BBA - JNU - 105 - Business Economics PDF

BUSINESS ECONOMICS
(BBA 105)
Jaipur National University

Directorate of Distance Education
_________________________________________________________________________________
Established by Government of Rajasthan
Approved by UGC under Sec 2(f) of UGC ACT 1956
(Recognised by Joint Committee of UGC-AICTE-DEC, Govt. of India)
BUSINESS ECONOMICS
Business Economics: Meaning, nature and scope. Difference between Traditional economics and business
economics. Role of Micro & Macro analysis in formulation of business policy; Inductive & deductive
methods.
Consumer Behavior: Utility Analysis, Law of Diminishing Marginal Utility, Equi-marginal utility,
Consumer's surplus, Indifference curve analysis, consumer equilibrium – price, income & substitution
effect.
Demand analysis: Determinants and Changes in Demand, Law of Demand, Elasticity of Demand & its
Measurement,haa Demand Forecasting.
Supply analysis: Determinants and Changes in Supply. Law of Supply, Elasticity of Supply.
Production Analysis: Production Function in Short-Run and Long Run, Law of Variable proportions,
Returns to scale, production and Equal product curves, least cost combination. Cost concepts and Revenue
Analysis.
Cost Analysis: Accounting Costs and Economic Costs, Short Run Cost Analysis: Fixed, Variable and
Total Cost, Curves, Average and Marginal Costs, Long Run Cost Analysis: Economies and Diseconomies
of Scale and Long Run Average and Marginal Cost Curves
Markets: Meaning and structure, Price and output determination under Perfect Competition, Monopoly,
Discriminating Monopoly, Monopolistic competition and Oligopoly.
Pricing Under Various Market Conditions: Perfect Competition - Equilibrium of Firm and Industry
under Perfect Competition, Monopoly - Price Determination under Monopoly, Monopolistic Competition -
Price and Output
Distribution: Marginal Productivity Theory of Distribution, Rent, Modern Theory of Rent, Wages : Wage
Determination under Imperfect, Bargaining in Wage Determination, Interest : Liquidity, Preference Theory
of Interest
Concepts of Macro Economics: Definitions importance, growth, limitations of macro-economics, macro-

economic variables, Circular flow of income in two, three, four sector economy, relation between leak ages
and injections in circular flow.
Macro Market Analysis: Theory of full employment and income: classical, modern (Keynes) approach,
consumption function, relationship between saving and consumption.
Investment function: concept of marginal efficiency of capital and marginal efficiency of investment.
National income determination in two, three and four sector models, Multiplier in two, three and four
sectors model.
Money Market: Functions and forms of money, demand for money-classical, Keynesian and friedman
approach, measures of money supply, quantity theory of money, inflation and deflation.
National Income Determination: Concepts, definition, method of measuring, National income in India,
problems in measurement of national income & precautions in estimation of national income.
Equilibrium of Product and Money Market: The IS-LM model, product market and money market,
derivation, shift, Equilibrium of IS-LM curve, Application of IS-LM model in monetary and fiscal policy.
CONTENTS
Unit 1: Business Economics 1-15
1.1 Meaning of Business Economics
1.2 Nature and Scope of Business Economics
1.3 Business Economics and Traditional Economics
1.4 Micro Economics Analysis and Business Policies
1.5 Macro Economics Analysis and Business Policies
1.6 Inductive Methods of Business Economics
1.7 Deductive Methods of Business Economics
1.8 Economic Systems
1.9 Summary
1.10 Keywords
1.11 Self Assessment Questions
1.12 Review Questions
Unit 2: Consumer Behaviour 16-29

2.1 Utility Analysis
2.2 Law of Diminishing Marginal Utility
2.3 Equi -marginal Utility
2.4 Consumer‘s Surplus
2.5 Indifference Curve Analysis
2.6 Consumer Equilibrium
2.7 Summary
2.8 Keywords
Unit 3: Demand Analysis 30-43

3.1 Determinants and Changes in Demand
3.2 Law Of Demand
3.3 Elasticity of Demand and Its Measurement
3.4 Demand Forecasting
3.5 Summary
3.6 Keywords
Unit 4: Supply Analysis 44-54

4.1 Determinants and Changes in Supply
4.2 Law of Supply
4.3 Elasticity of Supply
4.4 Summary
4.5 Keywords
Unit 5: Production Analysis 55-68

5.1 The Production Function
5.2 Law of Variable Proportions
5.3 Returns to Scale
5.4 Production and Equal Product Curves
5.5 Least Cost Combination
5.6 Cost Concepts and Revenue Analysis
5.7 Summary
5.8 Keywords
Unit 6: Cost Analysis 69-81

6.1 Meaning Cost Accounting of Economics cost
6.2 Short Run Cost Analysis: Fixed, Variable and Total Cost, Curves,
6.3 Short Run Average and Marginal Costs Curve
6.4 Long Run Cost Analysis: Economies and Diseconomies of Scale and Long
6.5 Long Run Average and Marginal Cost Curves
6.6 Summary
6.7 Keywords
Unit 7: Markets 82-95
7.1 Meaning and Structure
7.2 Perfect Competition
7.3 Monopoly
7.4 Monopolistic Market
7.5 Monopolistic Competition
7.6 Oligopoly
7.7 Summary
7.8 Keywords
Unit 8: Pricing Under Various Market Conditions 96-104

8.2 Equilibrium of Firm and Industry under Perfect Competition
8.3 Price Determination under Monopoly
8.4 Price and Output
8.5 Summary
8.6 Keywords
Unit 9: Distribution 105-116

9.1 Marginal Productivity Theory of Distribution
9.2 Rent
9.3 Modern Theory of Rent
9.4 Wages: Wage Determination under Imperfect
9.5 Bargaining in Wage Determination
9.6 Interest: Liquidity
9.7 Preference Theory of Interest
9.8 Summary
9.9 Keywords
Unit 10: Concepts of Macro Economics 117-128
10.1 Definitions and Importance of Macro Economics , Growth
10.2 Limitations of Macro-Economics
10.3 Macro-economic Variables
10.4 Circular Flow of Income in two, three, four Sector Economy
10.5 Relation Between Leakages and Injections in Circular Flow
10.6 Summary
10.7 Keywords
Unit 11: Macro Market Analysis 129-140

11.1 Theory of full employment and income
11.2 Classical Approach Theory of Employment
11.3 Keynesian Theory of Employment
11.4 Consumption Function
11.5 Relationship between Saving and Consumption
11.6 Summary
11.7 Keywords
Unit 12: Investment Function 141-152

12.1 Concept of Marginal Efficiency of Capital
12.2 Marginal Efficiency of Investment
12.3 National Income Determination
12.4 Money Multiplier Model
12.5 Summary
12.6 Keywords
Unit 13: Money Market 153-164

13.1 Functions and Forms of Money
13.2 Demands for Money Classical
13.3 Keynesian and Friedman Approach
13.4 Measures of Money Supply
13.5 Quantity Theory Of Money, Inflation and deflation
13.6 Summary
13.7 Keywords
Unit 14: National Income Determination 165-175

14.2 National Income in India
14.3 Problems in Measurement of National Income
14.4 Precautions in Estimation of National Income
14.5 Summary
14.6 Keywords
Unit 15: Equilibrium of Product and Money Market 176-187

15.1 The is-lm model
15.2 Product Market and Money Market
15.3 Application of Is-Lm Model In Monetary And Fiscal Policy
15.4 Summary
15.5 Keywords
1
Business Economics
CONTENTS
Objectives
Introduction
1.9 Summary
1.10 Keywords
Objectives
After studying this chapter, you will be able to:
Explain the meaning of business economics
Discuss the nature and scope of business economics
Understand the business economics and traditional economics
Discuss the micro economics analysis and business policies
Explain the macro economics analysis and business policies
Discuss the inductive methods of business economics
Explain the deductive methods of business economics
Discuss the economic systems
Introduction
Economics is a social science dealing with economic problem and man‘s economic behaviour. It deals with
economic behaviour of man in society in respect of consumption, production; distribution etc. We can call
it as an unending science. We know that definition of subject is to be expected but at this stage it is more
useful to set out few examples of the sort of issues which concerns professional economists. For example,
most of us want to lead an exciting life i.e. life full of excitements, adventures etc., but unluckily we do not
always have the resources necessary to do everything we want to do. Therefore, choices have to be made
or in the words of economists ―individuals have to decide ―how to allocate scarce resources in the most
effective ways‖. For this a body of economic principles and concepts has been developed to explain how
people and also business react in this situation. Economics is the study of choice under conditions of
scarcity. Economics provide optimum utilization of scarce resources to achieve the desired result. It
provides the basis for decision making.
Managerial economics or business economics is a branch of ―economic theory‖ and its application to
business problems and to take right decisions in right time. The nature of managerial economics is
normative science like psychology, sociology, and human behaviour etc. This subject deals with all aspects
of profit optimization. However, there are different views about the scope of the subject matter and its
applications.

Business economics is the application of economic principles and methods to business management
practices. It deals with the business organisation and decision making process of the firm. It helps firms in
business administration; decision making and business planning. Decision making involves the process of
choosing the best choice or course of action from the many alternatives available to the decision makers of
the firm. Forward planning involves the establishment of future plans.
Profit is the ultimate aim of almost all business firms.
Business economics is a discipline that deals with the application of economic concepts, theories, tools
and methodologies to the practical problems in a business. It facilitates the manager in decision-
making and acts as a link between theory and practice.
Business economics by nature is goal-oriented and aims at maximum achievement of objectives. In
particular managerial economics is concerned with the allocation of the resources available to a
business firm or an organization.
1.1.1 Some Definitions of Business Economics

Business economics deals with the application of economic principles and methods for business and
managerial decision making of firms. The following are some of the attempts to define business or
managerial economics. (See Figure 1.1)
Figure 1.1: Business economics.

1.1.2 Characteristics of Business Economic
(i) Micro economic in nature
(ii) Theory of firm or economics of firm
(iii) Importance of macro economics too
(iv) Pragmatic and applied approach
(v) Perspective nature

In business economics or managerial economics, economic principles are applied to problem solving at the
level of the firm. The problems, of course, relate to choices and application of resources in the process of
production and consumption of commodities which are basically economic in nature. Business economics
bridges economic theory and economics in practice. It also uses quantitative techniques such as correlation,
regression, calculus, game theory and linear programming. The bottom-line that runs through most of
business economics is the attempt to optimise business decisions, given the firm‘s objectives and given the
resource constraints (including time) imposed by the society. Decision makers of firms are confronted with
many issues of decision, having to choose from among a number of possible alternatives.
Business economics is concerned with the business firm and the economic problems that every business
management need to solve. Spencer and Siegel men point to the feet that ―Business Economics is the
integration of economic theory and business practice for the purpose of facilitating decision-making and
forward planning by management‖.
The nature of business economics is as follows:

1. Business economics is of micro economic in character
2. Business economics is concerned with normative micro economics
3. Business economics makes economic theory more application oriented
4. Business economics takes help of macroeconomic concepts
Macro Economic Conditions

The decisions of the firm are made almost always within the broad framework of economic environment
within which the firm operates, know as macro economic conditions. These conditions, stress three points.
The economy in which the business operates is predominantly a free enterprise economy asking prices
and market.
The present-day economy is the one undergoing rapid technological and economic changes.
The intervention of government in economic affairs has increased in recent times.
1.2.1 Scope of Business Economics

No uniform opinion as to the scope of managerial economics, but the following aspects may be said to
generally fell under the scope of managerial economics.
Demand Analysis and Forecasting

A business firm which take necessary steps to transform productive resources into goods that are to be sold
in a marketer mostly decision-making depends on accurate estimates of demand. Before preparing
production in schedules sales forecast is essential.
1. This forecast can also serve as a guide to management for maintaining or strengthening market
position and enlarging demand for a firm‘s product and thus provides guidelines to manipulating
demand.
2. Demand analysis and forecasting is essential for business planning and occupies a strategic place in
Managerial Economics. It mainly consists of discovering the forces determining sales and their
measurement.
The main topics covered under demand analysis and forecasting are:
Demand Determinants,
Demand Distinctions
Law of demand
Exception to rules
.
Cost and Production Analysis
A study of economic costs and their estimates are useful for management decisions. The factors causing
variations in costs must be recognized and allowed for if management is to arrive at cost estimates which
are significant for planning purposes. An element of cost uncertainty exists because all the factors
determining costs are not always known or controllable.
Discovering economic costs and being able to measure them, are necessary steps for more effective
profit plaguing, cost control and often for sound pricing practices. Production analysis is narrower in
scope than cost analysis.
Economic and diseconomies of scale, production functions and cost function cost control etc.
1.2.1 Relationship of Business Economics with other Disciplines

Statistics is widely used by managerial economics. Managerial economics aims at quantifying the past
economic activity to predict its future. Probability, correlation, interpolation are the concepts which are
also used by managerial economist to solve certain problems.
Business Economics and Operations Research

Both operational research and managerial economics are concerned with taking effective decisions. Both
economics and operations research resort to model building, economic models are more general and broad,
while operation models draw from various disciplines and are more jobs oriented. The operational research
models like transportation, linear programming, assignment etc., are routinely useful in business.
1.2.2 Uses of Business Economics

There are so many uses of managerial economics: They are:
1. Managerial economics accomplishes the objective of building a suitable tool kit from traditional
economics.
2. Managerial economics taken the aid of other academic disciplines having a bearing upon the business
decisions of a manager.
3. Managerial economics helps in reaching variety of business decision in a complicated environment
such as
4. Managerial economics makes a manager a more competent model builder.
1.2.4 Significance Importance of Business Economics

A major aspect of management is decision-making. Decision-making needs a balance between various
factors and objectives. It also needs common sense and good judgment. Business Economics or Managerial
economics helps the decision-making process in die following ways:
• Business economics provides a number of tools and techniques to build models and with the help of
these models, the manager can handle real situation.
• Business economics provides most of the concepts that are needed for the analysis of business
problems and also to solve various kinds of managerial problems. ―Concept of elasticity of demand,
fixed and variable costs, short and long-run costs, corporeity costs, net present value etc. all help in
understanding and solving decision problems.
.
1.2.5 Limitations of Business Economics
The theory of firm which is a fundamental to managerial economics is based upon certain assumption. The
basic assumptions are, the decision maker has:
Perfect knowledge
Rational in approach
Most of the economic theory also based on those assumptions and also firm has single goal of profit
maximizations.
But in real life neither the firm has perfect knowledge nor a single goal to pursue. Economic theory
assumes that every firm is a one man firm, run by its owner. The limitations are:
Firm do not continuously seek maximum profit.
Large firm run by salaried managers
Different groups working in a firm, each group has different objectives to pursue.
Profit maximization is not only die sole objective of a firm; other objectives are also important for the
firm.

Managerial is usually described as the economics applied in managerial decision making. It is that branch
of economics which bridges the gap between pure economics theory and managerial practice. But there are
certain differences between managerial economics and traditional economics. The Table 1.1 gives the
differences between business economics and traditional economics and it also shows the difference
between traditional economics and business economics.
Table 1.1: Comparison between business economics and traditional economics

Traditional Economics Business Economics
1. Traditional economics is both micro comics 1. Business economics is only
and macroeconomics in nature microeconomic in nature
2. Business economics has a limited scope. It is
concerned with decision making and economic
2. Traditional economic as a wide scope. It
theories that guide the managerial decision-
deals with each and every aspect of the firm.
making.
3. Traditional economics is both normative and 3. Business economics is a normative science.

positive sciences
4. Business economics deals with practical
4. Traditional economics is concerned with
aspects of the firm.
theoretical aspects of the firm.
5. Business economics considers both economic

5. Traditional economics consider only the
and non economic aspects of a problem while
economic aspects of a problem while decision
decision-making.
making.
6. Traditional economics deals with both micro 6. Business economics is concerned with
and macro of a firm decision making of a firm.
1.3.1 Role of a Business Economist

Managerial economics is now recognized as a useful science which is concerned with the systematic
examination of the day-to-day problems concerning business firms. A managerial economist occupies a
prominent place in the hierarchy of industry, trade and commerce.
He plays a dominant role in managerial decision making and the role of a managerial economist implies
the function and the responsibilities of the managerial economist.
1.3.2 Functions of a Business Economist
The functions of a business economist are discussed as:
A managerial economist or business economist serves as an economic adviser to a business firm or
executive to make correct decisions which are vital for the growth and survival of the business.
He helps the management, with specialized skill and modern techniques, to determine the key factors
influencing the business.
He collects the data concerning managerial problems in order to understand the factors influencing
business. He analyzes and interprets them for solving the problem of decision-making in business.
1.3.3 Responsibilities of a Business Economist

A managerial economist or business economist should be familiar with the day-to-day affairs of a
business firm but he should not be isolated from action.
He should recognize his responsibility to make successful forecasts in business.
He should bring about a synthesis of policies pertaining to production, investment, inventories and
price.
A managerial economist should have the responsibility to alert the management at the earliest possible
moment, in case he discovers an error in his forecast.

A business firm has to formulate a number of economic and managerial policies such as
Production policy,
Sales policy,
Advertising policy,
Purchase policy and
Investment policy etc.
In deciding these policies both, Micro-economic analysis and Macro-economic analysis, are very useful.
There are two branches of economic analysis, Micro-economic analysis and Macro economic analysis.
Micro-economic analysis is that branch of knowledge in which a particular firm or industry is studied.
1.4.1 Micro Economic Analysis

Micro-economic analysis is the branch of knowledge in which the study of particular economic unit is
made. It can be a particular person, a particular firm or a particular industry. Microeconomics deals with
how producers and consumers interact in individual markets.
According to Henderson and Quandt, ―Micro-economics is the study of economic actions of individuals
and well defined groups of individuals.‖
1.4.2 Scope of Micro Economic Analysis

Micro-economic analysis is related with particular or individual units. Marginal analysis is an essential tool
of micro-economics and all the laws based on it are studied in Micro-economics.
Following studies are made in Micro-economics:
Allocation of Resources in the production of Goods and Services

In any economy the quantity of the means of production is limited in a short period. What to produce, how
to produce and how much to produce are decided on the basis of allocation of resources. In a free
capitalistic economy the allocation of resources to different productions and services depends on the prices
of resources.
1.4.3 Role of Microeconomics Analysis in Formulation of Business Policies
Micro-economic analysis occupies a vital place not only in economic analysis but also in the formulation
of business policies.
The economic principles and methodologies of business economics are derived largely from it. Since
business managers are more interested in taking decisions about the working inside their firms to a large
extent, it is microeconomic analysis that comes to their aid.
Other Roles
(i) Microeconomic analysis is also helpful in understanding the construction and use of models for real
economic events. According to A.P. Lerner, ―The models help not only to describe the actual economic
situation but also to suggest policies that would most successfully and most efficiently bring about
desired results and to predict the outcomes of such policies and other events.‖
(ii) Micro economic analysis also helps in measuring the managerial efficiency of a firm keeping in view
the objectives and the performance within a given period.
1.4.4 Limitations of Microeconomic Analysis

Following are its main Limitations:
1. Analysis of Micro activities only: Only individual units are analyzed in Microeconomic analysis. As a
result we are not fully aware of the whole economy. Things which are correct about an individual unit are
not necessarily correct about a group in the same way.
2. Based on Unrealistic Assumptions: Microeconomic analysis is based on the two assumptions

(a) Other things remains the same and
(b) There is full employment in the society.
Both these assumptions are unrealistic.
3. Some of the Economic Problems cannot be studied through Microeconomic analysis. In every country
there are many problems of national level which cannot be analyzed by Microeconomic analysis. Public
finance, Fiscal policy, monetary policy, Economic planning, national income and employment are among
many such problems.
.
1.4.6 Positive and Normative Economics
Economics deals with both positive and normative questions,
A positive science may be defined as a body of systemized knowledge concerning what it is, and
normative science as a body of systematized knowledge relating to criteria what to be and concerned,
therefore, with the ideal as distinguished from the actual.‖
In positive economics we study only facts and make generalizations from them.

The term ‗Macro‘ as used in English language has its origin in the Greek word Makros, meaning large.
Hence, in macroeconomics, economic problems are studied from the point of view of the entire economy,
for example, aggregate consumption, aggregate employment, national income, general price-level etc.
According to Boulding, ―Macro economic theory is that part of economics which studies the overall
averages and aggregates of the system.
1.5.1 Scope of Macro Economic Analysis

Macro economics deals with the full utilization of national resources. These resources have complete
impact on national income, employment, effective demand, aggregate demand, aggregate supply, total
saving, total investment, price-level, economic development etc. Its scope can be divided into the
following parts:
Theory of National Income

Macroeconomics studies the concept of national income, its different elements, methods of its
measurement and social accounting.
Theory of Employment
It studies the problems of employment and unemployment. Different factors determining employment,
such as, effective demand, aggregate supply, aggregate demand, total consumption, total investment, total
saving, multiplier etc. are studied under this theory.
1.5.2 Role of Macro Economic Analysis in Formulation of Business Policies

Although microeconomic analysis plays a dominant role so far as the formulation of business policies are
concerned yet macroeconomic analysis too plays an equally important role in framing the business
policies. There are several macro economic problems which the business community has to tackle so as to
arrive at the correct decision.
1.5.3 Limitations of Macro Economic Analysis

The main limitations of macroeconomic analysis are as under:
Dependence on Individual Units
Several conclusions of macroeconomic analysis are based on the sum-total of individual units. In fact, it is
not correct, because what is true for individuals may not necessarily be true for the economy as a whole.
For instance, an individual may save in terms of money but if everybody starts saving, the aggregate
demand will fall causing reduction in national income. It will result into fall and not rise in aggregate
saving. Samuelson has called it, ―The fallacy of composition‖.
1.5.4 Relation between Microeconomics and Macroeconomics

Both microeconomics and macroeconomic analysis are important for the study of economics. Both are
complementary and not competitive to each other. Samuelson has rightly said,‖ There is really no
opposition between microeconomics and macroeconomics
Micro Economic Analysis depends on Macro Economic Analysis

Many a time, one has to depend on macro economics in order to study micro economic analysis.
For example
(i) Wages paid to the labourer by a firm depend on the wages paid by other firms in the economy.
(ii) Determination of price of a commodity does not depend on the demand for and supply of that very
commodity rather it also depends on the demand for and supply of other commodities.
(iii) How many goods a firm would be able to sell does not depend on the price of the goods produced by
that very firm , rather it also depends on how much money supply is there in the economy.
Study of Micro Economic Analysis is Necessary for Macro Economic Analysis

Study of macroeconomics necessitates study of microeconomics. Society, in reality, is the aggregate of
individuals. Just as many individuals form a society, likewise many types of rum constitute an industry and
many industries constitute an economy.
Need of microeconomics for macroeconomics is evident from the following:
(i) Entire economy is the aggregate of different units. To understand the functioning of the entire
economy it is necessary to know the functioning of the individual units.
(ii) To study national income, it is necessary to know about per capita income because national income is
the aggregate of the income of the individuals.
(iii) When income of all individuals increases, their demand for different goods also increases.
1.5.5 Difference between Microeconomics and Macroeconomics
Main differences between microeconomics and macroeconomics are:
Difference in the Degree of Aggregation
Degree of aggregation of economic variables differs in microeconomics and macroeconomics.
Microeconomics deals with the study of the economic problems of a single economic unit, like, a firm, a
consumer or a small group of economic units, like an industry. On the other hand, in macro economics, one
studies the economic problems of all the firms in an economy.
.
1.5.6 Business Economics, Microeconomics or Macroeconomics
Business economics essentially is microeconomics. It is concerned with business firms. It studies the
problems of a business firm such as forecasting the demand for its product, calculating the cost of
production, fixation of price, profit planning and capital management. Though basically being
microeconomics, Business Economics seeks the help of macro-economics. It is because that individual
units function in an environment in which all firms work If it has to survive, it has to modify its objectives,
plans, policies and programmes so as to make it in conformity with the whole economy.

The inductive method which is also called empirical method derives economic generalizations on the basis
of experience and observations. In this method detailed data are collected with regard to a certain
economic phenomenon and effort is then made to arrive at certain generalizations which follow from the
observations collected. But it is worth mentioning that the number of observations has to be large if it can
yield a valid economic generalize. One should not generalize on the basis of a very few observations.
There are three ways which can be used for deriving economic principles and theories. They are:
(a) Experimentation,
(b) Observations,
(c) Statistical or econometric method.
As has been mentioned above, the experimentation that is the use of contrived experiment is of limited
applicability in economics. First, unlike natural sciences which are concerned with analyzing the behaviour
of either inanimate objects or obedient animals such as rats and rabbits under the influence of chloroform,
economics deals with the behaviour of man who is quite fickle, wayward and unmanageable. Besides it
man cannot tolerate the idea of being experimented upon, of factors and causes acting and interacting upon
each other. Therefore economic phenomenon is the result of multiplicity does not repeat itself in the same
uniform pattern. Numerous factors acting on an economic phenomenon disturb it and make its exacts
repetition.
Inductive method is also another important and popular method of formulating economic theories. It is also
called
(i) Experimental Method,
(ii) Historical Method,
(iii) Analytical Method
(iv) Statistical Method
(v) A Post priori method.

Deductive method is an important method relating to the formulation of economic Theory. This method is
also called hypothetical method, abstract method and a priori method. Prof. bounding has called it,
‗method of intellectual experiment‘.
This method has been made use of by classical economists, like Adam smith and Ricardo; neo-classical
economists. Like Walras, manger etc. and modem economists like Robbins, Friedman etc.
it is based on certain salient facts of human nature.
For example, we perfect to buy from the cheapest market, or every consumer would like to maximize his
satisfaction. Classical writers assumed:
Man tries to promote his self-interest.
All men try to get rich with minimum sacrifice,
Law of diminishing returns operates on land,
Human beings reproduce at a rate permitted by natural resources, and
Deductions as methodology in economic theory involve the following stages:

Perception and exploration of a particular economic phenomenon or a problem
The formulation of assumption on the basis of which the facts are to be analyzed.
The process of logical reasoning whereby inferences are drawn. Inference is the process by which we
arrive at conclusion from given proportions;
The final step relates to the verification of conclusions arrived at. If the conclusions agree with the
observed facts, the hypothesis is verified.

Economic system may be defined as an arrangement by which the central economic problem like what to
produce, how to produce and how it should be distributed among the society etc; are settled.
Human wants are unlimited and the resources to satisfy them are scarce and are of alternative uses;
therefore human behaviour takes the form of choosing. This give rise to the problem of how it uses scarce
resources of alternative uses to attain maximum satisfaction. This is generally termed as economic
problem.
Reason Responsible for Arising:
(i) Unlimited ends or wants
(ii) Scarce resources.
(iii) Alternative uses of resources
(iv) Difference in intensity of ends.
Basically there are three types of economic system:
1.8.1 Capitalism
Capitalism is a system of economic organization featured by the private ownership and the use for private
profit of man-made and nature-made capital.
Following are the principal features of capitalism:
(1) Private Ownership of Property. Private ownership of property refers to the right vested in the owner to
own and enjoy the property in the manger he likes best. Individuals are free to own not only consumer
goods but also producer goods, such as, land, capital equipment, machinery, etc..
(2) The Right of Inheritance. Closely connected with the right of private property, is the right of
inheritance which is another basic institution of capitalism. If the right of inheritance were abolished, the
existence of private property could not support capitalism for long.
(3) Freedom of Individual Initiative. This can be interpreted in several senses. As a producer, an
individual is free to engage in any business activity that he desires, provided he complies with the law of
the State.
Advantages of Capitalism
The following advantages have accrued from the working of capitalism:
1. Automaticity. An important advantage of the ‗traditional‘ type of capitalism is its automatic or ‗self-
acting‘ nature. It works, unlike a socialist economy, without any manipulation on the part of a central
authority. There is no human agency charged with the task of operating it. And yet it works as if there
was some ‗invisible‘ hand operating it and steering productive resources into the right channels.
This invisible hand is nothing else than the price mechanism already referred to above. Even if there is
some maladjustment, they get automatically corrected through the operations of the price mechanism.
2. Flexibility. One of the principal advantages of capitalism has been its flexibility, adaptability and
resilience which have enabled it to change itself from time to time in accordance with the changed
circumstances.
3. Risk-taking. Under capitalism, the entrepreneurs resort to bold experimentation and innovations to earn
bigger profits for themselves. In so doing, they evolve new production techniques and processes to cut
down costs.
Disadvantages of Capitalism
The principal defects and shortcomings of capitalism are as follows:
1. Lack of Coordination. The main defect of capitalism is the absence of any machinery to coordinate the
decisions of millions of businessmen and producers functioning in the economy.‖
2. Trade Cycle. There is now conclusive evidence available to us that the trade cycle is the direct product
of the functioning of capitalism. It is now established beyond doubt that certain basic institutions of
capitalism, viz., competition, the profit motive and the freedom of individual initiative contribute
directly to the operation of the trade cycle.
3. Economic Inequality. The existence of economic inequality is major defect which corrodes and
undermines the very foundations of capitalism. Capitalism not only permits but also perpetuates
economic inequalities.
.
1.8.2 Socialism
Socialism is an economic organization of society in which the material means of production are owned by
the whole community and operated by organs representative of and responsible to the community
according to a general plan, all member of the community being entitled to benefits from the results of
such socialized-planned production on the basis of equal rights. An analysis of this definition reveals three
main points, viz.
(i) ownership of the means of production by the State as representative of the community;
(ii) The general planning of economic activity; and
(iii) An equitable distribution of national incoming among the people.
Advantages of Socialism
The principal arguments in favour of socialism are as follows:
1. It secures Coordinated Development. A socialist economy is planned economy and as such it secures
a balanced and coordinated development of a country‘s resources for raising the living standards of the
masses. Unlike capitalism, where there are millions of businessmen, each making his own decision
independent of others, there is, under socialism, one supreme.
2. It eliminates the Trade Cycle. Trade cycle is the direct outcome of capitalism. Under socialism,
however, there is no place for the trade cycle. It stands totally eliminated.
3. It prevents Unemployment. Socialism prevents mass unemployment by assuring a job to every citizen.
The entire economic life in a socialistic economy is planned beforehand so that there is little possibility
of maladjustments taking place or economic resources being wasted as very often happens under
capitalism. Socialism‘s ability to provide full employment is its greatest asset; an asset which has
secured so much popularity for it among the poorer sections of the community.
4. It secures Equitable Distribution of National Wealth. A socialistic society, by its very nature, is a
classless society. As such, it does not permit class distinctions of rich and poor, high and low.
Disadvantages of Socialism
The principal defects and shortcoming of socialism are as follows:
1. Too much Concentration of Powers. A socialistic economy is a state-planned economy. This naturally
results in the concentration of too much power in the hands of the State..
2. Evils of Bureaucracy. A socialist economy, being a state-planned economy, cannot free itself from the
evils of bureaucracy.
3. No Incentive to Improvement of Labour Efficiency. It is said that there is no incentive under socialism
on the part of the workers to bring about improvements in their performance.
1.8.3 Mixed Economy

This represents the intermediate system between capitalism and socialism. In several countries of the
world, it is this economic system which has been accepted by the peoples and governments. India affords
an outstanding example of a country which has adopted mixed economy as its economic system, though
the declared objective of the Government was to bring about ―a socialistic pattern of society‖ in due course
of time. A mixed economy allocates resources via market forces and government intervention.
Characteristics of Mixed Economy

1. Co-existence of Public and Private Sectors: An important characteristic of mixed economy is the
existence of two sectors, viz., the private sector and the public sector. The former comprises those
business units which are owned, managed and controlled by private enterprises..
2. Govt.’s influence on Price mechanism: The government may even influence the price mechanism
through various fiscal and economic measures.
3. Govt. control on private sector: In mixed economy govt. takes various measures to regulate and
control private sector. For this purpose it can introduce licensing system or use appropriate monetary
and fiscal policies.
Did you know?

India had the world‘s largest economy during the years 1 AD and 1000 AD.
Caution
It can be difficult to achieve the ultimate goal profit if the firm does not choose the specific course of
action.
Case Study-The Economic Success Story in Mongolia is Moving into a New Phase
GDP growth has escalated to an unprecedented 17.3% in 2011. Unemployment has fallen from 13% to 9%
in one year. These are headlines that you might expect from China or India or another of the ―BRIC‖
emerging markets, but, in actuality, these stellar economic results are from Mongolia, one of the fastest
growing economies on the planet.
Growth, however, does not always occur in a straight line. Consolidation periods are necessary in order
for weak points in the entire system to catch up with the overall momentum. Macroeconomic stability
going forward will depend on how well government officials adhere to prudent fiscal policies for the
balance of 2012.
There is still the possibility of a ―hard landing‖ or an external shock from its trading partners. China and
Russia are its major trading partners, each being more dependent on the uncertain global economic
environment, which has deteriorated somewhat due to the ongoing debt crisis in Europe.
Reduced demand from the West has forced emerging market economies to ratchet back their growth plans
for the future. Inflation and credit liquidity are becoming the issues that must be addressed appropriately
in the near term. The Mongolian economy is comprised primarily of agriculture, animal husbandry, and the
mining of extensive mineral deposits. The latter activity is more recent in nature and has drawn
international attention, capital investments, and widening banking involvement. One of the leading banks
in this non-traditional economic activity has been the Trade and Development Bank of Mongolia (―TDB‖).
Established in 1990, TDB has quickly become one of the leading banking and financial services providers
in the country. Their broad array of services include large corporate, SME and retail lending, deposit-
taking, trade finance, remittance, cash management, treasury, foreign exchange, and investment banking.
TDB, now one of the three largest banks in Mongolia, holds the largest portfolio of foreign assets, making
it the foremost player in the foreign exchange market. The bank was the first Mongolian bank to initiate
treasury activities in international foreign exchange and global money markets, and over time it has created
direct correspondent relationships with more than 150 foreign banks and financial institutions. The Bank
also maintains close relationships with the mining industry, facilitating its needs for credit, providing a
forum for gold trading, and supplying necessary international settlement services. Nearly two-thirds of the
gold producing companies in Mongolia are customers of TDB. When small countries grow quickly,
however, banks must expand their search for more capital, leading many to search overseas for much
needed domestic liquidity reserves. Banks in Mongolia have been suffering from a ―liquidity crunch‖
since November of 2011. Inflation has been in double-digits, and the central bank has had to tighten
monetary policy as a consequence. One local banker noted, ―The banks are out of money now. Liquidity
was very high a year ago but it‘s been burned up because there is such high growth and high lending.‖
Amid the mounting credit crisis, it came as good news that Goldman Sachs announced that it had
purchased a 4.8% interest in TDB, a capital infusion amounting to $50 million. Foreign investment in
Mongolia‘s burgeoning resources industry is a necessity if pressure is to be relieved on local credit
resources. As attention grows in the international investment community, additional capital flows will help
maintain a strong national currency and continue positive growth trends for the national economy.
Despite its amazing growth story in 2011, the future for Mongolia will be uncertain as it moves through the
critical ―consolidation‖ phase before it. Prospects are bright, but challenges must be prudently addressed.
Question
1. Discuss economic success story in Mongolia.
2. Discuss macroeconomic stability in Mongolia.
1.9 Summary
Economics is a social science dealing with economic problem and man‘s economic behaviour. It deals
with economic behaviour of man in society in respect of consumption, production; distribution etc
Decision making involves the process of choosing the best (optimum) choice or course of action from
the many alternatives available to the decision makers of the firm. Forward planning involves the
establishment of future plans
Business economics by nature is goal-oriented and aims at maximum achievement of objectives. In
particular managerial economics is concerned with the allocation of the resources available to a
business firm or an organization.
A business firm which take necessary steps to transform productive resources into goods that are to be
sold in a marketer mostly decision-making depends on accurate estimates of demand.
Macro economics deals with the full utilization of national resources. These resources have complete
impact on national income, employment, effective demand, aggregate demand, aggregate supply, total
saving, total investment, price-level, economic development etc
1.10 Keywords
Business Policy: denote the various type of decision taken by the business firms with regard to production,
pricing, sales, finance, personnel, marketing, etc. It effects the various business operations
Macro Economics: Macro economics deals with the functioning of the economy as a whole.
Managerial Economics: Managerial Economics or business economics consists of use of economic modes
of thought to analyze business situation.
Market: Market is any area over which buyers and sellers are in close touch with one another, either
directly or through dealers that the price obtainable in one part of the market affects the prices paid in other
parts.
Micro-economic Analysis: Micro-economic analysis is the branch of knowledge in which the study of
particular economic unit is made. It can be a particular person, a particular firm or a particular industry.

1. Economics is............................
(a). the study of the markets for stocks and bonds
(b). the study of choice under conditions of scarcity
(c). exclusively the study of business firms
(d). fundamentally the same as sociology
2. Business strategy focuses on............................

(a) how a firm competes within a particular market or industry.
(b) how to allocate resources between different parts of the business.
(c) strategies related to functional areas such as Marketing, Production and HRM.
(d) where a firm is going and the scope of its activities.
3. Microeconomics deals with which of the following?

(a) The total output of an economy
(b) The measurement of a nation's inflation rate
(c) How producers and consumers interact in individual markets
(d) How tax policies influence economic growth
4. Macroeconomics focuses on the behaviour of economic agents such as the consumer, a business firm, or
a specific market.
(a) True (b) False
5. A mixed economy:
(a) Allocates resources via supply but not demand
(b) Allocates resources via demand but not supply
(c) Allocates resources via supply and demand
(d) Allocates resources via market forces and government intervention
6. Which of the following is not a macroeconomic issue?

(a) Unemployment (b) Inflation
(c) The wages paid to footballers (d) Economic growth
7. The another name of inductive method is..............................
(a) dynamic method (b) hypothetical method
(c) empirical method (d) process method
8. The another name of inductive method is.............................

(a) hypothetical method (b) abstract method and
(c) priori method (d) All of these.
9. Microeconomics is not concerned with the behaviour of:

(a) consumers (b) aggregate demand.
(c) industries (d) firms.
10. Business economics is only microeconomic in nature.

(a) True (b) False

1. Give an appropriate definition of economics.
2. Define the business economics and write its scope.
3. Write the nature of business economics and discuss its characteristics.
4. What is the difference between business economics and traditional economics?
5. What is micro economic analysis? Explain role of microeconomics analysis in formulation of business
policies.
6. What is macro economic analysis? Explain role of macroeconomics analysis in formulation of business
policies.
7. Point out the importance or significance of business economics.
8. Identify and discuss the responsibility of business economist.
9. What is deductive and inductive methodology of economics?
10. What is the meaning of economic problem and economic system? Explain in detail.
Answers for Self Assessment Questions

1. (b) 2.(a) 3.(c) 4.(b) 5.(d)
6. (c) 7.(c) 8.(d) 9.(b) 10.(a)
2
Consumer Behaviour
CONTENTS
Objectives
Introduction
2.3 Equi -marginal Utility
2.4 Consumer‘s Surplus
2.7 Summary
2.8 Keywords
Objectives
Explain utility analysis
Explain Law of Diminishing Marginal Utility
Marginal and equi-marginal utility
Understand about Consumer's surplus
Discuss the concept of indifference curve analysis
Explain the factors affecting consumer equilibrium
Introduction
The study of chapter help to know how firms and organizations improve their marketing strategies by
understanding issues such as:
The psychology of how consumers think, feel, reason, and select between different alternatives (e.g.,
brands, products);
The psychology of how the consumer is influenced by his or her environment (e.g., culture, family,
signs, media);
The behaviour of consumers while shopping or making other marketing decisions;
Limitations in consumer knowledge or information processing abilities influence decisions and
marketing outcome;
How consumer motivation and decision strategies differ between products that differ in their level of
importance or interest that they entail for the consumer; and
How marketers can adapt and improve their marketing campaigns and marketing strategies to more
effectively reach the consumer.
One ―official‖ definition of consumer behaviour is ―The study of individuals, groups, or organizations and
the processes they use to select, secure, use, and dispose of products, services, experiences, or ideas to
satisfy needs and the impacts that these processes have on the consumer and society.‖ Although it is not
necessary to memorize this definition, it brings up some useful points:
Behaviour occurs either for the individual, or in the context of a group (e.g., friend‘s influence what
kinds of clothes a person wears) or an organization (people on the job make decisions as to which
products the firm should use).
Consumer behaviour involves the use and disposal of products as well as the study of how they are
purchased. Product use is often of great interest to the marketer, because this may influence how a
product is best positioned or how we can encourage increased consumption. Since many
environmental problems result from product disposal (e.g., motor oil being sent into sewage systems to
save the recycling fee, or garbage piling up at landfills) this is also an area of interest.
Consumer behaviour involves services and ideas as well as tangible products.
The impact of consumer behaviour on society is also of relevance. For example, aggressive marketing
of high fat foods, or aggressive marketing of easy credit, may have serious repercussions for the
national health and economy.

The term utility refers to the human want satisfying power of the commodity. It is the subjective entity and
can vary from person to person, time to time and place to place. We can create or add utility by the
following four functions:
(a) By changing time

(b) By changing place
(c) By changing form
(d) By changing person.
Utility Maximization: The process or goal of obtaining the highest level of utility from the consumption or
use of goods and services. This is based on the seemingly obvious presumption that people prefer more to
less, which is intimately tied to the unlimited wants and needs aspect of scarcity. In other words, because
people have unlimited wants and needs, because they always have unfulfilled wants or needs, satisfying
these wants and needs is a desirable thing to do.
The Scarcity Connection
The utility maximization goal is based on the seemingly obvious presumption that people prefer more to
less. This presumption is tied to the unlimited wants and needs aspect of scarcity. In other words, because
people have unlimited wants and needs, satisfying those wants and needs are a desirable thing to do.
Someone like Duncan Thurly would rather have a full belly than an empty one. He would rather live in a
cozy, climate-controlled house than in a cardboard box under a bridge.
Utility Measurement: A quantification of the satisfaction of wants and needs achieved through the
consumption of goods and services. In principle, utility measurement can take one of two forms:
1. Cardinal utility is the measurement of satisfaction using numerical values (1, 2, 3, etc.) that are
comparable and based on a benchmark or scale. Height and weight are common cardinal measures.
2. Ordinal Utility is the ranking of preferences (first, second, third, etc.) that are only comparable on a
relative basis. Sporting events are commonly subject to ordinal measures.
Value: Quite simply, this is the amount of consumer satisfaction directly or indirectly obtained from a
good. Service or resource. The more a good satisfies a person's want or need, then the more valuable it is to
that person. Furthermore, different people are likely to place different values on a good. Resources are
valuable to the degree that they are used to produce stuff that consumers want. The bottom line is that
value, like beauty, is truly in the eye of the beholder.
2.1.1 Analysis
Utility analysis, a subset of consumer demand theory, provides insight into an understanding of market
demand and forms a cornerstone of modern microeconomics. In particular, this analysis investigates
consumer behaviour, especially market purchases, is based on the satisfaction of wants and needs (that is,
utility) generated from the consumption of a good.
Utility analysis is primarily taught in introductory courses. A more sophisticated version of consumer
demand theory relies on the analysis of indifference curves and is more commonly found at the
intermediate course level and above. The primary focus of utility analysis is on the satisfaction of wants
and needs obtained by the consumption of goods. This is technically termed utility. The utility generated
from consumption affects the decision to purchase and consume a good. When used in the analysis of
consumer behaviour, utility assumes a very precise meaning, which differs from the everyday use of the
term. In common use, the term utility means "useful.
" For example, a "utility" knife is one with many uses, something that is handy to have around. In baseball,
a "utility" player can perform quite well at several different positions and is thus useful to have on the
team. Moreover, a public "utility" is a company that supplies a useful product, such as electricity, natural
gas, or trash collection. In contrast, the specific economic use of the term utility in the study of consumer
behaviour means the satisfaction of wants and needs obtained from the consumption of a commodity. The
good consumed need not be "useful" in the everyday sense of the term. It only needs to provide
satisfaction. In other words, a frivolous good that has little or no practical use, can provide as much utility
as a more useful good. An Omni Open Deluxe Can Opener is extremely useful, especially when a sealed
can needs to be opened. Figure 2.1 shows the total utility.
Figure 2.1: Total utility.

Utility analysis begins with the total utility derived from the consumption of different quantities of a good.
Total utility is simply a measure of the total satisfaction of wants and needs obtained from the consumption
or use of a good or service. It is often convenient to present total utility for a range of quantities in a table
such as the one displayed to the right. Utility analysis is based on the presumption that the amount of
utility generated from the consumption of a good can be explicitly measured. The total utility generated if
Edgar takes 8 rides is 32 utile. Edgar‘s utility increases for the first 6 rides, reaching a high of 36 utile,
before declining back to 32 utile for the 8th ride. Presumably Edgar‘s utility continues to decline after the
8th ride.
In this example, utility is maximized at 6 rides. In many situations, however, the consumption of a good
faces constraints. Edgar, for example, might face a time constraint because he plans to attend a live concert
of the rock-and-roll group, Live Headless Squirrels, that prevents him from riding more than 4 times. Or he
might face an income constraint because the amusement park charges INR 2 per ride and he has only INR5
in his pocket. In these situations Edgar, as well as other consumers, might pursue constrained utility
maximization. This means achieving the highest possible utility, given certain restrictions that prevent the
highest overall level of utility from being achieve.
Table 2.1: Total utility

Rides Total
utility(util)
0 0
1 22
2 20
3 27
4 32
5 35
6 36
7 35
8 32

It will be better to remind some terms again for understanding the law and they are:
Initial Utility: It is the utility of the initial or the first unit. In the table initial utility is 8.
Total Utility: In column 3 of the table, it gives the total utility at each step. For example it you consume on
mango are total utility is 3, if you consume two mangoes, the total utility is 14.
Zero Utility: When the consumption of a unit of a commodity makes no addition to the total utility, then it
is the point of zero utility.
Marginal Utility: The addition to the total utility by the consumption of the last unit considered just
worthwhile. The can be worked out by using following formula.
Negative Utility: It the consumption of a unit of a commodity is carried to excess, then instead of giving
any satisfaction, it may cause dissatisfaction. The utility in such cases is negative. In the table given above
the marginal utility of the 5th unit is negative.
Units of Commodity No. of Mangoes Total Utility (TU) Marginal Utility (MU)
1 3 8
2 14 6
3 16 2
4 16 0
5 14 –2
A clear pattern is displayed by the marginal utility values in the far right column. Marginal utility
decreases as Edgar takes more rides. This decreasing marginal utility reflects the law of diminishing
marginal utility. The law of diminishing marginal utility states that marginal utility or the extra utility
obtained from consuming a good, decreases as the quantity consumed increases.
In essence, each additional good consumed is less satisfying than the previous one. This law is particularly
important for insight into market demand and the law of demand. If each additional unit of a good is less
satisfying, then a buyer is willing to pay less. As such, the demand price declines. This inverse law of
demand relation between demand price and quantity demanded is a direct implication of the law of
diminishing marginal utility.
2.2.1 A Few Numbers

To illustrate this highly useful law, take a gander at the table presented to the right. The story behind the
table is this: Edgar Mill bottom, Shady Valley's most devoted roller coaster devotee, has spent the day
riding the Monster Loop Death Plunge roller coaster at the Shady Valley Amusement Park. After each ride,
he is hooked up to a hypothetical "utilnometer" to measure his total utility from all rides, and most
important to this discussion, his marginal utility from each additional ride.
As such, Edgar's first ride generates an extra 11 utils of satisfaction, the second ride provides an extra 9
utile, the third ride comes in with an extra 7 utils, and so forth. The declining marginal utility numbers-11,
9, 7, etc.--illustrate the law of diminishing marginal utility. Each additional ride generates less extra utility
than the previous one. In fact, marginal utility continues to decline until the seventh and eighth rides
generate negative marginal utilities. Edgar is less satisfied, in total, after 7 rides than after 6 rides.
Table 2.2: Roller coaster utility
2.2.2 The Law of Demand

While the law of diminishing marginal utility pops up throughout the study of economics, it is most
important to the study of demand and the law of demand. It offers preliminary insight into the age-old
question: ―Why does the demand curve have a negative slope?‖
The key to this connection is that the demand price that a buyer is willing and able to pay for a good
depends on the satisfaction (utility) generated from consumption. A buyer is willing to pay a higher
demand price if utility is greater or a lower demand price if utility is less. Because marginal utility
diminishes as the quantity of a good is consumed increases (the law of diminishing marginal utility),
buyers are willing and able to pay lower prices for larger quantities (the law of demand). Hence, the law of
demand exists because the less satisfaction is received for larger quantities. This law of diminishing
marginal utility is the counterpart of the law of diminishing marginal returns. As the law of diminishing
marginal utility offers an explanation for the law of demand and the negative slope of the demand curve,
the law of diminishing marginal returns offers an explanation for the law of supply and the positive slope
of the supply curve. (See Figure 2.2)
Figure 2.2: The positive slope of the supply curve.
2.2.3 Importance of the Law of DMU

Basic of Economic Law and Concepts: This law of DMU forms the basis of law of demand, law of equi-
marginal utility, elasticity of demand etc.
Public Finance: The Govt. can impose and justify progressive income tax on the ground of this law, as the
income increases, the MU of income diminishes.
Businessmen: A businessman or producer can increase the sale of his product by fixing a lower price. Since
consumers tend to buy more to equate MU with price, a producer can expect a rise in sale.
Example: An example from everyday life would be filling your gas tank up with gas, and then someone
offering you more gas. You do not need any more gas until you use the gas you have.
2.3 Equi-marginal Utility

It is a classical theory of consumer behaviour, law of substitution in consumption or maximum satisfaction.
The law of equi-marginal utility states that ―A rational person in order to get maximum satisfaction
allocates his expenditures on purchase of different goods in such a way that marginal utility of the last INR
Spent in each direction is the same‖. This is called the law of satisfaction because we substitute more
useful goods to less useful goods.
This is called the law of maximum satisfaction because through it we get maximum satisfaction and it is
called the law of equi-marginal utility because through it when the marginal utilities are equalized, through
the process of substitution, the maximum satisfaction is attained.
Utility is an extension to the law of diminishing marginal utility. The principle of equi-marginal utility
explains the behaviour of a consumer in distributing his limited income among various goods and services.
This law tells that how a consumer allocates his money income between various goods so as to obtain
maximum satisfaction
2.3.1 Importance of Equi-marginal Utility

The law of equi-marginal utility is of great practical importance. The application of the principle of
substitution extends over almost every field of economic enquiry. Every consumer consciously or
unconsciously trying to get the maximum satisfaction from his limited resources acts upon his principle of
substitution. Same is the case with the producer, in the field of exchange and in theory of distribution too,
this law play a vital role. In short, despite its limitations, the law of maximum satisfaction is meaningful
general statement of how consumers behave.
Practical Importance
1. This law is applied to all problems of scarce (limited) resource against unlimited wants.
2. This law plays an important role in the theory of distribution and exchange.
3. It extends over the field of the theory of production.
2.3.2 Limitations
Following are the limitations of the law:
No Rational Calculation: The law involves rational calculations. But in the busy and routine life we are
not capable to do so that who is rational and who is irrational.
Consumer’s Ignorance: The consumer may not aware of the goods which are more useful than the goods
which they are going to purchase. So, they cannot substitute more useful goods to the less useful goods and
hence the law is not applicable to them.
Indivisibility of Goods: Sometimes the goods are not divisible to small units. So MU cannot be calculated
and law is not applicable.
Wrong Assumption: It assumed that utilities are measurable but in actual utility cannot be calculated
because it is a state of mind. It is assumed that marginal utility of money remains constant but the law of
DMU applies to money equally.
2.4 Consumer‟s Surplus

Consumer surplus is the difference between what a person is willing to pay for a commodity and the
amount that he actually wants to pay.
Consumer surplus = Total willingness to pay for a goods – the total amount consumer actually do pay.
Consumer enjoys consumer surplus if he pays the same amount of money for each unit of good he buys. It
is a measure of the net benefits received by the consumer. Consumer Surplus occurs when people are able
to buy a good for less than they would be willing to pay. They enjoy more they had to pay for.
2.4.1 Application of Consumer Surplus

This concept has more public policy relevance. Since it is a measure of the net benefit received by the
consumer, government can estimate the loss or increase in consumer welfare due to any policy change.
Price Discrimination and Consumer Surplus

Producers often take advantage of consumer surplus when setting prices. If a business can identify groups
of consumers within their market who are willing and able to pay different prices for the same products,
then sellers may engage in price discrimination the aim of which is to extract from the purchaser, the price
they are willing to pay, thereby turning consumer surplus into extra revenue.
Airlines are expert at practicing this form of yield management, extracting from consumers the price they
are willing and able to pay for flying to different destinations are various times of the day, and exploiting
variations in elasticity of demand for different types of passenger service. You will always get a better
deal/price with airlines such as Easy Jet and Ryan Air. If you are prepared to book weeks or months in
advance. The airlines are prepared to sell tickets more cheaply then because they get the benefit of cash-
flow together with the guarantee of a seat being filled.
The nearer the time to take-off, the higher the price. If a businessman is desperate to fly from Newcastle to
Paris in 24 hours time, his or her demand is said to be price inelastic and the corresponding price for the
ticket will be much higher.
One of the main arguments against firms with monopoly power is that they exploit their monopoly position
by raising prices in markets where demand is inelastic, extracting consumer surplus from buyers and
increasing profit margins at the same time. We shall consider the issue of monopoly in more detail when
we come on to our study of markets and industries.

