the1nselves.
Thus, there is an increase of \VOrld
output through specialization and
international trade.
(b) Benefits of political, economy, )>
social and technology links ::s
rn
International trade enables
countries to develop political "1
rn
links. For instance, ASEAN and
the European Union help their
members through economic and
social cooperation. International
trade also promotes travel, sharing
of knowledge, research and
development, and information
and technology among trading
nations. Political differences can
be minin1ized and relationships
among trading partners can be
strengthened.
(c) Enjoy varieties of goods
Some countries have a surplus of
certain goods to their needs, while
others have deficits. A country with
a surplus in certain goods should
expo1t then1 to exchange for
goods which are scarce. By trading
globally \Vith other countries, it
gives consumers the opportunity
to be exposed to various goods
and services not available in their
own countries. This will result in
a higher living standard. It allows
provision of previously unavailable
products. For instance, consumers
in tropical regions enjoy temperate
fruits such as strawberries and
grapes.
(d) Earn foreign exchange
A country will be able to earn
foreign exchange when it exports
goods. This helps them to pay for
their imports and settle its debts. It
reduces a deficit in the balance of
pay1nents.
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Fajar.

A Capitalist econon1ic system, 18
Absolute advantage, 462-3
1nutual absolute advantage, 464
reciprocal, 464
resources, 463
specialize, 463
Acceptability, 359
Ada1n S1nith model, 463
Aggregate, 270
Anticipated inflation, 434
burden of debt, 434
standard of living, 435
tax burden, 435
Attainable and efficient, 8
curve, 8
Autonomous consumption, 320
Autonomous investment, 329
B contraction in supply, 55
Balanced budget, 406
Balance of payments, 474
Banking institutions, 372
central bank, 372
co1nmercial banks, 372
deposits, 372
loans, 372
Barriers to entry, 198
copyright, 199
econo1nies of scale, 198
licenses, 199
patents, 199
Break-even inco1ne, 325
break-even point, 325
Broad money, 368
discount houses, 368
Budget deficit, 406
Budget line, 133
Budget surplus, 406, 436
disposable income, 437
indirect taxes, 437
regressive tax structure, 43 7
tools of budget surplus, 436
Business cycle, 273
expansion, 273
peak,273
recession, 273
trough, 273
C con1parative, 466
Capital, 3
wealth, 3
Capital account, 476
consumers sovereignty, 20
economies of scale, 20
freedo1n of choice, 19
misallocation of resources, 20
monopoly power, 20
price mechanism, 19
Central planning, 16
Change in demand, 44
factors other than the price, 44
influencing demand, 45
shift of the demand curve, 44
Change in quantity demanded, 44
change in the price of the good itself, 44
moven1ent along the de1nand curve, 44
Change in quantity supplied, 55
movement along, 55
Change in supply, 55
decrease in supply, 55
expansion in supply, 55
increase in supply, 55
movement along, 56
supply curve, 55, 56
Choices, 5
Circular flow diagram, 284
Circular flo,,v of income, 283
transfer payments, 285
Classical une1nploy1nent, 445
market clearing levels, 445
minimum wage, 445
real wage unemployment, 445
trade unions, 445
Co1nmand econon1y, 16
Com1nercial bank, 379
accept deposits, 379
bank drafts, 379
borrowing rate, 379
cash credits, 379
de1nand deposits, 379
fixed deposits, 379
foreign exchange transactions, 379
lending rate, 379
lend money, 379
loans, 379
overdrafts facility, 379
savings accounts, 379
Comparative advantage, 462, 466
opportunity cost, 466
production possibility curve, 468
 sacrifice, 466 Convex, 11
terms of trade, 468 decreasing opportunity cost, 11
