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MICROECONOMICS
ORDINAL APPROACH
INDIFFERENCE CURVE ANALYSIS OF DEMAND
INTRODUCTION
✓ To overcome the shortcomings of Marshall’s Cardinal Utility Analysis, Indifference Curve
Analysis came into play
✓ Was first invented by a classical economist Edgeworth but he used it only to show the
possibilities of exchange between two persons and not to explain consumer’s demand
✓ Afterwards, two English economists, J.R. Hicks and R.G.D. Allen in their paper ‘A
Reconsideration of the Theory of Value’ severely criticised Marshall’s cardinal utility analysis
and put forth the indifference curve analysis based on the notion of ordinal utility to explain
consumer’s behaviour
✓ In 1939, Hicks reproduced the indifference curve theory of consumer’s demand in his book
‘Value and Capital’ modifying the version of the original paper
ASSUMPTIONS
1. More of a commodity is better than less
2. Preferences or indifferences of a consumer are transitive
3. Diminishing marginal rate of substitution
WHAT ARE INDIFFERENCE CURVES?

✓ Indifference curves are the tools which represent all those combinations of good which give
same satisfaction to the consumer
✓ The consumer will be indifferent between them, that is, it will not matter to him which one
he gets
✓ To understand Indifference curves, let us start with Indifference schedules. In the following
table two Indifference schedules are given. In each schedule the amounts of goods X and Y in
each combination are such that the consumer is indifferent among the combination schedule
✓ In schedule 1, the consumer has to start with 1 unit of X and 12 unit of Y. Now, the consumer
is asked to tell how much of good Y he will be willing to give up for the gain of an additional
unit of X so that his level of satisfaction remains the same
✓ If the gain of one unit of X compensates him fully for the loss of 4 units of Y, then the next
combination of 2 units of X and 8 units of Y (2X + 8Y) will give him as much satisfaction as the
initial combination (1X + 12Y). Similarly, by asking the consumer further how much of Y he will
be prepared to forgo for successive increments in his stock of X so that is level of satisfaction
remains unaltered, we get combinations (3X + 5Y), (4X + 3Y) and (5X + 2Y), each of which
provides same level of satisfaction
I II
Good X Good Y Good X Good Y
1 12 2 14
2 8 3 10
3 5 4 7
4 3 5 5
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Page | 1
5 2 6 4
Table: Two indifference schedules
✓ Combinations in schedule II: (2X + 14Y), (3X + 10Y), (4X + 7Y), (5X + 5Y) and (6X + 4Y)
✓ Combination in schedule 2 will give him more satisfaction than any combination in schedule
1 because it is assumed that more of a quantity is preferred to less of a quantity
✓ Now, indifference schedule 1 is converted into indifference curve paper
Indifference Map is a complete representation of consumer's tastes and preferences which consists
of a set of indifference curves. In other words, an indifference map portrays consumer's scale of
preferences.
✓ In the following figure, an Indifference map of a consumer is shown which consists of five
Indifference curves.
✓ all combinations on indifference curve 1 will give him equal satisfactions
✓ Similarly, all the combinations on indifference curve 2 and so on will provide the same
satisfaction
✓ But the level of satisfaction on indifference curve 2 will be greater than the level of satisfaction
on indifference curve 1 and likewise
This exemplifies the notion that a higher indifference curve represents a higher level of satisfaction
than a lower indifference curve but an important point to not here is that "how much higher" cannot
be indicated.
Page | 2
MARGINAL RATE OF SUBSTITUTION

✓ The rate at which the consumer is prepared to exchange goods X and Y is known as marginal
rate of substitution
✓ We may define the marginal rate of substitution of X for Y as the amount of Y whose loss
can just be compensated by 1 unit gain in X. In other words, marginal rate of substitution of
X for Y represents the amount of Y which the consumer has to give up for the gain of one
additional unit of X so that is level of satisfaction remains the same.
Now, how to measure marginal rate of substitution on indifference curve?

✓ In the following figure, when the consumer moves from point A to B on this indifference curve
he gives up AS of Y and takes up SB of X and remains on the same indifference curve. It means
that the loss of satisfaction caused by giving up AS of Y equals the gain in satisfaction due to
the increase in good X by SB.
✓ Therefore, it follows that:
MRSxy = AS/SB = ΔY/ΔX
Page | 3
Now, suppose that points A and B are very close to each other so that it can be assumed that both of
them lie on the same tangent tT. Now, in a right angled triangle ASB, AS/SB is equal to the tangent of
the angle ABS. It therefore follows that:
MRSxy = AS/SB = ΔY/ΔX = tangent of ∠ABS
✓ But in the figure, we can see that ∠ABS = ∠tTO
✓ And the tangent of ∠tTO is equal to Ot/OT
✓ The tangent of ∠tTO indicates the slope of the tangent line tT drawn at point A or B on the
indifference curve.
In other words, the slope of the indifference curve at point A or B is equal to the tangent of ∠tTO.
It therefore follows:
MRSxy = tangent of ∠tTO = slope of the IC on A and B = Ot/OT
It is thus clear from the above that if we have to find out the MRSxy at a point on the IC we can do so
by drawing tangent at the point on the IC and then measuring the slope by estimating the value of the
tangent of the angle which the tangent line makes with the X-axis.
PRINCIPLE OF DIMINISHING MARGINAL RATE OF SUBSTITUTION