It is based on Ordinal utility approach. First used by F.Y. Edgeworth in 1881 AD, to show the possibility
of exchange between products and factors between two persons efficiently. Irving Fisher also used the
concept of ordinal utility approach in 1892 AD.V. Pareto explained his theory ‗Pareto Optimality‘ by using
this ordinal approach in 1906 AD.U. Slutsky also used this concept in 1915 AD. Formally, two economists
J.R. Hicks and R.G.D. Allen developed the concept of Indifference Curve in 1934 AD. Again revised by
Hicks in 1939 in his book ―Value and Capital‖
An indifference curve is a line that shows all the possible combinations of two goods between which a
person is indifferent. In other words, it is a line that shows the consumption of different combinations of
two goods that will give the same utility (satisfaction) to the person.
A person would receive the same utility (satisfaction) from consuming 4 hours of work and 6 hours of
leisure, as they would if they consumed 7 hours of work and 3 hours of leisure.
Figure 2.3: An indifference curve for work and leisure.
An important point is to remember that the use of an indifference curve does not try to put a physical
measure onto how much utility a person receives.
The Shape of the Indifference Curve

Above figure highlights that the shape of the indifference curves is not a straight line. It is conventional to
draw the curve as bowed. This is due to the concept of the diminishing marginal rate of substitution
between the two goods. The marginal rate of substitution is the amount of one good (i.e. work) that has to
be given up if the consumer is to obtain one extra unit of the other good (leisure).The equation is below:
The marginal rate of substitution (MRS) = change in good X / change in good Y
Using above Figure, the marginal rate of substitution between point A and Point B is;
MRS = -3 / 3 = -1 = 1
Note: The convention is to ignore the sign.
The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal
utility. Where this principle states that the more units of a good are consumed, then additional units will
provide less additional satisfaction than the previous units.
Therefore, as a person consumes more of one good (i.e. work) then they will receive diminishing utility
for that extra unit (satisfaction), hence, they will be willing to give up less of their leisure to obtain one
more unit of work. The relationship between marginal utility and the marginal rate of substitution is often
summarized with the following equation;
MUX
M UY
MRS =
It is possible to draw more than one indifference curve on the same diagram. If this occurs then it is termed
an indifference curve map.
Figure 2.4: Indifference curve map.
2.5.1 Meaning of Indifference Curve

Indifference curve is the locus of different combinations of two commodities X and Y, from which the
consumer yields equal level of satisfaction. The consumer will be indifferent among all the combinations
of that curve. Also called as is-utility curve or equal satisfaction curve.
2.5.2 Assumptions of Indifference Curve

Utility cannot be presented numerically but can be presented in order. The consumer is rational. Two wants
are satiable at a time. Total utility of consumer depends on the units of commodities. Consumer is
consistent in his choice. Consumer‘s choices are characterized by transitivity. (if A>B, B>C then A>C)
Consumer has non-satiety nature. The consumer has scale of preferences. There is operation of law of
diminishing marginal rate of substitution.
2.5.3 Derivation of Indifference Curve

IC can be derived by using Consumer‘s indifference schedule as following:
Consumer‘s indifference schedule can be defined as the tabular presentation of various combinations of
two commodities which are equally acceptable to the consumer or which give equal level of satisfaction.
Prof. Watson, ―An indifference schedule is a list of combinations of two commodities, the list being so
arranged that a consumer is indifferent to the combinations, preferring none of any others.
Table 2.3: Consumer‘s preference schedule

Combination Unit of X Unit of Y MRSXY
A 1 20 –
B 2 15 5:1
C 3 11 4:1
D 4 8 3:1
E 5 6 2:1
F 6 4 1:1

When consumers make choices about the quantity of goods and services to consume, it is presumed that
their objective is to maximize total utility. In maximizing total utility, the consumer faces a number of
constraints, the most important of which are the consumer's income and the prices of the goods and
services that the consumer wishes to consume. The consumer‘s effort to maximize total utility, subject to
these constraints, is referred to as the consumer‘s problem. The solution to the consumer‘s problem, which
entails decisions about how much the consumer will consume of a number of goods and services, is
referred to as consumer equilibrium.
2.6.1 Determination of Consumer Equilibrium

Consider the simple case of a consumer who cares about consuming only two goods: good 1 and good 2.
This consumer knows the prices of goods 1 and 2 and has a fixed income or budget that can be used to
purchase quantities of goods 1 and 2. The consumer will purchase quantities of goods 1 and 2 so as to
completely exhaust the budget for such purchases. The actual quantities purchased of each good are
determined by the condition for consumer equilibrium, which is
This condition states that the marginal utility per dollar spent on good 1 must equal the marginal utility per
dollar spent on good 2. If, for example, the marginal utility per dollar spent on good 1 were higher than the
marginal utility per dollar spent on good 2, then it would make sense for the consumer to purchase more of
good 1 rather than purchasing any more of good 2. After purchasing more and more of good 1, the
marginal utility of good 1 will eventually fall due to the law of diminishing marginal utility, so that the
marginal utility per dollar spent on good 1 will eventually equal that of good 2. Of course, the amount
purchased of goods 1 and 2 cannot be limitless and will depend not only on the marginal utilities per dollar
spent, but also on the consumer's budget.
2.6.2 Price Effect

Price Effect is the effect on the consumer equilibrium exclusively as a result of change in the price of one
commodity while price of other good and income of the consumer remaining constant. The change in
demand in response to a change in price of a commodity, other things remaining the same (Ceteris
Paribus), is called Price effect.
Figure 2.5: Price Effect graph.

2.6.3 Income Effect
The income effect takes account of how price changes affect consumption choices by changing the real
purchasing power or real income of the consumer.
Figure 2.6: Income Effect graph.

2.6.4 Substitution Effect
Substitution effect of a price change when the price of a good changes. The price of that good relative to
the price of other goods also changes. Relative price changes cause consumers to substitute from one good
to another is known as the substitution effect.
Figure 2.7: Substitution Effect graph.
Did you know?

The (The Engel-Kollat-Blackwell) EKB model was further developed by Rice (1993) which suggested
there should be a feedback loop; Foxall (2005) further suggests the importance of the post purchase
evaluation.
Caution
With the climate of fierce competition led to a company must consider and understand consumer behaviour
in deciding the purchase of the product
Case Study-A Master at CRM

Every three months, millions of people in the United Kingdom (UK) receive a magazine from the
country‘s number one retailing company, Tesco. Nothing exceptional about the concept almost all leading
retailing companies across the world send out mailers/magazines to their customers.
These initiatives promote the store‘s products, introduce promotional schemes and contain discount
coupons. However, what set Tesco apart from such run-of-the-mill initiatives was the fact that it mass-
customized these magazines. Every magazine had a unique combination of articles, advertisements related
to Tesco‘s offerings, and third-party advertisements.
Tesco ensured that all its customers received magazines that contained material suited to their lifestyles.
The company had worked out a mechanism for determining the advertisements and promotional coupons
that would go in each of the over 150,000 variants of the magazine. This had been made possible by its
world-renowned customer relationship management (CRM) strategy framework.
The loyalty card 3 schemes (launched in 1995) laid the foundations of a CRM framework that made Tesco
post growth figures in an industry that had been stagnating for a long time.
The data collected through these cards formed the basis for formulating strategies that offered customers
personalized services in a cost-effective manner.Each and every one of the over 8 million transactions
made every week at the company‘s stores was individually linked to customer-profile information.
And each of these transactions had the potential to be used for modifying the company‘s strategies.
According to Tesco sources, the company‘s CRM initiative was not limited to the loyalty card scheme; it
was more of a companywide philosophy.Industry observers felt that Tesco‘s CRM initiatives enabled it to
develop highly focused marketing strategies.
CRM-The Tesco Way

Tesco‘s efforts towards offering better services to its customers and meeting their needs can be traced back
to the days when it positioned itself as a company that offered good quality products at extremely
competitive prices.
Reaping the Benefits
Commenting on the way the data generated was used, sources at Dunnhumby said that the data allowed
Tesco to target individual customers (the rifle shot approach), instead of targeting them as a group (the
carpet bombing approach).
Since the customers received coupons that matched their buying patterns, over 20% of Tesco‘s coupons
were redeemed - as against the industry average of 0.5%.
The number of loyal customers increased manifold since the loyalty card scheme was launched
From Customer Service to Customer Delight

To sustain the growth achieved through the launch of Club cards, Tesco decided to adopt a four pronged
approach: launch better, bigger stores on a frequent basis; offer competitive prices (e.g. offering everyday
low prices in the staples business); increase the number of products offered in the Value range; and focus
on remote shopping services (this included the online shopping venture). To make sure that its prices were
the lowest among all retailers, Tesco employed a dedicated team of employees, called ‗price checkers.‘
An Invincible Company? Not Exactly

Tesco‘s customer base and the frequency with which each customer visited its stores had increased
significantly over the years. However, according to reports, the average purchase per visit had not gone up
as much as it would have liked to see.
Analysts said that this was not a very positive sign. They also said that while it was true that Tesco was the
market leader by a wide margin, it was also true that and Morrison were growing rapidly. Given the fact
that the company was moving away from its core business within UK (thrust on non-food, utility services,
online travel services) and was globalizing rapidly (reportedly, it was exploring the possibilities of entering
China and Japan), industry observers were rather skeptical of its ability to maintain the growth it had been
posting since the late-1900s. The Economist stated that the UK retailing industry seemed to have become
saturated and that Tesco‘s growth could be sustained only if it ventured overseas.
The case describes the customer relationship management (CRM) initiatives undertaken by Tesco, the
number one retailing company in the United Kingdom (UK), since the mid-1990s. The company‘s growth
and its numerous customer service efforts are described. The case then studies the loyalty card scheme
launched by the company in 1995.
It examines how the data generated through this scheme was used to modify the company‘s marketing
strategies and explores the role played by the scheme in making Tesco the market leader. The case also
takes a look at the various other ways in which Tesco tried to offer its customers the best possible service.
Finally, the company‘s future prospects are commented on in light of changing market dynamics, the
company‘s new strategic game plan, and criticism of loyalty card schemes.
Questions
1. Examine how the information gathered through CRM tools can be used to modify marketing strategies
and the benefits that can be reaped through them.
2. Explain the benefits of CRM in Tesco.
2.7 Summary
Customer Value is the difference between all the benefits derived from a total product and all the cost
of acquiring those benefits.
Lifestyle of customers is important factor affecting the consumer buying behaviour.
The study of Consumer behaviour can be approach in three different perspectives namely; Consumer
Influence Perspective, holistic Perspective and Intercultural Perspective.
The term ―customer‖ is typically used to refer to someone who regularly purchases from a particular
store or company.
2.8 Keywords
Customer Lifetime Value: In marketing, customer lifetime value (CLV), lifetime customer value (LCV),
or user lifetime value (LTV) is a prediction of the net profit attributed to the entire future relationship with
a customer.
Customer Relationship Management: It is a widely implemented model for managing a company‘s
interactions with customers, clients, and sales prospects.
Customer: The term ―customer‖ is typically used to refer to someone who regularly purchases from a
particular store or company.
Marketing Strategy: It is a process that can allow an organization to concentrate its limited resources on
the greatest opportunities to increase sales and achieve a sustainable competitive advantage.
Utility Analysis: Cost–utility analysis (CUA) is a form of financial analysis used to guide procurement
decisions.

(1) Consumer behaviour is defined as:
(a) Behaviour displayed by consumer (b) Behaviour displayed by marketers
(c) Behaviour displayed by customer (d) None of these.
(2) Consumers and Customers:

(a) Both are different (b) Both are same
(c) Both are compliments (d) None of these.
(3) Type of consumers is:

(a) Three (b) Four
(c) Two (d) None of these
(4) We can create utility by changing:

(a) Time (b) Place
(c) Form (d) All of these.
(5) Consumer enjoys consumer surplus if he pays:

(a) Same amount for each good (b) Different amount for each good
(c) Both a and b (d) None of these.
(6) Indifference curve had been used by F.Y. Edge worth in:
(a) 1880 AD (b) 1871 AD
(c) 1882 AD (d) 1881 AD
(7) ―Pareto Optimality‖ had been explained in:

(a) 1904 AD (b) 1907 AD
(c) 1906 AD (d) None of these.
(8) Consumer equilibrium is affected by

(a) Price (b) Substitution
(c) Income (d) All of these.
(9) Ratio of marginal utility and price of good is known as:
(a) Equi- marginal utility (b) Consumer equilibrium
(c) Neither a nor b (d) None of these
(10) Indifference curve always slopes downwards from left to right

(a) True (b) False

1. What is Law of Diminishing?
2. What is the difference between customer and consumer?
3. How many types of consumer behaviour? Discuss the need of study of consumer behaviour.
4. What is the consumer behaviour theory?
5. Explain the different stages of consumer buying process.
6. What are the factors influencing consumers buying behaviour?
7. What is the utility analysis?
8. Discuss the diminishing marginal utility.
9. What is equi-marginal utility?
10. Discuss the indifference curve analysis.
Answers of Self Assessment Question

1. (a) 2. (b) 3. (c) 4. (d) 5. (a)
6. (d) 7. (c) 8. (d) 9. (b) 10. (a)
3
Demand Analysis
CONTENTS
Objectives
Introduction
3.2 Law Of Demand
3.5 Summary
3.6 Keywords
Objectives
Describe the determinants and changes in demand
Explain the law of demand
Define elasticity of demand and its measurement
Describe the demand forecasting
Explain the method of measurements
Introduction
Demand Analysis refers to how much (quantity) of a product or service is desired by buyers. The quantity
demanded is the amount of a product people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship.
In a market economy, if there is demand for something there will surely be people willing to supply it. In
that sense, supply is the flip side of demand. Economists think and talk in terms of the supply of cars and
housing, the supply of labour and materials, and so on. The supply of a product or service depends on
many things including the resources and productive capacity devoted to producing it and, again, its price.
In a market economy, the interaction of demand wants and needs and supply resources and productive
capacity largely determine what is produced and how it is allocated.
When price changes quantity demanded will change. That is a movement along the same demand curve.
When factors other than price changes, demand curve will shift. These are the determinants of the demand
curve:
Income: A rise in a person‘s income will lead to an increase in demand (shift demand curve to the
right); a fall will lead to a decrease in demand for normal goods. Goods whose demand varies inversely
with income are called inferior goods (e.g. Hamburger Helper).
Consumer Preferences: Favourable change leads to an increase in demand, unfavourable change lead
to a decrease.
Number of Buyers: The more buyers lead to an increase in demand; fewer buyers lead to decrease.
Price of Related Goods
Substitute goods: Those that can be used to replace each other. Price of substitute and demand for the
other good are directly related. Example: If the price of coffee rises, the demand for tea should
increase.
Complement goods: Those that can be used together. Price of complement and demand for the other
good are inversely related. Example: if the price of ice cream rises, the demand for ice-cream toppings
will decrease.
Expectation of Future
Future price: consumers‘ current demand will increase if they expect higher future prices; their
demand will decrease if they expect lower future prices.
Future income: consumers‘ current demand will increase if they expect higher future income; their
demand will decrease if they expect lower future income.
Population
Population is of course a key determinant of demand. Although all forest products do not necessarily enter
final consumer markets, the actual markets are largely presumed to be functionally related to population.
Growing populations are positively correlated to timber demands in the aggregate, as well as specifically to
individual forest products. Frequently, population and income estimators are combined, as in the case of
the use of Gross Domestic Product per capita.

The demand for a product or a service depends on a host of factors. Some factors are specific-to-specific
product or service-market. The importance of these factors may also vary over-time and over-space.
However, there are certain factors, which are common for all demands.
3.1.1 Income
Consider the demand for new homes. You want a new home and choose one you like. The price is INR 10,
00,000. You do not buy. One reason is that your income is not large enough to be able to afford this
amount. Therefore, income must be one of the factors that affect the demand for a given product.
Normally, we expect that as one‘s income rises (falls), the demand for a product will rise (fall).
Because we normally expect this to be true, a good for which this statement is true is called a normal good.
Knowing that as income rises, the demand will raise is useful information. But, as with the price of the
product, it is not enough information. A company or a government agency wants to know how much the
demand will rise if income rises by a certain percent. In particular, they want to know the income elasticity
of demand, given by the formula:
Income elasticity of demand =

In this case, we are measuring how greatly buyers respond to a change in their income. If the number is
positive, we know that this is a normal good (income and demand both rose). If the number is negative, we
know that this is an inferior good (income rose and demand fell).
Again, we commonly divide at one. If the number is less than or equal to +1, the product is called a
―necessity‖. This means that if income falls, the demand falls very little because the product is needed. If
the number is greater than 1, the product is called a ―luxury‖. This means that if income falls, the demand
falls greatly because the product is not needed.
3.1.2 The Price of a Complement

Return now to your decision to buy a new home. Assume that you are willing to pay the price and have
sufficient income. What other factors might enter into your decision? One factor might involve the method
you will use to pay for this home borrowing money. The price of borrowing money is called the interest
rate. The interest rate is one example of the price of a complement. A complement is a different good that
goes together with the one under consideration.
Homes and borrowing money tend to go together. So do bread and butter, coffee and sugar, gasoline and
automobiles, homes and furniture, peanut butter and jelly, and many other examples. What happens to the
demand for new homes if the interest rate rises? The answer, of course, is that it falls. When interest rates
rise, people are less likely to borrow. If they do not borrow, they will not buy the homes. It is also likely
that the demand for butter will fall if the price of bread rises, the demand for automobiles will fall if the
price of gasoline rises, and so on. Therefore, our relationship is: if the price of the complement rises (falls),
the demand for the product (homes) falls (rises).
3.1.3 Expectations
Demand curves may also be shifted by changes in expectations. For example, if buyers expect that they
will have a job for many years to come, they will be more willing to purchase goods such as cars and
homes that require payments over a long period of time, and therefore, the demand curves for these goods
will shift to the right. If buyers fear losing their jobs, perhaps because of a recessionary economic climate,
they will demand fewer goods requiring long-term payments and will therefore cause the demand curves
for these goods to shift to the left.
3.1.4 Population
The last of the factors affecting demand is the population (number of buyers). The market demand is
simply the sum of the individual demands. If, at the price of INR 50, Bill wants to buy 2 six packs of Coca
Cola, Jose wants to buy 3 six packs of Coca Cola, and Mary wants to buy 1 six pack of Coca Cola, then, of
course, the market demand is 6 six packs. If Jordan becomes a buyer and wishes to buy 4 six packs, the
market demand rises to 10 six packs. Therefore, if there are more buyers, there must be more market
demand.
The demand for a given product will rise if:
Incomes rise for a normal good or fall for an inferior good
The price of a complement falls
The price of a substitute rises
People like the product better
People expect the price to rise soon
People expect the product not to be available soon
People expect their incomes to rise in the near future
There are more buyers.
The opposite will cause the demand for the product to fall.
3.1.5 Change in Demand
A movement along a given demand curve caused by a change in demand price. The only factor that can
cause a change in quantity demanded is price. A related, but distinct, concept is a change in demand.
A change in quantity demanded is a change in the specific quantity of a good that buyers are willing and
able to buy. This change in quantity demanded is caused by a change in the demand price. It is illustrated
by a movement along a given demand curve.
In fact, the only way to induce a change in quantity demanded is with a change in the price. Anything else,
everything else, causes a change in demand.
As the demand price induces a change in the quantity demanded and a movement along the demand curve,
the five demand determinants (buyers‘ income, buyers‘ preferences, other prices, buyers‘ expectations, and
number of buyers) remain unchanged.
Demand and Quantity Demanded

To set the stage for an understanding of this difference, take note of two related concepts:
i. Quantity Demanded: Quantity demand is a specific quantity that buyers are willing and able to buy at a
specific demand price. It is but ONE point on a demand curve.
ii. Demand: Demand is the range of quantities that buyers are willing and able to buy at a range of
demand prices. It is ALL points that make up a demand curve.
So what happens when the phrase ―change in‖ is placed in front of each term?
i. Change in Quantity Demanded: A change in quantity demanded is a change from one price-quantity
pair on an existing demand curve to a new price-quantity pair on the SAME demand curve. In other
words, this is a movement along the demand curve. A change in quantity demanded is caused by a
change in price.
ii. Change in Demand: A change in demand is a change in the ENTIRE demand relation. This means
changing, moving, and shifting the entire demand curve. The entire set of prices and quantities is
changing. In other words, this is a shift of the demand curve. A change in demand is caused by a
change in the five demand determinants.
Changing the Quantity

A change in quantity demanded is a movement along a given demand curve. A change in demand is a shift
of the demand curve. These alternatives can be illustrated with the negatively-sloped demand curve
presented in this exhibit. This demand curve captures the specific one-to-one, law of demand relation
between demand price and quantity demanded. The five demand determinants are assumed to remain
constant with the construction of this demand curve.
Figure 3.1: A Change in quantity demanded.

A Change in Quantity Demanded: A change in quantity demanded, which is only triggered by a change in
demand price, is a movement along the demand curve.
A Change in Demand: A change in demand, which is triggered by a change in any of the five demand
determinants, is a shift of the demand curve.
An Important Difference
Why is this difference so important? The answer is as simple as cause and effect. The demand curve is
used (together with supply) to explain and analyze market exchanges. The sequence of events follows a
particular pattern.
A demand (or supply) determinant changes.
This determinant change causes the demand curve (or supply curve) to shift.
The change in demand (or supply) causes either a shortage or a surplus imbalance in the market. The
market is in a temporary state of disequilibrium.
The shortage and surplus imbalance causes the price of the good to change.
The change in price causes a change in quantity demanded (and supplied).
The change in quantity demanded (and supplied) eliminates the shortage or surplus and restores market
equilibrium.
3.2 Law of Demand

Among the many causal factors affecting demand, price is the most significant and the price- quantity
relationship called as the Law of Demand is stated as follows: ―The greater the amount to be sold, the
smaller must be the price at which it is offered in order that it may find purchasers, or in other words, the
amount demanded increases with a fall in price and diminishes with a rise in price‖. In simple words other
things being equal, quantity demanded will be more at a lower price than at higher price. The law assumes
that income, taste, fashion, prices of related goods, etc. remain the same in a given period. The law
indicates the inverse relation between the price of a commodity and its quantity demanded in the market.
However, it should be remembered that the law is only an indicative and not a quantitative statement. This
means that it is not necessary that such variation in demand be proportionate to the change in price.
3.2.1 Demand Curve

When the data presented in the demand schedule can be plotted on a graph with quantities demanded on
the horizontal or X- axis and hypothetical prices on the vertical or Y- axis, and a smooth curve is
hypothetical prices on the vertical or Y- axis, and a smooth curve is drawn Joining all the points so plotted,
it gives a demand curve. Thus, the demand schedule is translated into a diagram known as the demand
curve. (See Figure 3.2)
Figure 3.2: Demand curve.
The demand curve slopes downwards from left to right, showing the inverse relationship between price and
quantity as in Figure 3.3.
3.2.2 Market Demand

The market demand reflects the total quantity purchased by all consumers at alternative hypothetical
prices. It is the sum-total of all individual demands. It is derived by adding the quantities demanded by
each consumer for the product in the market at a particular price.
The table presenting the series of quantities demanded of all consumers for a product in the market at
alternative hypothetical prices is known as the Market Demand Schedule. If the data are represented on a
two dimensional graph, the resulting curve will be the Market Demand Curve. From the point of view of
the seller of the product, the market demand curve shows the various quantities that he can sell at different
prices. Since the demand curve of an individual is downward sloping, the lateral addition of such curves to
get market demand curve will also result in downward sloping curve.
3.2.3 Shifts in Demand Curve

The price-quantity relationship represented by the law of demand is important but it is more important for
the manager of the firm to know about the shifts in the demand function (or curve). For many products,
change in price has little effect in the quantity demanded in relevant price ranges. Many other determinants
like incomes, tastes, fashion, and business activity have larger effect on demand for such product. Thus,
changes or shifts in demand curve rather than movement along the demand curve is of greater significance
to the decision-maker in the firm. Let us clearly know the difference between movement along one and the
same demand curve and shift in demand curve due to changes in demand.
Figure 3.3: Demand curve.
When price of a good alone varies, ceteris paribus, the quantity demanded of the good changes. These
changes due to price variations alone are called as extension or contraction of demand represented by
movement along the same demand curve.
Such movement along the same demand curve is shown in Figure 3.3. Price declines from OP1 to OP2 and
demand goes up from OM1 to OM2. Here the demand for the good is said to have extended or expanded.
This is represented by movement from point A to point B along the demand curve. On the contrary, if price
rises from OP2 to OP1 demand falls from OM2 to OM1. Here the demand for the good is said to have
contracted. This is represented by movement from point B to point A along the demand curve D1D1.
Figure 3.4: Quantity demanded.
Shifts in demand curve take place on account of determinants other than price such as changes in income,
fashion, tastes, etc. The ceteris paribus assumption is relaxed; other factors than price influence demand
and the impact of these factors on demand is described as changes in demand or shifts in demand, showing
increase or decrease in demand. This kind of change is shown in Figure 3.4. The quantity demanded at OP1
is OM1. If, as a result of increase in income, more of the product is demanded, say OM2 at the same price
OP1. Note that OM2 is due to the new demand curve D2D2. This is a case of shift in demand. Due to fall in
income, less of the good may be demanded at the same price and this will be a case of decrease in demand.
Thus increase or decrease in demand with shifts in demand curves upward or downward are different from
extension or contraction of demand.
Causes of changes in demand may be due to:
Changes in the consumer‘s income.
Changes in the tastes of the consumer.
Changes in the prices of related goods (substitutes and complements).
Changes in exogenous factors like fashion, social structure, etc.
3.2.4 Different Types of Demand Law

The different types of demand law are:
Direct and Derived Demands
Direct demand refers to demand for goods meant for final consumption; it is the demand for consumers‘
goods like food items, readymade garments and houses. By contrast, derived demand refers to demand for
goods which are needed for further production; it is the demand for producers‘ goods like industrial raw
materials, machine tools and equipments.
Thus the demand for an input or what is called a factor of production is a derived demand; its demand
depends on the demand for output where the input enters. In fact, the quantity of demand for the final
output as well as the degree of substitutability/complementary between inputs would determine the derived
demand for a given input.
Domestic and Industrial Demands

The example of the refrigerator can be restated to distinguish between the demand for domestic
consumption and the demand for industrial use. In case of certain industrial raw materials which are also
used for domestic purpose, this distinction is very meaningful.
For example, coal has both domestic and industrial demand, and the distinction is important from the
standpoint of pricing and distribution of coal.
Perishable and Durable Goods’ Demands

Both consumers‘ goods and producers‘ goods are further classified into perishable/non-durable/single-use
goods and durable/non-perishable/repeated-use goods. The former refers to final output like bread or raw
material like cement which can be used only once.
The latter refers to items like shirt, car or a machine which can be used repeatedly. In other words, we can
classify goods into several categories: single-use consumer goods, single-use producer goods, durable-use
consumer goods and durable-use producer‘s goods. This distinction is useful because durable products
present more complicated problems of demand analysis than perishable products. Non-durable items are
meant for meeting immediate (current) demand, but durable items are designed to meet current as well as
future demand as they are used over a period of time. So, when durable items are purchased, they are
considered to be an addition to stock of assets or wealth.
Because of continuous use, such assets like furniture or washing machine, suffer depreciation and thus call
for replacement. Thus durable goods demand has two varieties replacement of old products and expansion
of total stock. Such demands fluctuate with business conditions, speculation and price expectations. Real
wealth effect influences demand for consumer durables.
New and Replacement Demands

This distinction follows readily from the previous one. If the purchase or acquisition of an item is meant as
an addition to stock, it is a new demand. If the purchase of an item is meant for maintaining the old stock
of capital/asset, it is replacement demand. Such replacement expenditure is to overcome depreciation in the
existing stock.
Final and Intermediate Demands

This distinction is again based on the type of goods- final or intermediate. The demand for semi-finished
products, industrial raw materials and similar intermediate goods are all derived demands, i.e., induced by
the demand for final goods. In the context of input-output models, such distinction is often employed.
Individual and Market Demands

This distinction is often employed by the economist to study the size of the buyers‘ demand, individual as
well as collective. A market is visited by different consumers, consumer differences depending on factors
like income, age, sex etc. They all react differently to the prevailing market price of a commodity. For
example, when the price is very high, a low-income buyer may not buy anything, though a high income
buyer may buy something. In such a case, we may distinguish between the demand of an individual buyer
and that of the market which is the market which is the aggregate of individuals.
Total Market and Segmented Market Demands

This distinction is made mostly on the same lines as above. Different individual buyers together may
represent a given market segment; and several market segments together may represent the total market.
For example, the Hindustan Machine Tools may compute the demand for its watches in the home and
foreign markets separately; and then aggregate them together to estimate the total market demand for its
HMT watches. This distinction takes care of different patterns of buying behaviour and consumers‘
preferences in different segments of the market. Such market segments may be defined in terms of criteria
like location, age, sex, income, nationality, and so on
Did You Know?

Michal Kalecki developed theories of effective demand similar to Keynes‘, based on Marxism rather than
the neoclassical framework.

The relative response of a change in quantity demanded to a change in price. More specifically the price
elasticity of demand is the percentage change in quantity demanded due to a percentage change in price.
This notion of elasticity captures the demand side of the market. A comparable elasticity on the supply side
is the price elasticity of supply. Other notable demand elasticity is income elasticity of demand and cross
elasticity of demand.
The price elasticity of demand reflects the law of demand relation between price and quantity. An elastic
demand means that the quantity demanded is relatively responsive to changes in price. An inelastic
demand means that the quantity demanded is not very responsive to changes in price.
The price elasticity of demand is delineated as the degree of responsiveness or sensitiveness of demand for
a commodity to the changes in its price. More precisely, elasticity of demand is the percentage change in
the quantity demanded of a commodity as a result of a certain percentage change in its price.
A formal definition of price elasticity of demand (e) is given below:
The measure of price elasticity (e) is called co-efficient of price elasticity. The measure of price elasticity
is converted into a more general formula for calculating coefficient of price elasticity given as
Where QO = original quantity demanded, PO = original price, ∆Q = change in quantity demanded and ∆P =
change in price.
Note that a minus sign (-) is generally inserted in the formula before the fraction with a view to making
elasticity coefficient a non-negative value.
According to the law of demand, higher demand prices are related to smaller quantities demanded. As
such, the numerator and denominator of this formula always have opposite signs-if one is positive, the
other is negative. If the demand price increases and the percentage change in price are positive, then the
quantity demanded decreases and the percentage change in quantity demanded is negative. When
calculated, the price elasticity of demand, therefore, is always negative.
However, it is often convenient to ignore the negative sign when evaluating the relative response of
quantity demanded to price. For example, quantity demanded is very responsive to price if a 10% increase
in price induces a 50% decrease in quantity demanded. This generates a large ―negative number,‖ which is
actually a small ―value.‖ To avoid the possible confusion over a big number being a small value, the
negative value of the price elasticity of demand is generally ignored and focus is placed on the absolute
magnitude of the number itself.
3.3.1 Measurement of Price Elasticity of Demand

There are five methods to measure the price elasticity of demand.
1. Total Expenditure Method.
2. Proportionate Method.
3. Point Elasticity of Demand.
4. Arc Elasticity of Demand.
5. Revenue Method.
1. Total Expenditure Method

The total expenditure method to measure the price elasticity of demand. According to this method,
elasticity of demand can be measured by considering the change in price and the subsequent change in the
total quantity of goods purchased and the total amount of money spend on it.
Total Outlay = Price x Quantity Demanded.
There are three possibilities:

If with a fall in price (demand increases) the total expenditure increases or with a rise in price (demand
falls) the total expenditure falls, in that case the elasticity of demand is greater than one i.e. (Ed >1.)
If with a rise or fall in the price (demand falls or rises respectively), the total expenditure remains the
same, the demand will be unitary elastic i.e. (Ed = 1).
With a fall in price (Demand rises), the total expenditure also falls, and with a rise in price (Demand
falls) the total expenditure also rises, the demand is said to be less elastic or elasticity of demand is less
than one i.e. (Ed <1).
2. Proportionate Method
This method is also associated with the name of Dr. Marshall. According to this method, ―price elasticity
of demand is the ratio of percentage change in the amount demanded to the percentage change in price of
the commodity.‖ It is also known as the Percentage Method, Flux Method, Ratio Method, and Arithmetic
Method.
3. Arc Elasticity of Demand

According to Prof. Baumol: ―Arc elasticity is a measure of the average responsiveness to price change
exhibited by a demand curve over some finite stretch of the curve‖.According to Watson: ―Arc elasticity is
the elasticity at the mid-point of an area of a demand curve.‖According to Leftwitch : ―When elasticity is
computed between two separate points on a demand curve, the concept is called Are elasticity.‖
4. Revenue Method
In this method elasticity of demand can be measured with the help of average revenue and marginal
revenue. Therefore, a sale proceeds that a firm obtains by selling its products is called its revenue.
However, when total revenue is divided by the number of units sold, we get average revenue. On the
contrary, when addition is made to the total revenue by the sale of one more unit of the commodity is
called marginal revenue.

There is great deal of uncertainty with regard to demand. Since the demand is uncertain, production, cost,
revenue, profit etc. are also uncertain. Through forecasting it is possible to minimize the uncertainties.
Forecasting simply refers to estimating or anticipating future events. It is an attempt to foresee the future
by examining the past. Thus demand forecasting means estimating or anticipating future demand on the
basis of past data.
3.4.1 Process of Demand Forecasting

Demand forecasting involves the following steps:
1. Determine the purpose for which forecasts are used.
2. Subdivide the demand forecasting program into small I parts on the basis of product or sales territories
or markets.
3. Determine the factors affecting the sale of each product and their relative importance.
4. Select the forecasting methods.
5. Study the activities of competitors.
6. Prepare preliminary sales estimates after, collecting necessary data.
7. Analyze advertisement policies, sales promotion plans, personal sales arrangements etc. and ascertain
how far these programs have been successful in promoting the sales.
8. Evaluate the demand forecasts monthly, quarterly, half yearly or yearly and necessary adjustments
should be done.
9. Prepare the final demand forecast on the basis of preliminary forecasts and the results of evaluation.
3.4.2 Methods of Demand Forecasting

There are several methods to predict the future demand. All methods can be broadly classified into two.
Survey methods,
Statistical methods
Did You Know?
The concept of elasticity of demand was introduced into the economic theory by Alfred Marshall.
Caution
The company must be aware of the need of the market because the unexpected demand of customers can
ruin the image of the company.
Case Study-Appraising Kolkata Metro Railway Corporation‟s East West Metro Corridor Project
Recognizing the need to improve the urban transportation infrastructure in Kolkata, a metro city in the
eastern part of India, the Kolkata Metro Rail Corporation (KMRC) proposed an integrated rapid mass
transportation system through its East West Metro Corridor (EWMC) project which would also involve the
contentious issue of land acquisition.
Another concern was that the existing North South metro railway corridor, which was to be integrated with
the proposed EWMC, was making continuous losses since its inception as the demand remained about
1/11th of the forecasted demand in 1990.
Yet another issue was that the KMRC‘s proposal included removal of the existing competitive bus services
running parallel to the proposed metro routes, which would adversely affect the general commuters who
would then end up having to pay higher metro fares.Critics contended that society did not seem to be
gaining anything from the project though the West Bengal Government was giving it concessions like
electricity on a no profit no loss basis and there was project financing by the central and the state
government.
Moreover, it was feared that the project might face the same kind of fate as the North South metro railway
corridor project. KMRC‘s proposed fares were significantly higher than some of the alternatives and even
the existing metro.In late 2010, the 14.67 km long East-West Metro Corridor (EWMC) in Kolkata, that
was initiated in March 2009 and was scheduled to be completed by October 31, 2014, at an estimated cost
of Rs.4 46,760 million, was negotiating hurdles in procuring land at Howrah and Sealdah stations.
Observers noted that the episodes of Singur and Nandigram had left the West Bengal government extra
cautious wherever any project involved a land acquisition issue. So critical was the issue that when it came
back again in the form of the Kolkata Metro Railway Corporation (KMRC) expansion project through
EWMC, few were left untouched about its impact on the future of the project itself.Having learned a bitter
lesson from the previous incidents and their fallout, the Buddhadeb Bhattacharya-led leftist government in
West Bengal decided this time around to do away with some of the important metro railway stations along
this much hyped corridor rather than get into a series of fresh controversies that would provide fresh
ammunition to the government‘s political opponents and critics. The most significant of these opponents
was Mamata Banerjee, leader of the largest opposition party in the state, the Trinamool Congress, and
Railway Minister in the cabinet of the Government of India (GoI). Though the Trinamool Congress
supported the project in principle, it said it was against the eviction of farmers and local traders from the
proposed metro station sites. Having learned a Contending that the project sanctioned under the GoI‘s
Jawaharlal Nehru National Urban Renewal Mission (JNNURM)10had not been handled properly by the
KMRC, the leaders of the Trinamool Congress demanded that it be awarded to the Railway Ministry under
the GoI11. These political issues apart, critics pointed out that the existing Kolkata North-South Metro
Railway had been suffering losses since its very inception. Questions were therefore raised about the
financial justification for the current project.
The Challenge
In 1984, Kolkata became the first city to have a metro rail system in India. The system was developed to
fulfil the increasing need for urban transportation which had been a perennial problem for the city, right
since the pre-independence era.
The Project
The EWMC project was conceived as comprising an underwater metro tunnel (a first in India - at around
15 meters below the bed of the river Hooghly), a few underground sections, and some elevated sections at
the median verge of roads.
The Project Rationale

There had always been a felt need for an urban rapid mass transportation system to mitigate the traffic
problems of Kolkata. The traffic was getting worse with the rapid urbanization and growth of the city,
especially due to expansion into newer areas, according to observers.
However, the problem was not limited to Kolkata. With the booming economic growth and rapid
urbanization across the country, most urban centres which had already grown or were growing rapidly
were expected to face problems of similar type and magnitude in the near future, i.e., if they were not
facing it already.
Questions
1. What is the need, which led to improve the urban transportation infrastructure in Kolkata?
2. Explain the benefits of the project incurred by the society?
3.5 Summary
A comparable elasticity on the supply side is the price elasticity of supply.
Cross elasticity of demand for firms, sometimes referred to as conjectural variation, is a measure of the
interdependence between firms.
Elasticity of demand measures the responsiveness of change in quantity demanded of a good because
of change in prices.
Income elasticity of demand refers to the percentage change in quantity demanded due to percentage
change in income.
Price elasticity of demand is the ratio of the percentage change in the quantity demanded of a
commodity to a percentage change in its prices.
The price elasticity of demand is commonly divided into one of five elasticity alternatives--perfectly
elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly inelastic--depending on the
relative response of quantity to price.
The price elasticity of demand is delineated as the degree of responsiveness or sensitiveness of demand
for a commodity to the changes in its price.
The relative response of a change in quantity demanded to a change in price.
3.6 Keywords
Cross Elasticity: Cross elasticity of demand measures the responsiveness of demand for one good to a
change in price of the other good.
Demand: Demand is the desire to own anything, the ability to pay for it, and the willingness to pay.
Basically Demand refers to how much (quantity) of a product or service is desired by buyers.
Elasticity: Elasticity measures the responsiveness of one variable to the variations in another variable.
Income Elasticity: Income elasticity of demand measures the responsiveness of demand for a commodity
to a change in consumer‘s income
Marginal Revenue: Marginal revenue of a product is how much revenue the product will generate with the
sale of one additional unit.
Price Elasticity: Price elasticity of demand measures the degree of responsiveness of the quantity
demanded of a particular commodity to a change in price of that commodity.
1. Elasticity of demand with respect to consumer‘s expectations regarding future price of the............
(a) commodity (b) voidable
(c) wealth (d) legal
2. ………… is the relative response of demand to changes in income.

(a) People (b) Price demand
(c) Determinant demand (d) Income elasticity demand
3. .............Elasticity of demand with respect to consumer‘s expectations regarding future price of the
commodity.
(a) Enforce elasticity (b) Source edacity
(c) Price expectation (d) Income elasticity
4. ………………it refers to the change in quantity of commodity.

(a) Decrease elasticity (b) Demand Analysis
(c) Cross Elasticity of Demand (d) Income
5. The …………… measures the responsiveness of changes in the quantity demanded to changes in the
level of advertising.
(a) enforce elasticity (b) advertising elasticity of demand (AED)
(c) cross elasticity (d) Income elasticity
6. ................it can be used to determine the impact of changes in product and factor prices, in technology.
(a) Supply analysis (b) Demand analysis
(c) Elasticity (d) Income enforcement
7. ……….. it is lie within the scope and operations of a firm and hence within the control of management.
(a) External factor (b) Analysis factor
(c) Internal factor (d) Enforcement
8. ……………. is defined as the total amount of purchases of a product or family of products within a
specified demographic.
(a) Market demand (b) Cross demand
(c) Factor demand (d) Income demand
9. …………… is a specific quantity that buyers are willing and able to buy at a specific demand price.
(a) Quantity demand (b) Demand Analysis
(c) Elasticity of demand (d) Income demand
10. An elasticity alternative in which relatively small changes in price cause relatively large changes in
quantity is called:
(a) Quantity Elastic (b) Cross elastic
(c) Relatively Elastic: (d) Income Elastic

1. Explain the determinants in demand analysis.
2. Define type of measurement of elasticity.
3. What do you understand by elasticity of demand?
4. Explain the various type of elasticity of demand.
5. Differentiate between a cross and income elasticity.
6. Describe the price elasticity of demand.
7. Define the elasticity of demand with respect to advertisement.
8. Explain the factors determining of elasticity of demand.
9. Describe the process of demand forecasting.
10. Write short note on:
(a) Income
(b) Population

1 (a) 2 (d) 3 (c) 4 (c) 5 (b)
6 (a) 7 (c) 8 (a) 9 (a) 10 (c)
4
Supply Analysis
CONTENTS
Objectives
Introduction
4.2 Law of Supply
4.4 Summary
4.5 Keywords
Objectives
Define changes in supply
Understand law of supply
Discuss the elasticity of supply
Introduction
Supply and demand are the most fundamental tools of economic analysis. Most applications of economic
reasoning involve supply and demand in one form or another. When prices for home heating oil rise in the
winter, usually the reason is that the weather is colder than normal and as a result, demand is higher than
usual. Similarly, a break in an oil pipeline creates a short-lived gasoline shortage, as occurred in the
Midwest in the year 2000, which is a reduction in supply.
At the other side of every transaction is a seller. Economists refer to the behaviour of sellers as that market
force of supply. It is the combined forces of supply and demand that make up a market economy. In
microeconomics, the smallest unit of supply is the firm, which is analogous to the demand unit of the
household. Firms operate independently of each other, making decisions about what to sell, and how much
to sell, depending on the price. How do firms make their selling decisions? Once they have decided what to
sell, a decision they make based on what they believe buyers will want to buy, their decision is then
influenced by the market price of the goods. If a firm in Boston decides to sell warm hats, they will want to
sell more hats if the going price is high than if the going price is low. Just like households, firms try to
maximize their utility when making selling decisions. Whereas a buyer‘s utility is a complex combination
of preferences, needs, and happiness, economists usually assume that sellers derive utility from profit, that
is, the more money a seller makes from a sale, the happier it will be. Firms will maximize their utility by
selling whatever will make them the most money. In this way, sellers‘ utility is somewhat easier to study
and understand, since we do not have to consider personal preferences. Instead, we look purely at price and
profit. In this unit on supply, we will look at graphical and mathematical ways to represent supply, and we
will see what factors can affect supply.
In a broad sense, supply analysis is a system of input and output equations used to determine supply
responses to changing circumstances by producers (including households). Supply analysis takes into
account changes in both output supply and input/factor demand. Supply analysis is central to policy
decisions in that it helps us understand the impact that alternative policy packages may have on the
producers themselves. Through the changes it induces in commodity supply and in factor demand, the
analysis of production response is an essential component of models that seek to explain market prices,
wages and employment, external trade and government fiscal revenues.
Supply analysis can be used to determine the impact of changes in product and factor prices, in technology,
and in access on factor demands (including labour), production, marketed output, aggregate supply, and
incomes. Generally, it can be used to analyze the impact on production of the removal of barriers to access
or other changes in markets. Supply analysis, in the employment context, deals with key staffing questions
related to current staffing levels in an organization.
Supply and demand is a fundamental factor in shaping the character of the marketplace, for it is understood
as the principal determinant in establishing the cost of goods and services. The availability, or ―supply,‖ of
goods or services is a key consideration in determining the price at which those goods or services can be
obtained. For example, a landscaping company with little competition that operates in an area of high
demand for such services will in all likelihood be able to command a higher price than will a business
operating in a highly competitive environment. But availability is only one-half of the equation that
determines pricing structures in the marketplace. The other half is ―demand.‖
A company may be able to produce huge quantities of a product at low cost, but if there is little or no
demand for that product in the marketplace, the company will be forced to sell units at a very low price.
Conversely, if the marketplace proves receptive to the product that is being sold, the company can establish
a higher unit price. ―Supply‖ and ―demand,‖ then, are closely intertwined economic concepts; indeed, the
law of supply and demand is often cited as among the most fundamental in all of economics.Economists
have a very precise definition of supply.
Economists describe supply as the relationship between the quantities of a good or service consumers will
offer for sale and the price charged for that good. More precisely and formally supply can be thought of as
―the total quantity of a good or service that is available for purchase at a given price.‖Supply is not simply
the number of an item a shopkeeper has on the shelf, such as ‗5 oranges‘ or ‗17 pairs of boots‘, because
supply represents the entire relationship between the quantity available for sale and all possible prices
charged for that good. The specific quantity desired to sell of a good at a given price is known as the
quantity supplied. Typically a time period is also given when describing quantity supplied.
Factors Impacting Supply and Demand

When using the term ―demand‖ most people think the word means a certain volume of spending, as when
we say that the demand for cars has fallen off or the demand for paper is high. But that is not what
economists mean when using the term. For economists, demand means not just how much we are spending
for a given item, but how much we are spending for that item at its price, and how much we would spend if
its price changed.
The demand for products and services is predicated on a number of factors. The most important of these
are the tastes, customs, and preferences of the target market, the consumer‘s income level, the quality of
the goods or services being offered, and the availability of competitors‘ goods or services. All of the above
elements are vital in determining the price that a business can command for its products or services,
whether the business in question is a hair salon, a graphic arts firm, or a cabinet manufacturer.
The supply of goods and services in the marketplace is predicated on several factors as well, including
production capacity, production costs (including wages, interest charges, and raw materials costs), and the
number of other businesses engaged in providing the goods or services in question. Of course, some factors
that are integral in determining supply in one area may be inconsequential in another. Weather, for
example, is an important factor in determining the supplies of wheat, oranges, cherries, and myriad other
agricultural products. But weather rarely impacts on the operations of businesses such as bookstores or
auto supply stores except under the most exceptional of circumstances.
―When we are willing and able to buy more, we say that demand rises, and everyone knows that the effect
of rising demand is to lift prices,‖ If incomes fall, so does demand, and so does price.‖ They point out that
supply can also dwindle as a result of other business conditions, such as a rise in production costs for the
producer or changes in regulatory or tax policies. ―And of course both supply and demand can change at
the same time, and often do,‖ added Heilbronn and Throw. ―The outcome can be higher or lower prices, or
even unchanged prices, depending on how the new balance of market forces works out.‖
Supply Curves
A supply curve is simply a supply schedule presented in graphical form. The standard presentation of a
supply curve has price given on the Y-axis and quantity supplied on the X-axis.
Working of supply curves

The law of supply is conveniently illustrated by a supply curve. In particular, it is illustrated by the positive
slope of a supply curve, such as the one presented to the right. The positive slope of the supply curve
means that higher prices are related to larger quantities and that lower prices are related to smaller
quantities. Price goes up, quantity goes up. Price goes down, quantity goes down. (See Figure 4.1)
Figure 4.1: The Supply curve.