Competitive den1and, 51 din1inishing, 11
Competitive supply, 60 Corporate income taxes, 289
Complementary demand, 51 Cost, 57
Complementary goods, 48 Cost-push inflation, 430
Components of macroeconomics, 282 aggregate demand, 430
firms, 282 aggregate supply, 430
foreign sector, 283 elastic, 430
government, 282 exchange rates, 431
households, 282 exhaustion of natural resources, 431
rest of the world, 283 import-push inflation, 430
Concave, 10 inelastic, 430
increasing opportunity cost, 10 n1onopoly, 431
Concepts of consumption, 320 oligopoly power, 431
average propensity to consume, 320 prices and incomes policies, 430
consumption function, 320 profit-push inflation, 431
n1arginal propensity to consun1e, 320 'supply shock' inflation, 430
Concepts of saving, 324 tax-push inflation, 431
autonomous saving, 324 trade union, 430
average propensity to save, 324 wage-price spiral, 430
marginal propensity to save, 324 Credit creation, 380
saving function, 324 assets-cash, 380
Consun1er price index, 420 banking habits, 384
base year, 420 booming, 385
basket of goods and services, 421 cash reserve ratio, 380
,veightage, 423 cash ,vithdrawal, 385
Consun1ers' income, 47 collateral securities, 384
inferior goods, 47 credit multiplier, 384
normal good, 47 currency drain, 385
superior goods, 47 depression, 385
Consu1ners' preferences, 47 excess cash reserves, 380
Consun1ers' reactions, 76 excess reserves, 384
elastic income elasticity ey > 1, 76 leakages, 380
inelastic income elasticity O < ey< 1, 76 liability, 380
negative income elasticity ey < 0, 76 loans, 380
zero income elasticity EY = 0, 76 money multiplier, 382
Consun1ption theory, 319 total credit creation, 382
consumption, 319 total 1noney supply, 382
ex ante consumption, 319 total reserves, 382
intended, 319 Cross-elasticity of demand, 77-8
planned, 319 complementary, 78
Contractionary fiscal policy, 436 con1plen1ents, 77
Contractionary monetary policy, 437 cross-elasticity will b e negative, 78
money creation, 438 cross price elasticity, 78
open market operations, 437 negative cross-elasticity EX < 0, 78
rate of interest, 438 not interrelated, 78
required reserve ratio, 438 not related, 77
special deposits, 438 positive, 78
Conventional economics, 5 positive cross-elasticity EX > 0, 78
scarce resources, 5 substitutes, 77
unlimited ,vants, 5 substitutes for each other, 78
 the cross-elasticity will be zero, 78 Diseconomies of scale, 165
�
"'O zero cross-elasticity ex = 0, 78 expansion of the whole industry, 166
.S Current transfers, 475 external diseconon1ies of scale, 166
unilateral transfer, 475 higher input price, 165
Cyclical unen1ployn1ent, 448 higher wages of specialists, 166
business cycle, 448 internal diseconomies of scale, 165
deflationary gap, 448 low morale, 165
demand deficient unemployment, 448 n1anagement difficulties, 165
expansionary fiscal poHcy, 448 mar!keting disecono111ies, 165
monetary policy, 448 social problems, 166
trade cycle, 448 technological problems, 166
,vage differential v,rithin the industry, 166
Disposable personal incon1e, 289
D Divisibility, 359
Definition of demand, 40
Double counting, 307
quantity demanded, 40
Durability, 359
Deflationary gap, 346
expansionary policies, 346
government spending, 346 E
taxes, 346 Economic, 49
Degree of inflation, 426 less goods, 49
creeping inflation, 427 Economic goods, 38
galloping inflation, 427 cost of production, 38
hyperinflation, 427 Econo1nic grov.rth, 272
jumping inflation, 427 Economic policy, 57
running inflation, 427 subsidies, 57
slumpflation, 427 taxation, 57
stagflation, 427 Economic resources, 236
trotting inflation, 427 factors of production, 236
walking inflation, 427 Economics, 2