✓ An important principle of economic theory is that marginal rate of substitution of X for Y
diminishes as more and more of good X is substituted for good Y. In other words, as the
consumer has more and more of good X, he is prepared to forego lesson less of good Y.
✓ This principle is illustrated in the following figures (a) and (b).
✓ In figure (a), when the consumer slides down from A to B on the indifference curve he gives
up ΔY1 of good Y for the compensating gain of ΔX of good X. Therefore, the marginal rate of
substitution (MRSxy) here is equal to ΔY1/ΔX.
✓ But as the consumer further slides down on the curve, the length of ΔY becomes shorter and
shorter, while the length of ΔX is kept the same. It can be seen from figure that ΔY2 is less than
ΔY1, and so on and so forth. It means that as the consumer's stock of X increases and his stock
of Y decreases, he is willing to forego less and less of Y for a given increment in X.
✓ Now, in figure (b) three tangents GH, KL and MN are drawn at the points P, Q and R
respectively to the given indifference curve
Page | 4
✓ Slope of the tangent GH is equal to OG/OH

✓ Hence, the MRS of X for Y at point P is equal to OG/OH
✓ Likewise, the MRS at point Q is equal to OK/OL and at point R it is equal to OM/ON
✓ It is important to note that OK/OL is smaller than OG/OH and, OM/ON is smaller than OK/OL
✓ It follows that MRSxy diminishes as the consumer slides down on his indifference curve
Factors responsible for diminishing marginal rate of substitution:

1. Want of a particular good is satiable
2. Goods are imperfect substitutes of each other
PROPERTIES OF INDIFFERENCE CURVES

Property I. Indifference curve slopes downward to the right.
This property implies that an indifference curve has a negative slope. Indifference curve being
downward sloping means that when the amount of one good in the combination is increased, the
amount of the other good is reduced. This must be so if the level of satisfaction is to remain the same
on an indifference curve. A little reflection on the four different possibilities of this property is
explained below.
1) If the indifference curve had a shape of a horizontal straight line (parallel to X-axis) as in the
below figure, that would mean as the amount of good X was increased, while the amount of
good Y remained the same, the consumer would remain indifferent as between various
combinations.
✓ But this cannot be so if assumption 1 is to hold good
✓ According to Assumption 1, the consumer always prefers a larger amount of a commodity to
the smaller amount of it, other things being constant
Page | 5
2) Likewise, indifference curve cannot be a vertical straight line because a vertical straight line
would mean that will the amount of good Y in the combination increases, the amount of good
X remains the same
3) A third possibility for a curve is to slope upward to the right as in the following figure
✓ Upward sloping curve means that the amount of both the good increases as one moves
to the right along the curve
✓ This would mean that a combination which contains more of both the goods give the same
satisfaction to the consumer as the combination which had smaller amounts of both the
goods.
✓ This is clearly invalid in view of our assumption 1
Page | 6
4) The last possibility for the curve is that it slopes downward to the right and this is the shape
which the indifference curve can reasonably take. In order that a consumer should get the
same satisfaction from the various combinations of a curve and thus to maintain his
indifference between them, the amount of good X should increase as the amount of good Y
reduces. And this is what a downward sloping indicates. A downward sloping curve means
that with every increase in the amount of good x, there is corresponding decrease in the
amount of good Y. It is also to note here that the slope of the indifference curve at its various
points will depend upon how much of good Y the consumer is willing to give up for an
additional unit of good X.
Property II. Indifference curves are convex to the origin.

This property follows from assumption 3 which states that marginal rate of substitution of X for Y
diminishes as more and more units of X is substituted for Y. A little reflection on the two different
possibilities of this property is explained below.
1) If indifference curve was concave to the origin it would imply that marginal rate of
substitution of X for Y increased as more and more of X was substituted for Y as shown in the
below figure (a).
 Likewise, indifference curve cannot be a straight line, except when goods are perfect
substitutes.
2) It can be seen from the following figure(b) that straight line indifference curve would mean
that MRSxy remains constant as more units of X are acquired in the place of Y. Since MRSxy is
equal to the slope of indifference curve at a point on it, and because a straight line has the
same slope throughout, therefore the straight-line indifference curve will mean the same MRS
throughout.
Page | 7
The degree of convexity of an indifference curve depends on the rate of fall in the marginal rate of
substitution
 The greater the fall in marginal rate of substitution, the greater the convexity of the
indifference curve and vice versa
Property III. Indifference curves cannot intersect each other.