Cash costs are those which represent actual monetary outlays. Noncash costs do not directly represent such
outlays but are permissible deductions from revenue, the sole impact of which is to reduce the income tax
liability.
4.1.1 Changes in Supply

An increase in supply comes about from a fall in the marginal cost – recall that the supply curve is just the
marginal cost of production. Consequently, an increased supply is represented by a curve that is lower and
to the right on the supply/demand graph, which is an endless source of confusion for many students. The
reasoning – lower costs and greater supply are the same thing is too easily forgotten. The supply curve
goes from S1 to S2, which represents a lower marginal cost. In this case, the quantity traded rises from q1
to q2 and price falls from p1 to p2. Computer equipment provides dramatic examples of increases in
supply. Consider Dynamic Random Access Memory, or DRAM. DRAMs are the chips in computers and
many other devices that store information on a temporary basis. Their cost has fallen dramatically, which is
illustrated in (See Figure 4.2)
The means by which these prices have fallen are themselves quite interesting. The main reasons are
shrinking the size of the chip, so that more chips fit on each silicon disk, and increasing the size of the disk
itself, so that more chips fit on a disk. The combination of these two, each of which required the solutions
to thousands of engineering and chemistry problems, has led to dramatic reductions in marginal costs and
consequent increases in supply. The effect has been that prices fell dramatically and quantities traded rose
dramatically.
Figure 4.2: An Increase in supply.
An important source of supply and demand changes are changes in the markets of complements. A
decrease in the price of a demand-complement increases the demand for a product, and similarly, an
increase in the price of a demand-substitute increases demand for a product. This gives two mechanisms to
trace through effects from external markets to a particular market via the linkage of demand substitutes or
complements. For example, when the price of gasoline falls, the demand for automobiles (a complement)
overall should increase. As the price of automobiles rises, the demand for bicycles (a substitute in some
circumstances) should rise.
When the price of computers falls, the demand for operating systems (a complement) should rise. This
gives an operating system seller like Microsoft an incentive to encourage technical progress in the
computer market, in order to make the operating system more valuable.
4.2 Law of Supply

Supply and demand is an economic model of price determination in a market. It concludes that in a
competitive market, the unit price for a particular good will vary until it settles at a point where the
quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at
current price), resulting in an economic equilibrium of price and quantity.
4.2.1 Definition of „Law of Supply‟

A microeconomic law stating that, all other factors being equal, as the price of a good or service increases,
the quantity of goods or services offered by supplier‘s increases and vice versa. (See Figure 4.3)
Figure 4.3: Law of supply.

4.2.2 Definition of „Law of Demand‟
A microeconomic law that states that, all other factors being equal, as the price of a good or service
increases, consumer demand for the good or service will decrease and vice versa. (See Figure 4.4)
Figure 4.4: Law of demand.

The demand for goods depends on the price for those goods, as well as on consumer income and on the
prices of other goods. Similarly, supply depends on price, as well as on variables that affect production
cost. How much the supply and demand will rise or fall is often difficult to predict. This measurement of a
product or service‘s responsiveness to market changes is known as elasticity. Elasticity is a measure of the
responsiveness of one economic variable to another. For example, price elasticity is the relationship
between a change in the supply of a good and the demand for that good. Economists are often interested in
the price elasticity of demand, which measures the response of the quantity of an item purchased to a
change in the item‘s price. A good or service is considered to be highly elastic if a slight change in price
leads to a sharp change in demand for the product or service. Products and services that are highly elastic
are usually more discretionary in nature—readily available in the market and something that a consumer
may not necessarily need in his or her daily life. On the other hand, an inelastic good or service is one for
which changes in price result in only modest changes in demand. These goods and services tend to be
necessities.
The degree to which a demand or supply curve reacts to a change in price is the curve‘s elasticity.
Elasticity varies among products because some products may be more essential to the consumer. Products
that are necessities are more insensitive to price changes because consumers would continue buying these
products despite price increases. Conversely, a price increase of a good or service that is considered less of
a necessity will deter more consumers because the opportunity cost of buying the product will become too
high.
A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the
quantity demanded or supplied. Usually these kinds of products are readily available in the market and a
person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or
service is one in which changes in price witness only modest changes in the quantity demanded or
supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or
her daily life. To determine the elasticity of the supply or demand curves, we can use this simple equation:
Elasticity = (% change in quantity / % change in price)
If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the
curve is said to be inelastic. As we mentioned, the demand curve is a negative slope, and if there is a large
decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more
horizontal. This flatter curve means that the good or service in question is elastic. (See Figure 4.5)
Figure 4.5: Elastic demand.
Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with
a large movement in price. (See Figure 4.6)
Figure 4.6: Inelastic Demand.
Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the
supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal
to one. (See Figure 4.7)
Figure 4.7: Elastic supply.
On the other hand, if a big change in price only results in a minor change in the quantity supplied, the
supply curve is steeper and its elasticity would be less than one. (See Figure 4.8)
Figure 4.8: Inelastic Supply.

4.3.1 Factors Affecting Demand Elasticity
There are three main factors that influence a demand‘s price elasticity:
The Availability of Substitutes

This is probably the most important factor influencing the elasticity of a good or service. In general, the
more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up
by INR 12, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an
elastic good because a raise in price will cause a large decrease in demand as consumers start buying more
tea instead of coffee.
However, if the price of caffeine were to go up as a whole, we would probably see little change in the
consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to
give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an
inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to
the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as
diamonds are inelastic because they have few if any substitutes.
Amount of Income Available to Spend on the Good

This factor affecting demand elasticity refers to the total a person can spend on a particular good or
service. Thus, if the price of a can of Coke goes up from INR 25 to INR 50 and income stays the same, the
income that is available to spend on coke, which is INR 1,00, is now enough for only two rather than four
cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is
an increase in price and no change in the amount of income available to spend on the good, there will be an
elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
Time
The third influential factor is time. If the price of cigarettes goes up INR 1,00 per pack, a smoker with very
few available substitutes will most likely continue buying his or her daily cigarettes.
This means that tobacco is inelastic because the change in price will not have a significant influence on the
quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra INR 100
per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that
consumer becomes elastic in the long run.
4.3.2 Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income stays the same, demand
will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The
degree to which an increase in income will cause an increase in demand is called income elasticity of
demand, which can be expressed in the following equation:
If EDy is greater than one, demand for the item is considered to have high income elasticity. If however
EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher
income elasticity because when people have a higher income, they do not have to forfeit as much to buy
these luxury items. Let us look at an example of a luxury good: air travel.
Bob has just received a INR 5,00,000 increase in his salary, giving him a total of INR 4,00,000 per annum.
With this higher purchasing power, he decides that he can now afford air travel twice a year instead of
once a year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob‘s air travel is seven - highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These
are considered goods and services of inferior quality that will be dropped by a consumer who receives a
salary increase.
An example may be the increase in the demand of DVDs as opposed to video cassettes, which are
generally considered to be of lower quality. Products for which the demand decreases as income increases
have an income elasticity of less than zero. Products that witness no change in demand despite a change in
income usually have an income elasticity of zero - these goods and services are considered necessities.
Did You Know?

According to Hamid S. Hosseini, the power of supply and demand was understood to some extent by
several early Muslim scholars, such as fourteenth-century Mamluk scholar Ibn Taymiyyah.
Caution
The unexpected change in ratio of supply and demand can affect the economic value of the company.
Case Study-The Benetton Supply Chain

Retail operations
Benetton‘s core business is in the manufacturing, production and sale of casual and sportswear, which
accounts for 95% of total revenues. The company has a market presence in over 120 countries and has
consistently generated revenues exceeding 2 billion throughout this decade. It has 5,000 retail outlets
around the world, the vast majority of which are run by independent managers as part of a franchise
arrangement whereby the licensees of those outlets sell products which carry the Benetton brand name .A
key objective of Benetton HQ (based in Treviso, Italy) has always been to retain overall control on every
aspect of product sales, thereby ensuring that the Benetton ―total look‖ is adhered to. The company is
renowned for having a distinctive philosophy which is espoused through controversial advertising
techniques. Its global network of sales agents each holds responsibility for their own geographic area. They
work closely with franchise operators in the sale and distribution of its goods, as well as overseeing all
aspects of merchandising. A global information system unites every link in the supply chain.
Physical distribution operation

The company describes itself as ―vertically de-integrated‖, meaning that it score functional activities such
as design and global strategy are still centralized. Nonetheless it is willing to outsource those activities
where it is unable to achieve in-house economies of scale. Its logistics operation has always been directly
controlled, in large part owing to the integral part it plays to the company‘s overall success. Key to
effectiveness is the rapid flow of market intelligence between customer and factories. This is achieved
through maximizing the benefits of EDI technology which facilitates direct flow of communication
between the agent networks representing the 5,000 retail outlets. EDI information allows Benetton
manufacturers to delay the dyeing process up until a clear understanding is reached on market
requirements. This eliminates the build-up of wasteful inventories, thereby reducing costs, slashing cycle
times and maximizing efficiencies. Once this information is relayed to the centre, Benetton is able to
arrange bulk delivery of products from its regional distribution centres which are highly automated and
thus able to cope with demand. The company describes their strong track record in distribution as being
down to its 360 degree vision; in other words recognition from the outset as to the strategic importance of
logistics through integrating suppliers, manufacturers and retailers in a value chain that thrived on speed,
efficiency and flexibility.
Factory and suppliers

Benetton‘s manufacturing processes are characterized by strong upstream vertical integration which entails
significant output at its own production centres, as well as outsourcing the more labour-intensive tasks
such as tailoring and ironing. The Treviso HQ has overall control over design activities. CAD technology
is fully utilised to maximize opportunities for the speedy bringing to market of mass-produced garments.
This is achieved through the effective usage of 500 sub-contractors who work in the vicinity of the
companies HQ and production base. The sub-contractor group, often themselves former Benetton
managers, organize the second tier of small factories who undertake the labour-intensive processes
A pyramid analogy has been used to describe the hierarchical nature of this relationship, with Benetton at
the apex, the sub-contractors forming the second tier and the army of small workshops forming the bottom
layer Benetton directly controls the supply of raw materials thereby achieving cost savings in supplier
overheads. It has a very close relationship with the sub-contractor base, thus ensuring that the factories
under their control are able to satisfy market trends at short notice. This is a distinct advantage to their
competitors who do not enjoy such flexibility and are hampered with fixed-cost overheads .Consider the
following statistic: in 1990 90% of Benetton garments we reproduced in Italy. Now it is only 30% and
within a few years it is expected to fall to only 10%. Such is the dramatic impact of globalization. Benetton
has responded by remaining true to its philosophy of tight central control by replicating its Treviso
production model on a global basis. For instance Benetton Hungary has production oversight of 7 countries
within the region. This is in keeping with the underlying company philosophy of creating global brands
which transcend national boundaries.
Questions
1. What are the retail operations?
2. Explain the factory and suppliers.
4.4 Summary
A decrease in the price of a demand-complement increases the demand for a product, and similarly, an
increase in the price of a demand-substitute increases demand for a product.
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in
both price and quantity demanded from one point to another on the curve.
A shift in a demand or supply curve occurs when a good‘s quantity demanded or supplied changes
even though price remains the same.
Economists have a very precise definition of supply. Economists describe supply as the relationship
between the quantities of a good or service consumers will offer for sale and the price charged for that
good.
Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy.
The degree to which a demand or supply curve reacts to a change in price is the curve‘s elasticity.
4.5 Keywords
Accounting: Accountancy is the process of communicating financial information about a business entity to
users such as shareholders and managers.
Manufacturing: It is the use of machines, tools and labour to produce goods for use or sale.
Marginal costs: In economics and finance, marginal cost is the change in total cost that arises when the
quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.
Produce: A producer sometimes called in charge of production, is a producer who was not involved in any
technical aspects of the film making or music process in the original definition, but who was still
responsible for the overall production.
Production: In economics, production is the act of creating output, a good or service which has value and
contributes to the utility of individuals.
Purchase: It refers to a business or organization attempting for acquiring goods or services to accomplish
the goals of the enterprise.

1. A decrease in the price of a demand-complement………………..for a product.
(a) increases the demand (b) decreases the demand
(c) Both (a) and (b) (d) None of these
2. An increase in the price of a demand-substitute……………………for a product.

(a) Decreases the demand (b) increases the demand
3. The degree to which a demand or supply curve reacts to a change in………..is the curve‘s elasticity.
(a) Demand (b) price
(c) Quality (d) None of these
4. The standard presentation of a supply curve has price given on the X-axis and quantity supplied on the
Y-axis.
(a) True (b) False
5. Price goes up quantity goes up Price goes down quantity goes down.
(a) True (b) False
6. Excess demand is created when price is.............. The equilibrium price.

(a) Set below (b) set up
7. A source of supply and demand changes are changes in the markets of complements.
(a) True (b) False
8. The positive slope of the supply curve means that higher prices are related to below quantities.
(a) True (b) False
9. The degree to which a demand or supply curve reacts to a change in price is the curve‘s elasticity.
(a) True (b) False
10. .......................occurs whenever the price or quantity is not equal.

(a) Equilibrium (b) Disequilibrium

1. What is the factors impacting supply and demand?
2. Understand changes in supply and demand in the term of business economics.
3. Explain the law of supply.
4. What is the elasticity of supply?
5. What is the income elasticity of demand?
6. Explain the supply curve and working of supply curve.
7. What is the economic relationship between shift and movement curve?
8. What is the law of demand?
9. What is the difference between changes in supply and demand?
10. Explain the factors affecting demand elasticity.

1. (a) 2. (b) 3. (b) 4. (b) 5. (a)
6. (b) 7. (a) 8. (b) 9. (a) 10. (b)
5
Production Analysis
CONTENTS
Objectives
Introduction
5.7 Summary
5.8 Keywords
Objectives
Discuss about production function in short-run and long run
Define law of variable proportions
Understand about returns to scale
Describe the production and equal product curves
Explain the least cost combination
Describe the cost concepts and revenue analysis
Introduction
Production analysis is a managerial economics function that focuses on the internal production processes
of a company. Managers review internal production processes to determine how efficient the company is
using economic resources or inputs to produce goods and services sold to consumers. This economic
function may include the use of management accounting, which develops cost allocation methods that
apply business costs to individual goods or services. Finding ways to increase production efficiency can
help companies achieve an economy of scale, which is the economic theory that companies that maximize
their production processes can lower overall business costs.
Production is the conversion of input into output. The factors of production and all other things which the
producer buys to carry out production are called input. The goods and services produced are known as
output. Thus production is the activity that creates or adds utility and value. In the words of Fraser, "If
consuming means extracting utility from matter, producing means creating utility into matter". According
to Edwood Buffa, ―Production is a process by which goods and services are created".
Production deals with the physical aspect of the business investment. It is the process whereby inputs are
transformed into outputs. Since we pay a price for these resources or inputs, efficient production means to
produce at a least cost way as degree of efficiency in production translates into a level of costs per unit of
output. Efficiency of production depends on the ratios in which various inputs are employed, absolute level
of each input and the productivity of each input.
A production function is the relation which gives us the technically efficient way of producing the output,
given the inputs. Actually, cost is the monetary side of the production.
Consider the assembly process for an automobile. There are certain inputs like land, building,
computerized plant and equipments to manufacture and assemble the car. All these inputs cannot be
changed on a short notice. These are fixed in the short run and hence costs associated to these are called
fixed costs. However, management can vary the number of workers to some extent depending on the level
of production. Thus, human input is a variable input and the cost associated to it is called variable cost.
Distinction of fixed and variable cost is crucial for production and cost analysis. Other examples of
variable inputs are power, fuel, etc.

Production is the process by which inputs are transformed in to outputs. Thus there is relation between
input and output. The functional relationship between input and output is known as production function.
The production function states the maximum quantity of output which can be produced from any selected
combination of inputs. In other words, it states the minimum quantities of input that are necessary to
produce a given quantity of output.
In general, we can represent the production function for a firm as: Q = f (x1, x2…xn) Where Q is the
maximum quantity of output, x1, x2.., xn are the quantities of various inputs, and f stands for functional
relationship between inputs and output. For the sake of clarity, let us restrict attention to only one product
produced using either one input or two inputs. If there are only two inputs, capital (K) and labour (L), we
write the production function as: Q = f (L, K) this function defines the maximum rate of output (Q)
obtainable for a given rate of capital and labour input. It may be noted here that outputs may be tangible
like computers, television sets, etc., or it may be intangible like education, medical care, etc. Similarly, the
inputs may be other than capital and labour. Also, the principles discussed in this unit apply to situations
with more than two inputs as well.
Another important attribute of production function is how output responds in the long run to changes in the
scale of the firm i.e. when all inputs are increased in the same proportion (by say 10%), how does output
change. Clearly, there are three possibilities. If output increases by more than an increase in inputs (i.e. by
more than 10%), then the situation is one of increasing returns to scale (IRS).
If output increases by less than the increase in inputs, then it is a case of decreasing returns to scale (DRS).
Lastly, output may increase by exactly the same proportion as inputs. For example a doubling of inputs
may lead to a doubling of output. This is a case of constant returns to scale (CRS).
For an economy as a whole, we might think of all the labour and capital used in the economy as producing
GDP, the total value of goods and services. A production function is a mathematical relation between
inputs and output that makes this idea concrete:
Y = AF (K; L);
Where Y is output (real GDP), K is the quantity of physical capital (plant and equipment) used in
production, L is the quantity of labour, and A is a measure of the productivity of the economy.
The production function tells us how different amounts of capital and labour may be combined to produce
output. The critical ingredient here is the function F. Production function is stated with reference to a
particular period of time. In economics we are concerned with two types of production function
.
Economic Efficiency and Technical Efficiency
We say that a firm is technically efficient when it obtains maximum level of output from any given
combination of inputs. The production function incorporates the technically efficient method of
production. A producer cannot decrease one input and at the same time maintain the output at the same
level without increasing one or more inputs. When economists use production functions, they assume that
the maximum output is obtained from any given combination of inputs.
5.1.1 Short Run and Long Run

The short run is defined in economics as a period of time where at least one factor of production is
assumed to be in fixed supply i.e. it cannot be changed. We normally assume that the quantity of capital
inputs (e.g. plant and machinery) is fixed and that production can be altered by suppliers through changing
the demand for variable inputs such as labour, components, raw materials and energy inputs. Often the
amount of land available for production is also fixed.
Increasing returns to scale occur when the % change in output > % change in inputs
Decreasing returns to scale occur when the % change in output < % change in inputs
Constant returns to scale occur when the % change in output = % change in inputs
All inputs can be divided into two categories:

i. fixed inputs
ii. variable inputs
5.1.2 Production Function with Two Variable Inputs

You are provided with the following functions where you are required to ascertain the type of production
function it relates to.
Q = 4L + 3K
Q = Min (4L.k)
Solution
Production function, Q = 4L + 3 K is a linear function. This is confirmed as under. Let L and K are
enhanced by a definite number λ,
Q‘ = 4 λL + 3 λK
λ can be featured outside and therefore,
Q‘ = λ (4L + 3K) = λQ.
Therefore, increasing each input by λ, productivity also enhances by λ. This depicts this production
function is linear homogenous.Production function, Q = Min (4L.K) is a Leontief production function.
This is so termed as a noted American economist Wassily Leontief used this production function to
describe the American economy. This a fixed proportion production function in which labour and capital
are combined in the ratio of 4L and 1K.
5.1.3 Assumptions of Production Function

The production function is based on the following assumptions.
1. The level of technology remains constant.
2. The firm uses its inputs at maximum level of efficiency.
3. It relates to a particular unit of time.
5.1.4 Managerial Use of Production Function

The production function is of great help to a manager or business economist. The managerial uses of
production function are outlined as below:
1. It helps to determine least cost factor combination: The production function is a guide to the
entrepreneur to determine the least cost factor combination. Profit can be maximized only by
minimizing the cost of production. In order to minimize the cost of production, inputs are to be
substituted. The production function helps in substituting the inputs.
2. It helps to determine optimum level of output: The production function helps to determine the optimum
level of output from a given quantity of input. In other words, it helps to arrive at the producer's
equilibrium.

The law of variable proportions states that as the quantity of one factor is increased, keeping the other
factors fixed, the marginal product of that factor will eventually decline. This means that up to the use of a
certain amount of variable factor, marginal product of the factor may increase and after a certain stage it
starts diminishing. When the variable factor becomes relatively abundant, the marginal product may
become negative.
Constant State of Technology: First, the state of technology is assumed to be given and unchanged. If
there is improvement in the technology, then the marginal product may rise instead of diminishing.
Fixed Amount of Other Factors: Secondly, there must be some inputs whose quantity is kept fixed. It is
only in this way that we can alter the factor proportions and know its effects on output. The law does not
apply if all factors are proportionately varied.
Possibility of Varying the Factor Proportions: Thirdly, the law is based upon the possibility of varying the
proportions in which the various factors can be combined to produce a product. The law does not apply if
the factors must be used in fixed proportions to yield a product.
Illustration of the Law: The law of variable proportion is illustrated in the following table 5.1. Suppose
there is a given amount of land in which more and more labour (variable factor) is used to produce wheat.
Table 5.1: Law of variable proportion
It can be seen that up to the use of 3 units of labour, total product increases at an increasing rate and
beyond the third unit total product increases at a diminishing rate. This fact is shown by the marginal
product which the addition is made to total product as a result of increasing the variable factor i.e. labour.
That the marginal product of labour initially rises and beyond the use of three units of labour, it starts
diminishing. The use of six units of labour does not add anything to the total production of wheat. Hence,
the marginal product of labour has fallen to zero. Beyond the use of six units of labour, total product
diminishes and therefore marginal product of labour becomes negative. Regarding the average product of
labour, it rises up to the use of third unit of labour and beyond that it is falling throughout.
It is necessary to understand the following terms:

Total Product or Total Physical Product (TPP): This is the quantity of output a firm obtains in total from
a given quantity of input.
Average Product or Average Physical Product (APP): This is the total physical product (TPP) divided by
the quantity of input.
Marginal Product or Marginal Physical Product (MPP): It is the increase in total output that results from
a one unit increase in the input, keeping all other inputs constant.
5.2.1 Importance and Applicability of the Law of Variable Proportion

The Law of Variable Proportion has universal applicability in any branch of production. It forms the basis
of a number of doctrines in economics. The Malthusian theory of population stems from the fact that food
supply does not increase faster than the growth in population because of the operation of the law of
diminishing returns in agriculture.
Ricardo also based his theory of rent on this principle. According to him rent arises because the operation
of the law of diminishing return forces the application of additional doses of labour and capital on a piece
of land. Similarly the law of diminishing marginal utility and that of diminishing marginal physical
productivity in the theory of distribution are also based on this theory.
The law is of fundamental importance for understanding the problems of underdeveloped countries. In
such agricultural economies the pressure of population on land increases with the increase in population.
This leads to declining or even zero or negative marginal productivity of workers. This explains the
operation of the law of diminishing returns in LDCs in its intensive form.
5.2.2 Assumptions of the Law

The law of variable proportion is valid when the following conditions are fulfilled:
1. The technology remains constant. If there is an improvement in the technology, due to inventions, the
average and marginal product will increase instead of decreasing.
2. Only one input factor is variable and other factor are kept constant.
3. All the units of the variable factors are identical. They are of the same size and quality.
4. A particular product can be produced under varying proportions of the input combinations.
5. The law operates in the short run.
5.2.3 Need of the Law of Variable Proportions

The law of variable proportion operates on account of the following reasons:
1. Imperfect substitutes: There is a limit to the extent to which one factor can be substituted for another. In
other words, two factors are not perfect substitutes. For example, in the construction of building, capital
cannot substitute labour fully.
2. Scarcity of the factors of production: Output can be increased only by increasing the variable factors. In
the short run certain input factors like land and capital are scarce. This leads to diminishing marginal
productivity of the variable factors.
5.2.4 Importance of the Law of Variable Proportion

The law of variable proportion is one of the most fundamental laws of Economics. The law of variable
proportion is applicable not only to agriculture but also to other constructive industries like mining, fishing
etc. It is applied to secondary or tertiary sectors too. This law helps the management in the process of
decision making. The law is a law of life and can be applicable anywhere and everywhere. The
applications of this law are as follows:
Basis of Malthusian theory of population: Malthus based his theory of population on the law of variable
proportion.
1. Basis of the Ricardian theory of rent: Ricardo's theory of rent is based on this law.
2. Basis of the marginal productivity theory of distribution: The marginal productivity theory of
distribution is also based on this law.
3. Optimum production: This law can be used to estimate the optimum proportion of the factors for the
producer.

The law of variable proportion analyses the behaviour of output when one input factor is variable and the
other factors are held constant. Thus it is a short run analysis. But in the long run all factors are variable.
When all factors are changed in same proportion, the behaviour of output is analysed with laws of returns
to scale. Thus law of returns to scale is a long run analysis. In the long period, output can be increased by
varying all the input Factors this law is concerned, not with the proportions between the factors of
production, but with the scale of production. The scale of production of the firm is determined by those
input factors which cannot be changed in the short period. The term return to scale means the changes in
output as all factors change in the same proportion. The law of returns to scale seeks to analyse the effects
of scale on the level of output. If the firm increases the units of both factors labour and capital, its scale of
production increases.
5.3.1 Constant Returns to Scale

If output increases in the same proportion as the increase in inputs, returns to scale are said to be constant.
Thus, doubling of all factor inputs causes output; tripling of inputs causes tripling of output to scale is
sometimes called linear homogenous production function. This is illustrated with the help of isoquants the
increase in scale. It can be observed from Figure 5.1. Isoquants is equal, that is, Oa = ab = bc. It means that
if both labour and capital are increased in a given proportion the output expands in the same proportion.
Figure 5.1: Constant returns to scale: Oa=ab=bc.
5.3.2 Increasing Returns to Scale

When the output increases at a greater proportion than the increase in inputs, returns to scale are said to be
increasing. When the return to scale are increasing, the distance between successive isoquants becomes
less and less, that is, Oa >ab >bc. It means that equal increases in output are obtained by smaller and
smaller increments in inputs. In other words, by doubling inputs the output is more than doubled.
Figure 5.2: Increasing returns to scale: Oa>ab>bc.
Increasing returns to scale arise on account of indivisibilities of some factors (Figure 5.2). As output is
increased the indivisible factors are better utilized and therefore increasing returns to scale arise. In other
words, the returns to scale are increasing due to economies of scale.

A curve that graphically represents the relation between total production by a firm in the short run and the
quantity of a variable input added to a fixed input. When constructing this curve, it is assumed that total
product changes from changes in the quantity of a variable input (like labour), while other inputs (like
capital) are fixed. This is one of three key product curves used in the analysis of short-run production. The
other two are marginal product curve and average product curve.
5.4.1 Production Curves

Consider the table 5.2. The table assumes that a certain good is produced by using labour and capital (K),
where varying amounts of labour are hired to work with a fixed amount of capital (4 units). For the sake of
this example, let's assume that these 4 units of capital are 4 pieces of equipment (e.g. 4 machines).
Each combination of labour (L) and capital (K) produces a different level of output (Q). Eventually,
however, adding labourers adds nothing to output and will even actually decrease output if more labourers
were hired. Once we know the output, it is possible to determine how our variable factor contributes to the
production of that output. To do so, we calculate the average product of labour (APL) and marginal
product of labour (MPL) by computing Q/L and DQ/DL respectively.
Table 5.2: Product curve entity
If we take this information and insert it into a graph, we have:

Figure 5.3: Production curve.
The Figure 5.3 shows several points where the relative position of the average and marginal product curves
tell us something about how the average product of labour is changing. This illustrates the average-
marginal rule where when a marginal value is less than (greater than) an average value, the average is
falling (rising). When the two are equal, the average is constant - which implies that the average should be
at a maximum or minimum point. On the graph, we see that when 4 units of labour are hired, MPL = APL
and APL is at a maximum. When 2 units (8 units) are hired, APL < MPL and APL is rising (APL > MPL
and APL is falling).

The ways in which resources can be combined to produce output are summarised by a firm‘s
Production function Optimum input combination or least cost combination is that combination which
produces maximum output at the minimum cost. In other words, the optimum or least cost combination is
that combination where the average cost of production is the minimum. This is the producer's equilibrium.
This can be found out by combining the firm's production function and cost function. The production
function is represented by isoquant and cost function is represented by iso-cost curve.
In the long run, all factors of production can be varied. The profit maximization firm will choose the least
cost combination of factors to produce at any given level of output. The least cost combination or the
optimum factor combination refers to the combination of factors with which a firm can produce a specific
quantity of output at the lowest possible cost.
There are two methods of explaining the optimum combination of factor:
(i) The marginal product approach.
(ii) The is quant/is cost approach.
These two approaches are now explained in brief:
The Marginal Product Approach

In the long run, a firm can vary the amounts of factors which it uses for the production of goods. It can
choose what technique of production to use, what design of factory to build, what type of machinery to
buy. The profit maximization will obviously want to use that mix of factors of combination which is least
costly to it. In search of higher profits, a firm substitutes the factor whose gain is higher than the other.
When the last rupee spent on each factor brings equal revenue, the profit of the firm is maximized. When a
firm uses different factors of production or least cost combination or the optimum combination of factors is
achieved when:
Mppa Mppb Mppc
pa pb pc
= =
In the above equation a, b, c, n is different factors of production. Mpp is the marginal physical product. A
firm compares the Mpp/P ratios with that of another. A firm will reduce its cost by using more of those
factors with a high Mpp/P ratios and less of those with a low Mpp / P ratio until they all become equal.
The Isoquant/Isocost Approach
The least cost combination of factors or producer‘s equilibrium is now explained with the help of
isoproduct curves and isocost. The optimum factors combination or the least cost combination refers to the
combination of factors with which a firm can produce a specific quantity of output at the lowest possible
cost.
As we know, there are a number of combinations of factors which can yield a given level of output. The
producer has to choose, one combination out of these which yields a given level of output with least
possible outlay. The least cost combination of factors for any level of output is that where the iso-product
curve is tangent to an isocost curve. The analysis of producer‘s equilibrium is based on the following
assumptions.
In order to select the optimum quantity of two inputs, the firm has to consider their quantities and their
prices. Factors of production are available at a price. Therefore their prices and amount of money which
the firm wants to spend has to be taken into consideration. Isocost line represents these two things.
5.5.1 Assumptions of Least Cost Combination

The main assumptions on which this analysis is based areas under:
(a) There are two factors X and Y in the combinations.
(b) All the units of factor X are homogeneous and so is the case with units of factor Y.
(c) The prices of factors X and Y are given and constants.
(d) The total money outlay is also given.
(e) In the factor market, it is the perfect completion which prevails. Under the conditions assumed above,
the producer is in equilibrium, when the following two conditions are fulfilled.
(1) The isoquant must be converting to the origin.
(2) The slope of the Isoquant must be equal to the slope of isocost line.
Figure 5.4: Least cost combination of factors.
The least cost combination of factors is now explained with the help of (figure 5.4). Here the isocost line
CD is tangent to the iso-product curve 400 units at point Q. The firm employs OC units of factor Y and
OD units of factor X to produce 400 units of output. This is the optimum output which the firm can get
from the cost outlay of Q. In this Figure 5.11 any point below Q on the price line AB is desirable as it
shows lower cost, but it is not attainable for producing 400 units of output. As regards points RS above Q
on isocost lines GH, EF, they show higher cost.
These are beyond the reach of the producer with CD outlay. Hence point Q is the least cost point. It is the
point which is the least cost factor combination for producing 400 units of output with OC units of factor Y
and OD units of factor X. Point Q is the equilibrium of the producer.
At this point, the slope of the isoquants equal to the slope of the isocost line. The MRT of the two inputs
equals their price ratio. Thus we find that at point Q, the two conditions of producer‘s, equilibrium in the
choice of factor combinations, are satisfied.
(1) The isoquant (IP) is convex the origin.
(2) At point Q, the slope of the isoquant ΔY/ΔX (MTYSxy) is equal to the slope of the isocost in
Px/Py. The producer gets the optimum output at least cost factor combination.
5.5.2 Least Cost Combination Principle

A rational firm/producer seeks maximisation of profit.
For this, he tries to minimise its cost of production.
The cost is minimises, when input combination is optimal.
Optimal input combination indicates the maximum returns to the factors employed.
Thus, a rational firm would combine the various factors of production. Its production functions in
factors of production in such a way that with the minimum input and maximum output is obtained at
the minimum cost.
Such a combination is referred to as the least cost combination.
Producer‘s equilibrium occurs when he earns maximum profit with optimal combination of factors.
A profit maximisation producer faces two choices of optimal combination of factors(inputs)
1. To minimise its cost for a given output.
2. To maximise its output for given cost.
Thus the least cost combination of factors refers to a firm producing the largest volume of output from
a given cost and producing a given level of output with the minimum cost when the factors output with
the minimum cost when the factors are combined in an optimum manner.

Basic elements are involved in cost analysis:
5.6.1 Cost Concepts
The word ―Cost‖ has different meanings in different situations. The accounting cost concept or the
historical cost concept is not useful as such for business decision-making. The accounting records end up
with the balance sheet and income statements which are meant for legal, financial and tax needs of the
enterprise. The financial recordings reveal what has been happening. It is a historical recording which is
not of very much help to the managerial economist in his business decision-making. The actual cost is not
the relevant cost concept for business decision-making because it only reveals what has been happening.
The decision-making concepts of cost aim at projecting what will happen in the alternative courses of
action. Business decisions involve plans for the future and require choices among different plans. These
decisions necessitate profitability calculations for which a comparison of future revenues and future
expenses of each alternative plan is needed.The term cost is a frequently used word that reflects a monetary
measure of the resources sacrificed or forgone to achieve a specific objective, such as acquiring a good or
service. The important point is that cost is rarely used without considering the type of that.
Cost Object: A cost object is any activity for which a separate measurement of costs is desired. As an
example of cost objects, we can mention the cost of a product or the cost of a rendering a service to a bank
customer.
Direct and Indirect Costs

Direct Costs: Those costs that can be specifically and exclusively identified with a particular cost object.
As an example we can mention the wood for manufacturing a particular type of a desk in an organization.
Indirect Costs: Those costs that cannot be identified specifically and exclusively with a given cost object.
As an example we can mention the salaries of factory supervisors or the rent of the factory.
It is considerable that sometimes direct costs are treated as indirect because tracing costs directly to the
cost object is not cost effective. As an example of this part we can mention the nails used to manufacture a
particular desk. Because the expense of nails is insignificant, their cost is not that much considerable for
justifying the profit.
Another point that should be considered is that a cost can be treated as direct for one cost object but
indirect in respect of another. For example if the cost object is the cost of using different distribution
channels, then the rental of warehouses will be regarded as direct cost. However, if the cost object is the
product, that cost will be considered as indirect one.
Opportunity Costs and Outlay Costs

This distinction is made on the basis of the nature of the sacrifice made. Outlay costs are those expenses
which are actually incurred by the firm. These are the actual payments made for labour, material, plant,
building, machinery, travelling, transporting etc. These are the expense items that appear in the books of
accounts. Outlay cost is an accounting cost concept. It is also called absolute cost or actual cost. Whenever
the inputs are to be bought for cash the outlay concept is to be applied.
Did You Know?
The study of actual existing markets made up of persons interacting in space and place in diverse ways is
widely seen as an antidote to abstract and all-encompassing concepts of ―the market‖ and has historical
precedent in the works of Fernand Braudel and Karl Polanyi.
Caution
The firm must undertake cost estimation and forecasting to judge the optimality of present output levels
and assess the optimal level of production in future.
Case Study-Cleaner Production

This case study originates from a cleaner production assessment carried out at a Polish herring filleting
plant. It shows what the company did and what the assessment achieved.
Phase I: Planning and Organization
The company was under pressure from the local authorities because the organic load in the wastewater was
too high; and the neighbours complained about odour and effluent from the plant. For these reasons, the
managing director committed the company to a project aimed at reducing the company‘s emissions to the
environment. A team was established, consisting of the managing director, the technical engineer and
supervisors from the various departments. In addition, consultants were commissioned to assist with the
project. The company decided on the following environmental policy:
Overall aim
To upgrade production whilst meeting the demands of the local and central authorities
To address the complaints of residents nearby
Targets
• To increase yield by 3%
• To reduce water consumption and wastewater volumes by 50%
• To receive no complaints from neighbours
• The project team decided to focus the cleaner production assessment on
• The filleting line. The timeframe set for implementing the cleaner
• Production initiatives were 2years
Phase II: Pre-assessment
The project team first prepared a short description and flow chart of the production processes (Shown in
Figure). The company processes both herring and cod. However this project involved the herring
processing lines only. The company processes 4000 tons of raw herring per year and produces frozen and
marinated fillets. The production of herring takes place in two mechanical filleting lines and a hand
filleting line. The solid waste is treated in a fish meal plant owned by the same company.
Figure Process flow chart of the operation.
A site inspection revealed the following problems: poor housekeeping, resulting in excessive waste on
floors; running hoses; poor hygiene; insufficient monitoring of yields; poor maintenance of equipment; a
very damp, cold work environment, with waste making the floors wet and slippery; an overall impression
of untidiness. The project team decided to focus the cleaner production assessment on the herring filleting
department because it generates a large quantity of wastewater with a high content of organic matter and it
causes economic losses. The yield had earlier been estimated to be 3–5% lower than optimum levels. In
addition, it was felt that quality, hygiene and waste treatment could be improved significantly.
Phase III: Assessment

The team made a sketch of the plant, showing the water and wastewater reticulation system. On the basis
of this sketch, the team decided where to install water meters and where to take samples of the wastewater
stream. For each key process are, the following were measured: water consumption; organic load (COD)
and suspended solids content of the wastewater; energy consumption; and product yields.
Operators read water meters regularly and, when necessary, took manual measurements of flow rates.
Effluent samples were sent to a labouratory. This data was tabulated for each process, resulting in key
figures that could then be used as benchmarks against which to track improvement. Cleaner Production
pitons were identified for every process and problem. Team members met with the consultants to discuss
solutions to the various problems.
Questions
1. What do you understand by pre-assessment cleaner production?
2. Discuss the planning and organization concept of cleaner production.
5.7 Summary
Laws of returns to scale refer to the long-run analysis of the laws of production. In the long run, output
can be increased by varying all factors.
Long-run production analysis extends and augments short-run production analysis commonly used to
explain the law of supply.
Production analysis is a managerial economics function that focuses on the internal production
processes of a company.
Production deals with the physical aspect of the business investment. It is the process whereby inputs
are transformed into outputs.
The law of variable proportions states that as the quantity of one factor is increased, keeping the other
factors fixed, the marginal product of that factor will eventually decline.
5.8 Keywords
Decision Making: When trying to make a good decision, a person must weigh the positives and negatives
of each option, and consider all the alternatives.
Forecast: The act of predicting business activity for a future period of time.
Isocost Line: In economics an isocost line shows all combinations of inputs which cost the same total
amount.
Production Management: It is deals with decision-making regarding the quality, quantity, cost, etc., of
production. It applies management principles to production.
Production versus Purchasing: It is to secure needed items at the best possible cost, while making
optimum use of the resources of the organization.

1. ……………..is a managerial economics function that focuses on the internal production.
(a) Management process (b) Selection process
(c) Production analysis (d) None of these
2. Production deals with the …………………..of the business investment.

(a) internal aspect (b) physical aspect
(c) Both a and b (d) None of these
3. The ………………..is a period of time in which at least one input used for production.
(a) short run (b) long run
4. Short-run production analysis commonly used to explain........................

(a) leadership (b) the law of supply
(c) production function (d) None of these
5. A fixed input is one whose quantity remained constant during the time under consideration.
(a) True (b) False
6. Long-run production analysis used for ………………..

(a) extends (b) augments
7. A variable input is one whose amount cannot be changed during the relevant period.
(a) True (b) False
8. The ……………..is a period of time in which at all inputs used for production.
9. The law of variable proportions states that as the quantity of one factor is …………..
(a) constant (b) decreased
(c) increased (d) None of these
10. Total product continues to increase but it diminishing until it reaches its maximum point.
(a) True (b) False

1. What is the function of production?
2. How can you explain the economic and technical efficiency?
3. What is the short and long run process?
4. What is the law of variable proportions?
5. Explain the stages of the law of variable proportions.
6. What is the use of determining optimal variable input?
7. Explain the function of production with two variable inputs.
8. Define the long-run production function?
9. What is the importance and applicability of the law of variable proportion?
10. What is a return to scale in production function?

1. (c) 2. (b) 3. (a) 4.( b) 5. (a)
6. (c) 7. (b) 8. (b) 9. (c) 10. (a)
6
Cost Analysis
CONTENTS
Objectives
Introduction
6.2 Short Run Cost Analysis: Fixed, Variable and Total Cost, Curves,
6.4 Long Run Cost Analysis: Economies and Diseconomies of Scale and Long
6.6 Summary
6.7 Keywords
Objectives
Understand the meaning cost accounting of economics cost
Explain the short run cost analysis: fixed, variable and total cost, curves
Describe the short run average and marginal costs curve
Define the long run cost analysis: economies and diseconomies of scale and long
Describe the long run average and marginal cost curves
Introduction
In this chapter you will learnt different cost concepts used by managers in decision-making process, the
relationship between these concepts, and the distinction between accounting costs and economic costs. We
will continue the analysis of costs in this chapter also. To make wise decisions concerning how much to
produce and what prices to charge, a manager must understand the relationship between firm‘s output rate
and its costs.
Cost accounting is the process of determining and accumulating the cost of product or activity. It is a
process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and
interpretation of cost. In other words, it is a system of accounting, which provides the information about
the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the
enterprise. It is an internal aspect of the organisation. Cost Accounting is accounting for cost aimed at
providing cost data, statement and reports for the purpose of managerial decision making.
The Institute of Cost and Management Accounting, London defines ―Cost accounting is the process of
accounting from the point at which expenditure is incurred or committed to the establishment of its
ultimate relationship with cost centres and cost units. In the widest usage, it embraces the preparation of
statistical data, application of cost control methods and the ascertainment of profitability of activities
carried out or planned‖A type of accounting process that aims to capture a company‘s costs of production
by assessing the input costs of each step of production as well as fixed costs such as depreciation of capital
equipment. Cost accounting will first measure and record these costs individually, then compare input
results to output or actual results to aid company management in measuring financial performance.
Costing includes ―the techniques and processes of ascertaining costs.‖ The ‗Technique‘ refers to principles
which are applied for ascertaining costs of products, jobs, processes and services. The ‗process‘ refers to
day to day routine of determining costs within the method of costing adopted by a business enterprise. Cost
accounting is often used within a company to aid in decision making; financial accounting is what the
outside investor community typically sees. Financial accounting is a different representation of costs and
financial performance that includes a company‘s assets and liabilities. Cost accounting can be most
beneficial as a tool for management in budgeting and in setting up cost control programs, which can
improve net margins for the company in the future. Costing involves ―the classifying, recording and
appropriate allocation of expenditure for the determination of costs of products or services; the relation of
these costs to sales value; and the ascertainment of profitability‖.
6.1.1 Scope of Cost Accounting

The terms ‗costing‘ and ‗cost accounting‘ are many times used interchangeably. However, the scope of
cost accounting is broader than that of costing.
Following functional activities are included in the scope of cost accounting:
Cost Book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to
their charge to departments, products and services. Such recording is preferably done on the basis of
double entry system.
Cost System: Systems and procedures are devised for proper accounting for costs.
Cost Ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the important function
of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing,
planning and control.
Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the
budgeted costs and fixation of responsibility for cost increases.
Cost Comparisons: Cost accounting also includes comparisons between cost from alternative courses of
action such as use of technology for production, cost of making different products and activities, and cost
of same product/ service over a period of time.
Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a
detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we
can state that cost is analysed to know whether the current level of costs is satisfactory in the light of
standards set in advance.
Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily
for use by the management at different levels. Cost Reports form the basis for planning and control,
performance appraisal and managerial decision making.
6.1.2 Controlling Cost

Cost accounting helps in attaining aim of controlling cost by using various techniques such as Budgetary
Control, Standard costing, and inventory control.
Each item of cost (viz. material, labour, and expense) is budgeted at the beginning of the period and actual
expenses incurred are compared with the budget. This increases the efficiency of the enterprise.
6.1.3 Providing Information for Decision-making

Cost accounting helps the management in providing information for managerial decisions for formulating
operative policies.
These policies relate to the following matters:

(i) Determination of cost-volume-profit relationship
(ii) Make or buy a component
(iii) Shut down or continue operation at a loss
(iv) Continuing with the existing machinery or replacing them by improved and economical machines.
6.1 4 Importance of Cost accounting

The limitation of financial accounting has made the management to realise the importance of cost
accounting.
The importance of cost accounting is as follows:
6.1.5 Importance to Management

Cost accounting provides invaluable help to management. It is difficult to indicate where the work of cost
accountant ends and managerial control begins.
The advantages are as follows:
Helps in ascertainment of cost
Cost accounting helps the management in the ascertainment of cost of process, product, Job, contract,
activity, etc., by using different techniques such as Job costing and Process costing.
Aids in price fixation

By using demand and supply, activities of competitors, market condition to a great extent, also determine
the price of product and cost to the producer does play an important role. The producer can take necessary
help from his costing records.
Helps in cost reduction

Cost can be reduced in the long-run when cost reduction programme and improved methods are tried to
reduce costs.
Elimination of wastage
As it is possible to know the cost of product at every stage, it becomes possible to check the forms of
waste, such as time and expenses etc., are in the use of machine equipment and material.
Helps in identifying unprofitable activities
With the help of cost accounting the unprofitable activities are identified, so that the necessary correct
action may be taken.
Helps in checking the accuracy of financial account

Cost accounting helps in checking the accuracy of financial account with the help of reconciliation of the
profit as per financial accounts with the profit as per cost account.
Helps in fixing selling prices

It helps the management in fixing selling prices of product by providing detailed cost information.
Helps in inventory Control

Cost furnishes control which management requires in respect of stock of material, work in progress and
finished goods.
Helps in estimate
Costing records provide a reliable basis upon which tender and estimates may be prepared.
6.1.6 Importance to Employees

Worker and employees have an interest in which they are employed. An efficient costing system benefits
employees through incentives plan in their enterprise, etc. As a result both the productivity and earning
capacity increases.
6.1.7 Cost Accounting and Creditors

Suppliers, investor‘s financial institution and other moneylenders have a stake in the success of the
business concern and therefore are benefited by installation of an efficient costing system. They can base
their judgement about the profitability and prospects of the enterprise upon the studies and reports
submitted by the cost accountant.
6.1.8 Importance to National Economy

An efficient costing system benefits national economy by stepping up the government revenue by
achieving higher production. The overall economic developments of a country take place due to efficiency
of production.
6.1.9 Data Base for Operating Policy

Cost Accounting offers a thoroughly analysed cost data which forms the basis of formulating policy
regarding day to day business, such as:
(a) Whether to make or buy decisions from outside?

(b) Whether to shut down or continue producing and selling at below cost?
(c) Whether to repair an old plant or to replace it?
6.2 Short Run Cost Analysis: Fixed, Variable and Total Cost, Curves
Distinguished between the short run and the long run. We also distinguished between fixed costs and
variable costs. The distinction between fixed and variable costs is of great significance to the business
manager. Variable costs are those costs, which the business manager can control or alter in the short run
by changing levels of production. On the other hand, fixed costs are clearly beyond business manager‘s
control, such costs are incurred in the short run and must be paid regardless of output.
6.2 1 Total Costs
Three concepts of total cost in the short run must be considered: total fixed cost (TFC), total variable cost
(TVC), and total cost (TC). Total fixed costs are the total costs per period of time incurred by the firm for
fixed inputs. Since the amount of the fixed inputs is fixed, the total fixed cost will be the same regardless
of the firm‘s output rate. Table 6.1 shows the costs of a firm in the short run. According to this table, the
firm‘s total fixed costs are Rs. 100. The firm‘s total fixed cost function is shown graphically (See Figure
6.1)
Table 6.1: A Firm‘s Short Run Costs (in Rs.)
Figure 6.1: Total Cost Curves.
Total variable costs are the total costs incurred by the firm for variable inputs. To obtain total variable cost
we must know the price of the variable inputs. Suppose if we have two variable inputs viz. labour (V1) and
raw material (V2)and the corresponding prices of these inputs are P1 and P2, then the total variable cost
(TVC) = P 1 * V1 + P2 * V2 They go up as the firm‘s output rises, since higher output rates require higher
variable input rates, which mean bigger variable costs. The firm‘s total variable cost function
corresponding to the data (See Table 6.1) is shown graphically (See Figure 6.1) finally; total costs are the
sum of total fixed costs and total variable costs. To derive the total cost column (See Table 6.1), add total
fixed cost and total variable Cost Concepts and cost at each output. The firm‘s total cost function
corresponding to the data given in Table 6.1 is shown graphically (See Figure 6.1).
Since total fixed costs are constant, the total fixed cost curve is simply a horizontal line at Rs.100.And
because total cost is the sum of total variable costs and total fixed costs, the total cost curve has the same
shape as the total variable cost curve but lies above it by a vertical distance of Rs. 100.
Corresponding to our discussion above we can define the following for the
Short run:
TC = TFC + TVC
Where,
TC = total cost
TFC = total fixed costs
TVC = total variable costs
Average Variable Costs
Average variable cost is the total variable cost divided by output. shows the average variable cost function
graphically. At first, output increases resulting in decrease in average variable cost, but beyond a point,
they result in higher average variable cost.

While the total cost functions are of great importance, managers must be interested as well in the average
cost functions and the marginal cost functions well. There are three average cost concepts corresponding to
the three total cost concepts. These are average fixed cost (AFC), average variable cost (AVC), and
average total cost (ATC). (See Figure 6.2) show typical average fixed cost function graphically. Average
fixed cost is the total fixed cost divided by output. Average fixed cost declines as output (Q) increases.
Thus we can write average fixed cost as:
AFC = TFC/Q
Figure 6.2: Short Run Average and Marginal Cost Curves.
Marginal costing is not a method of costing on the lines of Job or process costing, but is a special
technique which presents information to management enabling it to measure the Profitability of an
undertaking by considering the behaviour of costs. Marginal costing may be used in conjunction with other
costing methods like job or process costing or with other techniques such as standard costing or budgetary
control. Marginal cost is nothing but variable costs.
It is clearly composed of all direct costs and variable overheads. The I.C.M.A London has defined
marginal costs ‗as the amount at any given volume of output by which aggregate costs are changed, if
volume of output is increased or decreased by one unit‘. In simple words, marginal cost is the additional
cost of predicting additional units. An important point is that marginal cost per unit remains unchanged
irrespective of the level of activity. The following example would further clarify the concept of marginal
costs. This definition makes it clear that marginal costing goes beyond the ascertainment of costs. It is a
technique concerned with the effect on profit when the volume or type of output changes. In particular,
marginal costing studies the effect which fixed cost has on the running of a business.
6.3.1. Characteristics of Marginal Costing

The essential characteristic and mechanism of marginal costing technique may be summed up as follows:
Segregation of Costs into Fixed and Variable Elements
In marginal costing all costs are classified into fixed and variable. Semi-costs are also segregated into fixed
and variable elements.
Marginal costs as products costs.