Degrees of demand, 70 limited resources, 2
elastic, 70 scarce, 2
inelastic, 70 unlimited human wants, 2
perfectly elastic, 70 Economies of scale, 163
perfectly inelastic, 70 administrative economies, 164
unitary elastic, 70 division of labour, 163
Detnand-pull inflation, 428 economies of concentration, 164
aggregate de1nand, 428 economies of information, 165
aggregate supply, 428 existence of specialist con1panies, 165
booming economy, 429 external econon1ies of scale, 164
excess demand, 428, 429 financial economies, 163
idle resources, 429 infrastructure, 165
multiplier effect, 428 internal econo1nies of scale, 163
norn1al economy range, 429 labour economies, 163
recessionary stage, 429 large scale production, 163
Derived demand, 51,238 managerial, 164
Diminishing marginal rate of substitution, 130 mar!keting economies, 163
Direct credit control, 438 purchasing, 163
credit lilnit, 438 research and development
hire-purchase agreements, 439 econon1ies, 164
Direct tax, 106 risk-bearing economies, 164
directly, 106 supply of skilled ,vorkers, 165
person, 106 technical economies, 164
Effective interest rates, 246 Financial system, 371
pov,er of compounding into account, 246 Firm, 180-1
Elasticity of den1and, 68 1naximum profit, 181
cross-elasticity of den1and, 68 n1inimum losses, 181
cross-elasticity of demand, 77 First degree price discrimination, 207
income elasticity of demand, 68, 75 Fiscal policy, 407
price elasticity of demand, 68-9 contractionary fiscal policy, 407
Employees provident fund, 289 expansionary fiscal policy, 408
Entrepreneur, 3 Fixed exchange rates, 484
Equilibrium, 135, 274 Bretton Woods system, 484
balance of payments, 274 currency, 485
consumer equilibrium, 135 devaluation, 485
foreign sector, 274 external value, 485
Equilibrium interest rate, 248 higher fixed parity, 485
Equilibrium ,vage, 241 lo,ver fixed parity, 485
market demand and market supply of revaluation, 485
labour, 241 the gold standard, 484
Equilibrium ,vage rate, 243 Floating exchange rates, 486
Equitable distribution of income, 274-5 appreciation, 486
income inequality, 274 depreciation, 486
taxes, 274 fiscal policy, 488
Errors, 477 fixed pegs, 488
Exceptional de1nand, 49 instability, 488
Exceptional supply, 58 n1anaged exchange rates, 488
back1,vard bending supply curve, 58 managed floating, 488
income effect, 59 market forces, 487
substitution effect, 59 monetary policy, 488
Exchange rate, 483 overvaluation, 488
Exchange rate policies, 440 overvalued, 487
import cost-push inflation, 440 undervaluation, 488
Expansion, 273 undervalued, 487
Expenditure approach, 294 Four-sector economy, 338
government expenditure, 294 Free enterprise, 18
gross private don1estic investment, 294 Free goods, 38
net export, 295 Free market economy, 18
personal consumption expenditure, 294 Frictional unemployment, 446
transfer pay1nents, 295 geographical immobility, 446
Expenditure multiplier, 341 occupational i1nn1obility, 446
autonon1ous governn1ent te1nporary unemployment, 446
expenditure, 344 Full employn1ent, 272
autonomous taxes, 344 Functions of money, 360
balanced budget multiplier, 344 liquid form of 1A1ealth, 360
government spending n1ultiplier, 343 n1easure of value, 360
investment n1ultiplier, 342 n1edium of exchange, 360
tax multiplier, 344 standard for deferred payment, 361
store of value, 360
unit of account, 360
F Future prices, 48
Factor cost, 287
Factors, 57
cost of production, 57 G
increase in ,vages, 57 Giffen goods, 49
Factors of demand, 73 Goods, 3
Factors of production, 2 tangible things, 3
� Government expenditure, 400
"'O allocation function, 401
.S developn1ent expenditure, 403
distribution function, 40 l
operating expenditure, 403
stabilization function, 40 l
Government revenue, 400, 401
direct tax, 40 l
indirect tax, 401
non-revenue receipts, 402
non-tax revenue, 402
tax revenue, 401
Gross domestic product, 286
Gross interest, 246
amount paid by the borrower, 246
Gross national product, 286, 288
Growth rate, 302
H Interest, 245
Heckscher-Ohlin model, 463
Homogeneity, 360
I econo1nies of scale, 471
Incidence of tax, 107
burden of tax, 107
Income approach, 290
co1npensation of employees, 290
corporate profits, 291
net interest, 291
proprietor's income, 290
rental income, 290
Income elasticity of demand, 75
inferior good, 75
luxury, 75
normal, 75
quantity demanded for a particular
good, 75
Income policy, 439
productivity, 439
trade unions, 439
,vage-push inflation, 439
Indifference curves, 129
Indirect tax, 106
Individual demand, 42
single consumer, 42
Individual supply, 53
single seller, 53
Induced consumption, 320
consumption function, 322
expectation, 322
interest rate, 322
non-income factor changes, 322
price level, 322
stock of durable goods, 322
,vealth, 322
Induced investment, 329
Inflation, 420
average price level, 420
cost of living, 420
cost of living index, 420
persistent, 420
purchasing power, 420
sustained increase, 420
Inflationary gap, 346
aggregate de1nand, 346
contractionary policy, 346
full employment level, 346
inflation, 346
nominal income, 346
Insurance premium, 289
return on capital, 245
reward for capital, 245
International trade, 462,471
deficits, 471
efficiency, 471
employment, 471
exports, 462
global n1arket, 462
imports, 462
political dependence, 472
political links, 471
raw materials, 472
surplus, 471
Investment, 331
rate of return, 331
Islamic banking, 386
agreed profit-sharing ratio, 388
Al-Bai Bithaman Ajil (deferred payn1ent
sale), 388
A lDhamanah
- (guarantee), 387
A lIjarah
- (lease or rental), 389
A llvf
- udharabah (profit-sharing), 387
Al-1\tfusyarakah (partnership arrangen1ent
of profit and loss sharing), 389
A l - Wadiah (custody and guarantee), 387
Bay' al Muajjal, 388
Bay' Muazzal, 388
construction finance (istisna), 390
debt financing, 387
deceit, 386
equity financing, 387
for,vard lease (ijarah ma1vsoofa bil
thimma), 390
 gharar, 386 Land,2
hibah, 387 natural resources, 2
multi-tier profit-sharing ratios, 388 Law of demand, 41
operating lease (operating ijarah), 390 ceteris paribus, 41, 52
riba, 386 inverse relationship, 41
trust agreement,387 Law of diminishing marginal utility, 127
Islamic economics, 5 cardinal utility, 128
principles of Shariah, 5 ordinal utility, 128
Islan1ic economic system, 23 Law of diminishing returns, 146
hadith, 23 average product, 146
principles of Islamic Shari'ah, 23 law of diminishing marginal returns, 147
Qur'an, 23 la,-v of increasing marginal returns, 147
Islan1ic government expenditures, 410 1narginal product, 146
necessary in the light of the negative n1arginal returns, 147
Shari'ah, 411 short-run production function, 146
tasks assigned to the state by the total product, 146
people, 411 Law of supply, 52
tasks ordained by the Shari'ah, 410 ceteris paribus, 41, 52
Islan1ic govern111ent revenues, 409 Linear, 11
al-fai, 409 Liquidity preference curve, 364
jizyah, 409 active money balances,364
kharaj, 409 bonds, 364
sadaqah,409 checkable deposits, 364
taxation, 409-10 currency, 364
ushur, 409-10 interest-inelastic,364
waqaf, 409, 410 Internet banking, 364
zakat, 409 liquidity trap,366
money balances, 364
J n1ost liquid assets, 364
negotiable draft, 364
Joint demand, 51, 74
non-money financial assets, 364
elasticity, 74
saving accounts, 364
jointly de1nanded,74
spending power, 364
Joint supply, 60
treasury, 364
produced together, 60
vertical line, 364
Liquidity preference theory, 248
K precautionary motive, 249