Only marginal (variable) costs are charged to products costs.
Fixed costs as period costs
Fixed costs are treated as period costs are charged to costing Profit and Loss Account of the period in
which they are incurred.
Valuation of inventory
The work-in progress and finished stocks are valued at marginal costs only.
Contribution.
Contribution is the difference between sales value and marginal costs of sales. The relative profitability of
products or departments is based on a study of ‗contribution‘ made by each of the products or departments.
Pricing
In marginal costing, prices are based on marginal cost plus contribution.
6.3.2 Marginal costing and profit

In marginal costing, profit is calculated by a two stage approach. First of all contribution is‘ determined for
each product or departments. The contributions of various products or departments are pooled together and
such a total contributions from all products is called ‗Fund‘. Then from this fund is deducted the total fixed
cost to arrive at a profit or loss.
Figure 6.3: Marginal costing and profit.
Marginal Costing may be defined as ―the ascertainment by differentiating between fixed cost and variable
cost, of marginal cost and of the effect on profit of changes in volume or type of output." With marginal
costing procedure costs are separated into fixed and variable cost. Marginal costing is ―a technique of cost
accounting pays special attention to the behaviour of costs with changes in the volume of output." This
definition lays emphasis on the ascertainment of marginal costs and also the effect of changes in volume or
type of output on the company's profit.
Marginal Costing
Features of Marginal Costing
All elements of costs are classified into fixed and variable costs.
Marginal costing is a technique of cost control and decision making.
Variable costs are charged as the cost of production.
Valuation of stock of work in progress and finished goods is done on the basis of variable costs.
Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of selling price over
marginal cost of sales.
Profitability of various levels of activity is determined by cost volume profit analysis
6.4 Long Run Cost Analysis: Economies and Diseconomies of Scale
and Long
In the long run, all inputs are variable, and a firm can have a number of alternative plant sizes and levels of
output that it wants. There are no fixed cost functions (total or average) in the long run, since no inputs are
fixed. A useful way of looking at the long run is to consider it a planning horizon. The long run cost curve
is also called planning curve because it helps the firm in future decision making process.
Figure 6.4: Short-Run and Long-Run Average Cost Curves.
The long run cost output relationship can be shown with the help of a long run cost curve. The long run
average cost curve (LRAC) is derived from short run average cost curves (SRAC). Let us illustrate this
with the help of a simple example. A firm faces a choice of production with three different plant sizes viz.
plant size-1 (small size), plant size-2 (medium size), plant size-3(large size), and plant size-4 (very large
size). The short run average cost functions shown in Figure 6.4 (SRAC1, SRAC2, SRAC3, and SRAC4)
are associated with each of these plants discrete scale of operation. The long run average cost function for
this firm is defined by the minimum average cost of each level of output. For example, output rate Q1
could be produced by the plant size-1 at an average cost of C1 or by plant size-2 at a cost of C2 Clearly,
the average cost is lower for plant size-1, and thus point a is one point on the long run average cost curve.
By repeating this process for various rates of output, the long run average cost is determined. For output
rates of zero to Q2 plant size-1is the most efficient and that part of SRAC1 is part of the long run cost
function. For output rates of Q2 to Q3 plant size-2 is the most efficient, and for output rates Q3 to Q4,
plant size-3 is the most efficient. The scallop-shaped curve shown in boldface (See Figure 9.4) is the long
run average cost curve for this firm. This boldfaced curve is called an envelope curve (as it envelopes short
run average cost curves). Firms plan to be on this envelope curve in the long run. Consider a firm currently
operating plant size-2 and producing Q1 units at a cost of C2 per unit. If output is expected to remain at
Q1, the firm will plan to adjust to plant size-1, thus reducing average cost to C1.
6.4.1 Economies and Diseconomies of Scale

We have seen in the preceding section that larger plant will lead to lower average cost in the long run.
However, beyond some point, successively larger plants will mean higher average costs. Exactly, why is
the long run average cost (LRAC) curve U-shaped? What determines the shape of LARC curve?
This point needs further explanation. It must be emphasized here that the law of diminishing returns is not
applicable in the long run as all inputs are variable. Also, we assume that resource prices are constant.
What then, is our explanation? The U-shaped LRAC curve is explainable in terms of what economists call
economies of scale and diseconomies of scale. Economies and diseconomies of scale are concerned with
behaviour of average cost curve as the plant size is increased. If LRAC declines as output increases, then
we say that the firm enjoys economies of scale. If, instead, the LRAC increases as output increases, then
we have diseconomies of scale. Finally, if LRAC is constant as output increases, then we have constant
returns to scale implying we have neither economies of scale nor diseconomies of scale. Economies of
scale explain the down sloping part of the LRAC curve.
As the size of the plant increases, LRAC typically declines over some range of output for a number of
reasons. The most important is that, as the scale of output is expanded, there is greater potential for
specialization of productive factors. This is most notable with regard to labour but may apply to other
factors as well. Other factors contributing to declining LRAC include ability to use more advanced
technologies and more efficient capital equipment; managerial specialization; opportunity to take
advantage of lower costs (discounts) for some inputs by purchasing larger quantities; effective utilization
of by products, etc. But, after sometime, expansion of a firm‘s output may give rise to diseconomies, and
therefore, higher average costs. Further expansion of output beyond a reasonable level may lead to
problems of overcrowding of labour, managerial inefficiencies, etc, pushing up the average costs. In this
section, we examined the shape of the LRAC curve. In other words, we have analysed the relationship
between firm‘s output and its long run average costs.
The economies of scale and diseconomies of scale are sometimes called as internal economies of scale and
internal diseconomies of scale respectively. This is because the changes in long run average costs result
solely from the individual firm‘s adjustment of its output. On the other hand, there may exist external
economies of scale. The external economies also help in cutting down production costs. With the
expansion of an industry, certain specialized firms also come up for working up the by-products and waste
materials. Similarly, with the expansion of the industry, certain specialized units may come up for
supplying raw material, tools, etc., to the firms in the industry. Moreover, they can combine together to
undertake research etc., whose benefit will accrue to all firms in the industry. Thus, a firm benefits from
expansion of the industry as a whole. These benefits are external to the firm, in the sense that these have
arisen not because of any effort on the part of the firm but have accrued to it due to expansion of industry
as a whole.

Most firms will have many alternative plant sizes to choose from, and there is a short run average cost
curve corresponding to each. A few of the short run average cost curves for these plants are shown in
Figure 6.5, although many more may exist. Only one point of a very small arc of each short run cost curve
will lie on the long run average cost function. Thus long run average cost curve can be shown as the
smooth U-shaped curve. Corresponding to this long run average cost curve is a long run marginal cost
(LRMC) curve, which intersects LRAC at its minimum point a, which is also the minimum point of short
run average cost curve 4 (SRAC4 ). Thus, at a point a and only at a point a, the following unique result
occurs:
SRAC = SRMC when LRAC = LRMC
Figure 6.5: Short-Run and Long-Run Average Cost and Marginal Cost Curves.
The long run cost curve serves as a long run planning mechanism for the firm. It shows the least per unit
cost at any output can be produced after the firm has had time to make all appropriate adjustments in its
plant size. For example, suppose that the firm is operating on short run average cost curve SRAC3 as
shown in Figure 6.5, and the firm is currently producing an output of Q*. By using SRAC3 , it is seen that
the firm‘s average cost is C2 Clearly, if projections of future demand indicate that the firm could expect to
continue selling Q* units per period at the market price, profit could be increased significantly by
increasing the scale of plant to the size associated with short run average cost curve SRAC4 . With this
plant, average cost for an output rate of Q* would be C2 and the firm‘s profit per unit would increase by
C2 – C1
Thus, total profit would increase by (C2 – C1) * Q*.

The U-shape of the LRAC curve reflects the laws of returns to scale. According to these laws, the cost per
unit of production decreases as plant size increases due to the economies of scale, which the larger plant
sizes make possible. But the economies of scale exist only up to a certain size of plant, known as the
optimum plant size where all possible economies of scale are fully exploited. Beyond the optimum plant
size, diseconomies of scale arise due to managerial inefficiencies. As plant size increases beyond a limit,
the control, the feedback of information at different levels and decision-making process becomes less
efficient. This makes the LRAC curve turn upwards. Given the LRAC in Figure 6.5, we can say that there
are increasing returns to scale up to Q* and decreasing returns to scale beyond Q*. Therefore, the point Q*
is the point of optimum output and the corresponding plant size-4 is the optimum plant size.
If you have long run average cost of producing a given output, you can readily derive the long run total
cost (LRTC) of the output, since the long run total cost is simply the product of long run average cost and
output. Thus, LRTC = LRAC * Q.
Figure 6.6 shows the relationship between long run total cost and output. Given the long run total cost
function you can readily derive the long run marginal cost function, which shows the relationship between
output and the cost resulting from the production of the last unit of output, if the firm has time to make the
optimal changes in the quantities of all inputs used.
The ten Marginal Cost refers to the amount at any given volume of output by which the aggregate costs are
charged if the volume of output is changed by one unit. Accordingly, it means that the added or additional
cost of an extra unit of output. Marginal cost may also be defined as the ―cost of producing one additional
unit of product." Thus, the concept marginal cost indicates wherever there is a change in the volume of
output; certainly there will be some change in the total cost.
It is concerned with the changes in variable costs. Fixed cost is treated as a period cost and is transferred to
Profit and Loss Account. The technique of marginal costing is concerned with marginal cost. It is,
therefore, necessary for you to understand correctly the term `Marginal Cost'. Management Accountants,
Marginal Cost as "the amount at any given volume of output by which aggregate costs are changed if the
volume of output is increased by one unit".
On analysing this definition we can conclude that the term "Marginal Cost" refers to increase or decrease
in the amount of cost on account of increase or decrease of production by a single unit. The costs that vary
with a decision should only be included in decision analysis. For many decisions that involve relatively
small variations from existing practice and/or are for relatively limited periods of time, fixed costs are not
relevant to the decision. This is because either fixed costs tend to be impossible to alter in the short term or
managers are reluctant to alter them in the short term.
6.5.1 Definition
Marginal costing distinguishes between fixed costs and variable costs as convention ally classified.
The marginal cost of a product is its variable cost. This is normally taken to be; direct labour, direct
material, direct expenses and the variable part of overheads.
Marginal costing is formally defined as ‗the accounting system in which variable costs are charged to cost
units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special
value is in decision making‘.
The term ‗contribution‘ mentioned in the formal definition is the term given to the difference between
Sales and Marginal cost.
6.5.2 Contribution Sales Marginal Cost
The term marginal cost sometimes refers to the marginal cost per unit and sometimes to the total marginal
costs of a department or batch or operation. The meaning is usually clear from the context. Alternative
names for marginal costing are the contribution approach and direct costing we will study marginal costing
as a technique quite distinct from absorption costing.
6.5.3 Marginal Cost Equations and Breakeven Analysis

From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution...... (1)
Fixed cost + Profit = Contribution...... (2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application
in managerial decision-making problems.
The sales and marginal costs vary directly with the number of units sold or produced. So, the difference
between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution
to sales remains constant at all levels.
Did You Know?

The contemporary cost accounting began around 1885 though it was in use many years or centuries prior
in a limited form.
Caution
It can be difficult to achieve the ultimate goal profit if the firm does not choose the specific course of
action.
Case Study-A Major Time Saver – Automatic Linking of Accounting Data into ICE Format
One concern with which most government services providers must contend is the large amount of time
required to input accounting data into the specific spreadsheet format required by the government for all
cost-plus contracts – ICE (Incurred Cost Electronically).
Most accounting systems cannot link general ledger data to spreadsheets because it is a complex process.
Not long ago, however, Alde baron introduced a new standard feature into its SYMPAQ solution that does
just what government contractors like FRC need. By integrating a package called F9 into SYMPAQ, the
software now has the capability to automatically export general ledger data to the ICE format.
FRC was an early adopter of this ICE capability and have realized great time savings as a result. Julie
Wheels, FRC‘s Controller explained, ―Before we had this capability, I had spreadsheet templates that I had
personally spent a great deal of time creating a few years ago. When FRC got its first cost-plus contract, I
had to use these to move our data into ICE. With them, it took about 10 days to get everything done, much
of that time spent re-keying data and checking to make sure there were no mistakes. If I did not have those
templates, I could not imagine how long the process would take – probably weeks and weeks. And now
that we have implemented the new linking capability in SYMPAQ, once everything was set up and ready
to fly – mostly one-time set up operations – the actual linking of the data from SYMPAQ into ICE took a
matter of minutes. I still spent about half a day checking the data, but that‘s nothing compared with typing
all the data or even using my personal spreadsheet templates.‖ Paul Jacobs, Senior Vice President and
Chief Financial Officer of FRC, added, ―I think the ICE module is quite good. We have found it to be a
very important addition to our SYMPAQ system.‖
Profitable Results
Making a profit when your company is primarily in the business of government contracting is a delicate
matter. There are strict rules and guidelines by which all government contractors must comply – or risk
long-term or permanent cancellation of all contracts. Although the DCAA audits contractors to ensure they
adhere to the rules, FRC has always made a point of operating strictly by-the-book, while still significantly
increasing their profits year after year. ―I could not have foreseen this increase and have the confidence
that we have properly accounted for all costs without SYMPAQ,‖ Paul stated. ―I know that everything is
what it should be and I‘m willing to sign my name to it as a CFO – with confidence,‖ he continued.
Audits are not a novelty to FRC. They regularly conduct self-audits, generally on a daily or weekly basis.
―We have gone through two DCAA accounting audits and three outside independent industry audits by a
CPA firm – in 2002-2009, 2003 and 2004 – based on the SYMPAQ system. The fact that an outside CPA
will sign his name to his audit of FRC – that‘s pretty impressive,‖ Paul stated.
Today’s Situation
―FRC is highly successful and SYMPAQ has gotten us where we are today,‖ Paul explained. With over 50
employees, most of whom are actively providing important services to government and commercial
clients, FRC is profitable, significantly increasing their revenue every year resulting in a truly success
story.
Questions
1. Explain the present scenario of automatic linking of accounting data into ice format.
2. What are the relation between FRC and ICE format?
6.6 Summary
The profit-oriented firm‘s manager must consider both opportunity costs and explicit costs in order to
use all the resources most economically.
A firm‘s marginal cost is the additional variable cost associated with each additional unit of output.
The short run marginal cost curve increases beyond certain point, and cuts both average total cost
curve and average variable cost curve from below at their minimum points.
Economies or diseconomies of scale arise either due to the internal factors pertaining to the expansion
of output by a firm, or due to the external factors such as industry expansion.
6.7 Keywords
Break-even Point: It refers to the level of activity where the income of the business exactly equals its
expenditure. It is also termed as no profit, no loss' point.
Contribution: It refers to the excess of selling price over variable cost.
Economic: It is the social science that analyzes the production, distribution, and consumption of goods and
services.
Marginal Cost: The variable cost of one more unit of a product or service, i.e. a cost which would be
avoided if the unit was not produced or service not provided.
Marginal Costing: A technique whereby marginal cost of a product is ascertained. Only variable costs are
charged to production. Fixed costs are charged against the contribution of the period. It is also termed as
`variable costing'.

1. The collection and presentation of accounting information come within the area of Cost accounting.
(a) True (b) False
2. A study of sociology helps to understand the behaviour of man in groups.

(a) True (b) False
3. Cost accounting is.................. to management needs.
(a) Low sensitiv e (b) highly sensitive
(c) Both a and b (d) None of these.
4. Thus, cost......... analysis is an important medium through which one can

(a) Cost marginal (b) Profit
(c) Volume-profit (d) none of these
5. The work-in progress and finished stocks are valued at marginal costs only.
(a) True (b) False
6. The overhead expenses which do not vary with the activity level are called......
(a) Variable Overheads (b) Fixed Overheads
(c) Semi variable Overheads (d) none of these
7. To use of job...........method will be useful for accounting system

(a) Labour (b) Person
(c) Costing (d) Accountant
8. This method is followed where by-products cost………. are processed to dispose of waste material more
(a)Products cost (b) Financial
(c)Material (d) None of these
9. The standard may be arrived at on the basis of past average ……….. Or may be fixed according to the
principles of standard costing
(a) Price (b) financial
(c) Costing (d) None of these
10. The type of spoilage that should not affect the cost of inventories is
(a) Abnormal spoilage (c) Seasonal spoilage
(b) Normal spoilage (d) Indirect spoilage

1. Explain why short run marginal cost is greater than long run marginal cost.
2. Explain why short run average cost can never be less than long run average cost.
3. Why are all costs variable in the long run? Beyond the point at which they are equal.
4. Why is the long run average cost curve called an ―envelope curve‖?
5 Why cannot the long run marginal cost curve be an envelope as well?
6. What do you understand by‖ cost -efficiency‖? Draw a long run cost diagram and explain.
7. Economists frequently say that the firm plans in the long run and operates. Explain the statement.
8. What is short run cost analysis? For what type of decisions is it useful?
9. Explain the various economies of scale.
10. What is the required sales volume? Explain.
1. (a) 2.(a) 3.(b) 4.(b) 5.(a)
6. (b) 7.(c) 8.(b) 9.(b) 10.(a)
7
Markets
CONTENTS
Objectives
Introduction
7.3 Monopoly
7.6 Oligopoly
7.7 Summary
7.8 Keywords
Objectives
Define market
Describe the marketing environment
Discuss the perfect competition
Explain about the monopoly
Explain the monopolistic competition and oligopoly
Define price
Discuss price determination in markets
Explain the price discrimination
Introduction
Several definitions have been proposed for the term marketing. Each tends to emphasize different issues.
Memorizing a definition is unlikely to be useful; ultimately, it makes more sense to thinking of ways to
benefit from creating customer value in the most effective way, subject to ethical and other constraints that
one may have.
Note that the definitions make several points:
A main objective of marketing is to create customer value.
Marketing usually involves an exchange between buyers and sellers or between other parties.
Marketing has an impact on the firm, its suppliers, its customers, and others affected by the firm‘s
choices.
Marketing frequently involves enduring relationships between buyers, sellers, and other parties.
Processes involved include ―creating, communicating, delivering, and exchanging offerings.”
Delivering customer value The central idea behind marketing is the idea that a firm or other entity will
create something of value to one or more customers who, in turn, are willing to pay enough (or contribute
other forms of value) to make the venture worthwhile considering opportunity costs. Value can be created
in a number of different ways. Some firms manufacture basic products (e.g., bricks) but provide relatively
little value above that. Other firms make products whose tangible value is supplemented by services (e.g., a
computer manufacturer provides a computer loaded with software and provides a warranty, technical
support, and software updates). It is not necessary for a firm to physically handle a product to add value—
e.g. online airline reservation systems add value by
(1) Compiling information about available flight connections and fares,
(2) Allowing the customer to buy a ticket,
(3) Forwarding billing information to the airline, and
(4) Forwarding reservation information to the customer.
It should be noted that value must be examined from the point of view of the customer. Some customer
segments value certain product attributes more than others. A very expensive product—relative to others in
the category—may, in fact, represent great value to a particular customer segment because the benefits
received are seen as even greater than the sacrifice made (usually in terms of money). Some segments have
very unique and specific desires, and may value what—to some individuals—may seem a ―lower quality‖
item—very highly.
Some forms of customer value. The marketing process involves ways that value can be created for the
customer. Form utility involves the idea that the product is made available to the consumer in some form
that is more useful than any commodities that are used to create it. A customer buys a chair, for example,
rather than the wood and other components used to create the chair.
Some Forms of Customer Value: The marketing process involves ways that value can be created for the
customer. Form utility involves the idea that the product is made available to the consumer in some form
that is more useful than any commodities that are used to create it. A customer buys a chair, for example,
rather than the wood and other components used to create the chair.
The degree to which a market or industry can be described as competitive depends in part on how many
suppliers are seeking the demand of consumers and the ease with which new businesses can enter and exit
a particular market in the long run.
In many sectors of the economy markets are best described by the term oligopoly where a few producers
dominate the majority of the market and the industry is highly concentrated. In a duopoly two firms
dominate the market although there may be many smaller players in the industry.

Market structure is best defined as the organisational and other characteristics of a market. We focus on
those characteristics which affect the nature of competition and pricing – but it is important not to place too
much emphasis simply on the market share of the existing firms in an industry.
Traditionally, the most important features of market structure are:
The number of firms (including the scale and extent of foreign competition)
The market share of the largest firms (measured by the concentration ratio – see below)
The nature of costs (including the potential for firms to exploit economies of scale and also the
presence of sunk costs which affects market contestability in the long term)
The degree to which the industry is vertically integrated - vertical integration explains the process by
which different stages in production and distribution of a product are under the ownership and control
of a single enterprise. A good example of vertical integration is the oil industry, where the major oil
companies own the rights to extract from oilfields, they run a fleet of tankers, operate refineries and
have control of sales at their own filling stations.
The extent of product differentiation (which affects cross-price elasticity of demand)
The structure of buyers in the industry (including the possibility of monopsony power)
The turnover of customers (sometimes known as ―market churn‖). how many customers are prepared
to switch their supplier over a given time period when market conditions change. The rate of customer
churn is affected by the degree of consumer or brand loyalty and the influence of persuasive
advertising and marketing.
7.1.1 Market Structure and Innovation

Which market conditions are optimal for effective and sustained innovation to occur? This is a question
that has vexed economists and business academics for many years.
High levels of research and development spending are frequently observed in oligopolistic markets,
although this does not always translate itself into a fast pace of innovation.
The recent work of William Baumol provides support for oligopoly as market structure best suited for
innovative behaviour. Innovation is perceived as being ―mandatory‖ for businesses that need to establish a
cost-advantage or a significant lead in product quality over their rivals.
―As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price
variable is ousted from its dominant position…..But in capitalist reality as distinguished from its textbook
picture, it is not that kind of competition which counts but the competition which commands a decisive
cost or quality advantage and which strikes not at the margins of profits and the outputs of the existing
firms but at their foundations and their very lives. This kind of competition is as much more effective than
the other as a bombardment is in comparison with forcing a door‖ Supernormal profits persist in the long-
run in an oligopoly and these can be used to finance R&D
Government policy and innovation in the economy

The current government places a huge emphasis on the potential value from more innovation across all
sectors of the British economy. This is because of the economic gains that follow:
For example:
Improvements in the competitiveness of UK producers in home and overseas markets.
Innovation helps to protect and develop comparative advantage.
Higher productivity will keep down unit labour costs against the challenge of low-cost competition
from emerging market economies.
Innovation is a potential source of higher long-term trend growth – indeed supply creates its own
demand (―Say‘s Law‖) and can give businesses much higher rates of return on their investment than an
expansion of their existing capacity and product range.
Innovation can also create many thousands of new jobs even though some jobs may be lost because of
the adoption of labour-saving technology. The new jobs emerge in training and other services together
with the demand for labour that comes from expanding output to supply an expansion to new markets.
There might also be significant social benefits (positive externalities) from innovative behaviour – for
example the delivery of new health treatments or innovations that provide safer forms of transport.
Government policy and innovation
Supply-side strategies are usually linked directly with attempts to promote more innovative behaviour.
Indeed the focus of government policy is firmly focused on improvements in the microeconomics of
markets. Consider this extract from a recent speech by Gordon Brown
―If the past century of economic policymaking has taught us anything, it is that achieving strong long term
growth often has less to do with macroeconomic policies that with good microeconomics, including
fostering competitive markets that reward innovation and restricting government to only a limited role.‖
7.1.2 Important developments:

Increasingly most innovation is done by smaller firms indeed multinational corporations are now out-
sourcing their research and development spending to small businesses at home and overseas much is
being shifted to cheaper locations ―offshore‖ in India and Russia
Innovation is now a continuous process in part because the length of the product cycle is getting
shorter as innovations are rapidly copied by competitors, pushing down profit margins and (according
to a recent article in the economist) ―transforming today's consumer sensation into tomorrow's
commonplace commodity‖ a good example of this is the introduction of two major competitors to the
anti-impotence drug Viagra
Innovation is not something left to chance the most successful firms are those that pursue innovation in
a systematic fashion
Demand innovation is becoming more important: In many markets, demand is either stable or in long-
run decline. The response is to go for ―demand innovation‖ discovering new forms of demand from
consumers and adapting an existing product to meet them the toy industry is a classic example of this
Globalisation is driving innovation and not just in manufactured goods but across a vast range of
household and business services and in particular in high-value knowledge industries

Competitive markets operate based on a number of assumptions. When these assumptions are dropped, we
move into the world of imperfect competition. These assumptions are discussed below:
7.2.1 Price and Output for the Competitive Industry and Firm
In the short run the equilibrium market price is determined by the interaction between market demand and
market supply. In the 6.1 shown, price P1 is the market-clearing price and this price is then taken by each
of the firms. Because the market price is constant for each unit sold, the AR curve also becomes the
Marginal Revenue curve (MR). A firm maximises profits when marginal revenue = marginal cost. In the
Figure 7.1, the profit-maximising output is Q1. The firm sells Q1 at price P1. The area shaded is the
economic (supernormal profit) made in the short run because the ruling market price P1 is greater than
average total cost.
Figure 7.1 Marginal revenue curve.

Not all firms make supernormal profits in the short run. Their profits depend on the position of their short
run cost curves. Some firms may be experiencing sub-normal profits because their average total costs
exceed the current market price. Other firms may be making normal profits where total revenue equals
total cost (i.e. they are at the break-even output). In the Figure 7.2, the firm shown has high short run costs
such that the ruling market price is below the average total cost curve. At the profit maximising level of
output, the firm is making an economic loss (or sub-normal profits).
Figure 7.2: Average total cost.
7.2.2 Main Features of Perfect Competition

The following are the characteristics or main features of perfect competition:
Many Sellers
In this market, there are many sellers who form total of market supply. Individually, seller is a firm and
collectively, it is an industry. In perfect competition, price of commodity is decided by market forces of
demand and supply. i.e. by buyers and sellers collectively.
Here, no individual seller is in a position to change the price by controlling supply. Because individual
seller‘s individual supply is a very small part of total supply. So, if that seller alone raises the price, his
product will become costlier than other and automatically, he will be out of market. Hence, that seller has
to accept the price which is decided by market forces of demand and supply. This ensures single price in
the market and in this way, seller becomes price taker and not price maker.
Many Buyers
Individual buyer cannot control the price by changing or controlling the demand. Because individual
buyer‘s individual demand is a very small part of total demand or market demand. Every buyer has to
accept the price decided by market forces of demand and supply. In this way, all buyers are price takers
and not price makers. This also ensures existence of single price in market.
Homogenous Product
In this case, all sellers produce homogeneous i.e. perfectly identical products. All products are perfectly
same in terms of size, shape, taste, colour, ingredients, quality, trademarks etc. This ensures the existence
of single price in the market.
Zero Advertisement Cost

Since all products are identical in features like quality, taste, design etc., there is no scope for product
differentiation. So advertisement cost is nil.
Free Entry and Exit
There are no restrictions on entry and exit of firms. This feature ensures existence of normal profit in
perfect competition. When profit is more, new firms enter the market and this leads to competition. Entry
of new firms competing with each other results into increase in supply and fall in price. So, this reduces
profit from abnormal to normal level.
When profit is low (below normal level), some firms may exit the market. This leads to fall in supply. So
remaining firms raise their prices and their profits go up. So again this ensures normal level of profit.
Perfect Knowledge
On the front of both, buyers and sellers, perfect knowledge regarding market and pricing conditions is
expected. So, no buyer will pay price higher than market price and no seller will charge lower price than
market price.
Perfect Mobility of Factors

This feature is essential to keep supply at par with demand. If all factors are easily mobile (moveable) from
one line of production to another, then it becomes easy to adjust supply as per demand.
Whenever demand is more additional factors should be moved into industry to increase supply and vice
versa. In this way, with the help of stable demand and supply, we can maintain single price in the Market.
No Government Intervention
Since market has been controlled by the forces of demand and supply, there is no government intervention
in the form of taxes, subsidies, licensing policy, control over the supply of raw materials, etc.
No Transport Cost
It is assumed that buyers and sellers are close to market, so there is no transport cost. This ensures
existence of single price in market.
Characteristics of Perfect Competition

The four key characteristics of perfect competition are:
(1) A large number of small firms,
(2) Identical products sold by all firms,
(3) Perfect resource mobility or the freedom of entry into and exit out of the industry, and
(4) Perfect knowledge of prices and technology.
7.3 Monopoly
The term monopoly is derived from Greek words ‗mono‘ which means single and ‗poly‘ which means
seller. So, monopoly is a market structure, where there only a single seller producing a product having no
close substitutes.
This single seller may be in the form of an individual owner or a single partnership or a Joint Stock
company. Such a single firm in market is called monopolist. Monopolist is price maker and has a control
over the market supply of goods. But it does not mean that he can set both price and output level.
7.3.1 Features of Monopoly

Following are the features or characteristics of Monopoly:
A single seller has complete control over the supply of the commodity.
There are no close substitutes for the product.
There is no free entry and exit because of some restrictions.
There is a complete negation of competition.
Monopolist is a price maker.
Since there is a single firm, the firm and industry are one and same i.e. firm coincides the industry.
Monopoly firm faces downward sloping demand curve. It means he can sell more at lower price and
vice versa. Therefore, elasticity of demand factor is very important for him.
7.3.2 Types of Monopoly

Perfect monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product having no close
substitute; not even remote one. There is absolutely zero level of competition. Such monopoly is
practically very rare.
Imperfect monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single seller market
having no close substitute. It means in this market, a product may have a remote substitute. So, there is fear
of competition to some extent e.g. Mobile (Cellphone) telcom industry (e.g. videophone) is having
competition from fixed landline phone service industry (e.g. BSNL).
Private monopoly
When production is owned, controlled and managed by the individual, or private body or private
organization, it is called private monopoly. For example Tata, Reliance, Bajaj, etc. groups in India. Such
type of monopoly is profit oriented.
Public monopoly
When production is owned, controlled and managed by government, it is called public monopoly. It is
welfare and service oriented. So, it is also called as ‗Welfare Monopoly‘ e.g. Railways, Defence, etc.
Simple monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He operates in a single
market.
Discriminating monopoly
Such a monopoly firm charges different price to different customers for the same product. It prevails in
more than one market.
Legal monopoly
When monopoly exists on account of trademarks, patents, copy rights, statutory regulation of government
etc., it is called legal monopoly. Music industry is an example of legal monopoly.
Natural monopoly
It emerges as a result of natural advantages like good location, abundant mineral resources, etc. e.g. Gulf
countries are having monopoly in crude oil exploration activities because of plenty of natural oil resources.
Technological monopoly
It emerges as a result of economies of large scale production, use of capital goods, new production
methods, etc. e. g. engineering goods industry, automobile industry, software industry, etc.
Joint monopoly
A number of business firms acquire monopoly position through amalgamation, cartels, syndicates, etc, it
becomes joint monopoly. e. g. actually, pizza making firm and burger making firm are competitors of each
other in fast food industry but when they combine their business that leads to reduction in competition. So
they can enjoy monopoly power in market.
The term “Monopolistic Market” is derived from the Greek words ―monos‖ which means alone or single
and ―polien‖ which means to sell. It is defined as a situation in which a single company owns all or nearly
all of the market for a given type of product or service.
This would happen in the case that there is a barrier to entry into the industry that allows the single
company to operate within competition (for example, vast economies of scale, barriers to entry, or
governmental regulation). In such an industry structure, the producers will often produce a volume that is
less than the amount which would maximise social welfare.
It is also explained as the exclusive power; or privilege of selling a commodity; the exclusive power,
rights, or privilege of dealing, or of trading in some market, sole command of the traffic in anything,
however obtained; as the proprietor of a patented in given a monopoly of its sale for a limited time.
7.4.1 Characteristics of Monopolistic Market

The key characteristics of a monopolistic market are stated below:
1. Exclusive possession or control of one firm/company to produce and sell a commodity or a service.
2. The firm is an industry, since the distinction between firm and industry does not exist.
3. Contradicts a perfect competition market.
4. No close substitute of the product/service is available in the market.
5. The sellers are the price makers and not price takers, since they are the sole suppliers.
6. High entry barriers for the other firms, thus restricting competition.
7. The entry barriers can be legal, technological, economical or natural. As rightly said by Milton
Friedman that, monopoly frequently arises from government support or from collusive agreements
among individuals.
8. The firm faces a downward sloping demand curve for its product; since the firm is an industry. It means
it cannot sell more output unless the price is lowered.

Monopolistic competition refers to a market structure that is a cross between the two extremes of perfect
competition and monopoly. The model allows for the presence of increasing returns to scale in production
and for differentiated (rather than homogeneous or identical) products. However the model retains many
features of perfect competition, such as the presence of many firms in the industry and the likelihood that
free entry and exit of firms in response to profit would eliminate economic profit among the firms.
As a result, the model offers a somewhat more realistic depiction of many common economic markets. The
model best describes markets in which numerous firms supply products which are each slightly different
from that supplied by its competitors. Examples include automobiles, toothpaste, furnaces, restaurant
meals, motion pictures, romance novels, wine, beer, cheese, shaving cream and many more.
The model is especially useful in explaining the motivation for intra-industry trade, i.e. trade between
countries that occurs within an industry rather than across industries. In other words the model can explain
why some countries export and import automobiles simultaneously.
This type of trade, although frequently measured is not readily explained in the context of the Ricardian or
Heckscher-Ohlin models of trade. In those models a country might export wine and import cheese, but it
would never export and import wine at the same time.
7.5.1 Assumptions of Monopolistic Competition

A monopolistically competitive market has features which represent a cross between a perfectly
competitive market and a monopolistic market (hence the name). Below are listed some of the main
assumptions of the model.
1. Many, many firms produce in a monopolistically competitive industry. This assumption is similar to
that found in a model of perfect competition.
2. Each firm produces a product which is differentiated (i.e. different in character) from all other products
produced by the other firms in the industry. Thus one firm might produce red toothpaste with a
spearmint taste; another might produce white toothpaste with a wintergreen taste. This assumption is
similar to a monopoly, which produces a unique (or highly differentiated) product.
3. The differentiated products are imperfectly substitutable in consumption. This means that if the price
of one good were to rise, some consumers would switch their purchases to another product within the
industry. From the perspective of a firm in the industry, it would face a downward sloping demand
curve for its product, but the position of the demand curve would depend upon the characteristics and
prices of the other substitutable products produced by other firms. This assumption is intermediate
between the perfectly competitive assumption in which goods are perfectly substitutable and the
assumption in a monopoly market in which no substitution is possible.
4. There is free entry and exit of firms in response to profits in the industry. Thus if firms are making
positive economic profits, it acts as a signal to others to open up similar firms producing similar
products. If firms are losing money, making negative economic profits, then, one by one, firms will
drop out of the industry. Entry or exit affects the aggregate supply of the product in the market and
forces economic profit to zero for each firm in the industry in the long run. [Note: the long-run is
defined as the period of time necessary to drive economic profit to zero.] This assumption is identical
to the free entry and exit assumption in a perfectly competitive market.
5. There are economies of scale in production (internal to the firm). This is incorporated as a downward
sloping average cost curve. If average costs fall when firm output increases it means that the per-unit
cost falls with an increase in the scale of production. Since monopoly, markets can arise when there are
large fixed costs in production and since fixed costs result in declining average costs, the assumption
of economies of scale is similar to a monopoly market.
These main assumptions of the monopolistically competitive market show that the market is
intermediate between a purely competitive market and a purely monopolistic market. The analysis of
trade proceeds using a standard depiction of equilibrium in a monopoly market. However, the results
are reinterpreted in light of the assumptions described above. Also, it is worth mentioning that this
model is a partial equilibrium model since there is only one industry described and there is no
interaction across markets based on an aggregate resource constraint.
7.5.2 Monopolistically Competitive Industry Effects

Assume that there are two countries, each with a monopolistically competitive industry producing a
differentiated product. Suppose initially that the two countries are in autarky. For convenience we will
assume that the firms in the industry are symmetric relative to the other firms in the industry. Symmetry
implies that each firm has the same average and marginal cost functions and that the demand curves for
every firm‘s product are identical, although we still imagine that each firm produces a product that is
differentiated from all others. [Note: the assumptions about symmetry are made merely for tractability.
7.6 Oligopoly
A market structure characterized by a small number of large firms that dominate the market, selling either
identical or differentiated products, with significant barriers to entry into the industry. This is one of four
basic market structures. The other three are perfect competition, monopoly, and monopolistic competition.
Oligopoly dominates the modern economic landscape, accounting for about half of all output produced in
the economy. Oligopolistic industries are as diverse as they are widespread, ranging from breakfast cereal
to cars, from computers to aircraft, from television broadcasting to pharmaceuticals, from petroleum to
detergent. Oligopoly is a market structure characterized by a small number of relatively large firms
that dominate an industry. The market can be dominated by as few as two firms or as many as
twenty, and still be considered oligopoly. With fewer than two firms, the industry is monopoly.
As the number of firms increase (but with no exact number), oligopoly becomes monopolistic
competition.
Because an oligopolistic firm is relatively large compared to the overall market, it has a substantial degree
of market control. It does not have the total control over the supply side as exhibited by monopoly, but its
capital is significantly greater than that of a monopolistically competitive firm.
Relative size and extent of market control means that interdependence among firms in an industry is a key
feature of oligopoly. The actions of one firm depend on and influence the actions of another. Such
interdependence creates a number of interesting economic issues. One is the tendency for competing
oligopolistic firms to turn into cooperating oligopolistic firms. When they do, inefficiency worsens, and
they tend to come under the scrutiny of government. Alternatively, oligopolistic firms tend to be a prime
source of innovations, innovations that promote technological advances and economic growth.
Like much of the imperfection that makes up the real world, there is both good and bad with oligopoly.
The challenge in economics is, of course, to promote the good and limit the bad.
7.6.1 Characteristics of Oligopoly

The three most important characteristics of oligopoly are:
(1) An industry dominated by a small number of large firms
(2) Firms sells either identical or differentiated products
(3) The industry has significant barriers to entry.
Small Number of Large Firms: a small number of large firms, each of which is relatively large
compared to the overall size of the market, dominate an oligopolistic industry. This generates
substantial market control, the extent of market control depending on the number and size of the firms.
Identical or Differentiated Products: Some oligopolistic industries produce identical products, while
others produce differentiated products. Identical product oligopolies tend to process raw materials or
intermediate goods that are used as inputs by other industries. Notable examples are petroleum, steel,
and aluminium. Differentiated product oligopolies tend to focus on consumer goods that satisfy the
wide variety of consumer wants and needs. A few examples of differentiated oligopolistic industries
include automobiles, household detergents, and computers.
Barriers to Entry: Firms in a oligopolistic industry attain and retain market control through barriers to
entry. The most common barriers to entry include patents, resource ownership, government franchises,
start-up cost, brand name recognition, and decreasing average cost. Each of these makes it extremely
difficult, if not impossible, for potential firms to enter an industry.
7.6.2 Behaviour of Oligopoly

Although oligopolistic industries tend to be diverse, they also tend to exhibit several behavioural
tendencies:
(1) Interdependence,
(2) Rigid prices,
(3) Nonprime competition,
(4) Mergers, and
(5) Collusion.
Interdependence: Each oligopolistic firm keeps a close eye on the activities of other firms in the industry.
Decisions made by one firm invariably affect others and are invariably affected by others. Competition
among interdependent oligopoly firms is comparable to a game or an athletic contest. One team‘s success
depends not only on its own actions but on the actions of its competitor. Oligopolistic firms engage in
competition among the few.
Rigid prices: Many oligopolistic industries (not all, but many) tend to keep prices relatively constant,
preferring to compete in ways that do not involve changing the price. The prime reason for rigid prices is
that competitors are likely to match price decreases, but not price increases. As such, a firm has little to
gain from changing prices.
Nonprice competition: Because oligopolistic firms have little to gain through price competition, they
generally rely on non-price methods of competition. Three of the more common methods of non-price
competition are:
(a) Advertising
(b) Product differentiation
(c) Barriers to entry.
The goal for most oligopolistic firms is to attract buyers and increase market share, while holding the
line on price.
Mergers: Oligopolistic firms perpetually balance competition against cooperation. One way to pursue
cooperation is through merger--legally combining two separate firms into a single firm. Because
oligopolistic industries have a small number of firms, the incentive to merge is quite high. Doing so then
gives the resulting firm greater market control.
Collusion: Another common method of cooperation is through collusion two or more firms that secretly
agree to control prices, production, or other aspects of the market. When done right, collusion means that
the firms behave as if they are one firm, a monopoly. As such they can set a monopoly price, produce a
monopoly quantity, and allocate resources as inefficiently as a monopoly. A formal method of collusion,
usually found among international produces is a cartel.
Did You Know?

The time during which Monopoly was born and grew up spanned one stock market crash (in 1893) to
another in 1929.
Caution
Avoidance (avoiding price wars) is by far the best policy, but it is advice which may not always be taken if
the benefits seem attractive (which they may also be to competitors).
Case Study-Detergent Wars in India

On the 10th of March 2004, FMCG major Hindustan Lever Ltd. (HLL), the Indian subsidiary of Unilever,
convened an urgent meeting of its dealers. HLL wanted to discuss how to retain the volumes and market
shares in its fabric wash business in view of the price war, which Procter & Gamble (P&G) had unleashed.
In the first week of March 2004, P&G India had drastically slashed the prices of its detergents - Ariel and
Tide. P&G had reduced the price of a 500 gram pack of Ariel from Rs 70 to Rs 50 - a drop of 28 % and the
price of a 500 gram pack of Tide from INR 43 to INR 23 - a fall of 45 %. P&G‘s detergents were expected
to reach customers across India within a week of announcement of the price cuts. Within two days, in swift
retaliation, HLL slashed the price of its premium brand Surf Excel from INR 70 to INR 50 and the price of
Surf Excel Blue from INR 50 to INR 38 for 500 grams. HLL tried to ensure that the products reached the
retail shelves within a day or two of HLL‘s announcement, thus countering P&G‘s first mover advantage.
P&G and HLL were not the only major players in the Indian detergent market. Henkel and Nirma were
also becoming very aggressive. With a shakeout looking imminent, analysts wondered who would emerge
the winner in the long run.
The Indian Detergent Market
The Indian fabric wash products market was a highly fragmented one. There was a sizeable unorganized
sector. Of the 23 lakh-tonne market, laundry soaps and bars made from vegetable oils accounted for around
seven lakh tonnes with synthetic detergents making up the rest.
Washing powders were categorized into four segments - economy (selling at less than INR.25 per kg),
mid-priced (INR.25 - INR. 90 per kg), premium (INR. 90 - INR. 120 per kg) and compact (selling at over
INR. 120 per kg). The compact, premium and medium priced segments together accounted for 20% of the
volume share and 35% of the value share. The economy segment made up the remaining lion‘s share of the
market. The fabric wash industry in India was characterized by low per capita consumption, especially in
rural markets. The major players in the Indian detergent market were HLL, P&G, Nirma and Henkel
(through its joint venture with SPIC, a leading petrochemical company based in the south Indian city of
Chennai).
Evolution of the Indian Detergent Market
The first companies to manufacture detergents in India were HLL and Swastik. HLL test marketed Surf
between 1956 and 1958 and began manufacturing it from 1959. Swastik launched Det, a white detergent
powder, in 1957.
By 1960, Det had made rapid inroads in eastern India. Surf, a blue detergent powder, became the national
market leader with dominant positions in the west, north and south.
In the early 1960s, the total volume of detergents manufactured in India grew from around 1600 tonnes to
8000 tonnes. HLL dominated the market with a share of almost 70 % compared to Det‘s 25%. In 1966,
another player entered the fray. Tata Oil Mills Company (TOMCO) launched its detergent powder
‗Magic‘.
In 1973, TOMCO introduced ‗Tata‘s Tej‘ in the low-priced segment. TOMCO unveiled another economy
detergent powder called OK in 1977
The Detergent Wars
Hindustan Lever Ltd. vs. Nirma
In 2004, HLL was one of the oldest players in the Indian detergents market. The company‘s origin went
back to 1885 when the Lever Brothers set up ―William Hesketh Lever‖, in England.
Procter and Gamble vs. HLL
Procter & Gamble was established in 1837 as a small, family operated soap and candle company in
Cincinnati, Ohio, USA.
Henkel SPIC
Henkel SPIC India Ltd. (HSIL), a 66 % subsidiary of Henkel KgaA, Germany, entered India in 1989.
Detergent was the single largest contributor to the company‘s revenues followed by toilet soaps, talcum
powders and personal grooming products.
HSIL also exported detergents to Taiwan, Oman, Bahrain, Cyprus, Sri Lanka and Mauritius P&G
believed its lean business model would allow it to continue the onslaught. Each of P&G‘s
distributors was doing business worth INR. 65 to 70 crores, with returns on investment in excess
of 25%. The model was so successful that even HLL wanted to emulate it. In late 2003, HLL
appointed two distributors in Mumbai to serve the 300 odd self-service stores in the city.The
company also initiated a pilot project in key urban markets, by putting one distributor in charge of
all its categories - soaps and detergents, personal care, foods and beverages
Questions
1. Explain the reason of Detergent Wars in India.
2. Explain the evolution of the Indian detergent market.
7.7 Summary
A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in
monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less
than the average revenue.
Competitive markets operate on the basis of a number of assumptions. When these assumptions are
dropped we move into the world of imperfect competition.
Monopoly is derived from Greek words ‗mono‘ which means single and ‗poly‘ which means seller. So,
monopoly is a market structure, where there only a single seller producing a product having no close
substitutes.
Oligopoly is a market structure characterized by a small number of large firms that dominate the
market, selling either identical or differentiated products, with significant barriers to entry into the
industry.
Price discrimination or price differentiation exists when sales of identical goods or services are
transacted at different prices from the same provider.
Price wars are good for consumers, who can take advantage of lower prices. Often they are not good
for the companies involved. The lower prices reduce profit margins and can threaten their survival.
The short run the equilibrium market price is determined by the interaction between market demand
and market supply.
7.8 Keywords
Monopolistic Competition: It refers to a market structure that is a cross between the two extremes of
perfect competition and monopoly.
Monopoly: It is a market structure, where there only a single seller producing a product having no close
substitutes.
Oligopoly: A market structure characterized by a small number of large firms that dominate the market,
selling either identical or differentiated products, with significant barriers to entry into the industry.
Price Discrimination: Price discrimination or price differentiation exists when sales of identical goods or
services are transacted at different prices from the same provider. In a theoretical market with perfect
information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-
selling) to prevent arbitrage.
Price Skimming: In price skimming, price varies over time. Typically a company starts selling a new
product at a relatively high price then gradually reduces the price as the low price elasticity segment gets
satiated.
Price War: It is a term used in economic sector to indicate a state of intense competitive rivalry
accompanied by a multi-lateral series of price reduction.
Transfer Pricing: Transfer pricing is the price that is assumed to have been charged by one part of a
company for products and services it provides to another part of the same company, in order to calculate
each division‘s profit and loss separately.

1. When production is owned, controlled and managed by the individual or private body or private
organization, it is called …………
(a) legal monopoly (b) private monopoly
(c) public monopoly (d) simple monopoly
2 When production is owned, controlled and managed by government, it is called ….............

3 When monopoly exists on account of trademarks, patents, copy rights, statutory regulation of
government etc., it is called………….
4 When there are large numbers of firms in the market selling differentiated products which are close
substitute of each other it is known as.
(a) Monopoly (b) Monopolistic Competition
(c) Oligopoly (d) None of these.
5 There is only one buyer of the product/service; the other characteristics are same as monopoly, is
called…………….
(a) Monopoly (b) Duopoly
(c) Oligopoly (d) Monopsony
6 when sales of identical goods or services are transacted at different prices from the same provider.
Process is called …………
(a) price determination (b) price description
(c) price discrimination (d) contribution
7 The statement ―Transfer Pricing is the price that is assumed to have been charged by one part of a
each division‘s profit and loss separately‖, is
(a) True (b) False
8 The term indicates a state of intense competitive rivalry accompanied by a multi-lateral series of price
reduction, is called………….
(a) price discrimination (b) price war
(c) price description (d) simple monopoly
9. Monopolist is a price maker

(a) True (b) False
10. Simple monopoly firm charges a uniform price or single price to all the customers.
(a) True (b) False

1. What is the meaning of market?
2. Write a short note on perfect competition.
3. What is monopoly? Write its type and feature from it.
4. Write about the monopolistic market. What are the characteristics of Monopolistic Market?
5. Write a short note on monopolistic competition.
6. What is the meaning of oligopoly? Writes its characteristics and behaviour.
7. Write a short note on monopolistically competitive industry effects.
8. Discuss the price determination under different market structures.
9. What is transfer pricing?
10. Explain the term market structure and innovation?
Answers for Self-Assessment Questions

1 (b) 2 (c) 3 (a) 4 (b) 5 (d)
6 (b) 7 (a) 8 (b) 9 (a) 10 (a)
8
Pricing Under Various Market
Conditions
CONTENTS
Objectives
Introduction
8.5 Summary
8.6 Keywords
Objectives
Explain about perfect competition
Describe the equilibrium of firm and industry under perfect competition
Explain the price determination under monopoly
Define the price and output
Introduction
Several definitions have been proposed for the term marketing. Each tends to emphasize different issues.
Memorizing a definition is unlikely to be useful; ultimately, it makes more sense to thinking of ways to
benefit from creating customer value in the most effective way, subject to ethical and other constraints that
one may have.
Note that the definitions make several points:
A main objective of marketing is to create customer value.
Marketing usually involves an exchange between buyers and sellers or between other parties.
Marketing has an impact on the firm, its suppliers, its customers, and others affected by the firm‘s
choices.
Marketing frequently involves enduring relationships between buyers, sellers, and other parties.
Processes involved include ―creating, communicating, delivering, and exchanging offerings.”
In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition
on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of
monopolistic and oligopolistic markets where market power can be exercised. Otherwise, the moment the
seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to
the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market
frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for
some degree of differential pricing to different consumers, even in fully competitive retail or industrial
markets. Price discrimination also occurs when the same price is charged to customers which have
different supply costs.
The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower
prices for some consumers and higher prices for others. Output can be expanded when price discrimination
is very efficient, but output can also decline when discrimination is more effective at extracting surplus
from high-valued users than expanding sales to low valued users. Even if output remains constant, price
discrimination can reduce efficiency by misallocating output among consumers.