Keynesian theory of den1and for 1noney, 362 speculative 1notive, 249
active 111oney balances, 362 transaction n1otive, 249
financial assets, 363 Loanable funds,247
idle,363 bank credit, 247
passive money balances,363 consumption purposes, 247
precautionary n1otive, 362 dishoarding, 247
spare liquidity, 362 disinvestments, 247
speculative motive, 363 hoarding purposes, 247
transaction motive, 362 investment purposes,247
Khalifah, 24 savings, 247
Long run, 146, 194
L exit from the market, 196
Labour, 2 normal,196
Labour force participation rate, 444 nor1nal profit, 195
Laissez-fa ire, 18 subnor1nal profit, 196
 variable factors,194 Market structure, 185
�
zero profit, 196 differentiated products,185
"g
- Long-run costs, 166 distribution, 185
long-run average cost, 167 entry of new finns, 185
long-run average cost curves, 167 exit of existing firms, 185
long-run total cost,166 homogeneous products, 185
Long-run production, 162 industry, 185
Long-term capital flows,476 size, 185
unique product, 185
Market supply curve, 53
M horizontal summation,53
Ml,367
Maximization of employment generation, 275
M2,367
Maxin1ize profit,243
fixed deposits, 367
Microeconomics, 3, 270
near money, 367
individual entities, 3
negotiable certificates of deposits, 367
Minimum price, 102
negotiable instrument deposits,367
minimun1 ,.vage,102
quasi-1noney, 367
Mixed econo1nic system, 21
savings deposits, 367
basic goods, 23
M3,368
cost-effective method,23
Macroeconomic objectives,271-2, 274
demerit goods,21
conventional perspective,272
free market, 21
Islamic perspective, 274
incon1e inequality, 22
Macroeconon1ics, 4, 270
overall, 4 merit goods, 21
monopoly power, 22
Marginal approach,183,189,202
negative externalities,22,23
average revenue,183
price discri1nination,22
breakeven, 204
private goods,23
downward sloping, 185
progressive taxation, 22
losses,204
public goods,22
marginal cost, 183
public sector,23
marginal revenue,183
single producer, 22
normal profit, 204
social costs, 22
perfectly elastic, 185
state intervention, 21
profit, 185
Monetary inflation,432
profit-maximizing output,204
expansionary fiscal policy, 432
profit-maximizing price,204
required reserve ratio, 432
sho1t run profit maximization, 189
Monetary policy, 374
subnon11al profit,204
bank rate, 374
zero profit, 204
bonds, 374
Market, 90, 185
economic growth,374
interact,90
govern1nent securities, 374
Market demand, 42
inflation, 374
horizontal summation, 42
low unemployment, 374
Market equilibrium, 90
open market operations, 374
equilibrium price, 90
price stability,3 74
equilibrium quantity, 90
recession, 374
quantity de1nanded, 90
required reserve ratio, 374
quantity supplied,90
unemployment, 374
shortage, 9 I
Money, 356
stability point,90
surplus, 91 bank money,357
coins,358
Market price, 287
co1nn1odity 1noney, 357
 credit cards, 358
debit cards, 358
double coincidence of \vants, 356
fiat 1noney, 357
indivisibility of goods, 357
measure of value, 357
1nedium of exchange, 356
metallic n1oney, 357
paper money, 357
plastic money, 357
portability, 357
standards for deferred payments, 357
systen1 of barter, 356
token money, 357
Money market equilibrium, 370
equilibrium interest rate, 370
opportunity cost of holding money, 370
quantity of money demanded, 370
quantity of money supplied, 370
Monopolistic competition, 186
close substitutes, 186
differentiated products, 186
free entry and exit, 186
Monopoly, 186
barriers to entry and exit, 186
no close substitutes, 186
price maker, 186
single seller, 186
Monopoly demand curve, 199
elastic demand, 199
inelastic demand, 199
Muslim's consumer behaviour, 328
Al-Falah principle, 328
belief in the hereafter life, 328
ethics of consumption, 328
principle of consumption of goods and
services, 328
principle of ,.vealth, 328
N 0
Narro,.v money, 367
National income equilibrium, 318
aggregate de1nand, 318
aggregate supply, 318
expansion of the economy, 319
injection, 319
leakages, 319
leakages= injections approach, 319
withdrawal, 319
Natural rate of unemployment, 453
changing demographic structure, 453
frictional, 453
government social policies, 453
structural unen1ployn1ent, 453
Necessities vs Luxuries, 74
habituated, 74
particular good, 74
the demand for the good will be
inelastic, 74
Net factor income from abroad, 287
Net income balance, 475
Net interest, 246
payment of interest, 246
Net national product, 288
Nominal income, 301
Nominal interest rate, 246
coupon rate for fixed income, 246
Nominal \\'age, 238
1noney value, 238
Non-bank financial institutions, 372
discount houses, 372
finance companies, 372
Islamic banks, 372
1nerchant banks, 372
profit-sharing concept, 372
riba, 372
Shari'ah, 372
Non-bank financial intermediaries, 372
development financial institutions, 372
e1nployees provident fund, 372
foreign exchange reserves, 373
lender of last resort, 373
Non-price control, 106
Norn1al profit, 190, 259
average cost, 190
average revenue, 190
minimum reward, 259
total cost, 190
total revenue, 190
Official financing account, 477
Oligopoly, 186,216
barriers to entry, 217
differentiated products, I 86
homogeneous, 186
mutual interdependence, 186
01nissions, 477
Opportunity cost, 5
good forgone, 5
second best alternative, 5
Optimal rate of economic grov.rt:h, 275
 p Profit maximization, 243
"'O Peak,273 marginal revenue product, 243
C
Per capita income, 302 marginal wage cost, 243
Perfect competition, 186 Progressive tax,404
Price taker, 186 Proportional tax,404
Personal income, 289 Protectionism, 472
Phillips curve,452 quotas, 472
demand 1nanagement policies, 452 tariffs,4 72
full employment, 452 Protectionism tools, 473
inflation, 452 embargo,474
inverse relationship, 452 exchange controls,474
Portability,359 quota, 473
Price control,99,439 subsidies on export, 473
anti-hoarding campaigns, 439 tariff, 473
artificial shortages,439 Public finance, 400
black 1narkets, 100 Public goods,38
ceiling price, 99, 439 comfort goods, 40
fixed price, 99 luxury goods,40
floor price,99,439 necessity goods, 40
legal price, 99 non-excludable, 38
maximum price, 99 non-permissible goods, 40
minimum price, 99 non-rivalrous,38
price pegging, 439 partial public goods, 39
price regulation,99 pure public goods,39
price tagging, 439
rationing, 439 Q
sho1tages, 1O1 Qualitative instruments, 438
Price discrimination, 205 Qualitative n1onetary policy tool,375-6
elasticity of demand, 206 margin requirements, 376
market segregation, 206 statutory liquidity ratio, 3 75
monopoly po,ver,206 Quantity theory of money, 433
seg1nentation,206 velocity of circulation, 433
Price elasticity of revenue, 71 Quasi-rent,255
total revenue, 72 surplus earnings, 255
Price elasticity of supply,78-9
Price rigidity, 217
kinked de1nand curve,217
R
Rationing, 439
Sweezy n1odel, 217
Real income, 30 I
Price stability, 272
Real interest rate, 246
fiscal, 272
lender or investor receives, 246
monetary policies, 272
real rate,246
Problems of measuring national income, 306
Real ,vage,238
double counting, 307
purchasing power of money, 238
underground economy, 306
Recession, 273
Production function,145
Regressive tax,404
Production possibilities curve, 7
Regulated market economy, 21
Product or output approach, 298
Rent, 250
primary sector, 298
Retained earnings, 289
secondary sector, 298
Revenue, 171
tertiary sector, 298
average revenue, 172
Profit, 258
from trading, 171
return on entrepreneurship, 258
n1arginal revenue, 172