Competitive markets operate on the basis of a number of assumptions. When these assumptions are
dropped we move into the world of imperfect competition. These assumptions are discussed below:
8.1.1 Assumptions
1. Many suppliers each with an insignificant share of the market this means that each firm is too small
relative to the overall market to affect price via a change in its own supply each individual firm is
assumed to be a price taker.
2. An identical output produced by each firms in other words, the market supplies homogeneous or
standardised products that are perfect substitutes for each other. Consumers perceive the products to be
identical.
3. Consumers have perfect information about the prices all sellers in the market charge so if some firms
decide to charge a price higher than the ruling market price, there will be a large substitution effect
away from this firm.
4. All firms (industry participants and new entrants) are assumed to have equal access to resources
(technology, other factor inputs) and improvements in production technologies achieved by one firm
can spill-over to all the other suppliers in the market.
5. There are assumed to be no barriers to entry and exit of firms in long run which means that the market
is open to competition from new suppliers this affects the long run profits made by each firm in the
industry. The long run equilibrium for a perfectly competitive market occurs when the marginal firm
makes normal profit only in the long term.
6. No externalities in production and consumption so that there is no divergence between private and
social costs and benefits.

A firm is in equilibrium when it has no propensity to modify its level of productivity. It requires neither
extension nor retrenchment. It wants to earn maximum profits in by equating its marginal cost with its
marginal revenue, i.e. MC = MR. Diagrammatically, the conditions of equilibrium of the firm are:
(1) The MC curve must equal the MR curve. This is the first order and essential condition. But this is not a
sufficient condition which may be fulfilled yet the firm may not be in equilibrium.
(2) The MC curve must cut the MR curve from below and after the point of equilibrium it must be above
the MR.
This is the second order condition. Under conditions of perfect competition, the MR curve of a firm
overlaps with the AR curve. The MR curve is parallel to the X axis. Hence the firm is in equilibrium when
MC = MR = AR.
Figure 8.1: The first order cost curve
The first order Figure 8.1, the MC curve cuts the MR curve first at point X. It contends the condition of
MC = MR, but it is not a point of maximum profits for the reason that after point X, the MC curve is
beneath the MR curve. It does not pay the firm to produce the minimum output OM when it can earn huge
profits by producing beyond OM. Point Y is of maximum profits where both the situations are fulfilled.
Amidst points X and Y it pays the firm to enlarges its productivity for the reason that it‘s MR > MC. It will
nevertheless stop additional production when it reaches the OM1 level of productivity where the firm
fulfils both the circumstances of equilibrium. If it has any plants to produce more than OM1 it will be
incurring losses, for its marginal cost exceeds its marginal revenue beyond the equilibrium point Y. The
same finale hold good in the case of straight line MC curve and it is presented in the Figure 8.2.
Figure 8.2: The second order cost curve
An industry is in equilibrium, first when there is no propensity for the firms either to leave or either the
industry and next, when each firm is also in equilibrium. The first clause entails that the average cost
curves overlap with the average revenue curves of all the firms in the industry.
They are earning only normal profits, which are believed to be incorporated in the average cost curves of
the firms. The second condition entails the equality of MC and MR. Under a perfectly competitive industry
these two circumstances must be fulfilled at the point of equilibrium i.e. MC = MR…. (1), AC = AR…. ,
AR = MR. Hence MC = AC = AR. Such a position represents full equilibrium of the industry.
8.2.1 Short Run Equilibrium of the Firm and Industry

Short Run Equilibrium of the Firm:
A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its productivity
and needs to earn maximum profit or to incur minimum losses.
The short run is an epoch of time in which the firm can vary its productivity by changing the erratic factors
of production. The number of firms in the industry is fixed since neither the existing firms can leave nor
new firms can enter it.
Postulations
All firms use standardised factors of production
Firms are of diverse competence
Cost curves of firms are dissimilar from each other
All firms sell their produces at the equal price ascertained by demand and supply of the industry so that
the price of each firm, P (Price) = AR = MR
Firms produce and sell various volumes
The short run equilibrium of the firm can be described with the helps of marginal study and total cost
revenue study.
Marginal Cost, Marginal Revenue analysis – During the short run, a firm will produce only its price
equals average variable cost or is higher than the average variable cost (AVC). Furthermore, if the
price is more than the averages total costs, ATC, i.e. P = AR > ATC the firm will be earning super
normal profits. If price equals the average total costs, i.e. P = AR = ATC the firm will be earning
normal profits or break even.
If price equals AVC, the firm will be incurring losses. If price drops even a little below AVC, the firm
will shut down since in order to produce it must cover at least it‘s AVC through short run. So during
the short run, under perfect competition, affirm is in equilibrium in all the above mentioned
stipulations.
Super normal profits – The firm will be earning super normal profits in the short run when price is
higher than the short run average cost.
Normal Profits = the firm may earn normal profits when price equals the short run average costs.
Total Cost – Total Revenue Analysis – The short run equilibrium of the firm can also be represented
with the help of total cost and total revenue curves. The firm is able to maximise its profits when the
positive discrimination between TR and TC is the greatest.
Short Run Equilibrium of the Industry:

An industry is in equilibrium in the short run when its total output remains steady there being no
propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is also in
equilibrium. For full equilibrium of the industry in the short run all firms must be earning normal profits.
But full equilibrium of the industry is by sheer accident for the reason that in the short rum some firms may
be earning super normal profits and some losses. Even then the industry is in short run equilibrium when
its quantity demanded and quantity supplied is equal at the price which clears the market.

Monopoly is that market form in which a single producer controls the whole supply of a single commodity
which has no close substitute.
From this definition there are two points that must be noted:
Single producer: There must be only one producer who may be an individual, a partnership firm or a joint
stock company. Thus single firm constitutes the industry. The distinction between firm and industry
disappears under conditions of monopoly.
No close substitute: The commodity produced by the producer must have any closely competing
substitutes, if he is to be called a monopolist. This ensures that there is no rival of the monopolist.
Therefore, the cross elasticity of demand between the product of the monopolist and the product of any
other producer must be very low.
A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in
monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less than
the average revenue. In other words, under monopoly the MR curve lies below the AR curve.
The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost.
The producer will continue producer as long as marginal revenue exceeds the marginal cost. At the point
where MR is equal to MC the profit will be maximum and beyond this point the producer will stop
producing.
Figure 8.3 Equilibrium level in monopoly.
It can be seen from the Figure 8.3 that up till OM output, marginal revenue is greater than marginal cost,
but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist will be in
equilibrium at output OM where marginal revenue is equal to marginal cost and the profits are the greatest.
The corresponding price is MP‘ or OP. It can be seen from at output OM, while MP‘ is the average
revenue, ML is the average cost, therefore, P‘L is the profit per unit. Now the total profit is equal to P‘L
(profit per unit) multiply by OM (total output).
In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing.
In the long run, the monopolist can change the size of plant in response to a change in demand. In the long
run, he will make adjustment in the amount of the factors, fixed and variable, so that MR equals not only to
short run MC but also long run MC.

There are two potential costs of free trade in this model. The first cost involves the potential costs of
adjustment in the industry. The second cost involves the possibility that more varieties will increase
transactions costs. Each cost requires modification of the basic assumptions of the model in a way that
conforms more closely to the real world. However, since these assumption changes are not formally
included in the model the results are subject to interpretation.
1. The movement to free trade requires adjustment in the industry in both countries. Although firm output
rises, productive efficiency rises as well. Thus it is possible that each firm will need to lay off resources
labour and capital in moving to free trade.
Even if each firm did not reduce resources it is possible (indeed likely) that some firms will be pushed out
of business in moving to the long-run free trade equilibrium. Now it is impossible to identify which
country firms would closes, however, it is likely to be those firms who lose more domestic customers than
they gain of foreign customers, or firms that are unable or unwilling to adjust the characteristics of their
product to serve the international market rather than the domestic market alone. For firms that close, all of
the capital and labour employed will likely suffer through an adjustment process.
The costs would involve the opportunity cost of lost production, unemployment compensation costs,
search costs associated with finding new jobs, emotional costs of being unemployed, costs of moving, etc.
Eventually these resources are likely to be re-employed in other industries. The standard model assumption
is that this transition occurs immediately and without costs. In reality, however, the adjustment process is
likely to be harmful to some groups of individuals.
2. A second potential cost of free trade arises if one questions the assumption that more variety is always
preferred by consumers. Consider for a moment a product in which consumers seek their ideal variety. A
standard (implicit) assumption in this model is that consumers have perfect information about the prices
and characteristics of the products they consider buying. In reality, however, consumers must spend time
and money to learn about the products available in a market.
For example, when a consumer considers the purchase of an automobile, part of the process involves a
search for information. One might visit dealerships and test drive selected cars, one might purchase
magazines that offer evaluations, and one might talk to friends about their experiences with different autos.
All of these activities involve expending resources time and money and thus represent, what we could call,
a transactions cost to the consumer.
Before we argued that because trade increases the number of varieties available to each consumer, each
consumer is more likely to find a product which is closer to her ideal variety. In this way more varieties
may increase aggregate welfare. However, the increase in the number of varieties also increases the cost of
searching for one‘s ideal variety. More time will now be needed to make a careful evaluation. One could
reduce these transactions costs by choosing to evaluate only a sample of the available products. However,
in this case there might also a rise a psychological cost because of the inherent uncertainty about whether
the best possible choice was indeed made. Thus in welfare would be diminished among consumers to the
extent that there are increased transactions costs because of the increase in the number of varieties to
evaluate.
Did You Know?

The study of actual existing markets made up of persons interacting in space and place in diverse ways is
widely seen as an antidote to abstract and all-encompassing concepts of ―the market‖ and has historical
precedent in the works of Fernand Braudel and Karl Polanyi.
Caution
The unexpected change in ratio of supply and demand can affect the economic value of the company.
Case Study-Microsoft and Monopoly

Case Study of Strategies used by Microsoft to leverage its monopoly position in operating systems in
Internet Browser market
Introduction
Microsoft has monopoly in PC operating systems, Windows operating systems which are used` in more
than 80% of Intel based PC‘s. This market has high technological barriers.
Threat to Microsoft is not from new operating systems but from alternate products such as browsers, which
are new software‘s that can be used with multiple operating systems and can also act as an alternative
platform to which applications can be written. This posed a threat to Windows monopoly and perhaps its
long-term existence.
Initially Microsoft had tried to subdue competition by asking for explicit market sharing agreements with
competitors (such as Netscape). A failure to do so, allegedly, led Microsoft to adopt anti-competitive
strategies. This led to a set of consolidated civil actions against Microsoft in 1994 by the United States
Department of Justice (DOJ) and twenty U.S. states. DoJ alleged that Microsoft abused monopoly power
in its handling of operating system sales and web browser sales.
Issues
The issue central to the case was whether Microsoft was allowed to bundle its flagship Internet Explorer
(IE) web browser software with its Microsoft Windows operating system. Bundling them together is
alleged to have been responsible for Microsoft's victory in the browser wars (specifically Netscape) as
every Windows user was forced to have a copy of Internet Explorer. It was further alleged that this unfairly
restricted the market for competing web browsers (such as Netscape Navigator or Opera) that were slow to
download over a modem or had to be purchased at a store.
Underlying these disputes were questions over Microsoft‘s allegedly anti-competitive strategies – to
impose high entry barriers – including forming restrictive licensing agreements with OEM computer
manufacturers, entering into exclusionary.
Initially Microsoft had tried to subdue competition by asking for explicit market sharing agreements with
competitors (such as Netscape). A failure to do so, allegedly, led Microsoft to adopt anti-competitive
strategies. This led to a set of consolidated civil actions against Microsoft in 1994 by the United States
Department.
Questions
1. What are the roles of Microsoft monopoly in PC operating systems?
2. Discuss the Issues in Microsoft monopoly.
8.5 Summary
A firm is in equilibrium in the short run when it has no propensity to enlarge or contract its
productivity and needs to earn maximum profit or to incur minimum losses.
A firm is in equilibrium when it has no propensity to modify its level of productivity. It requires
neither extension nor retrenchment. It wants to earn maximum profits in by equating its marginal cost
with its marginal revenue, i.e. MC = MR.
An industry is in equilibrium in the short run when its total output remains steady there being no
propensity to enlarge or contract its productivity. If all firms are in equilibrium the industry is also in
equilibrium.
As marketing developed, it took a variety of forms. The marketing can be viewed as a set of functions
in the sense that certain activities are traditionally associated with the exchange process.
Marketing may be narrowly defined as a process by which goods and services are exchanged and the
values determined in terms of money prices.
8.6 Keywords
Firm in Equilibrium: A firm is in equilibrium when it has no propensity to modify its level of
productivity. It requires neither extension nor retrenchment.
Monopolistic Competition: It refers to a market structure that is a cross between the two extremes of
perfect competition and monopoly.
Price Discrimination: Price discrimination or price differentiation exists when sales of identical goods or
services are transacted at different prices from the same provider. In a theoretical market with perfect
information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-
selling) to prevent arbitrage.
Pricing: Pricing is the only part of the marketing mix which brings in revenue. Once a price has been set,
consumers will often show a great deal of resistance to any attempts to change it.
1. In the relationship marketing firms focus on __________ relationships with __________.
a) Short term; customers and suppliers b) Long term; customers and suppliers
c) Short term; customers d) Long term; customers
2. Political campaigns are generally examples of:

a) Cause marketing b) Organization marketing
c) Event marketing d) Person marketing
3. The Coca Cola organisation is an official sponsor of the Olympics. The firm is engaging in:
a) Place marketing b) Event marketing
c) Person marketing d) Organization marketing
4. Today's marketers need...

a) Neither creativity nor critical thinking skills
b) Both creativity and critical thinking skills
c) Critical thinking skills but not creativity
d) Creativity but not critical thinking skills
5. Which of the following is NOT an element of the marketing mix?

a) Distribution b) Product
c) Target market d) Pricing
6. The term "marketing mix" describes:

a) A composite analysis of all environmental factors inside and outside the firm
b) A series of business decisions that aid in selling a product
c) The relationship between firms‘s marketing strengths and its business weaknesses
d) A blending of four strategic elements to satisfy specific target markets
7. Newsletters, catalogues, and invitations to organisation-sponsored events are most closely associated
with the marketing mix activity of:
a) Pricing b) Distribution
c) Product development d) Promotion
8. A marketing philosophy summarized by the phrase "a good product will sell itself" is characteristic of
the _________ period.
a) Production b) Sales
c) Marketing d) Relationship
9. Which of the following factors contributed to the transition from the production period to the sales
period?
a) Increased consumer demand b) More sophisticated production techniques
c) Increase in urbanization d) The Great Depression
10. An organisation with a ______ orientation assumes that customers will resist purchasing products not
deemed essential. The job of marketers is to overcome this resistance through personal selling and
advertising.
a) Production b) Marketing
c) Relationship d) Sales
1. What is the meaning of Pricing under Various market conditions?
2. Write a short note on perfect competition.
3. What is pricing?
4. Write about the monopolistic competition with suitable example.
5. Write a short note on price and output monopolistic competition.
6. Explain the Price determination under monopoly.
7. Write a short note on equilibrium of firm and industry under perfect competition.
8. Discuss the price determination under different market structures.
9. Write a short note on short run equilibrium of the industry
10. Explain the short run equilibrium of the firm with the graph.
Answer for Self Assessment Questions

1 (b) 2 (d) 3 (b) 4 (b) 5 (c)
6 (d) 7 (d) 8 (a) 9 (b) 10 (d)
9
Distribution
CONTENTS
Objectives
Introduction
9.2 Rent
9.8 Summary
9.9 Keywords
Objectives
Describe the marginal productivity theory of distribution
Define concept of rent
Identify the modern theory of rent
Explain wage determination under imperfect
Define bargaining in wage determination
Explain interest: liquidity
Understand preference theory of interest
Introduction
Distribution is the species of Exchange by which produce is divided between the parties who have
contributed to its production. Exchange being divided according as both, or one only, or neither of the
parties have competitors, Distribution is similarly divided. The case in which both parties have competitors
will here be first and principally considered.
The simplest type of this distributive exchange would be of a kind which is effected once for all, without
reference to a series of future productions and exchanges, let it be supposed that on a particular occasion
each out of a number of white men hires one or more black men to assist in catching seals, on the
agreement that each white man shall give his black assistants a certain proportion of the take, the terms
having been settled in an open market in which any one white is free to bid against any other white and any
one black against any other blacks. A conception more appropriate to existing industry is that each white
agrees to pay in exchange for a certain amount of service a definite quantity of produce, not in general
limited to the result of a particular operation. On a particular day less seal may be taken than the employer
has agreed to give the employee for the day. In this case, even if payment is not made till the end of the
day, the employer must pay for help on a particular day in part with seal caught on a previous day. He must
pay altogether out of past accumulations when payment is made before the work is one. When the
employer agrees to pay a definite amount, he cannot expect to gain on each day's transaction, but on an
average of days.
This example is suited to illustrate some general properties of Exchange which attach to Distribution as a
species of Exchange. Such are the laws which connect a change in the supply or demand upon one side of
the market with a change in the advantage resulting from the transaction to the parties on either side. Thus,
competition on both sides being presupposed, a decrease of supply in a technical sense of the term on the
onside is, ceteris paribus, universally attended with detriment to the other side, but is not universally
attended with detriment to the side on which the supply is decreased.(4*) Accordingly, a limitation of
supply on one side may be advantageous to that side, though not to both sides.
The case of Distribution compared with Exchange in general in respect to such limitation of supply has
only this peculiarity, -- that the danger of this policy defeating itself is in the case of Distribution specially
visible and threatening. There is an evident limit to what the black man dealing with the white man can get
in exchange for a certain amount of his service; namely, the total product which that service utilized by the
white man will on an average produce. To be sure, there is here but a case of the general principle that no
one will give more for a thing, whether article of consumption or factor of production, than the equivalent
of its total utility to him, which total diminishes as the quantity of the commodity is reduced. But this limit
is less liable to escape attention when it is fixed by the material conditions of production rather than by the
desires of consumers. Conspicuous warning is given to parties in the position of our black men not to
attempt to benefit themselves by a considerable reduction in their supply of service; for, though they might
possibly obtain a larger proportion, they would probably obtain a smaller portion, of the average product.
The laws which have been stated and other general laws of Exchange are equally true in more complicated
cases of Distribution.

The marginal productivity theory of distribution determines the prices of factors of production. This theory
states that a factor of production is paid price equal to its marginal product. For example a labourer gets his
wage according its marginal product. He is rewarded on the basis of contribution he makes the total output.
Factors of production are demanded because they have productivity. Higher the productivity of a factor,
greater will be its price. Marginal product or otherwise called marginal physical product (MPP) refers to
addition to the total physical product by employing one more unit of a factor.
When MPP is multiplied by price it is called value of marginal product (VMP). Marginal revenue product
(MRP) is the addition made to total revenue by employing an additional unit of a factor. Average revenue
product (ARP) is the average revenue per unit of a factor of production.
Explanation of the Theory:

Marginal productivity theory explains the following facts,
(a) Reward of each factor is equal to its marginal productivity:
Under perfect competition a firm employs various units of a factor up to that point where the price paid to
the factor is equal to. Its marginal productivity. Every producer compares the price with its productivity.
The price paid to a factor is income to it while it is cost to the producer. The point of equilibrium reaches at
that point where MPP=price. If the producer employs less units of factors the productivity will be more
and the cost will be less. Thus in such a case the producer will increase his profit by employing more units
of factors and reaches the equilibrium point. On the other hand if the number of factor employed is more
than the equilibrium level, the cost will be more than the productivity. The producer will lower the units of
factors so long he reaches equilibrium. Thus his profit is maximized at the point of equilibrium
(MRP=MW). In other words a producer will employ the factors only up to the point where the cost of an
additional factor unit equals its marginal revenue.
(b) Reward for each factor is same in every use

Marginal productivity theory assumes that productivity of a factor is equal in all its uses. If the factor cost
in two different uses is not uniform i.e. of the factor cost in one use is greater than other use, factors will
move to that use where the factor cost is high.
This price will continue so long as the productivity of a factor becomes equal in all its uses. Besides this
the marginal productivity of, all factors is the same in a particular use and thus they are the perfect
substitutes of each other. The producer goes on substituting dearer factors by the cheaper factors so long as
the marginal productivity of the factor becomes proportional to their prices. This condition for achieving
equilibrium is stated as follows.
When a producer employees more and more of a factor unit, the marginal physical productivity of
additional factor will start diminishing. That is why Marginal Productivity Curve diminishes after a
particular point of employment of a factor. Since the objective of a firm is to maximize profit, he will
always compare the cost of employing (MR) an additional labourer with the contribution (MP) made by
that additional labourer.
He will go on employing additional factor so long as Marginal factor cost is equal to Marginal
Productivity. The moment the productivity of an additional factor equals the marginal factor cost, he will
stop employing additional factors and thereby his profit is maximized. The equilibrium situation is
explained by the following diagram.
As there is perfect competition in factor market, AFC and MFC are the same. At point Q, AFC (MFC) is
equal to MRP. The number of labourers employed is ON. At point Q the producer attains equilibrium. At
point Q, MFC=MRP. If the producer employees ON1 of factors, the MRP is P1N1, but factor cost is Q" Nr
as Q1N1, < P1N1, the producer will increase additional factors. It he employees ON2 labourers, MRP is
P2N2 and MFC is Q2N2. As Q2N2 > P2N2 he will incur loss. He will reduce the number of labourers. Thus it
is concluded that a producer will get maximum profits in production only if the different factors are so
employed by him that their prices equal their marginal productivity.
Assumptions of the theory

1. Prevalence of perfect competition in factor as well as product market.
2. All factors are identical.
3. Factors are perfect substitute for each other.
4. Factors are perfectly mobile.
5. Perfect divisibility of factors.
6. The theory operates in the long-run.
7. The theory is based on full employment.
Criticism:
(1) Unrealistic assumptions:
The theory is founded on certain unrealistic assumptions like prevalence of perfect competition and they
are perfectly mobile. In reality there assumptions are not found.
(2) Difficulty in the measurement of MRP:

It is difficult to measure marginal revenue productivity of a factor. Marginal revenue productivity is the
addition made to total revenue by employing an additional unit of a factor. But actually it is difficult to get
it. In a large-scale industry if the work of a labourer is decreased, it will have no fall in total production.
(3) Factors are not perfectly identical:

In reality, different units of a factor are not identical. They are heterogeneous and hence cannot be
substituted by one another. Land and capital cannot be substituted for each other. Labour as a factor cannot
be equal in health and efficiency. They are not equally productive.
(4) Reward determines productivity:

The reward of a factor is determined by the factor's marginal productivity. Hence MRP is the cause and
reward is the effect. When a labourer is given higher wages, his living standard will develop and his health
and efficiency will increase. Hence reward is the cause and not the wage.
Caution
If the number of factor employed is more than the equilibrium level, the cost will be more than the
productivity
9.2 Rent
Rent, in economics, the income derived from the ownership of land and other free gifts of nature. The
neoclassical economist, and others after him, chose this definition for technical reasons, even though it is
somewhat more restrictive than the meaning given the term in popular usage. Apart from renting land, it is
of course possible to rent (in other words, to pay money for the temporary use of any property) houses,
automobiles, television sets, and lawn mowers on the understanding that the rented item is to be returned to
its owner in essentially the same physical condition.
The classical economic view

In classical economics, rent was the income derived from the ownership of land and other natural resources
in fixed supply. This definition originated in the 18th century as part of the explanation of the distribution
of income within society. The concern of economic theorists was to explain what determined the share of
each class in the national product.
The income received by landlords as owners of land was called rent. It was observed that the demand for
the product of land would make it profitable to extend cultivation to soils of lesser and lesser fertility, as
long as the addition to the value of output would cover the costs of cultivation on the least fertile acreage
cultivated. On land of greater fertility—―intramarginal land‖—the costs of cultivation per unit of output
would be below that price. This difference between cost and price could be appropriated by the owners of
land, who benefitted in this way from the fertility of the soil—a ―free gift of nature.‖Marginal land (the
least fertile cultivated) earned no rent.
Since, therefore, it was differences in fertility that brought about the surplus for landowners; the return to
them was called differential rent. It was also observed, however, that rent emerged not only as cultivation
was pushed to the ―extensive margin‖ (to less fertile acreage) but also as it was pushed to the ―intensive
margin‖ through more intensive use of the more fertile land. As long as the additional cost of cultivation
was less than the addition to the value of the product, it paid to apply more labour and capital to any given
piece of land until the net value of the output of the last unit of labour and capital hired had fallen to the
level of its incremental cost.
The intensive margin would exist even if all land were of equal fertility, as long as land was in scarce
supply. It can be called scarcity rent, therefore, to contrast it with differential rent. However, because the
return to any factor of production, not only to land, can be determined in the same way as scarcity rent, it
was often asked why the return to land should be given a special name and special treatment. A
justification was found in the fact that land, unlike other factors of production, cannot be reproduced. Its
supply is fixed no matter what its price. Its supply price is effectively zero. By contrast, the supply of
labour or capital is responsive to the price that is offered for it. With this in mind, rent was redefined as the
return to any factor of production over and above its supply price. With the supply price of zero for land,
the whole of its return is rent, so defined.
The return to any other factor may also contain elements of rent, as long as the return stands above the
next-most-lucrative employment open to the factor. For example, a singer‘s employment outside the opera
may bring a great deal less than the opera actually pays. A large part of what the opera pays must therefore
be called rent. The opera singer‘s specific talent may be no reproducible; like land, it is a ―free gift of
nature.‖ A particularly effective machine also, though its supply can be increased in time by productive
effort, may for a period also earn a quasi-rent, until supply has caught up with demand. Where its supply is
artificially restricted by a monopoly, the quasi-rent may in fact continue indefinitely. All monopoly profits,
it has been argued, should therefore be classified as quasi-rent. Once this point has been reached in the
argument, there is perhaps no logical barrier to extending the meaning of rent to cover all property returns.
After all, profits and interest can persist only as long as there is no glut of capital. The possibility of
producing capital would presage such a glut, one that has been staved off only by new scarcities created by
technical progress.
Did You Know

Classical economists of the 18th and 19th centuries divided society into three groups: landlords, labourers,
and businessmen (or the ―moneyed classes‖). This division reflected more or less the socio political
structure of Great Britain at the time.

Ricardo's theory explains why one land commands higher rent than another. But it fails to answer who rent
arises. The modern economist‘ has evolved a theory called the scarcity rent. Scarcity rent is the modified
version of the demand and supply applied to land. According to the modern theory, rent arises due to the
relative scarcity of land in relation to its demand. The greater the demand for land the higher shall be its
rent. Thus Rent is the resultant of the interaction of the forces of demand and supply in relation to land.
The modern theory of rent is also called on the demand and supply theory.
Demand side
The demand for land is derived demand. It is derived from the demand of the products of land. If the
demand for products increases, there will be a corresponding increase in the demand for the use of land.
The demand for a factor depends upon its marginal productivity which is subject to the law of diminishing
marginal productivity.
That is why the demand curve for a factor slopes downward from the left lo the right. The downward
sloping demand curve expresses that more land will be demanded at lower rent. Hence the demand curve
for land slopes downward from left to right.
Supply side
So far as community is concerned the supply land is fixed. Thus increased rent cannot increase supply. Nor
fall in price of land can decrease its supply. Land has alternative i.e. it can be used in several ways. For a
particular industry. So far a particular industry, or firm, the supply of land can be changed it is elastic.
Any individual can get more land. Hence the supply curve of land for an individual industry is having an
"upward slope". Supply of land is negligible. Land represents present mobile. Land represents a case of
perfectly inelastic supply- The rent of d may rise or fall but the supply of land remains the same.
Rent is determined at the point where demand for and supply land intersect each other. This is shown in the
diagram given
'DD' and 'SS' are the demand as well as supply curves o land respectively. At point E the demand for and
supply of land are equal OW is the rent. If the rent is less than OW, the demands for land will- increase.
Since the supply of land is fixed, rent will rise again to OW. If rent rises above OW i.e. OW, then the
demand for land will decrease and bring the rent back to OW.
Did You Know

Modern theory of rent is an improvement or modification over the Ricardian theory of rent. Economists
like Marshall, Mrs. Joan Robinson and Bounding contributed to the ideas of rent which is called modern
theory of rent

Workers are often not hired competitively. In a company town, a firm that is the only or dominant
employer has monopoly power in the local labour market and is referred to as a monopolist. A monopolist
faces the rising market supply curve of labour which indicates that it must pay higher wages to hire more
workers. As a result, the change in the total cost of hiring an additional unit of labour or marginal resource
cost of labour (MRCL) exceeds the wage rate. To maximize total profits, the firm hires labour until MRPL
= MRCL and pays the wage indicated on the supply curve of labour for that quantity of labour.
Example In Table 9.1, columns 1 and 2 are the market supply schedule of labour facing the monopolist.
Column 1 times column 2 gives column 3, which measures the total cost of hiring various quantities of
labour. Column 4 shows the change in total costs in hiring each additional unit of labour or MRCL Note
that MRCL exceeds W.
(1) (2) (3) (4)

Wage Rate Quantity of Total Cost of Marginal Cost of
($) Labour Labour Labour
1 1 1
3
2 2 4
5
3 3 9
7
4 4 16
9
5 5 25
Plotting columns 1 and 2 as SL and columns 2 and 4 us MRCL in Figure and superimposing the firm‘s
MRPL on the same graph, we see that the monopsonist will hire 3 units of labour (given by point F, where
MRPL = MRCL) and pay the wage of $3 (on SL at QL=3).
Caution
Workers are often not hired competitively. In a company town, a firm that is the only or dominant
employer has monopoly power in the local labour market and is referred to as a monopolist

In the standard analyses of wage bargaining, firms and employees bargain without interference from other
job searchers. The negotiating parties are specified a priori. Thus it is impossible to address the question of
how they achieve and retain their bargaining position, on which their bargaining power is based. In the
conventional wage bargaining models, the bargaining power of the negotiators is portrayed either as
exogenously given(Nash bargaining, where the negotiators‘ bargaining power is depicted by a constant
exponent of the Nash product) or by the preferences of the specified negotiators (strategic bargaining,
where bargaining power depends on the negotiators‘ relative rates of time preference or risk aversion). Job
searchers who are not party to the negotiations affectthese wage bargains only through their inuence on the
outside options and fall-back positions of the negotiators.
But what gives the negotiators their privileged negotiating position? Why do firms often choose to
negotiate with their incumbent employees before turning to new recruits? Unless these questions are
tackled, we can gain little insight into the sources of bargaining power, and thus little understanding of the
ultimate determinants of negotiated wages. This paper addresses these questions straightforwardly in a
simple analytical context, where a firm is free to negotiate either with its incumbent employees or with
unemployed job seekers.
Our analysis indicates that, in the presence of unemployment, the ultimate sources of employees‘
bargaining power are labour turnover costs (which, in our analysis, are firing costs and productivity
deferential between incumbent employees and new recruits). The reason is that, in the absence of such
costs, employees could not have any market power; for if they would claim any wage in excess of their
reservation wage, their employers could costless replace them by unemployed job seekers. On this account,
labour turnover costs must play a critical role in the wage bargaining process.
What is the mechanism whereby these costs generate employees‘ bargaining power? Our analysis shows
that labour turnover costs determine the firm‘s degree of substitutability between two alternative sets of
wage negotiations:
(i) those the firm conducts with its incumbent employees (―insiders‖) and
(ii) Those it could conduct with other job seekers(―outsiders‖). In other words, the turnover costs
determine the degree of interdependence between the firm-insider bargains and the firm-outsider
bargains. It is only when these bargains are imperfect substitutes that incumbents may be able to
negotiate wages in excess of their reservation wage.
Specifically, consider a firm facing unemployed job seekers who behave atomistic ally, and suppose that
the firm makes its employment decisions unilaterally. The greater are a firm‘s labour turnover costs, ceteris
paribus, the more profitable the firm finds negotiations with an insider relative to those with an outsider,
and consequently the less dependent is an insider on the bargain the employer could have made with an
outsider.
There are only two circumstances in which labour turnover costs do not affect the negotiated wages:(i)
when these costs are zero, so that the two sets of negotiations are perfect substitutes for the firm and
consequently insiders and outsiders become perfect competitors; and (ii)when the costs are prohibitively
high, so that the firm-insider negotiations are independent of the firm-outsider negotiations, thereby
creating a bilateral monopoly between the firm and its insiders.
Between these extremes, the negotiations between the firm and an insider are conducted with a view to the
negotiations that could take place between the firm and an outsider; and the firm-outsider negotiations, in
turn, proceed with a view to the negotiations that occur if the outsider eventually turns into an insider. In
this interaction between the two sets of negotiations, labour turnover costs may be interpreted as a fee for
switching the employer‘s negotiating partners. It is here, we argue, that the central role of labour turnover
costs in wage bargaining is to be found.

Liquidity is the amount of capital that is available for investment and spending. Most of the capital is credit
rather than cash. That's because the large financial institutions that do most investments prefer using
borrowed money. Even consumers have traditionally preferred credit cards to debit cards, checks or cash.
High liquidity means there is a lot of capital. That usually happens when interest rates are low, and so
capital is easily available. Low interest rates mean credit is cheap, which reduces the risk of borrowing.
That's because the return only has to be higher than the interest rate, so more investments look good. In this
way, high liquidity spurs economic growth. The Federal Reserve manages liquidity by guiding the interest
rate with monetary policy to set the target for the Fed.
A liquidity glut develops when there is too much capital looking for too few investments. This can lead to
inflation. As cheap money chases fewer and fewer good investments, whether its houses, gold, or high tech
companies, then the prices of those assets increase. This leads to "irrational exuberance." Investors only
think that the prices will rise, and everyone wants to buy more now so they do not miss any profit.
Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go
defunct and do not pay out their promised return, investors are left holding worthless assets. Panic ensues,
resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before
prices drop further. This is what happened with mortgage-backed securities during the Subprime Mortgage
Crisis. This phase of the business cycle, known as contraction, usually leads to a recession.
Constrained liquidity is the opposite of a liquidity glut. It means there is not a lot of capital available, or
that it's really expensive. It's usually a result of high interest rates. It can also happen when banks and other
lenders are hesitant about making loans. Banks become risk-averse when they already have a lot of bad
loans on their books.
Liquidity Trap
At the bottom of a recession, families and businesses are afraid to spend. They are afraid they will lose
their job, business will fall off, or they would not get loans needed to expand. If there is deflation, they
might also wait for prices to fall further before spending. As people default on their debts, banks need to
hoard cash to write down the bad loans. They become even less likely to lend. As this vicious cycle
continues spiraling downward, the economy is caught in a liquidity trap.
Three things can get the economy out of a liquidity trap.

1. First, prices can fall to such a low point that investors with enough cash start buying, knowing they can
hold onto the asset long enough to outlast the slump. The future reward has become greater than the
risk.
2. Second, a government policy, such as increased defense spending or a interest rate cut, creates
confidence that the government will support economic growth. This can work in a mild recession.
3. Third, a financial innovation can create a totally new market. This happened with the internet boom in
1999.
Business Liquidity
In business and investments, liquidity is how easily an asset can be converted to cash. After the 2008
financial crisis, homeowners found out that houses had little liquidity. That's because the home price fell
below the mortgage owed. Many owners had to allow the home to foreclose, losing all their investment.
Stocks are more liquid. At least if a stock becomes worth less than you paid, you could deduct the loss on
your taxes. Furthermore, you can pretty much always find someone to buy it, even if it's only pennies on
the dollar. During the depths of the recession, some homeowners found that they could not sell their home
for any amount of money.
Businesses use liquidity ratios to measure their financial health. The three most important are:
1. Current Ratio- the company's current assets divided by its current liabilities. It determines whether a
company could pay off all its short-term debt with the money it got from selling its assets.
2. Quick Ratio- The same as the current ratio, only using just cash, accounts receivable and stocks/bonds.
The business cannot count its inventory or prepaid expenses that can' be easily sold.
3. Cash Ratio- Like the name implies, the company can only use it cash to pay off its debt. If the cash
ratio is one or greater, that means the business will have no problem paying its debt, and has plenty of
liquidity.
Did You Know

The concept was first developed by John Maynard Keynesin his book The General Theory of Employment,
Interest (1936)

The liquidity preference theory of Interest has been propounded by J.M. Keynes. According to him,
―Interest is the reward for parting with liquidity.‖ In the words of Keynes interest is a monetary
phenomenon. Liquidity means the convenience of holding cash. Liquidity preference means desire to hold
cash. This is inherent in human nature. Everyone in this world likes to have money with him for a number
of purposes. This constitutes his demand for money to hold.
According to Keynes, demand for money or liquidity preference is based on three motives.
1. Transactions Motive
People like to hold some cash in order to meet their daily expenses in the interval between the receipt of
income and its expenditure. Businessmen have also to meet routine expenses of transport, raw materials,
wages etc. The cash held by people under this motive depends upon the level of income and business
activity. The transactions motive is income elastic, but interest inelastic.
2. Precautionary Motive
Every one lays something against a rainy day Future is always uncertain. Hence people require cash to
meet unforeseen contingencies like unemployment, sickness, accident etc. the demand for precautionary
motive depends on the level of income and nature of the people. This motive is also income elastic, but
interest inelastic.
3. Speculative Motive
This motive relates to the demand for money to earn profits. Future is uncertain and unpredictable. Rate of
interest in the market continues changing. No one can guess what turn the change will take. But everybody
hopes with confidence that his guess is likely to be correct. It may or may not be so. Some money therefore
is kept to speculate on these probable changes to earn profit. The demand for cash for the two motives is
limited and is not affected much by the rate of interest. Speculative demand for money and interest are
inversely related. At higher rate of interest people keep less cash, purchase more bonds, and vice versa. At
a very low rate of interest, the liquidity preference of the people is unlimited. This implies that people lend
nothing and keep everything in cash. This is what Keynes calls Liquidity Trap.
Case Study-Florida Distribution Center, Sarasota, Florida

Challenge
The Florida Distribution Center contains about 1,000,000 square feet of cold and dry storage in the 21
million square foot Sarasota industrial submarket. The tenant, Winn-Dixie, declared bankruptcy and
ceased paying rent on this and several other locations owned by a consortium of bond holders, serviced by
Wachovia Bank. The building's location outside the bulk distribution corridor and its design for a single
tenant created significant lease up risk for future owners; it could not be demised to meet the needs of even
the largest local tenants. Wachovia took control of the property at foreclosures in late September 2005 at a
price of $27 million.
The owners required disposition in a time frame of less than six months without contingencies for change
of use.
Strategy
We managed a defined time marketing process, exposing the property to over 11,000 potential purchasers.
We provided access to complete property data on a securewebsite with 35 prospects signing confidentiality
agreements. We worked closely with the Wachovia legal team and with the buyer to facilitate the sale
process.
Services
• Strategic planning before and after the foreclosure;
• Marketing in a defined time period with an intense campaign;
• Website creation, document management and distribution;
• Coordination with servicing bank, legal and property management team; and
• Comprehensive reporting and management of the sale process.
Results
The property went under contract and was sold within three months of the foreclosure.
Back up offers were encouraged and marketing continued to assure a timely closing mitigating re-trade
risk. The bank and the bondholders met their timing and price requirements with $30 million s
Question
1. Describe challenge of florida distribution center?
2. What is the strategy florida distribution center applied to overcome of its challenges?
9.8 Summary
Distribution is the species of Exchange by which produce is divided between the parties who have
contributed to its production
Liquidity is the amount of capital that is available for investment and spending. Most of the capital is
credit rather than cash. That's because the large financial institutions that do most investments prefer
using borrowed money. Even consumers have traditionally preferred credit cards to debit cards, checks
or cash
Rent, in economics, the income derived from the ownership of land and other free gifts of nature.
The demand for land is derived demand. It is derived from the demand of the products of land. If the
demand for products increases, there will be a corresponding increase in the demand for the use of
land.
The marginal productivity theory of distribution determines the prices of factors of production. This
theory states that a factor of production is paid price equal to its marginal product.
9.9 Keywords
Demand: An economic principle that describes a consumer‘s desire and willingness to pay a price for a
specific good or service. Holding all other factors constant, the price of a good or service increases as its
demand increases and vice versa.
Distribution: Distribution is the species of Exchange by which produce is divided between the parties who
have contributed to its production
Marginal Productivity: Change in output that results from changing the labour input by one unit, all other
factors remaining constant.
MPP: Marginal Physical Product (MPP) refers to addition to the total physical product by employing one
more unit of a factor.
MRP: Marginal revenue product (MRP) is the addition made to total revenue by employing an additional
unit of a factor.

1. ............is the species of Exchange by which produce is divided between the parties who have
contributed to its production.
(a) Demand (b) Distribution
(c) Supply (d) None of these.
2. When the........... agrees to pay a definite amount, he cannot expect to gain on each day's transaction,
but on an average of days.
(a) Employer (b) Customer
(c) Consumer (d) None of these.
3. Factors of production are demanded because they have productivity.

(a). True (b). False
4. Under perfect competition a firm employs various units of a factor up to that point where the price paid
to the factor is equal to. Its marginal productivity.
5. The .........of distribution determines the prices of factors of production.

(a) Rent productivity theory (b) Liquidity productivity theory
(c) Marginal productivity theory (d) None of these
6. ..............in economics, the income derived from the ownership of land and other free gifts of nature.
(a) Sale (b) Rent
(c)Buy (d) All of these.
7. It is the amount of capital that is available for investment and spending. Most of the capital is credit
rather than cash..
(a)Liquidity (b) Interest
(c) Both (d) All of these.
8. Liquidity is the amount of capital that is available for investment and spend.
(a)True (b) False
9. ............ use liquidity ratios to measure their financial health

(a) Employee (b) Business
(c)Both (d) none of these.
10. The theory is founded on certain unrealistic assumptions like prevalence of perfect competition and
they are perfectly mobile. In reality there assumptions are not found.
(a) True (b) False

1. What is distribution?
2 Explain marginal productivity theory of distribution.
3. What are assumptions of the marginal productivity theory?
4. What are the criticisms of the marginal productivity theory?
5. What do you mean by rent?
6. Define modern theory of rent.
7. Explain the wage determination under imperfect.
8. What is bargaining in wage determination?
9 Give the definition of liquidity?
10 Explain the preference theory of interest?

1. (b) 2.(a) 3.(a) 4.(a) 5.(c)
6. (b) 7.(a) 8.(a) 9.(b) 10.(a)
10
Concepts of Macro Economics
CONTENTS
Objectives
Introduction
10.6 Summary
10.7 Keywords
Objectives
Understand the definitions and importance of macro economics, growth
Explain the limitations of macro-economics
Describe the macro-economic variables
Define the circular flow of income in two, three, four sector economy
Discuss the relation between leakages and injections in circular flow
Introduction
Macroeconomics (Greek makro = ‗big‘) describes and explains economic processes that concern
aggregates. An aggregate is a multitude of economic subjects that share some common features. By
contrast, microeconomics treats economic processes that concern individuals.
Example: The decision of a firm to purchase a new office chair from company X is not a macroeconomic
problem. The reaction of Austrian households to an increased rate of capital taxation is a macroeconomic
problem.
Why macroeconomics and not only microeconomics? The whole is more complex than the sum of
independent parts. It is not possible to describe an economy by forming models for all firms and persons
and all their cross-effects. Macroeconomics investigates aggregate behaviour by imposing simplifying
assumptions (―assume there are many identical firms that produce the same good‖) but without abstracting
from the essential features.
These assumptions are used in order to build macroeconomic models. Typically, such models have three
aspects: the ‗story‘, the mathematical model, and a graphical representation.
Macroeconomics is ‗non-experimental‘: like, e.g., history, macroeconomics cannot conduct controlled
scientific experiments (people would complain about such experiments and with a good reason) and
focuses on pure observation. Because historical episodes allow diverse interpretations, many conclusions
of macroeconomics are not coercive.
Classical motivation of macroeconomics: politicians should be advised how to control the economy, such
that specified targets can be met optimally. Policy targets: traditionally, the ‗magical pentagon‘ of good
economic growth, stable prices, full employment, external equilibrium, just distribution

10.1.1 Definition of Macro Economics
Macroeconomics can be best understood in contrast to microeconomics which considers the decisions
made at an individual or firm level. Macroeconomics considers the larger picture, or how all of these
decisions sum together. An understanding of microeconomics is crucial to understand macroeconomics. To
understand why a change in interest rates leads to changes in real GDP, we need to understand how lower
interest rates influence decisions, such as the decision of how much to save, at the firm or household level.
Once we understand how an individual, on average, will change their behaviour we will then understand
the large scale relationships in an economy.
10.1.2 Importance of Macro Economics

Economics is the foundation of all commercial activity and comprises two areas: microeconomics and
macroeconomics. Macroeconomics is concerned with the big picture, for example, the national economy
and gross domestic product. By contrast, microeconomics is concerned with the small picture and focuses
on theories of supply and demand. Microeconomics is very important in business.
New Businesses
Entrepreneurs create businesses by purchasing and utilizing factors of production. In order to estimate the
potential return on investment (ROI) of those factors of production, entrepreneurs must have a basic grasp
of microeconomic concepts: supply, demand, cost, profit. Without such a grasp, it is impossible to know
how much a particular good can be sold for in a particular area. Furthermore, without a grasp of costs and
earnings, it is impossible to estimate ROI, thus leading to poor financial investments.
Marketing
Marketing people must have a basic understanding of microeconomics so that they can set prices for
products and decide in which markets to sell those products.
A comprehension of microeconomics enables, say, a computer company marketing manager to advise the
CEO to start allowing instalment payments in case of an economic downturn, thus recovering business
from customers hit hard by the recession. A marketing manager without a sense of economics might not
realize that such options are available.
Management
Managers must understand the concept of ROI when setting salaries for new hires, as employees are
supposed to generate profits for the company. Managers must also have a grasp of microeconomics when
making general budget decisions; a project should not be given a budget that exceeds what the project is
expected to produce in future earnings. These kinds of decisions are based on the microeconomic concepts
of cost, revenue and profit.
Finance and Accounting

Finance people probably use microeconomics more than anyone else in business. Financial analysts use
microeconomic and macroeconomic theories in order to forecast the future value of financial assets -- e.g.,
gold, stocks, and bonds -- and other investments. For example, a securities analyst might use
microeconomic data to determine the change in income of people in a given country, then use the
microeconomic concept of "price elasticity of demand" -- the responsiveness of consumer demand to
changes in consumer income -- to determine whether the price of a given asset will rise or fall in that
country. Accountants use financial ratios that are derived from microeconomics.
10.1.3 Growth
Growing economies provide the means for people to enjoy better living standards and for more of us to
find work. But what is economic growth and how best can a country achieve it?
Defining economic growth

Economic growth is best defined as a long-term expansion of the productive potential of the economy.
Sustained economic growth should lead higher real living standards and rising employment. Short term
growth is measured by the annual % change in real GDP.
Growth and the Production Possibility Frontier

An increase in long run aggregate supply is illustrated by an outward shift in the PPF.
Figure 10.1: Growth and the Production Possibility Frontier
Advantages of Economic Growth

Sustained economic growth is a major objective of government policy – not least because of the benefits
that flow from a growing economy.
Higher Living Standards – for example measured by an increase in real national income per head of
population – see the evidence shown in the chart below
Employment effects: Growth stimulates higher employment. The British economy has been growing since
autumn 1992 and we have seen a large fall in unemployment and a rise in the number of people employed.
Fiscal Dividend: Growth has a positive effect on government finances - boosting tax revenues and
providing the government with extra money to finance spending projects
The Investment Accelerator Effect: Rising demand and output encourages investment in new capital
machinery – this helps to sustain the growth in the economy by increasing long run aggregate supply.
Growth and Business Confidence: Economic growth normally has a positive impact on company profits
and business confidence – good news for the stock market and also for the growth of small and large
businesses.
Rising national income boosts living standards

And an expanding economy provides the impetus for a rising level of employment and a falling rate of
unemployment.
Figure 10 2: Rising national income boosts living standards
Disadvantages of Economic Growth

There are some economic costs of a fast-growing economy. The two main concerns are firstly that growth
can lead to a pickup in inflation and secondly, that growth can have damaging effects on our environment,
with potentially long-lasting consequences for future generations.
Inflation risk: If the economy grows too quickly there is the danger of inflation as demand races ahead of
aggregate supply. Producer then take advantage of this by raising prices for consumers
Environmental concerns: Growth cannot be separated from its environmental impact. Fast growth of
production and consumption can create negative externalities (for example, increased noise and lower air
quality arising from air pollution and road congestion, increased consumption of de-merit goods, the rapid
growth of household and industrial waste and the pollution that comes from increased output in the energy
sector) These externalities reduce social welfare and can lead to market failure. Growth that leads to
environmental damage can have a negative effect on people‘s quality of life and may also impede a
country‘s sustainable rate of growth. Examples include the destruction of rain forests, the over-exploitation
of fish stocks and loss of natural habitat created through the construction of new roads, hotels, retail malls
and industrial estates.

1. Fallacy of Composition
In macro economic analysis the ―fallacy of composition‖ is involved, i.e. aggregate economic behaviour is
the sum total of the economy of individual activities. But what is true of individuals is not necessarily true
to the fiscal entirely. For instance, savings are a private virtue but a public vice. If total savings in the
economy increases, they may initiate a depression unless they are invested. Again, if an individual
depositor withdraws his money from the bank, there is no risk. But if all depositors simultaneously do this,
there will be a run on the banks and the banking system will be affected adversely.
2. To Regard the Aggregates as Homogenous
The main defect in macro analysis is that it regards the aggregates as homogenous without caring about
their internal composition and structure. The average wage in a nation is the sum total of wages in all
professions, i.e. wages of clerks, typists, teachers, nurses etc. But the volume of aggregate employment
depends on the relative structure of wages rather than on the average wage. If, for instance, wages of
nurses increase but of typist rises much aggregate employment would increase.
3. Aggregate Variables may not be Important Necessarily

The aggregate variables which form the economic system may not be of much significance. For instance,
the national income of a country is the total of all individual income. A hike in national income does not
mean that individual incomes have risen. The increase in national income might be the result of the
increase in the incomes of a few rich people in the nation. Thus a rise in the national income of this type
has little significance from the point of view of the community.
4. Indiscriminate Uses of Macro Economics Misleading

An indiscriminate and uncritical use of macro economics in analysing the complexities of the real world
can frequently be misleading. For instance, if the policy measures needed to achieve and maintain full
employment in the economy are applied to structural redundancy in individual firms and industries, they
become irrelevant. Likewise, measures aimed at controlling general prices cannot be applied with much
advantage for controlling prices of individual products.
5. Statistical and Conceptual Difficulties

The measurement of macro economics concepts involves a number of statistical and conceptual
complexities. These problems relate to the aggregation of micro economic variables. If individual units are
almost similar, aggregation does not present much difficulty.

The economy always has an impact on marketing--whether it is weak or strong. Interestingly, marketers
may be affected positively or negatively by a strong or weak economy. Making lemons out of lemonade
can benefit certain types of businesses in a weak economy--a strong economy can be negative for others. It
pays to understand the market and the effect the economy will have on them.
Changing Media Impacts Media Buys

The newspaper industry has been reeling over the past few years as consumers have turned online for
information. Fewer readers mean lower demand from advertisers and decreased revenue for print outlets.
The economic effects have resulted in job losses and even the dissolution of some daily papers. Members
of the advertising industry need to keep a close eye on how the economy shifts the consumption of
information--and the emerging role that technology is playing.
Even Good Times Can Be Bad
Oddly enough, even a very strong economy can hurt some types of businesses. Discount stores and fast
food restaurants do well in a down economy, but may not do as well in a healthy economy as consumers
turn to higher-end food providers. In marketing in terms of economic impact is it all depends. It depends
on who the market is and what the marketer is selling.

The circular flow of income and expenditure refers to the process whereby the national income and
expenditure of an economy flow in a circular manner continuously through time. The various components
of national income and expenditure such as saving, investment, taxation, Govt, expenditure, exports,
imports, etc.
flow in the form of currents and cross currents in such a way that national income equal national
expenditure. The circular flow of economic activity is maintained not only in two sector closed economy
but also in three sector economies and four sectors, open economy in which foreign trade is included. In
order to attain the circular flow of economic activity necessary adjustments of transactions in the various
sectors of the economy are made.
The circular flow in a three sector closed economy:

The three sector model of an economy includes government transactions side by side house hold and
business sectors. These three sectors the economy is formed as ―closed economy‖ as foreign transactions
are excluded from it. Thus in a closed economy only three sectors such as households, firms. To arrive at
the national income in a closed economy we combine the income and product of the household sector and
business sector with the income and product of the Govt, sector.
The household sector owns the factors of production viz land, labour and capital. Household sector
receives income by selling the services of factors to the business (firms) sectors. Households are basically
consumer units and their climate aim is to satisfy the wants.
Business sector (firms), on the other hand, employs the factors of production or resources (inputs) and
produces the final output for sale. Business firms take economic resources from households and intern
supply them goods and services. These basic exchanges are known as real flows. Business sector given
money for the purchase of scarce economic resources from the resource market and also receives money
by selling goods and services in the product market. Thus business sector pays for factor services and incur
factor costs and receives income in return.
Government incurs expenditure on goods and services and gets receipts in the firm of taxes. Taxes
constitute an important leakage besides saving. Govt, expenditure on the purchase of goods and services
constitutes an important source of injection. When Govt, takes money in form of taxes, the ability to spend
of the taxpayer is reduced but this is offset through spending more on the purchase of goods and services
called injection. This act of levying taxes (leakage) and incurring public expenditure is called fiscal action.
The working of the three sector closed economy involving Govt, transactions is shown in the diagram
given below.
First of all let us take the circular flow between the household sector and Govt sector. Taxes that includes
both direct tax and commodity tax paid by the household sector constitute leakage firm circular flow. But
Govt purchases the services of the household, makes transfer payments in the fort of old age pensions,
unemployed, relief etc and spends on the social services like education, health, etc. All such expenditures
by the Govt are injections into the circular flow.
The circular flow between the business sector and the Govt sector. All types of taxes paid by the business
sector also constitute leakage from the circular flow. On the other hand Govt purchases final goods from
the business sector, provides subsidies and makes transfer payments to firms in order to help them in
production. These government expenditures are injections into the circular flow.
The inflow and outflow among household, business and government sectors:
Taxation constitutes leakages from the circular flow; it reduces savings and- consumption of the
households. The reduction in consumption leads to decrease in the sales and incomes of the firms. Taxes
on business firms will also curtain investment. The Govt offsets these leakages by making purchases from
business sector and household sectors, thus total sales again equal production of firms. In this way the
circular lows of income and expenditure remain in equilibrium.
In the above diagram taxes are shown to flow out of the house hold and business sectors and go to the
government. Govt makes investment and purchases goods from firms and also factors from households.
This Govt purchases firms an injection in the circular flow of income and taxes are leakages.
If Govt purchases exceed net taxes then the Govt will incur a deficit the difference between taxes precede
and public expenditure. The Govt finances its deficit by borrowing from the capital market which receives
funds from households in the form of saving. On the other hand, if net taxes exceed Govt purchases the
Govt will have a budget surplus. In such a case the Govt reduces the public debt and supplies fund to the
capital market which are received by firms.

10.5.1 Three-sector Injections-leakages Model:
A variation of the Keynesian injections-leakages model that includes the three domestic sectors--the
household sector, the business sector, and the government sector. This model provides an alternative to the
three-sector aggregate expenditures (Keynesian cross) analysis of government stabilization policies,
especially how fiscal policy changes in government purchases and taxes can be used to close recessionary
gaps and inflationary gaps. Equilibrium is identified as the intersection between the S + T line and the I +
G line. Two related variations are the two-sector injections-leakages model and the four-sector injections-
leakages model.
The three-sector injections-leakages model provides an alternative to the more common three-sector
Keynesian model; the Keynesian cross, aggregate expenditures-aggregate production model of the macro
economy. Both models provide essentially the same analysis and are essentially "two sides of the same
coin." The key difference between the two models is that consumption is explicitly eliminated from the
injections-leakages variation. Whereas the Keynesian cross builds on the consumption function, the
injections-leakages model builds on the saving function.
10.5.2 Three Sectors

The three sectors included in this three-sector injections-leakages model are the household sector, the
business sector, and the government sector.
Household Sector: The household sector includes everyone in an economy who consumes goods and
services. It is the entire population of an economy. The household sector is responsible for
consumption expenditures on gross domestic product.
Business Sector: The business sector contains the private, profit-seeking firms in the economy that
combine scarce resources into the production of wants-and-needs satisfying goods and services. The
business sector is responsible for investment expenditures on gross domestic product.
Government Sector: The government sector, or public sector, forces involuntary resource allocation
decisions on the rest of the economy through laws, rules, and regulations. The public sector enters this
model in two ways--by adding government purchases to aggregate expenditures and by subtracting
taxes from aggregate expenditures.
10.5.3 Injections and Leakages

One half of the injections-leakages model is injections, which are non-consumption expenditures on
aggregate production. The three injections are investment expenditures, government purchases, and
exports. These are termed injections because they are "injected" into the core circular flow of consumption,
production, and income. In the three-sector injections-leakages model, investment expenditures and
government purchases are the two injections included.
The other half of the injections-leakages model is leakages, which are non-consumption uses of the income
generated from production. The three leakages are saving, taxes, and imports. These are termed leakages
because they are "leaked" out of the core circular flow of consumption, production, and income. In the
three-sector injections-leakages model, saving and taxes are the two leakages included.
Equilibrium in the injections-leakages model relies on a balance between the injections into the core
circular flow and leakages out of the flow. If leakages match injections, then the volume of the core
circular flow does not change.
This is the same as achieving a balance between the water flowing from a faucet into a sink and that
flowing out through the drain. When these two flows are equal, then the total amount of water IN the sink
does not change. Equilibrium!
In the three-sector injections-leakages model, equilibrium is identified as a balance or equality between the
sum of saving and taxes and the sum of investment expenditures and government purchases.
10.5.4 The Injections-leakages Balance

A balance between injections and leakages generates the same equilibrium as a balance between aggregate
expenditures and aggregate production. A little manipulation of the Y= AE equilibrium condition
illustrates why.
Aggregate expenditures (AE) are the sum of consumption (C), investment (I), and government purchases
(G).
AE = C + I + G
The income generated by aggregate production (Y) is used by the household sector for consumption (C),
saving (S), and taxes (T).
Y=C+S+T
Substituting each of these equations into the Y = AE equilibrium condition gives us:
C+S+T=C+I+G
Because consumption (C) is on both sides, it cancels out.
S+T=I+G
This last equation indicates that equilibrium can be achieved by equating injections I + G with leakages S
+ T. Most importantly, when aggregate expenditures equal aggregate production (Y = AE), then injections
are necessarily equal to leakages S + T = I + G.
This result indicates why the key classical assumption that saving is equal to investment does not
necessarily hold. Saving need not equal investment (if taxes do not equal government purchases) when the
macro economy is equilibrium.
10.5.5 The Graphical Model

The exhibit to the right can be used to present the three-sector injections-leakages model. This diagram
displays the basic two-sector injections-leakages model. Aggregate production is measured on the
horizontal axis. Leakages and injections are measured on the vertical axis. The saving line is labeled S and
the investment line is labelled I.
We now need to add the government sector‘s injection and leakage, starting with government purchases.
Like we did with investment, let us assume that government purchases are autonomous. Using induced
government purchases would not really change the conclusions.
Figure 10.3: The injection Leakages Model
The next addition is taxes, the government sector‘s leakage. For simplicity, let's also presume that taxes are
autonomous.
You should see a new line appear in this diagram, labelled S + T. This line is the sum of saving and taxes
and is derived by adding autonomous taxes, T, to the saving line, S. The slope of the S + T line is parallel
to the saving line, S, and is equal to the marginal propensity to save.
The inclusion of government purchases and taxes gives us the three-sector injections-leakages model.
Equilibrium in this model is found in much the same way as the two-sector model, by equating injections
and leakages. The only difference is the number of injections and leakages included.
More specifically, equilibrium is the level of aggregate production corresponding with the intersection of
the I + G line and the S + T line.
What special insight can be derived from this equilibrium?

First, the equilibrium level of aggregate production depends on the overall height of the lines, but not on
the mix of injections and leakages that make up each line. If, for example, autonomous investment and
government purchases total INR 500 billion, it does not matter if investment is INR 400 billion and
government purchases are INR 100, or if investment is INR 100 billion and government purchases are INR
400, equilibrium is the same.
Second, fiscal policy can be seen as shifts in the I + G line and the S + T line. Expansionary fiscal policy
raises the height of the I + G line and lowers the height of the S + T line. Both of these lead to a greater
level of aggregate production. Contractionary fiscal policy lowers the height of the I + G line and raises the
height of the S + T line. Both of these lead to a smaller level of aggregate production.
Third, comparable to the two-sector model, the vertical difference between the S + T line and I + G line is
unplanned inventory changes. If leakages equal injections, then inventories do not change. If leakages
exceed injections, inventories increase. If injections exceed leakages, inventories decrease.
A key conclusion from this variation of the injections-leakages model is that equilibrium depends on total
injections and leakages. In particular, saving need not equal investment. In fact, saving will not equal
investment if taxes do not equal government purchases. The equality of taxes and government purchases is
a balanced government budget. If the budget is not in balance, then saving is not equal to investment.
Did You Know?

Okun‘s law represents the empirical relationship between unemployment and economic growth.
Caution
If micro economic variables relate to dissimilar individual units, their aggregation into one aggregation
into one macroeconomic variable may be incorrect and hazardous.
Case Study
Macroeconomics is the study of the aggregate performance of the economy. It concentrates on economy-
wide concepts such as national income, gross domestic product, rate of growth of the economy, changes in
unemployment levels, inflation and price levels, which when analysed reveals the overall health of the
economy. Since it is influenced by numerous factors, Macroeconomics is a complicated study when
compared to Microeconomics, which concentrates more on individuals and how they make economic
decisions. In other words, Macroeconomic studies help consumers, businesses and government to make
better economic decisions by forecasting the economic trends.
Macroeconomic Analysis The basic parameters employed to judge the health of an economy are national
output, unemployment and inflation. National Output or GDP: It refers to the total amount of goods and
services produced in a country, and are commonly known as the gross domestic product (GDP). GDP can
be calculated in terms of real GDP, which takes into account inflation, or in terms of nominal GDP, which
reflects only changes in prices. The current GDP would always be an estimated one, deciphered from the
historical figures. The GDP figures can be compared across economies to determine which countries are
economically strong or weak. Apart from this, the analysis of the reasons for a robust GDP growth, such as
government policy, consumer behaviour or international phenomena help business organisations in better
decision-making.
Unemployment: The unemployment rate shows the percentage of people from the available pool of labour
force who are without work. When an economy witnesses a high GDP growth rate, unemployment levels
are relatively low. This is because, in order to sustain the greater levels of production during the period,
more work forces is required.
Inflation: Inflation rate is the indicator of the rate at which prices rise. Inflation can be measured in two
ways: through the Consumer Price Index (CPI) and the GDP deflator. The
CPI is based on the current price of a selected basket of goods and services, while the GDP deflator is the
ratio of nominal GDP to real GDP.
Demand and Disposable Income: The growth of the economy is determined by demand for goods and
services, which is linked to the consumers (consumption or savings), the government (spending on goods
and services of federal employees), and the internationally trade (imports and exports). But demand alone
cannot be depended upon to determine the output levels, because customers may not be able to afford what
they demand. Hence in order to determine the actual demand, the customer‘s disposable income is also
taken into consideration. This is the amount of money left over after paying taxes, for spending and/or
investment.
Demand will determine the supply (production levels) of goods and services within thee economy, but in
order to meet the production levels money is required. To determine how much money is needed in the
economy, the sum of all individual demands is taken into account. For this, the economists look at the
nominal GDP, which measures the aggregate level of transactions. The Central Bank of the country then
regulates the money supply accordingly. Though it is the consumers who ultimately determine the
direction of the economy, governments also influence it through fiscal and monetary policy.
Figure 1: Macroeconomics Polices.

Macroeconomics and Business
Business decisions involve huge parameters, both intrinsic as well as extrinsic. Most of the extrinsic
factors are believed to be influenced by government‘s macroeconomic decisions. Successful businesses
understand how macroeconomic variables, such as economic growth, earnings, unemployment and
inflation, could affect the markets where they operate.
With a large number of companies becoming global companies, global trade and international capital flows
that drive the world economy and force reactive policies from governments, have a far reaching impact on
the business operations.
Questions
1. What do you understand by economy-wide?
2. Discuss the demand and disposable income.
10.6 Summary
Microeconomics tells us about individuals and firms have demand curves for goods and services.
The aggregate demand curve shifts when economic variables change the aggregate demand.
Growth cannot be separated from its environmental impact. Fast growth of production and
consumption can create negative externalities.
Economics is the foundation of all commercial activity and comprises two areas: microeconomics and
macroeconomics.
The main defect in macro analysis is that it regards the aggregates as homogenous without caring
about their internal composition and structure.
10.7 Keywords
Budget: An estimation of the revenue and expenses over a specified future period of time. A budget can be
made for a person, family, group of people, business, government, country, multinational organization or
just about anything else that makes and spends money
Entrepreneurs: An entrepreneur is an enterprising individual who builds capital through risk and/or
initiative.
Macro Economics: Economics is the foundation of all commercial activity and comprises two areas
microeconomics and macroeconomics.
Motivation: Motivation is the psychological feature that arouses an organism to action toward a desired
goal and elicits, controls, and sustains certain goal directed behaviours.

1. Macroeconomics distinguishes between the real economy and the..................
(a) monetary economy (b) virtual economy.
(c) normative economy (d) underground economy
2. During business cycles the opposite of a trough is.............

(a) an inflation (b) a hyperinflation.
(c) a trend (d) a peak
3 In order to influence spending on goods and services in the short-run, monetary policy is directed at
directly influencing......................
(a) unemployment rates (b) .inflation rates.
(c) interest rates (d) .economic growth rates
4. ―Inflation is generally procyclical‖ means......................

a) ―higher rates of inflation tend to precede periods of high economic growth.‖
b) ―the rate of inflation tends to rise in periods of high economic growth and fall in periods of low
economic growth‖.
c) ―prices on average rise in an economic expansion but fall after a business cycle peak.‖
d) ―more inflation results in less capacity utilization.‖
5. Macroeconomics is ‗non-experimental‘.
(a) True (b) False
6. ―Dynamic inefficiency‖ in the context of a model of economic growth mean………………..

a) the economy‘s output per unit labour is below its steady-state value.
b) the economy‘s unemployment rate is too high.
c) the economy‘s steady state is not at the golden-rule steady-state.
d) None of the other answers are correct
7. Economic growth normally has a negative impact on company profits and business confidence – good
news for the stock market and also for the growth of small and large businesses
(a) True (b) False
8. Which of the following would not be a cost of inflation?

(a) Anticipated inflation leads to redistribution between borrowers and lenders.
(b) Random redistributions that occur when relative price fluctuations rise with inflation.
(c) Variable rates of inflation begin to mask the meaning of relative price changes.
(d) The loss of value of money in inflation leads to real costs when households engage in efforts to
economize on their cash holdings.
9. Suppose the market interest rate is equal to 5%. The price of a bond that promises one payment of INR
100 in one year would be equal to:
a) INR 100.00 - 5.00
b) INR 100.00
c) INR 100.00 + INR 5.00
d) INR 100 ÷ 1.05
10. Equilibrium is identified as the intersection between the S + T line and the I + G line.
(a) True (b) False

1. What are the concepts of macro economics?
2. How can you explain definitions and importance of macro economics?
3. What are the limitations of macro-economic?
4. What is the economic growth? Explain it.
5. What are the macro-economic variables?
6. Define the indiscriminate uses of macro economics misleading
7. Explain the circular flow of income in two, three, four sector economy.
8. What is the relation between leakages and injections in circular flow?
9. Explain the relation between leakages and injections in three sectors.
10. Define the graphical model leakages and injections?
1. (a) 2. (d) 3. (d) 4. (b) 5. (a)
6. (d) 7. (b) 8. (a) 9. (d) 10. (a)
11
Macro Market Analysis
CONTENTS
Objectives
Introduction
11.6 Summary
11.7 Keywords
Objectives
Define full employment and income
Describe the classical approach theory of employment
Discuss the Keynes approach
Explain the consumption function
Explain the relationship between saving and consumption
Introduction
The General Theory, Keynes argued that employment is determined by the aggregate demand for goods,
which is in turn determined (in a closed economy) by consumption demand and investment demand.
Consumption depends mainly on the level of real income while investment demand depends on the interest
rate, which is determined by money supply and the demand for money, and by business expectations.
Given expectations and monetary conditions, employment is determined so that output produced is equal
to aggregate demand. The level of employment thus determined might be less than the full employment
level, at which the supply and demand for labour (which depend on the real wage) become equal. He also
examined the aggregate supply side of the economy with a given money wage, and a production function
relating output to employment, which determined the average price level. Keynes argued that the wages
are likely to be rigid downward when unemployment exists because of the concern of workers with their
wage relative to that of others: however, even if wages (and hence the price level) fall, it is unlikely to
increase the level of aggregate demand in the face of uncertainty and the negative effect of falling prices on
the demand for goods by debtors.
Keynes‘s analysis is most simply depicted with the income-expenditure model, in which the axes measure
income and output, Y, and expenditures or demand, E. The line marked C is the consumption function that
shows the relation between consumption and real income, and the line marked C + I + G is aggregate
demand that adds (planned) investment, I, and government expenditure, G, both assumed to be
exogenously given, to it. Equilibrium output, YE, is determined where the aggregate expenditure line
intersects the 45° line so that output equals expenditure. The level of output determines employment,
which may imply unemployment. Fiscal and monetary expansion, by increasing G or I, can increase output
and reduce employment.
Economists such as John Hicks and Franco Modigliani, who were persuaded by Keynes‘s theory, tried to
relate it to pre-Keynesian neoclassical macroeconomic theory in which the economy was generally thought
to be at full employment. A series of models, including the IS-LM and later the aggregate demand–
aggregate supply (AD-AS) models, were developed to produce what has come to be called the neoclassical
synthesis approach to Keynesian economics. This approach, which uses different types of demand and
supply curves and equilibrium condition as in neoclassical theory, implies that unemployment can exist,
due to wage rigidity, in the short run, but in the medium and long runs, in which the wage is flexible, the
economy is at full employment. When unemployment exists, over the medium and longer runs the money
wage falls, which reduces the costs of firms and hence the price level, which reduces the nominal demand
for money. The resulting excess supply of money is used to increase spending on goods (by what is called
the real balance effect), or is lent out, implying a fall in the interest rate and a rise in investment (and
possibly consumption) demand. With rigid wages in the short run, however, this mechanism does not work
itself out, and unemployment can exist. Expansionary fiscal and monetary policy can increase output in the
short run, but only increases the price level in the medium and long runs when the economy is at full
employment.
In the 1960s, after most advanced countries experienced low unemployment for long periods (arguably due
to the success of Keynesian macroeconomic policies), and inflationary pressures began to mount,
alternative approaches to macroeconomics began to emerge. Three of them adopted positions opposed to
Keynesian economics and can be briefly discussed to show what it is not. The first, monetarist, approach
developed by Milton Friedman in 1968 and others returned to the pre-Keynesian idea of flexible wages in
the short run, so that full employment always prevails, but allows changes in aggregate demand to affect
the level of output and employment, because of misperceptions about the effects of aggregate demand
changes, to make it consistent with the facts regarding business cycles. For instance, when money supply
increases, workers find their money wage to be higher, but by not taking into account that the price of
goods is higher too, they supply more labour, which leads to an increase in output.
In the longer run, as workers revise their price expectation, this expansionary effect disappears. According
to this approach, although full employment always prevails due to the flexibility of wages, macro policy
has a temporary effect on real variables due to the misperceptions of the workers. The second also
maintains the assumption of flexible, labour-market clearing wages, but assumes that economic agents do
not make systematic expectation errors as they do in the earlier monetarist approach, and assumes rational
expectations.
This new classical approach developed by Robert Lucas in 1983 and others points out that with agents
having rational expectations in the sense that they use all relevant information about the economy to
calculate price expectations, fiscal and monetary policy (apart from tax policy changes that affect the
supply of labour) are not effective even in the short run, unless the policies‘ changes are random and hence
unanticipated. The third approach, called the real business cycle approach, continues in this tradition, but
explains business cycle fluctuations in terms of technology shocks that affect investment demand and the
interest rate and bring about the inter temporal substitution of labour to explain changes in employment.

According to the classical economists there is full employment in the economy, every job seeker gets the
job in accordance with his capabilities and there is never involuntary unemployment. Moreover, the
resources of the economy are fully employed.
The classical economists believed in Lassies fair economy, there should be no government intervention in
the economic affairs.
In other world, the classical believed in the free enterprise economy. It is told that the classical economists
never presented their model in a refined form. However, the credit goes to modern economists who
integrated classical form. However, the credit goes to modern economists who integrated classical ideas.
The classical model has two pillars. They are Says law of market and quantity theory of money.
The say's law is concerned with the real sector or production sector of the economy. While quantity theory
is linked with, the classical views regarding labour market and credit are also presented. All such means
the classical model is explained with the help of four markets of the economy: Goods market, credit
market, labour market and money market.
A closed private economy where there is no foreign trade and no government, Short run model where
population, capital, technology and organizational knowledge remain the same.
11.1.1 Salient Features

According to Keynes, equilibrium level of NI takes place where aggregate expenditure is equal to
aggregate supply ( aggregate output).
The equilibrium level may be at above the full employment and may be at below the full employment
level. Full employment represents maximum level of output which could be obtained by utilizing all
the natural and human resources of the economy. Thus at the level of full employment AD = AS and
the equilibrium level of NI will be maintained at full employment level.
If at the level of full employment AD > AS, NI will take place above the full employment increased in
AD means more demand for goods + services. So profit of the producer will increase, so investment
also increases, so NI increases. The increases in NI will be only in monetary units. If at the level of full
employment AD < AS, NI will take place below the full employment level. Decreased AD means less
dd for goods + service. So producers profit and will decrease. Hence NI will also decrease and in this
situation unemployment occurs.
Keynes introduced the idea of ―effective demand‖ effective dd represents AS, AD and the level of NI.
According to Keynes higher level of effective demand, higher will be the level of output and
employment. He says effective dd deficiency is responsible for unemployment.
In response to classical utopianism of ―Laissez-faire‖ Keynes is in favour of government intervention
in inflation and deflation also. He is advocating deficit budget and deficit financing which increases
employment and output and also effective dd.
11.1.2 Equilibrium/Basic Thesis of the Model

According to Keynes; the equilibrium level of NI and employment is determined where AD (aggregate
expenditure) = AS (aggregate output) it is as: y= C+1=C+s
So
S=I
Thus we see that there are two approaches to present equilibrium level of NI;
AD = AS method
S = I (Leakage and injection Approach)
Equilibrium level of NI- AD = AS approach
Economy equilibrium level of NI takes place, where AD = AS, where AD=y = C + 1 (aggregate DD y = C
+ 1). AD = in 2-sec services or AD is the national income received by the four factors of production
against their services, such income will be spent by them on consumption goods and an investment goods.
So on one hand AD represents the total income earned is NI while on the other hand AD is total
expenditure (On consumer as well as on producer goods) of the economy.
Along with increase in NI, AD = C + 1. (See figure 11.1)
Figure11.1: Economy equilibrium level
In diagram when NI increases, AD = C + 1 also increases. We also know that at zero level of NI, there are
some fizzed consumption as well as autonomous II,
i.e. c0+L0 as: y=C+s
As: y = C + S consists of total output produced in the economy or AS is that NI which has been produced
by the factors of production produce the goods + services, they get payments against their services.
They will spend a part of such economy or consumption goods and a part will be saved. Thus AS
represents total goods + services produced. On the other hand AS also represents total factor‘s payments
along with increase in output of the economy, the factor‘s payment (AS) also increases. (See Figure 11.2)
Figure 11.2: Increases Diagram
In diagram as the level of NI (produced goods + services) increases, the level of factor‘s carrying also
increase which will be split in to consumption and saving.

The term ‗classical economists‘ was firstly used by Karl Marx to describe economic thought of Ricardo
and his predecessors including Adam Smith. However, by ‗classical economists‘, Keynes meant the
followers of David Ricardo including John Stuart Mill, Alfred Marshal and Pigou.
According to Keynes, the term ‗classical economics‘ refers to the traditional or orthodox principles of
economics, which had come to be accepted, by and large, by the well known economists by then. Being the
follower of Marshal, Keynes had himself accepted and taught these classical principles. But he repudiated
the doctrine of laissez-faire. The two broad features of classical theory of employment were:
(a) The assumption of full employment of labour and other productive resources, and
(b) The flexibility of prices and wages to bring about the full employment
11.2.1 Full employment:
According to classical economists, the labour and the other resources are always fully employed.
Moreover, the general over-production and general unemployment are assumed to be impossible. If there is
any unemployment in the country, it is assumed to be temporary or abnormal. According to classical views
of employment, the unemployment cannot be persisted for a long time, and there is always a tendency of
full employment in the country.
According to classical economists, the reasons for unemployment are:
(i) Intervention by the government or private monopoly,
(ii) Wrong calculation by entrepreneurs and inaccurate decisions, and
(iii) Artificial resistance.
The economy is assumed to be self-adjusting and perfectly competitive economy. It is the economy in
which the relative values of goods and services are determined by the general relations of demand and
supply. The pricing system serves as the planning mechanism.
11.2.2 Flexibility of prices and wages:

The second assumption of full employment theory is the flexibility of prices and wages. It is the flexibility
of prices and wages which automatically brings about full employment. If there is general over-production
resulting in depression and unemployment, prices would fall as a result of which demand would increase,
prices would rise and productive activity will be stimulated and unemployment would tend to disappear.
Similarly, the unemployment could be cured by cutting down wages which would increase the demand for
labour and would stimulate activity. Thus, if the prices and wages are allowed to move freely,
unemployment would disappear and full employment level would be restored. Further, the classical
economists treated money as mere exchange medium. They ignored its role in affecting income, output and
employment.
Say’s Law:
Say‘s Law is the foundation of classical economics. Assumption of full employment as a normal condition
of a free market economy is justified by classical economists by a law known as ‗Say‘s Law of Markets‘.
It was the theory based on which classical economists thought that general over-production and general
unemployment are not possible.
According to the French economist J. B. Say, supply creates its own demand. According to him, it is
production which creates market for goods. More of production, more of creating demand for other goods.
There can be no problem of over-production. Say denies the possibility of the deficiency of aggregate
demand. The conceived Say‘s Law describes an important fact about the working of free-exchange of
economy that the main source of demand is the sum of incomes earned by the various productive factors
from the process of production itself. A new productive process, by paying out income to its employed
factors, generates demand at the same time that it adds to supply. It is thus production, which creates
market for goods, or supply creates its own demand not only at the same time but also to an equal extent.
According to Say, the aggregate supply of commodities in the economy would be exactly equal to
aggregate demand. If there is any deficiency in the demand, it would be temporary and it would be
ultimately equal to aggregate supply. Therefore, the employment of more resources will always be
profitable and will take to the point of full employment.
According to Say‘s Law, there will always be a sufficient rate of total spending so as to keep all resources
fully employed. Most of the income is spent on consumer goods and a par of it is saved. The classical
economists are of the view that all the savings are spent automatically on investment goods. Savings and
investments are interchangeable words and are equal to each other. Since saving is another form of
spending, according to classical theory, all income is spent partly for consumption and partly for
investment.
If there is any gap between saving and investment, the rate of interest brings about equality between the
two.
Basic assumptions of Say‘s Law:
(a) Perfectly competitive market and free exchange economy.
(b) Free flow of money incomes. All the savings must be immediately invested and all the income must be
immediately spent.
(c) Savings are equal to investment and equality must bring about by flexible interest rate.
(d) No intervention of government in market operations, i.e., a laissez faire economy, and there is no
government expenditure, taxation and subsidies.
(e) Market size is limited by the volume of production and aggregate demand is equal to aggregate supply.
(f) It is a closed economy.
11.2.3 Pigou‟s Theory:

According to Professor Pigou, the unemployment which exists at any time is because of the fact that
changes in demand conditions are continually taking place and that frictional resistances prevent the
appropriate wage adjustment from being made instantaneously.
Thus, according to classical theory, there could be small amounts of ‗frictional unemployment‘ attendant
on changing from one job to another but there could not be ‗involuntary unemployment‘ for a long period.
According to Professor Pigou, if people were unemployed, wages would fall until all seeking employment
was in fact employed.
Involuntary unemployment which was found at times of depression was because of the fact that wages
were kept too high by the actions of labour unions and governments. Therefore, Professor Pigou advocated
that a general cut in money wages at a time of depression would increase employment. According to
Pigou, perfectly elastic wage policy would abolish fluctuations of employment and would ensure full
employment.

Keynes has strongly criticized the classical theory in his book ‗General Theory of Employment, Interest
and Money‘. His theory of employment is widely accepted by modern economists. Keynesian economics is
also known as ‗new economics‘ and ‗economic revolution‘. Keynes has invented new tools and techniques
of economic analysis such as consumption function, multiplier, marginal efficiency of capital, liquidity
preference, effective demand, etc. In the short run, it is assumed by Keynes that capital equipment,
population, technical knowledge, and labour efficiency remain constant. That is why, according to
Keynesian theory, volume of employment depends on the level of national income and output. Increase in
national income would mean increase in employment. The larger the national income the larger the
employment level and vice versa. That is why, the theory of Keynes is known as ‗theory of employment‘
and ‗theory of income‘.
11.3.1 Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on aggregate effective demand for
goods in the country. Greater the aggregate effective demand, the greater will be the volume of
employment and vice versa. According to Keynes, the unemployment is the result of deficiency of
effective demand. Effective demand represents the total money spent on consumption and investment.
The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap can be
filled up by increasing investment and hence effective demand, in order to maintain employment at a high
level. According to Keynes, the level of employment in effective demand depends on two factors:
(a) Aggregate supply function, and
(b) Aggregate demand function.
Aggregate supply function:
1. According to Dillard, the minimum price or proceeds which will induce employment on a given scale,
is called the ‗aggregate supply price‘ of that amount of employment.
2. If the output does not fetch sufficient price so as to cover the cost, the entrepreneurs will employ less
number of workers.
3. Therefore, different numbers of workers will be employed at different supply prices.
4. Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to induce
varying quantities of employment.
5. We can have a corresponding aggregate supply price curve or aggregate supply function, which slopes
upward to right.
Aggregate demand function:

1. The essence of aggregate demand function is that the greater the number of workers employed, the
larger the output. That is, the aggregate demand price increases as the amount of employment
increases, and vice versa.
2. The aggregate demand is different from the demand for a product. The aggregate demand price
represents the expected receipts when a given volume of employment is offered to workers.
3. The aggregate demand curve or aggregate demand function represents a schedule of the proceeds of
the output produced by different methods of employment.

The consumption function or propensity to consume refers to. Income consumption relationship. It is a
―functional relationship between two aggregates, i.e., total consumption and gross national income.‖
Symbolically, the relationship is represented as C = f- (Y), where C is consumption, Y is income, and f is
the functional relationship. Thus the consumption function indicates a functional relationship between C
and Y, where C is dependent and Y is the independent variable, i.e., C is determined by Y. This
relationship is based on the ceteris paribus (other things being equal) assumption, as such only income
consumption relationship is considered and all possible influences on consumption are held constant. In
fact, propensity to consume or consumption function is a schedule of the various amounts of consumption
expenditure corresponding to different levels of income. A hypothetical consumption schedule is given in
Table 11.1.
Table 11.1 shows that consumption is an increasing function income because consumption, expenditure
increases with increase in income. Here it is shown that when income is zero during the depression, people
spend out of their past savings on consumption because they must eat in order to live. When income is
generated in the economy to the extent of Rs. 60 crores, it is not sufficient to meet the consumption
expenditure of the community so that the consumption expenditure of Rs. 70 crores is still above the
income amounting to Rs 60 crores. (Rs. 10 crores are dis-saved). When both consumption expenditure and
income equal Rs 120 crores, it is the basic consumption level.
Table11.1: Consumption Schedule

Figure 11.3: Consumption Function
After this, income is shown to increase by 60 crores and consumption by 50 crores. This implies a stable
consumption function during the short-run as assumed by Keynes. The above Figure illustrates the
consumption function diagrammatically.
The income is measured horizontally and consumption is measured vertically. The 45° is the unity-line
where at all levels income and consumption are equal. The C curve is a linear consumption function based
on the assumption that consumption changes by the same amount (Rs 50 crores). Its upward slope to the
right indicates that consumption is an increasing function of income. B is the break-even point where C= Y
or OY1 = OC1. When income rises to 0 YI consumption also increases to OC2, but the increase in
consumption' is less than the increase in income, C1 C2 < Y1 Y2. The portion of income not consumed is
saved as shown by the vertical, distance between 45° line and C curve, i.e., SS‘. Thus the consumption
function measures not only the amount spent on consumption but also the amount saved. This is because
the propensity to save is merely the propensity not to consume. The 45° line may therefore be regarded. As
a zero-saving line, and the shape and position of the C curve indicate the division of income between
consumption and saving.

Consumption and saving decisions are at the heart of both short- and long-run macroeconomic analysis (as
well as much of microeconomics). In the short run, spending dynamics are of central importance for
business cycle analysis and the management of monetary policy. In addition, in the long run, aggregate
saving determines the size of the aggregate capital stock, with consequences for wages, interest rates, and
the standard of living.
Since the pioneering work of Friedman and of Modigliani and Brumberg in the 1950s, the principal goal of
the economic analysis of saving has been to formulate mathematically rigorous theories of behaviour. But
that goal was difficult until recently because the optimal response of saving to uncertainty was difficult to
compute. Research was generally carried out under the assumption that uncertainty might boost saving
somewhat, but that behavior in the presence of uncertainty was likely to be broadly similar to optimal
behavior in a world in which households had perfect foresight about their future circumstances.
The presence of uncertainty could change the nature of optimal behavior in qualitatively and quantitatively
important ways. Specifically, it examined the optimal behavior of consumers with standard attitudes
toward risk (constant relative risk aversion) facing income uncertainty of the kind that appears to exist in
household-level data sources. The target or "buffer-stock" saving may be optimal under some
circumstances; it is found that, depending on households' income profiles and their degree of impatience, it
can be optimal for average household spending patterns to mirror average household income profiles over
much of the life cycle. This was surprising because, in models without uncertainty, optimizing consumers
spend based on their expected lifetime resources without regard to the expected timing of income. That is,
spending patterns by age are not intrinsically y determined by income patterns by age.
In the presence of uncertainty, households with low levels of wealth will respond more to a windfall
infusion of cash than households with ample resources. The other paper demonstrated that the logic of
precautionary saving undermines the standard "Euler equation" method of testing for optimizing
consumption behavior.
Mathematical and computational aspects of optimal behaviour have remained a theme in my research to
the present. The rigorous foundations for the mathematical methods employed in my earlier work. The
theoretical implications of borrowing limitations; and, a very short new paper describes a conceptual trick
that can be used to simplify and accelerate the solution of many kinds of optimal intertemporal choice
models.
In the end, however, mathematical models are useful only insofar as they can be related to empirical
evidence about the real world. Toward the end of matching theory and data, a quantitative sense of the
nature and magnitude of household responses is to uncertainty. A standard source of microeconomic data,
the Panel Study of Income Dynamics, implied that income uncertainty was very large indeed. According to
the benchmark specification, a conservative estimate was that in any given year about a third of households
could expect their "permanent" income to rise or fall by as much as 10%.
An important caveat about these results is that many of the wealthiest households are missing from the
PSID dataset on which the estimates are based. Since a large proportion of aggregate wealth is held by the
richest few percent of households, these estimates very likely overstate the proportion of aggregate wealth
that can be attributed to precautionary motives. Wealthy individuals are assumed to be more patient than
others. A bequest motive in which bequests are a "luxury" good is essential to explaining why saving rates
of wealthy households are so high. The "bequests as luxuries" model can also explain a variety of facts
about the portfolio choices of wealthy households, particularly their comparatively high tolerance for
financial risk.
Another potential problem is that it forced by data limitations to make the assumption that income risk is
something over which people have no control. The likeliest effect would be to underestimate the
importance of precautionary behavior, since the theory tends to suggest that those who dislike risk more
will both avoid risky occupations and save more. But in an attempt to get around this problem, temporary
regional variations in unemployment risk (over which individual households have no control) to measure
the size of uncertainty. Empirical results suggested that precautionary motive s for saving were more
important for people in the upper half of the income distribution, and that precautionary behaviour is
manifested partly in a reluctance to borrow against home equity when unemployment is high, rather than
an explicit accumulation of greater liquid assets.
Did you know?

In the 1990s Franco Modigliani teamed up with Francis Vitagliano to work on a new credit card, and he
also helped to oppose changes to a patent law that would be harmful to inventors.
Caution
If people make employment choices based partly on the riskiness of the different alternatives (for example,
if risk-averse people seek civil service jobs while the risk-lovers become entrepreneurs), then the estimated
effect of uncertainty on saving might be incorrect.
Case Study-Labour, State, and Crisis an Israeli
Michal Kalecki argued forcefully that while the goal of full employment was economically achievable, it
would come aground on political bedrock: the opposition of employers (and consequently the state') to
losing the power hitherto afforded by the presence of a jobless reserve army. Kalecki's prediction is
mirrored, albeit in very different terms, in the Philips Curve assumption of tradeoff between
unemployment and labour "pushfulness."
More recently, though, many observers of the European scene claim to have discerned a seemingly
painless alternative to the discipline of recession for regulating trade union power. This alternative
corporatism involves explicit or implicit bargaining between strong union peak organizations and the state,
in which the unions agree to restrain worker demands and actions in return for supportive public policies.
In addition to the presence of an authoritative union confederation with a broad membership base,
corporatist "political exchange" is thought to be fostered by the stable presence in government of a political
party with strong ties to the union movement. Generalized across nations, the argument is that both the
degree to which labour market conditions approach full employment, and the degree to which trade unions
are oriented to self-restraint and partnership with employers, are a function of just a few institutional and
political variables the scope, unity, and centralization of the unions, the political power of Labour or Social
Democratic parties, and the ties that bind party and union few theoreticians of Social Democratic
corporatism have considered the Israeli case, yet on the face of it Israel ought to provide resounding
confirmation of the theory's predictions. The Histadrut labour center is probably the most broadly based,
monopolistic, and hierarchical to be found in any democratic nation. In politics, until the electoral
turnaround of 1977, the Israeli Labour Party had dominated every Israeli government since independence.
and from a structural perspective, the intimacy between the party and the Histadrut could hardly have been
greater. This paper focuses primarily on Israel's performance with respect to the unemployment variable,
for which the record is at first sight highly supportive of the corporatist hypothesis.
Ever since quarterly labour force surveys (similar to the Current Population Survey) were instituted in
1958, the annual unemployment rate has, with one exception (1966-1967), never risen above 6%. In fact, it
has typically fluctuated between 3 and 4%—a level which, in view of conditions in the "development
towns" on the country's geographical periphery, has been widely perceived as full (or even "overfull")
employment.
This record is all the more impressive given certain structural weaknesses of the Israeli economy and its
vulnerability to debilitating trends in the world economy since the early seventies. On the other hand, the
history of unemployment in Israel also contains a sharp deviation from full employment during the
recession of the mid-sixties, when unemployment rose to doubledigit levels. This was a period in which—
under the stewardship of a Labourdominated government—both Labour and the Histadrut consciously and
even enthusiastically embraced unemployment as a policy instrument to restore discipline to the labour
market.
Questions
1. Brief Discuss about Michal Kalecki.
2. Write short note on ―Kalecki's prediction‖.
11.6 Summary
Keynes argued that the wages are likely to be rigid downward when unemployment exists because of
the concern of workers with their wage relative to that of others.
The classical economists, there is full employment in the economy, every job seeker gets the job in
accordance with capabilities and there is never involuntary unemployment.
Keynes introduced the idea of ―effective demand‖.
Law of Markets the theory based on which classical economists thought that general over-production
and general unemployment are not possible.
Supply creates its own demand, it is production which creates market for goods.
The classical economists are of the view that all the savings are spent automatically on investment
goods.
According to Professor Pigou, if people were unemployed, wages would fall until all seeking
employment was in fact employed.
11.7 Keywords
Aggregate Demand (Ad): It is the total demand for final goods and services in the economy (Y) at a given
time and price level.
Classical Economics: It is widely regarded as the first modern school of economic thought.
Economic Statistics: It is a topic in applied statistics that concerns the collection, processing, compilation,
dissemination, and analysis of economic data.
Monetary Policy: Monetary policy is the process by which the monetary authority of a country controls the
supply of money, often targeting a rate of interest for the purpose of promoting economic growth and
stability.
Gross National Income: It consists of the personal consumption expenditures, the gross private
investment, the government consumption expenditures, the net income from assets abroad (net income
receipts), and the gross exports of goods and services, after deducting two components.

1 ....................is determined so that output produced is equal to aggregate demand.
(a) People (b) Private
(c) Employment (d) None of these
2 The level of employment thus determined might be less than the full....................
(a) legal level (b) employment level
(c) public (d) None of these
3 This new classical approach developed by Robert Lucas in ......................

(a) 1983 (b) 1985
(c) 1987 (d) None of these
4 The ..................believed in Lassies fair economy, there should be no government intervention in the
economic affairs.
(a) Keynes (b) Classical economists
(c) Both(a) and (b) (d) None of these.
5 The ................is concerned with the real sector or production sector of the economy.
(a) Robert Lucas (b) Rechard
(c) say's law (d) None of these
6 Classical economists‘ was firstly used by ...................to describe economic thought of Ricardo and his
predecessors including Adam Smith.
(a) Ricardo (b) Karl Marx
(c) Say's law (d) None of these
7 The statement ―Transfer Pricing is the price that is assumed to have been charged by one part of a
each division‘s profit and loss separately‖, is
(a) True (b) False
8 ........................has strongly criticised the classical theory in his book ‗General Theory of Employment,
Interest and Money‘.
(a) Ricardo (b) Keynes
9. Keynesian economics is also known as ‗new economics‘ and ‗economic revolution‘

(a) True (b) False
10. The consumption function or propensity to consume refers to income consumption relationship.
(a) True (b) False

1. Define the theory of full employment and income.
2. What are the features of theory of full employment?
3. Describe the basic thesis of the model.
4. What are classical approach to employment?
5. How to you define full employment?
6. What is the flexibility of prices and wages?
7. Describe the Keynesian theory of employment.
8. Write short note on Pigou‘s Theory.
9. Describe relationship between saving and consumption.
10. Briefly describe consumption function.

1 (c) 2 (b) 3 (a) 4 (b) 5 (c)
6 (b) 7 (a) 8 (b) 9 (a) 10 (a)
12
Investment Function
CONTENTS
Objectives
Introduction
12.5 Summary
12.6 Keywords
Objectives
Define the concept of marginal efficiency of capital
Explain marginal efficiency of investment
Determine the national income
Understand the money multiplier model
Introduction
Investment function does not provide a detailed survey of investment theories, since space limitations
preclude this and several already exist. Nor does it try to explain why most econometric models based on
these theories have not performed well against datasets recording actual investment outcomes. Our more
modest aim is to examine four classes, and in some cases their sub-classes, of investment function to
demonstrate the presence of a common explanatory. It should come as no surprise that investment is
determined by profitability or, in our formulation, a profitability gap. But investment theory has developed
in diverse and sometimes complex ways from paradigms that embody very different worldviews. This
heterogeneity of approach has generated a rich variety of functions that attempt to encapsulate the motive
forces behind entrepreneurs‘ investment decisions. It is not always readily apparent, however, whether this
diversity of functions has any single factor in common. It demonstrates, through both logical and
mathematical reasoning, that there is:
When a man buys an investment or capital-asset, he purchases the right to the series of prospective returns,
which he expects to obtain from selling its output, after deducting the running expenses of obtaining that
output, during the life of the asset. This series of annuities Q1, Q2 ... Qn it is convenient to call the
prospective yield of the investment.
Over against the prospective yield of the investment we have the supply price of the capital-asset, meaning
by this, not the market-price at which an asset of the type in question can actually be purchased in the
market, but the price which would just induce a manufacturer newly to produce an additional unit of such
assets, i.e. what is sometimes called its replacement cost. The relation between the prospective yield of a
capital-asset and its supply price or replacement cost, i.e. the relation between the prospective yield of one
more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal
efficiency of capital of that type. More precisely, we define the marginal efficiency of capital as being
equal to that rate of discount which would make the present value of the series of annuities given by the
returns expected from the capital-asset during its life just equal to its supply price. This gives us the
marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can
then be regarded as the marginal efficiency of capital in general.
The marginal efficiency of capital is here defined in terms of the expectation of yield and of the current
supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it
were invested in a newly produced asset; not on the historical result of what an investment has yielded on
its original cost if we look back on its record after its life is over.
Thus for each type of capital we can build up a schedule, showing by how much investment in it will have
to increase within the period, in order that its marginal efficiency should fall to any given figure. We can
then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the
rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate
of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the
schedule of the marginal efficiency of capital.
Now it is obvious that the actual rate of current investment will be pushed to the point where there is no
longer any class of capital-asset of which the marginal efficiency exceeds the current rate of interest. In
other words, the rate of investment will be pushed to the point on the investment demand-schedule where
the marginal efficiency of capital in general is equal to the market rate of interest.
The same thing can also be expressed as follows.
If Qr is the prospective yield from an asset at time r, and dr is the present value of £1 deferred r years at the
current rate of interest, ΣQrdr, is the demand price of the investment; and investment will be carried to the
point where ΣQrdr becomes equal to the supply price of the investment as defined above. If, on the other
hand, ΣQrdr, falls short of the supply price, there will be no current investment in the asset in question.
It follows that the inducement to invest depends partly on the investment demand-schedule and partly on
the rate of interest. Will it be possible to take a comprehensive view of the factors determining the rate of
investment in their actual complexity? We would, however, ask the reader to note at once that neither the
knowledge of an asset‘s prospective yield nor the knowledge of the marginal efficiency of the asset enables
us to deduce either the rate of interest or the present value of the asset.
Annual percentage yield earned by the last additional unit of capital. It is also known as marginal
productivity of capital, natural interest rate, net capital productivity, and rate of return over cost. The
significance of the concept to a business firm is that it represents the market rate of interest at which it
begins to pay to undertake a capital investment. If the market rate is 10%, for example, it would not pay to
undertake a project that has a return of 9 1 ⁄ 2 %, but any return over 10% would be acceptable. In a larger
economic sense, marginal efficiency of capital influences long-term interest rates. This occurs because of
the law of diminishing returns as it applies to the yield on capital. As the highest yielding projects are
exhausted, available capital moves into lower yielding projects and interest rates decline. As market rates
fall, investors are able to justify projects that were previously uneconomical. This process is called
diminishing marginal productivity or declining marginal efficiency of capital.
According to Keynes, the marginal efficiency of capital is the prime determinant guiding the capitalist‘s
decisions on investments, the size of which depends on the expected rate of profit. The second determinant
of the capitalist‘s investment decisions is the rate of interest. The capitalist compares the marginal
efficiency of capital and the rate of interest. Investments are made only when the rate of interest on capital
is lower than the expected rate of profit from invested capital. As the gap between these two indicators
increases, the capitalist‘s incentive to invest becomes stronger. Thus, the volume of current investment
depends on the relationship between the marginal efficiency of capital and the rate of interest. An increase
in the rate of interest produces a decrease in the marginal efficiency of capital and a decline in investment.
A decrease in the rate of interest, accompanied by increased availability of credit, produces an increase in
investment.
Keynes assumed that the entrepreneur would expand his investments until the marginal efficiency of
capital fell to the level of the rate of interest. This, however, is an untenable assumption. Keynes believed
that the entrepreneur was using only borrowed capital. In reality, however, to have access to borrowed
capital, the entrepreneur must have his own capital. Therefore, the question of the interest rate can only be
of subordinate importance to him. Moreover, Keynes accepted the law of diminishing returns on capital, a
principle that is widely held in bourgeois political economy. According to this law, as investment
increases, each additional unit of capital brings a decline in the productivity, or efficiency, of capital.
Keynes does not explain why the rate of profit should decline with an increase of capital applied to
production or why, in the final analysis, it must decline to the level of the interest rate.
Keynes‘ theory of the marginal efficiency of capital is a crude, oversimplified attempt to account for the
tendency toward a falling rate of profit, part of the reality of capitalism discovered by K. Marx. Referring
to this tendency as a reduction in the marginal efficiency of capital, Keynes associated it with surplus
capital. In his opinion, an increase in investments results in the creation of new capital goods, which
compete with the old ones. Keynes believed that the expansion of output would inevitably lead to lower
prices, which would reduce the expected profit. This situation would continue until the interest rate was
higher than the marginal efficiency of capital. If, however, the interest rate fell to zero, capital would be
supplied continuously until the market was glutted. At this point, surplus capital (capital with no outlet for
investment) would emerge, and the rate of profit would fall catastrophically.
Keynes offered a distorted analysis of the tendency toward a declining rate of profit a tendency that
operates even under monopoly capitalism. His interpretation fails to make a clear distinction between the
rate and volume of profit, offers an incorrect explanation of the factors causing the rate of profit to fall, and
misrepresents the effect of declining profitability on capitalist accumulation.
Caution
We must ascertain the rate of interest from some other source, and only then can we value the asset by
―capitalizing‖ its prospective yield.