 money received, 171 equal distribution of income, 17
total revenue, 172 inequalities of income, 17
Ricardian n1odel, 463 price syste1n, 17
Rububiyyah, 24 rationed, 17
Social justice, 274
Social security contributions, 289
s Socio, 49
Satiation, 127
non-satiation, 129 Straight line, 11
satiation point, 127 capital intensive, 15
constant opportunity cost, 11
Savings, 440
distribution of income, 16
co1npulsory provident fund, 440
labour intensive, 15
provident fund cum-pension schemes, 440
Saving theory, 323 luxury goods, 16
necessity goods, 16
autonomous saving, 323
purchasing power, 16
dissaving, 324
resource allocation, 15
induced saving, 323
Structural unemployment, 447
Scarcity, 5, 8, 359
regional unemploy1nent, 447
Seasonal une1nployn1ent, 446
diversification, 447 Subnormal profit, 190
average cost, 190
integration, 447
average revenue, 190
matching seasonal industries, 447
total cost, 190
Second degree price discrimination, 207
total revenue, 190
different blocks, 207
Subsidy, 111
Service account balance, 475
aid, 111
Services, 3
negative tax, 111
intangible things, 3
producers, 111
Shortage, 92
Substitute goods, 47, 51
Short run, 146,188
Supernonnal profit, 190, 259
variable inputs, 188
average cost, 190
Short-run costs, 152
average revenue, 190
costs of production, 152
total cost, 190
explicit cost, 152
total revenue, 190
fixed costs, 153
Supply of labour, 240
implicit cost, 152
variable costs, 153
households, 240
individuals, 240
Short-run production, 144
capital intensive, 145
Supply of money, 249
fixed inputs, 145 bank notes, 249
coins, 249
labour intensive, 145
demand deposits, 249
short-run production, 145
government policies, 249
variable inputs, 145
Supply side policies, 439
Short-term capital flows, 476
hot n1oney, 476 inflationary pressures, 439
liquid, 476 long-term competitiveness, 439
productivity, 439
short-term securities, 476
treasury bills, 476
Surplus, 93
Shutdo,\1n condition, 193
average revenue, 193 T
average variable cost, 193 Tauhid, 24
fixed cost, 193 Tazkiyyah, 24
variable cost, 193 sadaqah,24
Socialist econo1nic system, 16 zakat, 24
bureaucratic system, 18 Technological unen1ployment, 447
"'O
The current account, 474
inflov,, 474
u
C Ukhuwah, 25
international con1petitiveness, 474 Unanticip ated inflation, 435
invisible trade account balance, 474 creditors, 435
outflow, 474 debtors, 435
service account balance, 474 pensioners, 435
trade balance, 474 purchasing po,ver of money, 435
visible trade account, 474 real inco1ne, 435
Theory of 1narginal productivity, 236 redistribution of income or wealth, 435
average revenue product, 237 savers, 435
marginal physical product, 237 wage earners, 435
marginal revenue product, 237 Unattainable production, 8
n1arginal value product, 23 7 Une1nployed resources, 8
total revenue product, 237 Unemployment, 442
Third degree price discrimination, 207 economically active, 442
subgroups, 207 economically inactive, 442
Three-sector economy, 335 involuntary unemployment, 443
induced taxes, 336 underemployment, 443
Three stages of production, 149 voluntary unemployment, 443
efficient use of inputs, 149 Unemployment rate, 444
Total approach, 181, 188 Unifonnity, 360
equilibrium price, 181 Universal education, 275
equilibriun1 quantity, 181 Uses of national income, 305
in1perfect market, 182 Utility, 126
perfect market, 181 Marginal utility, 126
total cost, 181 Total utility, 126
total revenue, 181
Trade balance, 475
Transfer earnings, 253 V
alternative use, 253 Veblen goods, 50
Transportability, 359
Trough, 273 w
T\vo-sector economy, 332 v\Tages, 238
circular flow of income and payment to labour, 238
expenditure, 333
factors of production, 332
firms, 332
households, 332