Marginal efficiency of investment is defined below:
Interest Rates and Planned Capital Investment
The Keynesian theory of investment places emphasis on the importance of interest rates in investment
decisions. But other factors also enter into the model - not least the expected profitability of an investment
project.
Changes in interest rates should have an effect on the level of planned investment undertaken by private
sector businesses in the economy.
A fall in interest rates should decrease the cost of investment relative to the potential yield and as result
planned capital investment projects on the margin may become worthwhile. A firm will only invest if the
discounted yield exceeds the cost of the project.
The inverse relationship between investment and the rate of interest can be shown in a figure (See Figure
12.1). The relationship between the two variables is represented by the Marginal Efficiency of Capital
Investment (MEC) curve. A fall in the rate of interest from R1 to R2 causes an expansion of planned
investment.
Figure 12.1: Rate of interest with planned investment
Shifts in the Marginal Efficiency of Capital

Planned investment can change at each rate of interest. For example a rise in the expected rates of return on
investment projects would cause an outward shift in the marginal efficiency of capital curve. This is shown
by a shift from MEC1 to MEC2 in the figure below.
Conversely a fall in business confidence (perhaps because of fears of a recession) would cause a fall in
expected rates of return on capital investment projects. The MEC curve shifts to the left (MEC3) and
causes a fall in planned investment at each rate of interest. (See Figure 12.2)
Figure 12.2: Marginal efficiency of capital.

The Importance of Hurdle Rates for Investment
British firms are continuing to demand rates of return on new investments that are far too high,
undermining industry's ability to re-equip and close the productivity gap with competitor countries
according to a survey by the confederation of British industry. ―Hurdle rates" for major investment projects
are 50% higher than they need to be, while the payback periods required are much shorter than in countries
such as Germany.
The CBI survey of more than 300 firms showed that they expected to earn an internal rate of return
averaging 17% and recover the cost of their investment in two to four years. But experts said that post-tax
real returns of 10% were sufficient to justify most investments. Britain's poor investment record has been a
concern both for the CBI and government ministers. Gordon Brown believes that low investment is one of
the main reasons for sluggish economic performance, and that macroeconomic stability and a tax regime
less biased towards dividends will encourage capital spending. The CBI survey shows that small firms set
the highest hurdle rates averaging 24%. Two thirds of all firms said that projects which failed to meet the
required level of return were seldom or never given the go-ahead
12.2.1 Marginal Efficiency of Investment (MEI) vs. Marginal Efficiency of Capital (MEC)
The MEI curve represents the interest elasticity of demand for investment (or capital goods), or in other
words, how responsive investment is to a change in interest rates. Interest rates represent the cost of
borrowing. Theoretically, the lower the rate of interest, the cheaper it is for firms to finance investment,
and the more profitable the investment will be. Hence, the level of investment will rise. (See Figure 12.3)
Figure 12.3: Rate of interest of MEI.
Keynes, however, suggested that investment is in fact relatively unresponsive to changes in interest rates,
particularly at the extreme ends of the Trade Cycle. During a recession, businessmen are generally
pessimistic about the future outlook and there is also likely to be excessive unused productive capacity,
which prevents a fall in interest rates from stimulating I On the other hand, during a boom, their optimism
may cause them to disregard high interest rates. Hence, MEI is more likely to look like the relatively
inelastic MEI1 than the relatively elastic MEI2.
Keynes instead emphasized the importance of expectations (entrepreneurship mood), which is affected by
the state of the market for their product (which is in turn determined by factors like political stability, cost
of production, conducive business climate etc). The expected rate of returns from investment is measured
by Marginal Efficiency of Capital (MEC).
MEC is a downward sloping curve because, as the firm invests more, MEC will fall due to diminishing
returns (i.e. the first few projects invested in tend to give a higher rate of returns, with subsequent projects
yielding lower and lower returns).(See Figure 12.4)
Figure 12.4: Rate of interest of MEC.
The decision to invest is determined by a comparison of MEC and the opportunity cost of the investment
(i.e. interest rate). As long as the MEC is greater than interest rates, firms will invest more (i.e. the project
is regarded as worthwhile). It will stop investing when the MEC = i/r. Hence, as seen in the above figure, if
interest rates fall from r1 to r2, projects with lower expected returns, seen previously as unprofitable, will
now appear viable, and so, more I will occur. This increases I from I1 to I2.
Increasing optimism translates into higher expected returns and the MEC can shift to the right. Similarly, a
collapse of business confidence causes a downward revision of future returns and the MEC curve shifts to
the left. (See Figure 12.5)
Figure 12.5: MEC curve with rate of interest.

The study of national income is important because of the following reasons:
To see the economic development of the country.
To assess the developmental objectives.
To know the contribution of the various sectors to National Income.
Internationally some countries are wealthy, some countries are not wealthy and some countries are in-
between. Under such circumstances, it would be difficult to evaluate the performance of an economy.
Performance of an economy is directly proportionate to the amount of goods and services produced in an
economy. Measuring national income is also important to chalk out the future course of the economy. It
also broadly indicates people‘s standard of living.
Income can be measured by Gross National Product (GNP), Gross Domestic Product (GDP), Gross
National Income (GNI), Net National Product (NNP) and Net National Income (NNI). In India the Central
Statistical Organization has been formulating national income. However some economists have felt that
GNP has a measure of national income has limitation, since they exclude poverty, literacy, public health,
gender equity and other measures of human prosperity. Instead they formulated other measures of welfare
like Human Development Index (HDI).
Calculating National Income
There are various methods for calculating the national income such as production method, income method,
expenditure method etc.
Production Method
The production method gives us national income or national product based on the final value of the
produce and the origin of the produce in terms of the industry.
All producing units are classified sector wise:
Primary sector is divided into agriculture, fisheries, animal husbandry.
Secondary sector consists of manufacturing.
Tertiary sector is divided into trade, transport, communication, banking, insurance etc.
Income Method
Different factors of production are paid for their productive services rendered to an organization. The
various incomes that includes in these methods are wages, income of self employed, interest, profit,
dividend, rents, and surplus of public sector and net flow of income from abroad.
Expenditure Method
The various sectors the household sector, the government sector, the business sector, either spend their
income on consumer goods and services or they save a part of their income. These can be categorized as
private consumption expenditure, private investment, public consumption, public investment etc.
Calculation of National Income of India: A Brief History

The first attempt to calculate National Income of India was made by Dadabhai Naroji in 1867 -68. This
was followed by several other methods. The first scientific method was made by Prof. V.K.R Rao in 1931-
32. But this was not very satisfactory. The first official attempt was made by Prof. P. C. Mahalnobis in
1948-49, who submitted his report in 1954.
Difficulties in Calculation of National Income

In India there are various difficulties in calculating the national incomes .The most severe one is the
finding of reliable data. Most of the time, it is based on assumptions. Soon after independence the National
Income Committee was formed to collect data and estimate National Income. The two major problems
which remain in the calculation of National Income are:
Most of the data is not from the current year.
Even if current data are available then values are underreported.
Obstacles in High Growth of National Income of India

Even if the Indian economy grows faster than the BRIC countries and G 6, the benefits of the growth
would not be evenly distributed. India‘s progress in education cannot be termed as satisfactory. In terms of
higher education it has achieved tremendous success, but its unsatisfactory performance in primary
education and secondary education has been a major obstacle to growth. Similarly India‘s healthcare
system is in a less than desirable state. Governments‘ spending on public health has not been up to the
required levels.
12.3.1 Keynesian Model of Income Determination in a Two Sector Economy

This model assumes that the aggregate supply curve is perfectly elastic up to the full employment level of
output after which it becomes perfectly inelastic. Hence price level, until the full employment level, will be
determined solely by the height of the supply curve. Hence, the price variable gets less attention while
entire focus is on the determination of equilibrium level of income, which is determined solely by the
aggregate demand.
Aggregate Demand in a Two Sector Economy
The following are the postulations for the above analysis:
The prices are constant or invariable
Given the price level, the firms are willing to sell any amount of the output at that price level
The short run aggregate supply curve is perfectly elastic or flat
Investment is assumed to be autonomous and thus independent of the income level
There exist only two sectors in the economy, the households and the firms
Aggregate demand is the total amount of goods demanded in an economy. The aggregate demand
function can be expressed as:
AD = C + I
Where, C = aggregate demand for consumers goods
I = aggregate demand for investment goods
12.3.2 Determination of equilibrium income or output in a Two Sector Economy

In the most basic terms, an economy can be said to be in equilibrium when the production plans of the
firms and the expenditure plans of the households are realized.
Below are the postulations of the analysis:
There exists only two sectors of the economy; there is no government sector and foreign sector
All the factors of production are owned by the households who sell the factor services to earn an
income. With a part of this income, they purchase goods and services and save the rest
As there is no government in the economy there are no taxes and subsidies and no government
expenditure
As there are no foreign sectors in the economy there are no exports and imports and external inflows
and outflows
As far as the firms are concerned there are no undistributed profits
All the prices are constant and does not change
The technology and the supply of capital are given
According to Keynesian theory, there are two approaches; they are aggregate demand aggregate supply
approach and saving investment approach.

The RBI releases a lot of data on monetary aggregates on a weekly basis. Though, analysing monetary data
is not in fashion anymore, it does throw long term trends. Take the case of money multiplier (MM). It is a
common measure mentioned in most text books. When it comes to practice or seeing research on monetary
policy, we hardly find a mention. With this crisis we expect renewed focus on monetary variables etc. MM
is the amount of money the banking system generates with each rupee of reserves. It works like this.
Say you deposit INR 100 with a bank. Banks are required to maintain a percentage of deposits
collected as cash reserves with central bank.
The central bank imposes this reserve on the bank to manage liquidity situation in an economy. In
India we call this Cash reserve ratio (CRR).
So let us assume CRR is 10%. Then Bank deposits Rs 10 with RBI and lends the Rs 90 to another
customer X.
X takes the loan and says buys machinery from Y. Y takes the payment and deposits the money in his
bank.
The bank again gives the money for credit after netting out the reserves. And the cycle goes on this
manner. So INR 100 of deposit with a bank leads to multiplies of the same amount. This is called
money multiplier.
Measurement of Money Multiplier
It can be measured as: (1+c)/(c+r), where, c is currency-deposit ratio and r is reserve requirement ratio
(CRR in India‘s case).
Currency is currency held by the public for transactions and is given by RBI on a fortnight basis.
A deposit is measured as term deposits at banks and is also given by RBI on a fortnight basis.
Both currency and term deposits form part of the money supply.
We take the ratio of both as people keep part of money as currency and part as deposits. The relation
between currency, term deposit and reserve ration gives us the money multiplier. A reduction in r leads
to an increase in the money multiplier and vice versa.
Did You Know?

Between April 08-Aug-08, multiplier declined from 4.3 to 4.1 levels as RBI increased CRR from 7.5% to
9%.
Case Study-SJF Ventures – Investment

Headquartered in Kennesaw, GA, Ryla provides call centre services and other customer care solutions for
large and medium-sized corporate customers. Service is delivered by a highly
Motivated workforce, which is trained to focus on courtesy and empathy when interacting with customers.
The agents‘ friendly attitude is ideal for clients that strive to differentiate themselves through superior
customer interactions.
Mark Wilson and his wife Shelly founded Ryla in October 2001. Initially the company focused on the
financial services area, maintaining and updating databases for financial service firms such as D&B, for
which Mark Wilson formerly worked as a vice president managing call centres. From the beginning, the
firm worked to create a superior business culture, which also translated into one of the firm‘s mottos,
―excellent interactions every time.‖
The Investment Partnership

In 2002, SJF Ventures provided the first institutional investment in Ryla and followed on with additional
equity infusions in subsequent years. When looking at the investment opportunity, SJF was struck by a
large market, respectable customer traction, innovative workforce policies, and management‘s strong sales
and marketing skills.
Prior to meeting SJF Ventures‘ team, Ryla‘s founder and CEO Mark Wilson was reluctant to accept
venture capital money, but he changed his mind after seeing that SJF‘s positive impact focus aligned with
his own values. "I did not want to take venture capital,‖ said Wilson. ―I thought the VC industry was
predatory. I did not like what it stood for, and I did not think venture capitalists would share my vision. But
the Elpis Group told me about a new type of VC. They introduced us to SJF."
Rapid Growth
SJF‘s initial investment and subsequent financings by SJF, CDVCA and Frontier Capital helped propel
rapid growth at Ryla. Revenues climbed steadily from less than $1.1 million in 2002 to over $100 million
in 2009. The number of employees increased from 20 at the time of SJF‘s investment to more than 3,500
today. This rapid expansion led to national recognition for the company. Ryla has been named one of the
5,000 fastest growing private companies in America by Inc.
Magazine, the fastest growing private company in Atlanta by the Atlanta Business Chronicle, a Top Small
Workplace in the U.S. by The Wall Street Journal, and one of the top 500 African American Owned
Businesses in the U.S. by DiversityBusiness.com.
Workforce Innovation
While Ryla‘s success is aided by a strong operations platform and cutting edge technologies, the
employee-focused culture stands out as the distinctive competitive advantage of the organization.
Workforce innovation strategies include comprehensive recruiting, extensive training, promoting from
within, team-based operations, subsidized meals, a broad-based stock option plan, and attractive health
benefits. Perhaps most importantly, Ryla‘s work environment buzzes with a palpable friendliness and
vibrancy, a tone first established by CEO Mark Wilson.
Creating an atmosphere where our people feel it‘s ―the best job they have ever had‖ is an essential element
of Ryla‘s business model according to Wilson, and employees say that the tone of mutual respect is key to
attracting and retaining a loyal and committed team. Ryla‘s workforce innovation has created employee
retention rates that are twice as high as the industry average and show-up-rates that are well above industry
norms, which is an important differentiator for an industry that may see 25% of its agents not show up to
work on a particular day. Ryla‘s attractive workplace culture also helps the company scale faster than its
competitors when new projects arise. The company‘s own employees often recruit friends to work at Ryla
when the company is ramping for a new project, and new employees are often willing to work for a
onetime project with the hope of becoming a permanent employee at this special company.
SJF Involvement
While serving on the board of Ryla, SJF acted as a sounding board and trusted advisor, which
proved to be especially helpful in the company‘s early days. SJF helped to refine workforce
strategies, especially by helping to implement a broad-based stock option plan that generated strong
financial results for some long-time employees in 2010. SJF assisted in management and board
recruitment and helped to orchestrate additional growth capital from Frontier Capital and CDVCA. SJF
also assisted in arranging lines of credit and public relations connections
Exit
In April 2010, Ryla received a large investment from California-based Alorica, Inc. The extra capital will
help Ryla continue to grow and serve its customers with industry-leading customer interactions. Ryla will
remain a stand-alone entity and continue to be managed by Mark Wilson. Ryla and Alorica together
represent over 10,000 customer care employees located throughout the United States. Both companies are
certified minority business enterprises. As part of the transaction, SJF Ventures and all other investors
realized exits on their investments.
Positive Impacts
Led by Mark Wilson, a talented African American CEO who serves as an inspiration to many, Ryla has
improved the lives of thousands of individuals. Ryla‘s commitment to provide employees with the best job
they have ever had translates into a work environment that is uplifting and inspirational. Furthermore, Ryla
has provided numerous concrete improvements for many entry-level workers. They receive significant
training and benefit from promote-from-within policies. Employees are eligible for health coverage after
their first 90 days of work, and some long-time employees who started at entry level received stock options
that created meaningful value during the recent transaction.
Questions
1. Which types of services are provided by SJF Ventures to the customer?
2. What is the reason of rapid growth of the company? And also explain the impact of this.
12.5 Summary
Investment function does not provide a detailed survey of investment theories, since space limitations
preclude this and several already exist.
The marginal efficiency of capital is defined in terms of the expectation of yield and of the current
supply price of the capital-asset.
The marginal efficiency of capital is the prime determinant guiding the capitalist‘s decisions on
investments, the size of which depends on the expected rate of profit.
Income can be measured by Gross National Product (GNP), Gross Domestic Product (GDP), Gross
National Income (GNI), Net National Product (NNP) and Net National Income (NNI).
The MEI curve represents the interest elasticity of demand for investment (or capital goods), or in
other words, how responsive investment is to a change in interest rates.
12.6 Keywords
Entrepreneur: An entrepreneur is an enterprising individual who builds capital through risk and/or
initiative.
Gross Domestic Product (GDP): It is the market value of all officially recognized final goods and services
produced within a country in a given period.
Gross National Product (GNP): It is the market value of all products and services produced in one year by
labour and property supplied by the residents of a country.
Interest Rate: An interest rate is the rate at which interest is paid by a borrower for the use of money that
they borrow from a lender.
Marginal Efficiency of Capital (MEC): It is that rate of discount which would equate the price of a fixed
capital asset with its present discounted value of expected income.

1. Personal saving:
(a) is that part of personal income that is not consumed
(b) equals income minus consumption
(c) both a and b
(d) neither a nor b
2. Expansionary monetary policy

(a) tends to lead to an appreciation of a nation's currency
(b) usually has no effect on a currency's exchange value
(c) tends to lead to a depreciation of the currencies of other nations.
(d) tends to lead to a depreciation of a nation's currency
3. If the number of people classified as unemployed is 20,000 and the number of people
classified as employed is 230,000, what is the unemployment rate?
(a) 8% (b) 8.7%
(c) 9.2% (d) 11.5%
4. In economics, aggregation refers to

(a) collecting sample specimens for reclassification
(b) using small stones to pave an artistic walkway
(c) combining many markets into one overall economy
(d) using large computers to solve economic problems
5. Real GDP
(a) is nominal GDP adjusted for changes in the price level
(b) is also called nominal GDP.
(c) measures GDP minus depreciation of capital
(d) will always change when prices change
6. If the prices of all goods and services rise during the year
(a) a. real GDP may fall (b) nominal GDP must rise
(c) nominal GDP may increase (d) real GDP must rise
7. The Great Depression of the 1930s led to a revolution in macroeconomic thinking,

following the work of
(a) Arthur Laffer (b) Milton Friedman
(c) Adam Smith (d) John Maynard Keynes
8. When Keynes took the British civil service exam, his lowest score was on the
................. section
(a) a. Logic (b) mathematics
(c) statistics (d) economics
9. Which of the following is a primary cause of periods of recession and economic growth?
(a) inflation (b) unemployment
(c) investment fluctuations (d) None of these
10. Which of the following is not a determinant of investment?

(a) Demand for output produce by the new investment
(b) Interest rates and taxes that influence the costs of the investment
(c) Business expectations
(d) None of the above

1. What do you understand by investment?
2. What is the concept of marginal efficiency of capital?
3. Define the interest rates and planned capital investment.
4. Explain the importance of hurdle rates for investment.
5. Differentiate between marginal efficiency of investment (MEI) and marginal efficiency of capital
(MEC).
6. Write short notes on national income.
7. Explain the Keynesian model of income determination in a two sector economy.
8. What is the money multiplier model?
9. Which types of difficulties occur in calculation of national income?
10. Write short notes on:
(a) GDP (b) GNP (c) MEC

1 (a) 2 (d) 3 (a) 4 (c) 5 (a)
6 (c) 7 (d) 8 (d) 9 (c) 10 (a)
13
Money Market
CONTENTS
Objectives
Introduction
13.6 Summary
13.7 Keywords
Objectives
Understand the functions and forms of money
Explain the demand for money-classical
Discuss the Keynesian and Friedman approach
Explain the measures of money supply
Discovering quantity theory of money, inflation and deflation
Introduction
The demand for money arises from two important functions of money. The first is that money acts as a
medium of exchange and the second is that it is a store. If value. Thus individuals and businesses wish to
hold money partly in cash and paltry in the form of assets.
What explains changes in the demand for money? There are two views on this issue. The first is the "scale"
view which is related to the impact of the Income or wealth level upon the demand for money. The demand
for money is directly related to the income level. The higher the income level, the greater will he the
demand for money. The second is the "substitution" view which is related to relative attractiveness of asset
that can be substituted for money. According to this view, when alternative assets like bonds become
unattractive due to fall in interest rates, people prefer to keep their assets in cash, and the demand for
money increases, and vice versa. The scale and substitution view combined together have been used to
explain the nature of the demand for money which has been split into the transactions demand, the
precautionary demand and the speculative demand.

Money can be defined as any medium which facilitates the exchange of goods and services between
people. Exchange has taken on different forms throughout history, starting with the barter system in the
earliest centuries, where commodities were directly exchanged for each other. During the barter era, people
would trade the things they had, for the things they needed, for example pigs for fabric. Barter suffered
from the major shortcoming of dependence on a ―double coincidence of wants (the pig farmer needing
fabric finding a weaver needing pigs and in roughly the same quantities for exchange). Generally desired
commodities therefore came to serve as intervening means of exchange. (If oxen are generally accepted,
then the pig farmer can exchange pigs for oxen and use oxen to purchase textiles). By social preference,
different countries adopted the use of individual items as a standard for the exchange of goods and
services. Convenience required that such commodities should have the characteristics of durability (unlike
rock salt) divisibility (unlike live oxen) and relative scarcity (unlike leaves in a tropical rainforest). In this
context, precious metals standardized by weight and then coinage came to be used as currency.
13.1.1 Functions of Money

The definition states that money satisfies three basic functions. These are as Follows:
It acts as a medium of exchange
It acts as a unit of account and
It acts as a store of value.
Medium of Exchange
Recalling the example of the barter system, money therefore solves the problem of double coincidence of
wants. As such, money frees up resources to be used in their most productive capacity. In addition, without
money, exchange is limited to only two parties, while money allows for trade among many groups. Thus it
can be said to smooth the flow of goods and services within and among countries. Money has therefore
been purported to be one of the greatest socially evolved phenomena.
Unit of Account
Defining money as a unit of account means that the value of assets and commodities is given in terms of
money. In this case, it provides a reference for the pricing of commodities and therefore a more efficient
exchange system. Money also provides a standard on which to measure the level of profitability of
business ventures. As a unit of account, money can be compared with other standards such as the metric
system, which is used to measure weights and distance. To illustrate the importance of this function, let us
examine a barter economy.
Assuming that only three commodities are traded, fish, rice and soap, then each commodity has two prices,
for example, the price of fish in terms of rice and the price of fish in terms of soap. In that case, each
person in the society would have to remember at least three prices. By extension, if ten commodities are
traded then each person must remember at least forty-five prices. Imagine the confusion involved in
shopping in this environment where individuals are faced with such a range of prices. In a monetary
system however, each item has a unique price, in which case the number of prices quoted is equal to the
number of commodities traded.
Store of Value
As a store of value, money allows individuals to save a portion of their present income for consumption in
the future. In other words money represents a store of wealth from one time period to another. There are
also other assets, such as property and jewellery that function as a store of value. These other assets may
have the advantage of increasing in value over time, while money in the form of notes and coins usually
pays no interest and in times of rapid price increases, it loses value. Notwithstanding, money has the
advantage of being readily accepted as a means of payment. This implies that money is a very liquid asset.
Therefore, the use of money eliminates the cost of converting these other assets into a form which is
generally accepted in the exchange of goods and services.
Caution
As a medium of exchange, the item must be readily accepted as payment for goods purchased or services
rendered.
13.1.2 Features of Money

For an object to serve efficiently as money, it should possess the following features:
It must be widely accepted as a means of payment.
It must be divisible, that is, it must exist in different denominations.
It must be easily identified.
It must not be easily duplicated or counterfeited (i.e. it must be relatively scarce).
It must be easily transported.
It must be durable, allowing it to last for very long periods.
Bank deposits, which are easily transferable, meet these criteria even more efficiently in modern
economies. Deposits have consequently become the largest component of money supply.

The demand for money is affected by several factors, including the level of income, interest rates, and
inflation as well as uncertainty about the future. The way in which these factors affect money demand is
usually explained in terms of the three motives for demanding money: the transactions, the precautionary,
and the speculative motives.
13.2.1Transactions Motive.
The transactions motive for demanding money arises from the fact that most transactions involve an
exchange of money. Because it is necessary to have money available for transactions, money will be
demanded. The total number of transactions made in an economy tends to increase over time as income
rises. Hence, as income or GDP rises, the transactions demand for money also rises.
13.2.2 Precautionary Motive.

People often demand money as a precaution against an uncertain future. Unexpected expenses, such as
medical or car repair bills, often require immediate payment. The need to have money available in such
situations is referred to as the precautionary motive for demanding money.
13.2.3 Speculative Motive.

Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of return
and its opportunity cost. Typically, money holdings provide no rate of return and often depreciate in value
due to inflation. The opportunity cost of holding money is the interest rate that can be earned by lending or
investing one's money holdings. The speculative motive for demanding money arises in situations where
holding money is perceived to be less risky than the alternative of lending the money or investing it in
some other asset. For example, if a stock market crash seemed imminent, the speculative motive for
demanding money would come into play; those expecting the market to crash would sell their stocks and
hold the proceeds as money. The presence of a speculative motive for demanding money is also affected
by expectations of future interest rates and inflation. If interest rates are expected to rise, the opportunity
cost of holding money will become greater, which in turn diminishes the speculative motive for demanding
money. Similarly, expectations of higher inflation presage a greater depreciation in the purchasing power
of money and therefore lessen the speculative motive for demanding money.
The classical economists did not explicitly formulate demand for money theory but their views are inherent
in the quantity theory of money. They emphasized the transactions demand for money in terms of the
velocity of circulation of money. This is because money acts as a medium of exchange and facilitates the
exchange of goods and services. In Fisher's "Equation of Exchange",
MV=PT.
Where M is the total quantity of money, V is its velocity of circulation, P is the price level, and is the total
amount of goods and services exchanged for money. The right hand side of this equation PT represents the
demand for money which, in fact, "depends upon the value of the transactions to be undertaken in the
economy, and is equal to' a constant fraction of those transactions." MV represents the supply of money
which is given and in equilibrium equals the demand for money. Thus the equation becomes
Md=Pt
This transactions demand for money, in turn, is determined by the level of full employment income. This is
because the classicists believed in Say's Law whereby supply created its own demand, assuming the full
employment level of income. Thus the demand for money in Fisher's approach is a constant proportion of
the level of transactions, which in turn, bears a constant relationship to the level of national income.
Further, the demand for money.' is linked to the volume of trade going on in an economy at any time. Thus
its underlying assumption is that people hold money to buy goods. But people also hold money for other
reasons, such as to earn interest and to provide against unforeseen events. It is, therefore, not possible to
say that V will remain constant when M is changed. The most important thing about money in Fisher's
theory is that it is transferable. But it does not explain fully why people hold money. It does 'not clarify
whether to include as money such items as time ,deposits or savings deposits that are not immediately
available to pay debts without ,first being converted into currency. It was the Cambridge cash balance
approach which raised a further question: Why do people actually want to hold their assets in the form of
money? With target incomes, people want to make larger volumes of transactions and that larger cash
balances will, therefore, be demanded. The Cambridge demand equation for money is
Md=Kpy Where Md is the demand for money. Which must equal the supply? To money (Md_Ms) in
equilibrium in tile economy. K is the fraction of the real money income (PY) which people wish to hold in
cash and demand deposits or the ratio, of money stock to income, P is the price level, and Y is the
aggregate. Real income. This equation tells us that "other things being equal, the demand for money in
normal terms would be proportional to the nominal level of income for each individual, and hence for the
aggregate economy as well." Its Critical Evaluation. This approach includes time and saving deposits and
other convertible funds in the demand for, money. It also stresses the importance of factors that make
money more or less useful, such as the costs of holding it, uncertainty about the future and, so on. But it
says little about the nature of the relationships that one expects to prevail between its variables, and it does
not say too much about which ones might be important. One of its major criticisms arises from the neglect
of store of value function of money.
The classicists emphasized only the medium of exchange function of money which simply acted as a go-
between to facilitate buying and selling. For them, money performed a neutral. It was barren, and would
not multiply, if stored in the form of wraith. This was an erroneous view because money performed the
"asset'-' function when it is transformed into other forms of assets like bills, bonds, equities, debentures,
real assets (houses, cars, TV S, and so 'on), etc. Thus the neglect of the asset function of money was the
major weakness of classical approach to the demand

Keynes in his General 'Theory used a new term "liquidity preference" for the demand for money. Keynes
suggested three motives which led to the demand for money in 'an economy:
The transactions demand,
The precautionary, demand,
The speculative demand.
13.3.1 The Transactions Demand for Money

The transactions demand for money arises from the medium of exchange function of money in making
regular payments for goods and services. According to Keynes, it relates to "the need of cash for the
current transactions of personal and business exchange." It is further divided into income and business
motives. The income motive is meant "to bridge the interval between the 'receipt of income and' its
disbursement." Similarly, the business motive is meant "to bridge the interval between, the time of
incurring business costs and, that of the receipt of the sale proceeds." If the time between the incurring, of
expenditure and receipt of income is, small, less cash will be held by the people for current, transactions,
and vice versa. There will, however, be changes in the transitions demand for money depending upon the
expectations of income recipients and businessmen. They depending upon‘ the level of income, the interest
rate, the business turnover, the normal period between _he receipt and disbursement of income, etc' Given
these factors, the transactions demand for money is a direct proportional and positive function of the level
of income, and is expressed as
LT=kY'
Where LT is the transactions demand for money_ k is the proportion of income which is kept for
transactions purposes, and Y is the income. This equation is illustrated in Figure 27.1 where the line kY
represents a linear and proportional relation between transaction1? Demand and the level of income.
Assuming k=1/4 and income Rs 10OO crores, the demand for transactions balances would be Rs 25O,
crores, .at point A. With the increase in income to Rs 1200 crores, the transactions demand would be Rs
300 crores at point Bon the curve kY. If the transactions demand falls due to a change in the institutional
and structural conditions of the economy, the value of k is reduced and the new transactions demand curve
is k'Y. It shows that for income of Rs 1000 and 1200 crores, transactions balances would be Rs 200 and
240 crores at points C and D respectively in the, figure. "Thus we conclude that the chief' Determinant of
changes in the actual amount of the transactions balances held is changes in 'income. Changes in the
transactions balances are result of movements along a line like KY rather than changes in the slope of the
line. In' the equation, changes in transactions balances are the result of changes in Y' ratchet than changes
in k." Interest Rate and Transactions Demand. Regarding the rate of interest as the determinant of the
transactions demand for money Keynes made the L T function interest inelastic. But he pointed out that the
"demand for money in the active circulation is also to some extent a function of the rate of interest, since (a
higher rate of interest may lead to a more economical use of active balances." "How, ever, he did not stress
the role of the rate of interest in this part of his analysis, and many of his popularizes ignored it altogether."
In recent years, two post Keynesian economists William J. Baumo16 and James Tobin1 have shown that
the rate of interest is an important determinant of transactions .demand for, money. They have, also pointed
out that. The relationship between transactions demand for money and income is not linear and
proportional. Rather, changes in income lead to.
Proportionately smaller changes in transactions demand: Transactions balances are held because income
received once a month is not spent on the same day. In fact, an individual spreads his expenditure evenly
over the month. Thus a portion of money meant for transactions purposes can be spent on short-term
interest yielding securities. It is possible to "put funds to work for a matter of days, weeks, or months in
interest-bearing securities such 11M U.S. Treasury bills or commercial paper and, other short-term money
market torments. The problem here is that there is a cost involved in buying and selling. One must weigh
the financial cost and inconvenience of frequent entry to and exit from the market for securities against the
apparent advantage of holding interest-bearing securities in place of idle transactions balances. Among
other things, the cost per purchase and sale, the rate of interest, and the frequency of purchases and sales
determine the profitability of switching from transactions balances to earning assets. Nonetheless, with the
cost per purchase and sale given, there is clearly some rate of interest at which it becomes profitable to
switch what otherwise would be transactions balances Into interest-bearing securities, even if the period for
which these funds may be _pared from transactions needs is measured only in weeks. The higher the
Interest rate, the larger will be the fraction of any given amount of transactions balances that can be
profitably diverted into securities.
The structure of cash and short-term bond holdings. Suppose an individual receives Rs 1200 as income on
the first of every month 'and spends it evenly over the month. The month has four weeks. His saving is
zero. Accordingly, his transactions demand for money in each week is Rs 300. So he has Rs 900 idle
money in the first week, Rs 600 in the second week, and Rs 300 in the third week. He will, therefore,
convert this idle money into interest bearing bonds, as illustrated in Pan. He keeps and spends Rs 300
during the first week and invests Rs 900 in interest-bearing bonds. On the first day of the second week, be
sells bonds worth Rs 300 to cover cash transactions of the second week, and his bond holdings are reduced
to Rs 60b. Similarly, he will sell bonds worth Rs 300 in the beginning of the third and keep the remaining
bonds amounting to Rs 300 which he will sell on the 'first day of the fourth week to meet his expenses for
the last week of the month. The amount of cash held for transactions purposes by the individual during
each week is shown in saw-tooth pattern and the bond holdings in each week. The modern view is that the
transactions demand for money is a function of both income, and interest rates which can be expressed as
LT=f(Y,r). This relationship between income and interest rate and the transactions demand for money for
the economy as a whole is illustrated in Figure 15.3. We Saw above that LT=kY. If Y=Rs 1200 crares and
k=l/4, then LT=Rs 300 crores.
This is shown as Yi curve in Figure 27.3. If the income level rises to Rs 1600 crores, the transactions
demand also increases to Rs 400 crores; given k=1/4.Consequently, the transactions demand curve shifts to
Y2 The transactions demand curves Y, and Y2 are interest-inelastic so long as the rate of interest does not
rise above 8%. As the rate of interest starts rising above the transactions demand for money becomes
interest elastic. It indicates that "given the cost of switching into and out of securities, an interest rate
above 8% is sufficiently high to attract some amount of transaction balances into securities." The backward
slope of the Y. curve shows that at still higher rates, the transaction deI11and for money declines. Thus
when the rate of interest raises to r'2' the transactions demand declines to Rs 250 crores with an income
level of its 1200 crores. Similarly, when the national income is Rs 1600 crares the transactions demand
would decline to Rs 350 crores at r'2 interest rate. Thus the transactions demand for money varies directly
with the level of income and inversely with the rate of interest.
13.3.2 The Precautionary Demand for Money

The precautionary motive relates to "the desire to provide for contingencies requiring sudden expenditures
and for unforeseen opportunities of advantageous purchases." Both individuals 'and' businessmen keep
cash in reserve to meet unexpected needs. Individuals hold some cash to provide for illness, accidents;
unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide
over unfavourable conditions or to gain from unexpected deals. Therefore, "money held under the
precautionary motive is rather like water kept in reserve in a water tank."
The precautionary demand' for money depends upon the level of income, and business activity;
opportunities for unexpected profitable deals, availability of cash, the cost of holding liquid assets in bank
reserves, etc. Keynes held that the precautionary demand for money, like transactions demand, was a
function of the level of income. But the post-Keynesian economists believe that like transactions demand,
it is inversely related to high interest rates. The transactions and precautionary demand for money will be
unstable, particularly if the economy is not at full employment level and transactions are, therefore, less
than the maximum, and are liable to fluctuate up or down. Since precautionary demand, like transactions
demand is a function of income Rnd interest rates, the demand for money for these two purposes
13.3.3The Speculative Demand for Money

The speculative (or asset or liquidity preference) demand for money is for securing profit from knowing
better than the market what the future will bring forth". Individuals and' businessmen having funds, after
keeping enough for transactions and precautionary purposes, like to make a speculative gain by investing
in bonds. Money held for speculative purposes is a liquid store of value which can be invested at an
opportune moment in interest-bearing bonds or securities. Bond prices and the rate of interest are inversely
related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low
interest rates.
'A bond carries a fixed rate of interest. For instance, if a bond of the value at Rs. 100 carries 4% interest
and the market rate of interest rises to 8%, the value of this bond falls to Rs 50 in the market. If the market
rate of interest falls to 2%, the value of the bond will rise to Rs 200 in the market. This can be worked out
with the help of the equation10 V=R/r Where V is the current market value Of a bond, R is the annual
return on the bond, and r is the rate of return currently earned or the market rate of interest. So a bond
worth Rs 100 (V) and carrying a 4% rate; of interest (r), gets an ' annual return (R) of Rs 4, that is, V=Rs
4/0.04=Rs100. When the market rate of interest rises to 8%, then V=Rs 4/0.08=Rs 50; when it fall to 2%,
then V=Rs; 1! 0.02=Rs 200. Thus individuals and businessmen can gain by buying bonds worth Rs 100
each at the market price of Rs 50 each when the rate of interest is high (8%), and sell them again when
they are dearer (Rs 200 each when the rate of interest falls (to 2%). According to Keynes, it is expectations
about changes in bond prices or in the current market rate of interest that determine the speculative demand
for money. In explaining the speculative demand for money, Keynes had a normal or critical rate of
interest (r) in mind. If the current rate of interest (r) is above the ―critical" rate of interest, businessmen
expect it to fall and bond price to rise. They will, therefore, buy bonds to sell them in future when their
prices rise in order to gain thereby. At such times, the speculative demand for money would fall.
Conversely, if the current rate of interest happens to be below the critical rate, businessmen expect it to rise
and bond prices to fall they will, therefore, sell bonds in the present if they have any, and the speculative
demand for money would increase. Thus when r=rc an investor holds all his liquid assets in bonds, and
when r=rc his entire holdings go into money. But when r=re, he becomes indifferent to hold bonds or
money.

This section examines the more frequently used measures of money supply. Money supply is the total
stock of assets that are generally acceptable as media of exchange within an economy at a particular time.
A number of items may qualify as media of exchange. The decision as to what items are to be included in
the money supply remains an issue in economic debates. There is no universally applicable empirical
definition of money supply and the choice may vary dependent on what issue is being examined. There are
varying degrees of liquidity or ‗moneyless‘, depending on how easily an asset can be converted into other
assets. With the most liquid assets being notes and coins established as medium of exchange by legal fiat,
―moneyless‖ of other assets depends on how easily they may be converted to notes and coins.
Furthermore, as the degree of liquidity falls, the distinction between monetary assets and other financial
assets becomes increasingly blurred. Therefore, in this context, the International Monetary Fund (IMF) has
sought to outline standards for the measurement of the amount of money in an economy.
13.4.1 Standard measurements of Money Supply

According to the IMF‘s manual, money supply is measured as the combined deposit liabilities of the
banking system and the currency liabilities of the central bank, both held by households, firms, nonprofits
institutions and all public sector entities outside of the central government. In this official or standard
representation of money supply, there are three monetary aggregates delineated; M0, M1 and M2. M0
includes only currency in the hands of the public, banks‘ statutory reserve deposits held at the central bank
and banks‘ cash reserves. This aggregate represents the monetary liabilities of the central bank and is
usually referred to as the monetary base or reserve money. The second aggregate M1 comprises currency
held outside the banking system and the current account deposit liabilities of commercial banks held for
transitive purposes. It may also include some foreign currency deposits that are used for domestic
transactions. This definition implies that only assets that are directly used in making payments should be
considered as money. It should be noted that although most current account deposits do not attract interest,
they provide a convenient and safe alternative to cash as a means of payment. The M2 aggregation of
money supply seeks to broaden the range of liquid assets to include some interest earning items, such as
savings deposits and fixed or time deposits.
This broad monetary aggregate, M2, comprises M1 plus short-term (usually a year and under) savings and
time deposits, certificates of deposit, foreign currency transferable deposits and repurchase agreements.
Although some of these assets are not readily accepted as payment for goods and services, the transaction
cost associated with their conversion is relatively small. For example, with the introduction of automated
banking machines, holders of savings accounts no longer have to go directly to the bank to make
withdrawals thus the burden of converting savings balances to cash is minimised. As such, savings
accounts are now used in a similar manner as current accounts in many societies, thereby enhancing
depositors‘ capacity and convenience in undertaking expenditure. With respect to time deposits, since
these deposits can be withdrawn on short notice, they also provide some degree of liquidity to depositors.
It should also be noted that there is an interest penalty associated with the pre-mature closure of these
accounts. However, as long as the benefit of breaking these arrangements outweighs the cost, they do
represent an alternative to cash and current accounts. In some countries, broad aggregation of money has
been extended beyond M2 to include some less liquid financial assets. These aggregates add to M2, long-
term foreign currency time deposits, travellers‘ cheques, short-term bank notes and money market mutual
funds. Although these instruments are primarily used to promote long-term savings, they can be easily
converted into currency or demand deposits at little cost. As such, they are said to facilitate the exchange
of goods and services among individuals.

If money greatly facilitates economic activity, and if the Fed can expand the money supply by using tools
like open market operations, the discount rate or the required reserve ratio to conduct monetary policy,
why not just put the \pedal to the metal" and expand the money supply dramatically? The answer is that
excessive increases in money supply lead to inaction. Intuitively, think about it as follows. Suppose that
the economy used used gold coins as money. Then a new discovery of gold would enable the government
to issue more gold coins, and since gold coins (money are more plentiful) people would pay more gold
coins in order to purchase other goods and services. In other words, the price of all other goods in the
economy would rise there would be inaction. A similar story applies to paper money. if overnight, large
bundles of paper money were left on people's doorsteps, then the next morning we would see people taking
the extra cash they own and go on a shopping spree. Soon rms will catch on to the fact that there is excess
demand for goods in their stores and will raise prices accordingly.
In other words if we have more money without a corresponding increase in goods, what will happen is that
the price of goods will rise. We can write down a more formal relationship between the money and prices.
Since money is being used for transactions, the amount of money multiplied by the number of times that
money is used for making purchases of new goods and services in a given period should be equivalent to
the value of production in the economy. The Quantity Equation of Money (one of the more famous
equation in economics) summarizes this relationship as
M *V = P *Y
Here M is the money supply, V is velocity - the number of times a unit of currency is used for making
purchases of new goods and services in a given period, P is the price level (think of it as the GDP dilator),
and Y is real GDP. Velocity in the economy is not constant. It can be ejected by technology. For example,
the presence of ATMs means that people carry around less cash with them and are more likely to use the
cash they have for transactions (because they know they can get more from the ATM if the need arises. In
that case, the velocity of money would increase. A restatement of the quantity equation using growth rates
leads to a convenient relationship
Money growth + Velocity growth = Inaction + Real GDP growth

The intuition for this equation is the same as for the quantity equation in levels. The left hand side is a
measure of how fast the amount of money used for transactions is growing (it increases both because the
stock of money is increasing, and because a given amount of money is being used for more transactions).
The right hand side is a measure of how fast the value of production is growing (it is increasing both
because the quantity of goods being produced is rising and because the price of those goods are rising).
The two sides have to be equal by dentition since the money being used for transactions is purchasing the
goods that are being produced. In the long run, we assume that real GDP growth is equal to potential GDP
growth. We also assume that the growth rate of potential GDP is not driven by changes in the growth rate
of the money supply. If we could change the growth path simply by printing money then growth would
hardly be a challenge, so that seems to be a reasonable assumption. This equation lends itself to a lot of
interesting economic analysis, some of which we explore below.
The Constant Velocity Case

Now, suppose that velocity is constant, which of course means that the growth rate of velocity is zero.
Also assume that money growth is 3% and that potential GDP growth is 3%. We calculate the rate of
inaction predicted by the quantity equation to be 3% + 0% = Inaction + 3%, which implies that
inaction is zero.
Now, suppose that the central bank increases the rate of money growth to 8%. Then (since we are
assuming a) that velocity does not change and b) that real GDP growth is always equal to the given
potential GDP growth rate of 3%), inaction has to be 8% + 0% = Inaction + 3%, which implies
inaction rises to 5%.
Finally, supposes instead that the central bank had lowered money growth to 1%, Then the rate of
inaction would be 1% + 0% = Inaction + 3%, which implies an inaction rate of 2%, which is a situation
of dilation.
What we then have is a relationship that says that if the growth rate of money is equal to the growth
rate of production, then inaction will be zero. If, on the other hand, money growth exceeds the growth
rate of output, then we have inaction. Intuitively, this is because there is proportionally more money
chasing goods, and thus prices will rise, i.e. we will experience inaction. Conversely, if money growth
is less than the growth rate of output, then we have proportionally less money chasing goods, and thus
prices will fall, i.e. we will experience inaction.
Furthermore, we have a one-to-one correspondence between money and inaction. If we in-crease the
growth rate of money by percentage points then inaction rose by percentage points. Conversely, when
we lowered money growth by percentage points, the rate of inaction fell by percentage points.
Our assumption that velocity is constant may be a bit extreme.
Did you know?

As money became a commodity, the money market became a component of the financial markets for
assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or
less.
Case Study-Indicted: A retail success story

Spanish global retailer Indicted achieved a whopping 32% increase in net income in 2010, despite a
recession at home and the costs involved in opening hundreds of new stores globally and online.
And the future for the company – which owns the Zara, Zara Kids, Zara Home, Berksha, Pull & Bear,
Stradivarius, Massimo Dutti, Oysho and Uterqüe brands – remains bright. ―Inditex achieved a 13%
increase in net sales in 2010 to €EUR12, 527m and a 32% increase in net income to €EUR7, 422m,‖ says
Charlotte Woods, analyst at Data monitor Retail. It opened 437 new stores - 52 of which were located in
China and 15 in Mexico, she said. The company plans capital expenditure of about €EUR800m this year,
up from €EUR754m a year earlier. This will be used to open more stores – a further 77 across China for
nearly all its brands, along with new sites in Mumbai and Delhi.
In total around 500 outlets will open this year, half of which will be Zara stores in Asia. Just recently,
Inditex opened its first Zara store in Australia, and has plans to launch in South Africa during the second
half of this year. The Zara brand is also available online in 16 countries and Inditex plans to expand
coverage to the U.S. and Japan. According to Isabel Cavill, Senior Retail Analyst at Planet Retail, Inditex‘s
aggressive international growth, particularly of the Zara brand, has played a key role in its success. ―Unlike
its competitors, it has not been scared to venture into new markets and operate under different business
models, such as franchise agreements. Growing through franchise stores has proven to be less risky for
Inditex, enabling them to adapt more quickly to local market conditions.‖
Success in international markets outside Europe has helped offset difficult markets like Portugal and Spain,
she added. Academics like Kasra Ferdows, Chair Professor of Global Manufacturing at McDonough
School of Business at Georgetown University, are not surprised by Inditex‘s continued success, despite the
recessionary climate: ―There are of course many reasons for its success, ranging from its aggressive
expansion outside Europe, to its ability to provide cutting edge fashion at relatively inexpensive prices for
growing market segments around the world, and without having to resort to as much discounting as is
common in the industry.‖
Inditex‘s ―secret‖ is not really a secret, claims Professor Ferdows. ―It is the responsiveness of its design
and global supply chain. Inditex controls substantial parts of its design, production, distribution and
retailing functions and the whole organisation is focused on making them more responsive, agile and
aligned. Unfortunately for the competitors, there is no one big idea that explains Inditex‘s success. Rather,
like a jigsaw puzzle, it‘s built on many pieces that fit and reinforce each other. And this powerful
combination makes it very difficult for competitors to imitate.‖
Those looking to replicate Inditex‘s success ―should consider expanding into high growth markets, be
ruthless in closing unprofitable stores, and seek to gain tighter control over their manufacturing and
logistics chain to enable them to respond rapidly to consumer demand and trends,‖ says Woods.
Questions
1. What are the growing market segments?
2. What is the new store globally and online?
13.6 Summary
Defining money as a unit of account means that the value of assets and commodities is given in terms
of money. In this case, it provides a reference for the pricing of commodities and therefore a more
efficient exchange system
The transactions demand for money arises from the medium of exchange function of money in making
regular payments for goods and services. According to Keynes, it relates to "the need of cash for the
current transactions
Money, like other stores of value, is an asset. The demand for an asset depends on both its rate of
return and its opportunity cost. Typically, money holdings provide no rate of return and often
depreciate in value due to inflation
The demand for money is affected by several factors, including the level of income, interest rates, and
inflation as well as uncertainty about the future People often demands money as a precaution against
an uncertain future. Unexpected expenses, such as medical or car repair bills, often require immediate
payment. The need to have money available in such situations is referred to as the precautionary
motive for demanding money.
13.7 Keywords
Deflation: In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the general price level rises, each unit of currency buys fewer goods
and services
Inflation: In economics, deflation is a decrease in the general price level of goods and services. Deflation
occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with
disinflation
Money Supply: In economics, the money supply or money stock is the total amount of monetary assets
available in an economy at a specific time.
Precautionary Motive: Precautionary savings occurs in response to uncertainty regarding future income.
The precautionary motive to delay consumption and save in the current period rises due to the lack of
completeness of insurance markets.
Store of Value: A recognized form of exchange can be a form of money or currency, a commodity like
gold or financial capital. To act as a store of value, these forms must be able to be saved and retrieved at a
later time, and be predictably useful when retrieved.

1. Money also provides a standard on which to measure the level of profitability of..............
(a) Management market (b) process
(c) Production analysis (d) business ventures
2. Production deals with the …………………..of the business investment.

(a)market analysis (b) physical aspect
3. The ………………..is a period of time in which at least one input used for production.
4. Short-run production analysis commonly used to explain........................

(a) leadership (b) the law of supply
(c) production function (d) None of these
5. As a store of value, money allows individuals to save a portion of their present income for consumption
in the future
(a) True (b) False
6. As a medium of exchange, the item must be readily accepted as .......... for goods purchased
(a)medium (b) payment
7. The transactions demand for money arises from the medium of exchange function of money
(a) True (b) False
8. This section examines the more frequently used measures of .........is the total stock.
(a) stock. (b) money supply
9. ............Can be defined as any medium which facilitates the exchange of goods and services
(a) Money (b) services
(c) medium (d) None of these
10. Money also provides a standard on which to measure the level of profitability of business ventures.
(a) True (b) False

1. What explains changes in the demand for money?
2. What are the motives for holding cash balances according to Keynes?
3. Give the modifications made by modern economists.
4. Analyze the inventory theory approach to the transactions demand for money.
5. What is its Relationship with the rate of interest?
6. Discuss the portfolio selection approach to the speculative demand for money
7. How is it Superior to Keynes's liquidity preference approach?
8. Bring out the relationship between money and interest.
9. Explain the measures of money supply.
10. Discuss quantity theory of money, inflation and deflation.
1. (d) 2.(b) 3.(a) 4.(b) 5.(a)

6. (b) 7.(a) 8.(b) 9.(a) 10.(a)
14
National Income Determination
CONTENTS
Objectives
Introduction
14.5 Summary
14.6 Keywords
Objectives
Define national income determination
Describe national income in India
Explain the problems in measurement of national income
Define the precautions in estimation of national income
Introduction
In this chapter we look at the determination of national income, employment and inflation in the short run:
i.e. over a period of up to two years. The analysis is based on the theory developed by John Maynard
Keynes in the 1930s, a theory that has had a profound influence on economics. Keynes argued that,
without government intervention to steer the economy, countries could lurch from unsustainable growth to
deep and prolonged recessions.
In Sections 8.1–8.4 we examine what determines the level of national out-put and why it tends to fluctuate
(i.e. why there is a business cycle). As we shall see, Keynes placed particular emphasis on the role of
aggregate demand (total spending) in determining economic activity. If aggregate demand is too low, there
will be a recession with high unemployment. On the other hand, if aggregate demand is too high, there will
be inflation.
Then in the remainder of the chapter we look at the use of government policy to control aggregate demand
so as to stabilize the level of output and keep the economy as close as possible to full employment. We
focus on the use of fiscal policy. This involves altering taxes and/or government spending.
National income accounting refers to a set of rules and techniques that are used to measure the national
income of a country. Singapore follows the concepts and methodology recommended in the United
Nations publication ―A system of National Accounts, 1968‖ for the compilation of national figures. This is
to ensure that Singapore national statistics will be consistent and compared with other countries. National
income is a measure of the value of goods and goods produced by the residents of an economy in a given
period of time, usually a quarter or a year. National income can be real or nominal. Nominal national
income refers to the current year production of goods and services valued at current year prices. Real
national income refers to the current year production of goods and service valued at base year prices.
In estimating national income, only productive activities are included in the computation of national
income. In addition, only the values of goods and services produced in the current year are included in the
computation of national income. Hence, gain from resale is excluded but the services provided by the
agents are counted. Similarly, transfer payments are excluded as there is income received but no good or
service produced in return. However, not all goods and services from productive activities enter into
market transactions. Hence, imputations are made for these non-marketed but productive activities e.g.
imputed rental for owner-occupied housing. Thus, national income refers to the market value or imputed
value of additional goods and services produced and services performed in the current period.
14.1.1 GDP, GNP, NDP and NNP

National income in many countries is either in Gross Domestic Product (GDP) or Gross National Product
(GNP). Gross Domestic product (GDP) refers to the total value of goods and services produced within the
geographical boundary of a country before the deduction of capital consumption. Net Domestic product
(NPD) refers to the total value of goods and services produced within the geographical boundary of a
country after the deduction of capital consumption.
Gross National Product (GNP) refers to the total value of goods and services produced by productive
factors owned by residents of the country both inside and outside of the country before the deduction of
capital consumption. Net National Product (NNP) refers to the total value of goods and services produced
by productive factors owned by residents of the country both inside and outside of the country after the
deduction of capital consumption.
Relationship between GDP and GNP

GNP = GDP + NPIFA (Net Property Income from Abroad)
Net Property Income from abroad refers to the difference between incomes from abroad and income to
abroad.
Market Price and Factor Cost
Market price refers to the actual transacted price and it includes custom duty, excise duty and other indirect
taxes but it excludes government grants and subsidies. Factor cost refers to the actual cost of the various
factors of production and it includes government grants and subsidies but it excludes indirect taxes.
Relationship between Market Price and Factor Cost

GNP at factor cost = GNP at market price – indirect taxes + subsidies
GDP at factor cost = GDP at market price – indirect taxes + subsidies
14.1.2 Transfer Payments

Transfer payment refers to government to individuals for which there no economic activity is produced in
return by these individuals. Examples of transfer are scholarship, pension.
Personal Income and Disposable Income:
Personal Income refers to the income available to individuals. Disposable income refers to the income that
the individuals can actually spend or save.
National Income (NNP at factor cost)

Less Retained earnings, company taxes
Add transfer Payments
Personal Income
Less CPF, CDAC
Disposable Income
14.1.3 Measurement of National Income

There are 3 approaches to measure national income i.e. output approach, income approach and expenditure
approach. Theoretically, the national income calculated from the 3 approaches is the same i.e.
Hence, GDE = GDP + GDI, GNE = GNP = GNI, NDE = NDP = NDI,
NNE = NNP +NNI.. But in practice, these measures are usually not equal to one another.
Output Approach
Output approach measures national income by adding the total value of the final goods and services
produced in the year or by adding the value added by each sector of the economy.
Value Added
Value added refers to the difference between the value of gross output of all goods and services produced
in a given period and the value of intermediate inputs used in the production process during the same
period. In distributive trade, value added is the difference between the gross margin and the cost of
intermediate inputs. In the banking sector, value added is the difference between the sum of actual and
imputed bank service charges and intermediate inputs. For government services and non-profit institutions,
value added is the wages and salaries, and depreciation allowance set aside for consumption of fixed
capital.
14.1.4 Concepts
1. The concept of national income determination
The principle that is central to this part of the Guide is the multiplier, which shows that a boost in
aggregate demand normally results in an income increase that is greater than the initial boost. The really
important point about the multiplier is that it can be worked out and analysed in three different ways:
dynamic analysis; comparative static analysis; graphical analysis.
2. Presenting the concept of national income determination

The topic should start with a straightforward motivational example, along the following lines.
Step 1:
What happens if Government spending rises by £1 billion, i.e. if the Government injects £1bn into
economy, by e.g. raising unemployment benefits?
A rise in Government spending generates an immediate rise in total household income of the same amount.
This is obvious: if the Government gives £1bn to households, households will receive 1bn! However, this
is not the end of the story.
Step 2:
The next thing is, what will the households do with the 1bn? Naturally, they will spend some of it, and
save the rest. Let‘s assume they spend three quarters of it [in economic terms, we would say that the
marginal propensity to consume (MPC) is 0.75.] So, the households spend 0.75bn. What happens to the
0.75bn? It goes into the pockets of the employees of firms producing the goods. What do they do with the
0.75bn? They spend three quarters of it, 0.56bn, and save the rest, and so on, ad infinitum.
What is the total effect on the economy of the injection of 1bn? Answer:
[1 + 0.75 + 0.56 + 0.42 + 0.32 + 0.24 + 0.18 + 0.13 + 0.10 + 0.07 + 0.06 + 0.04 + L]bn
= 4bn
Thus, the injection of £1bn into the economy has brought about an increase in Income of 4bn. Since the
eventual increase in income is four times the initial boost, we say that the multiplier is 4.
Step 3:
Students can then move on to a formal economic analysis.
Total expenditure (or ―aggregate demand‖) is:
AD = C + I + G (1)
Where C = total spending by households (―Consumption‖)
I = total spending by firms (on capital equipment); also known as ―Investment‖.

G = total spending by Government
AD = total spending by households, firms and Government; also known as ―Aggregate Demand‖.
The first part of this, Consumption (C) depends on income (Y), according to:
C = a + By (2)
This is the Consumption Function. A graph of the consumption function looks like this:
a is the level of autonomous consumption, and b is the marginal propensity to consume.
Step 4:
The other components of Aggregate Demand, I and G, are assumed to be exogenous, i.e. they do not
depend on income, Y. Hence, a graph of aggregate demand is simply the consumption function shifted
upwards by I + G:
Remember the Engel Curve (Guide 2), which shows expenditure against income for a single household.
The Aggregate Demand function is a bit like one big Engel curve, with an important difference: we can
only be at one point on the Aggregate Demand function, because total spending in the economy must be
equal to total income earned, that is:
AD ≡Y, or Y≡AD.
The three lined symbol (≡) in (3) indicates that the relationship between the two quantities is an identity.
This is more than just equality: for an identity, it is always the case that the two quantities are equal. Since
AD and Y must be equal, we must be on the 450-line in Figure X above. Therefore the equilibrium level of
income in the economy is given by the point E, where the aggregate demand curve crosses the 450-line.
Returning to the question we are asking, we need to consider what happens to the graph when G rises.
Referring to Figure Y below, let us assume that aggregate demand is initially given by AD1 and we are
initially at equilibrium E1. Let us next assume that G rises by an amount ∆G. this causes an upward shift in
the Aggregate Demand curve from AD1 to AD2, and we might imagine that this takes us temporarily off
the 450-line to point a. The resulting first-round increase in income is equal to ∆G and takes us from a to b.
Consumers, as a result of now being better off by the amount ∆G, spend a certain proportion of this, taking
us from b to c. The resulting second-round increase in income takes us from c to d. The process continues
until we reach the point E2, which is, of course, the point of intersection between the new aggregate
demand curve (AD2) and the 450-line.
Step 5:
Obtaining the multiplier using algebra
(1) Tells us that:
AD = C + I + G
While (3) tells us that: AD = Y
Essentially, what we have here is two simultaneous equations in the unknowns AD and Y. This is the main
reason why this topic fits in with the theme of the Guide.
Combining the two equations, we obtain:
Y =C +I +G (4)
Inserting the consumption function (2) into (4):
Y=a+bY+I+G (5)
Collect terms:
Y–bY=a+I+G
∴ (1 − b ) Y = a + I + G
a G I
Y
1 b 1 b 1 b
We could write this last line as:
From equation, it is clear that, if G rises by £1 billion, Y will rise as a result by:
1
 billion
1 b
Thus we see that the multiplier is always one over one minus the marginal propensity to consume (mpc):
In the numerical example, the mpc was 0.75, so the multiplier is:

A number of estimates of the Indian National Income have been made in the past, and will no doubt be
made in the future; for the quest after the elusive figure of the per capita income is really a most fascinating
field of study, not merely because of the numerous interesting figures one has to gather before one reaches
the goal, but also because there is a definiteness and a completeness about the per capita income which is
not to be seen in the results of other economic investigations. Actually, however, this definiteness is the
most misleading characteristic of such a figure, and con-tributes not a little to the bad reputation which
statistics have acquired in common conversation.
Thus, for example, the National Income is made up of the totals of a number of individual money incomes,
but the marginal utility of money to the different
Owners of income are widely different, and the National Income becomes in result a sum of dissimilar
units. Then again, what is individual income is not necessarily national income, and what is national
income is not necessarily income to the individual. And above all, there is the immense difficulty of
obtaining the necessary statistics without which the figure cannot be compiled. In spite of these, and many
other considerations, over which we do not enlarge in this work, the concept of national income has come
to stay; and the works of men like Flux, Bowley, Gini, Mitchell, King, Stamp, Sutcliffe and Clark are
ample proof of the real importance of trying to compute the country/‘s national income, and in our own
country we have had a series of attempts, and none can say that these attempts are now annually over.
Before proceeding to enter upon our own calculations, it may be worthwhile to describe and discuss briefly
the estimates made so far ; for the best way of avoiding mistakes and overcoming difficulties in any
particular branch of knowledge is to study the attempts previously made in that field.

A community organized for self-subsistence. Or, how to evaluate untraded goods and services for which
there was no market price and no market equivalent. In Northern Rhodesia, a primitive native economy,
largely dependent upon self-subsistence production, exists side by side with a highly capitalized modern
industry operated by immigrants. It was estimated that in 1938 between 35 and 40% of total native income,
about 1.08 million, was from self-subsistence production.
Profits drawn from the territory by foreign firms amounted to something like 5.4 million out of a total
national income, defined to include this item, of millions. The difficulties in the way of measuring the
national income of a backward territory spring from two main sources. First, the concepts and experience
from which the national income estimator usually derives his definitions and methods have for the most
part been developed in dealing with advanced industrial economies such as those of the United Kingdom
or the United States. How far they are applicable to less advanced economies must be deduced from a
series of practical tests. Second, data on which to base estimates are scarce. The relative inaccessibility of a
backward territory and the poverty of its exchequer reduce to a bare minimum the material that can be
collected or that can be compiled systematically by the administration.
The possibility of combining the existing quantitative and qualitative information to form the basis of a
useful estimate can be determined only by trying. In October 1941 the National Institute of Economic and
Social Research, London, undertook the enquiry into colonial national incomes described in this paper.
Regarded as an experiment, it attempted to apply to selected colonial territories a method of measurement
evolved to meet the circumstances of the United Kingdom. Several interdependent objectives were kept in
view. It was hoped to test the wider applicability of the method and to adapt it to colonial conditions, to
reveal and solve the main problems involved in obtaining the necessary measurements, to throw some light
on economic conditions in the selected territories, and to construct a working basis for future estimates.
Since the enquiry has so far been based entirely on published material or other data available in the United
Kingdom, the conclusions that can be drawn at this stage are provisional and subject to the corrections
field surveys may render necessary.
The method that formed the basis of the experiment is described in detail in The Construction of Tables of
National Income, Expenditure, Savings and Investment by J. E. Meade and Richard Stone.' In brief,
national income is estimated from three viewpoints: income, output, and expenditure. The estimates of the
items that make up the totals and the totals themselves are checked and cross-checked against one another.
The aim, a thoroughly integrated series of estimates covering every aspect of the national economy and
presented in a form that minimizes problems of definition, is achieved by the construction of accounts of
national income, output, and expenditure, and of transactions with countries abroad on the lines indicated
in Tables. The colonies selected for study were Northern Rhodesia, Nyasaland, and Jamaica. Northern
Rhodesia was chosen because it seemed to present in an extreme form the problems of a mixed economy.
Nyasaland, similar in that its output contained a large element of self-subsistence production, was included
because information came to hand with which the value of the methods used in calculating the self-
subsistence output of Northern Rhodesia could be checked indirectly.
Jamaica was taken as an example of a relatively advanced colonial economy and, in view of the greater
amount of information available; the Jamaican estimates were carried back ten years. This paper is
concerned principally with the estimates for Northern Rhodesia. Since the concept of national income that
formed the starting-point of the enquiry had been formulated primarily to meet the needs of the United
Kingdom, problems of definition became of immediate practical concern. It was not that they were new,
but that the conditions of this economy were such as to strike at the very roots of a concept appropriate to
an exchange economy. National income can be briefly described as the value of the customarily
exchangeable goods and services currently produced by a nation or community. It can be measured in
terms of (a) the rents, profits, interest, salaries and wages paid to individuals or retained by enterprises in
return for their services in the current production of goods and services; or (b) the net value of each
industry's contribution to the national aggregate of goods and services; or (c) the net value of the goods and
services consumed or added to capital equipment. For the purposes of this enquiry it was measured in all
three ways and the estimates checked against one another.
There are certain obvious difficulties in applying this form of measurement to a backward economy.
If we ignore the complications arising from transactions with other countries, the distinction between
income and outlay, for example, depends on the existence of two equal money flows to nationals in return
for their productive activity and from nationals to purchase goods and services for purposes of
consumption or investment. In an economy where most output is not offered for sale but is consumed by
the producer and his family, these two flows do not exist, or exist for merely a fraction of total output. The
national income tables are thus deprived of a valuable cross- check; i.e., only one estimate can be made for
the output of self-subsistence producers and it must be entered twice in the basic table the distinction
between income and output, however, depends upon a single flow arranged in two ways, not on different
equivalent flows. Given inadequate records, approaching the total in two ways provides a cross-check that
strengthens the estimate for self-subsistence output.
Output can be estimated from such data as acreage and yields, and intake from per capita consumption of
each commodity and estimates of population. Other conceptual problems that arose during the experiment
will be dealt with below. For example, How to define the nation in a territory where immigrant capital and
labour play a large part in the exploitation of its economic resources.
Where to draw the line between economic and non-economic activity for a community organized for self-
subsistence. Or, how to evaluate untraded goods and services for which there was no market price and no
market equivalent. In Northern Rhodesia, a primitive native economy, largely dependent upon self-
subsistence production, exists side by side with a highly capitalized modern industry operated by
immigrants. It was estimated that in 1938 between 35 and 40% of total native income, about 1.08 million,
was from self-subsistence production. Profits drawn from the territory by foreign firms amounted to
something like £5.4 million out of a total national income, defined to include this item, of millions.

The following precautions should be taken while calculating national income using income method:
All kinds of transfer payments are not to be included in the national income. This is so be-cause these
are unilateral payments.
The value of the output kept for self-consumption and the imputed rent of the self-occupied house are
included in the national income.
Windfall gains like income from lottery are not included in the national income.
Income tax on personal income is a part of compensation of employees. This should not be separately
included in the national income.
Death duty, wealth-tax, capital gains tax etc. are paid out of past saving and assets. These are not
related to current flows of goods and services; therefore, they are not the part of national income.
Income from the sale of second hand goods is not included in the national income because it does not
relate to the current flow of goods and services.
Income of gamblers, smugglers, thieves etc. is not included in the national income because these are
not the part of regular productive activities.
Financial transactions are not included in the national income such as sale of shares, bonds and so on.
Did You Know?

The Gross national income (constant LCU) in India was last reported at 56386757326276 in 2011,
according to a World Bank report published in 2012.
Caution
Only expenditure on final goods and services is to be included, otherwise there will be double counting.
Case Study-Classical Remedies for Unemployment

Keynes rejected the classical remedies for unemployment. According to Keynes, they were more than just
useless: they actually made the problem worse. So what were the classical remedies? And why would they
make unemployment worse? ‗People should be encouraged to save. This would reduce interest rates and
encourage more investment, more growth and more jobs‘.
But if people save more, they spend less. Firms will therefore sell less. They will thus have idle capacity
and will lay off workers. Unemployment will rise. What is more, firms will be discouraged from investing.
After all, what is the point in installing extra machines when you are not using all of the existing
ones?Keynes called this the paradox of thrift. If the nation becomes more thrifty, it will thereby become
poorer. ‗People should be prepared to take wage cuts.
This would reduce firms‘ costs and allow them to take on more labour.‘ But workers are also consumers. If
people are paid less, they will spend less and firms will sell less. Firms will thus want to employ less
workers, not more. ‗The government should attempt to balance its budget. If the government were
currently running a budget deficit, then it should attempt to eliminate it. This would release resources for
private-sector investment. More investment would lead to more employment.‘
But if the economy is in recession and unemployment is already high, the budget deficit may be quite
large. There are two reasons: a) the government will be spending a lot of money on unemployment benefit;
b) if incomes and consumption are low, tax receipts will be low. To eliminate the deficit then, the
government would either have to raise taxes or have to reduce its expenditure, for example by reducing the
level of benefits. Either way, aggregate demand would fall and firms would sell less. This would merely
encourage them to lay off more workers. Unemployment would rise, not fall. ‗Reduce the supply of
money. This would reduce prices. This in turn would make British goods more competitive overseas and
would lead to a recovery in the export industry. Employment would rise.‘ But reducing the money supply
would raise interest rates and reduce investment. The economy would slide further into recession and
unemployment would rise.
So if all these classical remedies were wrong, what was Keynes‘ answer? That was simple. There must be
more spending, not less. Aggregate demand must be boosted, either directly through a programmer of
public works, or indirectly by giving tax cuts and thus encouraging more consumer expenditure. Either
way it would mean a policy of a deliberately unbalanced budget. According to Keynes, therefore, budget
deficits were highly desirable in recessions.
Questions
1. How would a classical economist reply to each of Keynes‘ criticisms?
2. Would each of the above classical policies be suitable if there were a problem of excess demand and
inflation?
14.5 Summary
National income accounting refers to a set of rules and techniques that are used to measure the national
income of a country.
Indian National Income have been made in the past, and will no doubt be made in the future; for the
quest after the elusive figure of the per capita income is really a most fascinating field of study.
National Institute of Economic and Social Research, London, undertook the enquiry into colonial
national
Gross national income is derived as the sum of GNP and the terms of trade adjustment. Data are in
constant local currency.
National incomes there are three approaches to measure national income i.e. output approach, income
approach and expenditure approach.
14.6 Keywords
GDP: Gross domestic product is the market value of all officially recognized final goods and services
produced within a country in a given period.
GNP: Gross national product is the market value of all products and services produced in one year by
labour and property supplied by the residents of a country.
NNP: Net national product is the total market value of all final goods and services produced by residents in
a country or other polity during a given time period (gross national product or GNP) minus depreciation.
NPD: Net domestic product accounts for capital that has been consumed over the year in the form of
housing, vehicle, or machinery deterioration.
Subsidy: A subsidy is assistance paid to a business or economic sector.

1. Keynes' macroeconomic theories were developed as a response to the failure of classical theories to
explain the UK's problems of:
(a) persistent unemployment in the 1930s.
(b) slow economic growth in the 1960s.
(c) balance of payments problems in the 1950s.
(d) unemployment and inflation in the 1970s.)
2. The total quantity of goods and services produced (or supplied) in an economy in a given period is:
(a) aggregate expenditure. (b) aggregate output.
(c) aggregate investment. (d) aggregate demand.
3. In macroeconomics, equilibrium is defined as that point at which:

(a) planned aggregate expenditure equals aggregate output.
(b) planned aggregate expenditure equals consumption.
(c) saving equals consumption.
(d) aggregate output equals consumption minus investment.
4. The ratio of the change in the equilibrium level of output to a change in some autonomous variable is
the :
(a) elasticity coefficient. (b) automatic stabilizer.
(c) multiplier. (d) marginal propensity of the autonomous
variable.
5. The marginal propensity to withdraw is:

(a) the proportion of national income that is withdrawn from the circular flow of income.
(b) MPS + MPT + MPM.
(c) 1-(1/injections multiplier).
(d) 1/investment multiplier.
6. According to the "paradox of thrift," increased efforts to save will cause:

(a) an increase in income and an increase in overall saving.
(b) a decrease in income and a overall decrease in saving.
(c) an increase in income but no overall change in saving.
(d) a decrease in income but an increase in saving.
7. If injections are less than withdrawals at the full-employment level of national income there is:
(a) Hysteresis. (b) a deflationary gap.
(c) Hyperinflation. (d) an inflationary gap.
8. The accelerator theory of investment says that induced investment is determined by:
(a) The level of aggregate demand. (b) Expectations.
(c) The level of national income. (d) The rate of change of national income.
9. In which phase of the business cycle do firms try to cut stocks in order to save costs:
(a) The recession. (b) The peaking out.
(c) The upturn. (d) The expansion.
10. Fiscal policy refers to:

(a) The spending and taxing policies used by the government to influence the economy.
(b) The government's regulation of financial intermediaries.
(c) The actions of the central bank in controlling the money supply.
(d) The government‘s attitude to taxation.

1. What do understand by income determination?
2. Write a short note on national income in India.
3. Write down the concepts of national income determination.
4. Write a short note on national income determination.
5. Explain the relationship between GDP and GNP.
6. Write a short note on net property income from abroad.
7. Write down the factor include in national income.
8. What do you know about transfer payments?
9. Explain the concepts of measurement of national income.
10. What are the problems in measurement of national income?
1 (a) 2 (b) 3 (a) 4 (c) 5 (b)
6 (b) 7 (b) 8 (d) 9 (a) 10 (a)
15
Equilibrium of Product and Money
Market
CONTENTS
Objectives
Introduction
15.4 Summary
15.5 Keywords
Objectives
Explain the is-lm model
Define product market and money market
Describe application of is-lm model in monetary and fiscal policy.
Introduction
This chapter relates to money market. The need to study money market arises from the fact that this market
along with goods market determines the equilibrium level of income and interest rate. We known that
introduction of money are necessitated by the difficulties encountered in the operation of barter system of
exchange. You would be introduced to the nature of supply of money and demand for money to help in
understanding the equilibrium in money market. Since money market can be in equilibrium at various
combinations of interest rates and national income, LM curve will be introduced along with the factors
determining its slope as well as shift.
Role of Money
Money is anything, which is generally acceptable as a means of payment in the settlement of transactions.
It is commonly used as a medium of exchange or a means of transferring purchasing power. In absence of
money, people exchange goods for goods.
Supply of Money
Supply of money is a stock, which can be measured at a point of time. It is taken to be autonomously
determined.
Measures of Money Supply

Once we have settled on a theoretical definition of money, we can identify empirically the things that serve
as money in an economy. Then, the total stock of money of various kinds at a particular point of time can
be computed. By repeated measurements at different points of time, a whole time series of money supply
can be constructed. This will show the time behaviour of money supply. Coupled with other data and
helped by theory, this information can be used to throw light on the effect of changes in the supply of
money on several key variables such as income, prices, wages, employment, rate of interest and balance of
payments, and how to control changes in the supply of money to attain certain policy goals.
At the outset, we must note two things about any measure of money supply.
First, supply of money refers to its stock at any point of time. This is because money is a stock variable in
contrast with a flow variable, such as real income, which refers to its rate per unit of time (say, per year). It
is the change in stock of money, say, per year, which is a flow.

This model has two schedules that reflect the equilibrium in two markets: goods and money. In other
words, one schedule represents the market in which the supply of goods is equal to the demand of goods,
and the other schedule represents the market in which the supply of money is equal to the demand of
money.
Model for a closed economy

First assume that the economy is closed. This will help us better understand the basic model; later we will
proceed with the more complicated version when there are international transactions on goods and capital.
The total supply of goods in an economy is what we call output: Y. The total demand is what the agents do
with all those goods: either they consume (C), invest (I), or the government consumes them (G). Imposing
the fact that the supply of goods is equal to the demand of goods requires:
Y=C+G+I
We can rearrange this equation such that we equate savings to investment
Y-C-G=I
As can be seen, on the left-hand side we have the total income generated (Y) in the economy minus the
expenses (C+G). This reflects the savings made by consumers and government. On the other hand, the
right hand side is the investment.
Is not this interesting? When we impose that the supply of goods has to be equal to the demand of goods,
immediately it has the implication that total savings are equal to investment.
This represents the IS in the model. Savings behaviour
We are interested in understanding what the savings behaviour when fiscal is and monetary policy are
implemented. This is what we are going to do here. We know that part of consumers' income is taxed. For
simplicity assume the tax rate is fixed and given by t. The savings can be written as follows:
S=(1-t)Y-C + tY-G
What this equation implies is that total savings in the economy are equal to consumers' savings (the first
two terms) plus the government‘s savings (the negative of the fiscal deficit).
From the microeconomic literature we know that consumers will consume depending on their disposable
income and the interest rate. The microeconomic literature does not have a precise answer of what is the
effect of interest rates on current consumption. There are two effects that go in opposite directions: the
income and substitution effect. We are not interested in solving this problem at the macro level, and we
will make the assumption that consumption is unaffected by the interest rate. When this is the case, we can
write consumption as follows:
C=c(1-t)Y
Where c (less than one) is the marginal propensity to consume for each additional unit of disposable
income ((1-t)Y).
S=(1-c)(1-t)Y + tY-G
Note that if Y or t increases, savings increase. If G or c increases, savings decrease. We will represent this
in the following way: where the sign on top of the variable indicates the relationship between savings and
the variable.
A positive number indicate that they move in the same direction, a negative implies they move in opposite
directions. Therefore, when output increases (a positive) savings increase; while when the marginal
propensity of consumption increases (a negative) savings go down.
Consumer sentiment or consumer confidence is one of the most important variables in the economy
because they have a direct effect on consumption patterns.
In fact this is the case when the elasticity of substitution is equal to one. Investment
Let‘s now concentrate on investment. It is easy to argue that investments in the economy are inversely
proportional to the interest rate. The nominal interest rate is some measure of the cost of capital, and
according to our macro (and finance) theories, we should observe less accumulation of capital. For
simplicity we will write the following: Where is the interest rate. We have also included the business
sentiment variable indicating that when sentiment about investment improves, then investment tends to
increase. This is similar to consumer confidence but now about investment.
Equilibrium
Assume that point A is a point in which there is equilibrium: Therefore savings are equal to investment.
Assume that maintaining the same interest rate; we increase output in the economy.
According to our behavioural equations investment remains the same, but savings increase. Thus this is a
point in which savings is larger than investment.
Now, assume we return to point A and maintaining the same output we reduce the interest rate. As we
argue before, there is no change in consumption (this is obviously a simplification) and therefore on total
savings. However, there is an increase in investment. Thus this is a point in which savings are smaller than
investment.
Going from the point in which savings is larger than investment to the point in which savings is smaller
than investment we have to cross a point in which savings is equal to investment. What this implies is that
all the points in which savings are equal to the investment are represented by a downward sloping curve.
The IS.
The intuition is quite easy. If we are at a point in which savings are equal to investment, a reduction in the
interest rate will produce an increase in investment that has to be compensated by an increase in savings.
The only way to accomplish this is to increase output. What is the effect of changes in savings rates (1-c)
and fiscal policy? Let‘s analyze only one of them. Assume we are at point A. If there is an increase in
government expenditure (or a reduction in taxes, or a reduction in the savings rate) total savings in the
economy are going to go down. Therefore, at the same interest rate and the same output, point A is no
longer equilibrium of the economy – i.e. supply is not equal to demand.
In order to return to equilibrium we have to reduce investment or compensate the loss in savings. Thus,
either output goes up, or the interest goes up, or both. This means that the IS schedule has shifted upward.
Now let‘s concentrate on the other market: the equilibrium on the monetary side. Assume there are only
two assets: currency and government bonds. Money does not earn interest, but the government bonds carry
the market interest rate: i. Currency, however, has a role in the economy given that it allows people to
perform transactions that otherwise could have not been implemented (pay cabs, buy coffee, etc.).
We assume the supply of currency is determined by the central bank: M. the demand for currency is then
determined by what the consumers decide to do with their holdings. We assume consumers solve a
portfolio problem and allocate part of their wealth (which is proportional to income: Y) as currency and the
rest is saved in bonds.
We should expect two things: first, when the interest rate increases a smaller proportion is held in
currency. The intuition is that the opportunity cost of holding cash increases and individuals should shift
part of their portfolio toward bonds. Second, when wealth increases individuals should hold more cash. In
other words, the shares assigned to money might change with increases in wealth but not in such a way that
will overcome the initial impact.
In other words, we should expect that an increase in the interest rate reduces the demand for money, and
that an increase in output will increase the demand for money. You can think of this demand as a
transactional demand for money. The more transactions there are, the larger the cash required to perform
them. Thus, This is a very prolific area of study in macro that we have been unable to answer satisfactory.
In economics we do not have very good reasons why money exists.
We have some ideas that indeed justify its existence in the past, but it is hard nowadays. In any case, you
should feel good if for you is hard to make sense why individuals hold currency. You are definitely in
incredibly good company. Where the functions (and x) are decreasing in the interest rate, but is increasing
in output. Let's draw the curve then.
Assume point A is a place in which the demand for money equals the supply.
Assume there is an increase in the interest rate maintaining output constant. We have argued that the
demand for money will fall, because the supply is determined exogenously by the central bank, this is a
situation in which the demand for money is smaller than the supply.
Assume that now we return to point A and here we increase output only. Income goes up and the amount
required in cash increases. The demand for money is larger than the supply.
Moving from this point to the previous one we will have to cross zero and this implies that the
LM is an increasing schedule.
Let's see what happens when there is an expansion in the money supply. Assume that we are at point A,
where there is equilibrium in the money market. If the central bank increases the money supply, suddenly
A is a place in which the demand for money is smaller than the money supply. Therefore, for the same
interest rate and output, point A is no longer equilibrium. To return to equilibrium, then, it is necessary that
the demand for money has to increase. This is achieved by increasing output, reducing interest rates, or
both.
Usually the intuition of how the LM works is not very clear. Do not worry! Do not panic!
For sure I can tell you that you are in good company.
So, let‘s do it again in a simplified portfolio model. Assume consumers have some wealth
(W) That they allocate between two assets: money (issued by the central bank) and government bonds
(issued by the bad guys).
The consumer has to decide how much should be allocated to bonds and how much to money. Money
produces utility to consumers given that it provides some services. Bonds, on the other hand, pay an
interest rate. We are not terribly interested in the particular portfolio problem; however, it should be
intuitive that the demand for bonds is a decreasing function of its price. In other words, demand for bonds
is an increasing function of the interest rate.
Assume the supply of government bonds is fixed then the equilibrium price of the bonds is given by:
Note that if the supply of bonds increases the equilibrium price has to fall, which means that the implicit
yield on the bond increases. This makes sense given that an increase in the supply of bonds has to convince
consumers to hold more bonds and the same amount of cash. To do so,
What is even more interesting in this simple framework is how the central bank policy works.
In this transaction, the share of consumers‘ wealth invested in bonds has come down, and the cash holdings
have increased. This situation is called an ―expansionary monetary policy.‖
The central bank increased the money supply (cash in the hands of the consumers) and the outcome is that
the interest rate has come down. This is the day to day operation of a central bank; they are in the business
of buying and selling government bonds to satisfy the money demands of consumers.
You might ask ―but that is not the way the US central bank works.‖ That‘s right. There are several ways in
which monetary policy is implemented. Some of them control the money supply and the price is decided
by the market; others decide the interest rate and the money supply is decided by the market (so the central
bank decides the price at which to buy or sell the government bonds and buys or sells all the quantities the
market decides); others have more complex objectives such as the exchange rate, etc. We will come back
to these issues later. For the moment, this should be enough to understand how the ISLM works.
IS-LM: The model.

Let‘s now put both schedules together. As any respectable model in economics, there is a downward and
an upward schedule. And as it should be expected, they intersect once, and we tend to like this point. This
model indicates what is the unique combination of output and interest rates that is consistent with both
equilibrium in the goods market and equilibrium in the money market.
.
Finally, a decrease in the marginal propensity to save (an increase in c) increases the interest rate and
output.
Let‘s do these shocks slowly:
Assume we start at point A. And that we receive a shock – let us assume that the shock is a drop in
consumer confidence. The first thing we ask is how the shocks change the four variables of interest: how it
affects, savings, investment, money supply and money demand assuming the interest rate and output
remain the same.
The idea of this procedure is to determine if the equilibriums still prevail at the original interest rate and
output level. In other words, if we receive a in which the economy still it is in equilibrium at the original
interest rate and level of output, the shock has no impact in the economy. The only way a shock has an
impact is if it changes the equilibrium in the goods market or the money market.
So, at the original interest rate and level of output, a drop in consumer confidence implies the following:
1. Does the money supply change? No
2. Does the money demand change? No. because the interest rate and the output level are the same, then
money demand remains identical.
3. Does investment change? No. investment depends on interest rates – which are the same by assumption,
and business sentiment which is also constant.
4. Does savings change? Yes. A drop in consumer confidence increases private savings, and therefore, it
increases all savings.
What is the implication of this thought process? We know that at the original point A, because the money
demand and money supply are identical, it still is equilibrium of the money market. In other words, the LM
has to continue to cross or include point A. On the other hand, we know that in point A, investment is the
same as before, but savings have increased. So, the point A that used to be a point in the IS curve – where
savings are the same as investment – is now a point in which savings are larger than investment. Therefore,
we know that the LM crosses A, but that the IS does not cross.
How do we know where the IS moves?

The easiest way is to move right or left, or up and down. In that movement what we ask is whether or not
the movement in the economy is reducing the differences between savings and investment. If the
movement exacerbates the differences, then we have to move in the opposite direction. Let‘s see first the
case when we move to the right.
If we move to the right starting at point A, then interest rates are the same – hence investment remains the
same, but the increase in output implies an increase in savings. This implies that we are actually making
savings even bigger. Therefore, the actual movement should be to the left as opposed to the right. When
we move to the left, interest rates are the same, investment remains constant, and the decrease in output
drives savings down, making the difference between savings and investment that existed in point A
smaller.
How much do we move? Hard to tell, except for one thing: we move exactly until savings equal
investment. So, we drop output all the way until savings have dropped enough. In the end, a fall in
consumer confidence implies a fall in output and a drop in interest rates – quite similar to a recession, is
not it?
What happens if money supply increases? Same procedure. At the original equilibrium
(A), keeping interest rates and output constant, the increase in the money supply has no impact on savings,
no impact on investment, no impact on the money demand, but an increase in the money supply. This
means that at the original point, investment and savings are still the same – therefore, the IS still crosses
point A. How to return to equilibrium? We do the same as before. If we start at A, this is a point where
money supply is larger than money demand. If we start moving to the right, output goes up, increasing
money demand and reducing the degree of disequilibrium - hence, the LM must have moved to the right.
(It is instructive if you follow these instructions and do them in the graph).
A couple of lessons: First, savings. We usually talk about savings as if they mean the things the same:
savings to invest, savings from my personal income, and savings in financial assets. This model highlights
that this intuition is severely wrong. One thing is investment, performed by firms and that is negatively
correlated with interest rates. This is the I in the IS curve. Another thing is the portfolio decision between
cash and bonds. Here an increase in interest rates implies that bonds are more desirable and investors shift
from cash toward bonds. This is an opportunity cost argument. Finally, we have the decision about
savings: which is the total resources we set aside after we have produced and paid taxes. That decision,
given our previous discussion, is one in which we are assuming that interest rates have no impact -
meaning that substitution and income effects cancel each other. So, interest rates reduce investment, keep
savings the same, and increase resources invested in bonds. At a first glance this seems inconsistent, but as
we have seen in this model, all these three things occur and still money and goods market are in
equilibrium. Complicated? Confused? Welcome to macro! I do not expect you to get this right away, but I
hope we start understanding the differences and start getting comfortable with the intuitions.
Second, this model tells us what is the interest rate and output consistent with equilibrium. In other words,
this model answers the question: what would be the interest rate and level of production is X occurs?
Third, everything (except interest rates and output) will move the schedules. Everything! Consumer
confidence, business confidence, productivity, financial crises, taxes, money supply, credibility in the
central bank, earthquake, riots. Elections, political crises, expenditures, innovation, etc. Where the
schedules move? Pick the shock and think how the shock affects savings, investment, money demand, and
money supply...
Finally, a very important discussion in the literature was (this is 20 years ago) the slope of the curves. In
particular, a very important discussion was whether or not some of these curves are totally vertical or
horizontal. The interesting thing is that each of these cases has a particular name and is kind of a particular
"sickness" that an economy suffers. Again, as a summary, here you have how the different schedules
move.
Caution
The actual movement should be to the left as opposed to the right.

A market used to exchange a final good or service. Product markets exchange consumer goods purchased
by the household sector, capital investment goods purchased by the business sector, and goods purchased
by government and foreign sectors. A product market, however, does not include the exchange of raw
materials, scarce resources, factors of production, or any type of intermediate goods. The total value of
goods exchanged in product markets each year is measured by gross domestic product. The demand side of
product markets includes consumption expenditures, investment expenditures, government purchases, and
net exports. The supply side of product markets is production of the business sector.
According to the RBI, "The money market is the centre for dealing mainly of short character, in monetary
assets; it meets the short term requirements of borrowers and provides liquidity or cash to the lenders. It is
a place where short term surplus investible funds at the disposal of financial and other institutions and
individuals are bid by borrowers, again comprising institutions and individuals and also by the
government."
According to Nadler and Shipman, "A money market is a mechanical device through which short term
funds are loaned and borrowed through which a large part of the financial transactions of a particular
country or world are degraded. A money market is distinct from but supplementary to the commercial
banking system."
These definitions help us to identify the basic characteristics of a money market. A money market
comprises of a well organized banking system. Various financial instruments are used for transactions in a
money market. There is perfect mobility of funds in a money market. The transactions in a money market
are of short term nature.

Policy Makers (IMF, US Treasury) can use the ISLM model to determine what happens to interest rates
and output when they increase/decrease the money supply.
Before we continue, we look at factors that cause the IS and LM curves to shift.
Factors that cause the IS curve to shift
A change in the interest rate or aggregate output will cause a movement along the IS curve. Changes
that cause the expenditure function to shift cause the IS curve to shift.
Changes in autonomous consumption e.g. increase in confidence about the economy, changes in
wealth, etc
Changes in investment spending (unrelated to the interest rate) e.g. increase in business confidence,
changes in technology, etc
Changes in government spending
Changes in taxes
Changes in Net Exports (unrelated to the interest rate) e.g. changes in taste, trade policy, etc
Factors that cause the LM curve to shift
Did You Know?

The IS/LM model was born at the Econometric Conference held in Oxford during September, 1936. Roy
Harrod, John R. Hicks, and James Meade.
Case Study-Money market funds success story

Hedge funds, private equity funds and property would appear to have been the main beneficiaries of
disappointing returns from many traditional investments.
But lurking beneath the radar of many investors are funds that have attracted an avalanche of money,
dwarfing inflows into alternative investments.
Money market funds have seen extraordinary inflows in the last five years with new funds being launched
at the rate of two a month in Europe to cope with the demand.
Money market funds started life in the US in the 1970s as a way for smaller investors to pool funds and
obtain the higher rates that big institutions enjoyed. Both retail and institutional investors seized the
opportunity and the sector has grown to about INR2, 000bn.
Europe is now seeing similar levels of growth. From €7bn in 1997, the European sector for AAA money
market funds, the highest-graded funds as rated by S&P and Moody's, is now worth more than €200bn.
These funds are decidedly unglamorous compared with their equity and bond counterparts and their
managers will never become ―stars‖. But James Finch, of JP Morgan Fleming Asset Management, a
leading provider, says in a low-interest rate, low-return environment, making cash reserves work harder is
essential for both companies and investors.
―In a pension scheme, cash can be 5 or 10% of the fund,‖ says Mr Finch. ―If this is just left with the
underlying managers or custodians, you are giving up the opportunity to put it into a more efficient
vehicle.‖ The biggest users of the funds include corporate treasurers with fluctuating levels of cash on their
balance sheets, insurance companies, small private companies that may have just received venture capital
funding and high-net-worth individuals. They are all looking for alternatives to overnight bank deposit
rates which yield less and are less secure because no European bank, except Rabo bank, has a AAA rating.
They also alleviate the burden of scouting around every day for the best rates to park spare cash.
Like deposits, instant access is guaranteed. To achieve this, the funds invest in short-term liquid
instruments such as commercial paper, certificates of deposit and government bonds. The duration to
maturity must not exceed 12 months. The funds tend to yield about 10 basis points less than the central
bank base rate and to charge 10-20 basis points to investors.
―Price and yield is probably less important to investors than security, diversification of instruments and
ease of use,‖ says Mr Finch. ―Money market funds free asset managers, treasurers and institutions to do
what they are employed to do.‖
He believes the arrival of subsidiaries of US multinationals in Europe and the advent of the euro have been
the main reasons for the growth of money market funds up to now. He thinks assets will continue to grow
as the hedge fund industry expands and as deregulation in continental Europe highlights credit rating
problems at local banks.
―Money supply in Europe is INR8, 000bn-INR9, 000bn, about the same as the US. So there is good reason
to think the European market could move towards the US's INR2, 000bn mark,‖ says Mr Finch.
But not all providers are likely to survive as competition mounts in the sector.
Annette Cusins, of Goldman Sachs Asset Management, says the bigger the fund and the fund provider, the
more purchasing power they have in the market transactions. In addition, treasurers often have to invest in
funds that are at least 10 times as big as the investment they are making.
―There is a strong chance we are going to see consolidation in this industry. It is questionable how long
some of the smaller new entrants to the market will last,‖ says Ms Cusins. The biggest funds hold tens of
billions of dollars in assets.
Mr Finch points out that the top 10 providers have enjoyed 90% of the market growth in the past year. ―We
think the large banks will be the winners in this sector, not standalone asset managers. Banks have
distribution opportunities through investment bank transactions such as capital raising and merger and
acquisition advisory services. They also have access to custody, treasury and trust clients.‖
But, if consolidation does take place there is still likely to be a battle royal between the likes of JPMF and
GSAM and their chief rivals such as Deutsche Bank, UBS and Barclays.Ms Cusins admits the sector risks
becoming commoditised and says differentiation is hard. ―Security is very important. Our funds are rated
AAA by both S&P and Moody's and we are cautious in our approach.
That helps distinguish us. In terms of access, the cut-off times are important, particularly for treasurers
who have unpredictable cashflow needs.―We have put our euro and sterling cut-off times back to 12.45pm
to meet this demand. This compares to 10.30am for some funds.‖ The European market, already growing
at 50% a year, may get a further boost if retail investors join the fray. In the US, money market funds are
widely used as a way of sweeping surplus cash from mutual funds. They are also popular in periods of
rising interest rates when banks are slow to pass on rates, whereas funds make an instant adjustment.
Peter Crane, managing editor of iMoneyNet, a US-based money market research and publishing house,
says: ―Whether Europe truly develops a sizeable homogenous mutual funds market will be a big factor in
the growth of money market funds there.
Questions
1. How money markets fund become more popular according this case study?
2. Write the summary of the following case study?
15.4 Summary
Money is anything, which is generally acceptable as a means of payment in the settlement of
transactions. It is commonly used as a medium of exchange or a means of transferring purchasing
power.
Supply of money is a stock, which can be measured at a point of time. It is taken to be autonomously
determined.
Is-Im model has two schedules that reflect the equilibrium in two markets: goods and money.
A market used to exchange a final good or service. Product markets exchange consumer goods
purchased by the household sector, capital investment goods purchased by the business sector, and
goods purchased by government and foreign sectors.
The money market is the centre for dealing mainly of short character, in monetary assets; it meets the
short term requirements of borrowers and provides liquidity or cash to the lenders.
15.5 Keywords
Demand: An economic principle that describes a consumer‘s desire and willingness to pay a price for a
specific good or service. Holding all other factors constant, the price of a good or service increases as its
demand increases and vice versa.
Equilibrium: The state in which market supply and demand balances each other and, as a result, prices
become stable.
Monetary: Pertaining to money. The word is often used in the context of macroeconomics, for example
monetary policy and monetary indicators.
Policy: A "policy" is very much like a decision or a set of decisions, and we "make", "implement" or
"carry out" a policy just as we do with decisions.
Supply: Supply can relate to the amount available at a specific price or the amount available across a range
of prices if displayed on a graph.

1. ............ is anything, which is generally acceptable as a means of payment in the settlement of
transactions.
(a) Demand (b) Money
2. ............of money is a stock, which can be measured at a point of time. It is taken to be autonomously
determined.
(a) Demand (b) Buy
3. supply of money refers to its stock at any point of time.

4. The microeconomic literature does not have a precise.

5. This model has two schedules that reflect the equilibrium in two markets: goods and money.
(a)Product model (b) Money Model
(c) Is- Im model (d) None of these
6. In this..........., the share of consumers‘ wealth invested in bonds has come down, and the cash holdings
have increased.
(a) Transation (b) consumers
(c)both (a )and (b ) (d) All of these.
7. ........markets exchange consumer goods purchased..

(a)Market (b) Product
(c)Consumer (d) All of these.
8. The total value of goods exchanged in product markets each year is measured by gross domestic
product..
(a)True (b) False
9. The ........is the centre for dealing mainly of short character, in monetary assets;
(a) Product market (b) money market
(c)Both a and b (d) none of these.
10. Various financial instruments are used for transactions in a money market.
(a) True (b) False

1. Define equilibrium of product and money market?
2 What is Is –Im model?
3. What is money market?
4. Explain product market.
5. What do you mean by equilibrium?
6. Define application of is-lm model in monetary.
7. Explain the application of is-lm model in Fiscal policy.
8. What is role of money?
9 Does the money supply change? Explain your statement.
10 Explain the role of supply?

1. (b) 2.(c) 3.(a) 4.(a) 5.(c)
6. (a) 7.(b) 8.(c) 9.(b) 10.(a)

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BUSINESS ECONOMICS

Jaipur National University

Concepts of Macro Economics: Definitions importance, growth, limitations of macro-economics, macro-

Unit 2: Consumer Behaviour 16-29

Unit 3: Demand Analysis 30-43

Unit 4: Supply Analysis 44-54

Unit 5: Production Analysis 55-68

Unit 6: Cost Analysis 69-81

Unit 8: Pricing Under Various Market Conditions 96-104

Unit 9: Distribution 105-116

Unit 11: Macro Market Analysis 129-140

Unit 12: Investment Function 141-152

Unit 13: Money Market 153-164

Unit 14: National Income Determination 165-175

Unit 15: Equilibrium of Product and Money Market 176-187

1.1 Meaning of Business Economics

1.1.1 Some Definitions of Business Economics

Figure 1.1: Business economics.

1.2 Nature and Scope of Business Economics

The nature of business economics is as follows:

Macro Economic Conditions

1.2.1 Scope of Business Economics

Demand Analysis and Forecasting

1.2.1 Relationship of Business Economics with other Disciplines

Business Economics and Operations Research

1.2.2 Uses of Business Economics

1.2.4 Significance Importance of Business Economics

1.3 Business Economics and Traditional Economics

Table 1.1: Comparison between business economics and traditional economics

3. Traditional economics is both normative and 3. Business economics is a normative science.

5. Business economics considers both economic

1.3.1 Role of a Business Economist

1.3.3 Responsibilities of a Business Economist

1.4 Micro Economics Analysis and Business Policies

1.4.1 Micro Economic Analysis

1.4.2 Scope of Micro Economic Analysis

Allocation of Resources in the production of Goods and Services

1.4.4 Limitations of Microeconomic Analysis

2. Based on Unrealistic Assumptions: Microeconomic analysis is based on the two assumptions

1.5 Macro Economics Analysis and Business Policies

1.5.1 Scope of Macro Economic Analysis

Theory of National Income

1.5.2 Role of Macro Economic Analysis in Formulation of Business Policies

1.5.3 Limitations of Macro Economic Analysis

1.5.4 Relation between Microeconomics and Macroeconomics

Micro Economic Analysis depends on Macro Economic Analysis

Study of Micro Economic Analysis is Necessary for Macro Economic Analysis

1.6 Inductive Methods of Business Economics

1.7 Deductive Methods of Business Economics

Deductions as methodology in economic theory involve the following stages:

1.8 Economic Systems

1.8.3 Mixed Economy

Characteristics of Mixed Economy

Did you know?

1.11 Self Assessment Questions

2. Business strategy focuses on............................

3. Microeconomics deals with which of the following?

6. Which of the following is not a macroeconomic issue?

8. The another name of inductive method is.............................

9. Microeconomics is not concerned with the behaviour of:

10. Business economics is only microeconomic in nature.

1.12 Review Questions