Only one indifference curve will pass through a point in the Indifference map
This property follows from assumptions 1 and 2 and can be easily proved by first making two
indifference curves cut each other and then showing the absurdity or self-contradictory result it leads
to.
Page | 8
In the above figure, two Indifference curves are shown cutting each other at point C
Now take point A on indifference curve IC2 and point B on indifference curve IC1 vertically below A
Since indifference curve represents those combinations two commodities which give equal
satisfaction to the consumer, the combinations represented by A and C will give equal satisfaction to
the consumer because both lie on the same indifference curve IC2 and likewise holds good for
combination B and C, both being on IC1
 If combination A is equal to combination C in terms of satisfaction, and combination B is equal
to combination C, it follows that combination A will be equivalent to B in terms of satisfaction.
But a glance at the given figure will show that this is absurd conclusion since combination A contains
more of good Y than combination B. Thus, the consumer will definitely prefer A to B, that is, A will get
more satisfaction to the consumer than B (assumption 1).
 But the two indifference curves cutting each other leads us to an absurd conclusion of A being
equal to B in terms of satisfaction.
We therefore conclude that indifference curves cannot cut each other.
Important points to note
 Combination A=C and B=C implies that combination A=B
 Now, combination A is at a higher IC than combination B, which will of course get him more
satisfaction.
Property IV. A higher indifference curve represents higher level of satisfaction than a lower
indifference curve.
The last property of indifference curve means that the combinations which lie on a higher indifference
curve will be preferred to the combinations which lie on a lower indifference curve. Consider
Indifference curves IC1 and IC2 in the following figure. IC2 is a higher indifference curve than IC1.
Combination Q has been taken on a higher indifference curve IC2 and combinations S on a lower
indifference curve IC1. This is so because combination Q contains more of both goods X and Y than
combination S and assumption 1 states that more of a commodity is preferred by the consumers over
less.
Page | 9
INDIFFERNCE CURVES OF PERFECT SUBSTITUTES AND PERFECT COMPLIMENTS

Indifference Curves of Perfect Substitutes: In case of perfect substitutes, the indifference curves are
parallel straight lines because the consumer equally prefers the two goods and is willing to exchange
one good for the other at a constant rate.
Examples of goods that are perfect substitutes are not difficult to find in the real world; one of the
examples could be that of cold drink such as Pepsi Cola and Coca Cola.
Indifference Curves of Perfect Compliments: The greater the fall in marginal rate of substitution, the
greater the convexity of the indifference curve. The less the ease with which two goods can be
substituted for each other, the greater will be the fall in marginal rate of substitution. At the extreme,
when two goods can not at all be substituted for each other, that is, when the two goods are perfect
complementary goods, will consist of two straight lines with a right angle bent which is convex to the
origin.
Page | 10
✓ As it can be seen in the above figure, the left-hand portion of an indifference curve of the perfect
complementary goods is a vertical straight line which indicates that an infinite amount of Y is
necessary to substitute one unit of X
✓ Similarly, the right-hand portion of the indifference curve is a horizontal straight line which means
that an infinite amount of X is necessary to substitute one unit of Y
✓ Compliments are thus those good which are used jointly in consumption so that their consumption
increases or decreases simultaneously. Pen and ink, right shoe and left shoe, automobile and
petrol, type writer and typist are some of the examples of complementary goods.
BUDGET LINE
The concept of budget line is essential for understanding the theory of consumer's equilibrium.
Budget line is a graphical representation of all possible combination two goods which can be
purchased with given income and prices, such that the cost of each of these combinations is equal
to the money income of the consumer.
Suppose, a consumer has got an income of rupees 50 to spend on two goods X and Y
And Px = Rs.10 per unit
Py = Rs.5 per unit
Now, on the budget line shown in the following figure, any combination lying on the line is a
combination where the consumer is using all of his money income. However, any combination lying
within the budget line such as K(2X and 2Y) represents a combination where he will not be spending
all of his income of Rs 50.
The budget line can be written algebraically as follows:
PxX + PyY = M
where, Px and Py denote prices of goods X and Y respectively, X and Y represent the quantity purchased
and M stands for money income
NOTE: Budget line is also known by the names-

1. Price line
2. Price opportunity line
3. Price-income line
4. Outlay line
Page | 11
5. Budget constraint
6. Expenditure line
7. Consumption possibility line
A budget space shows a set of all commodity combinations that can be purchased by spending
the whole or a part of the given income. It can algebraically be expressed as:
PxX + PyY ≤ M
It is presented with blue shading in the above figure.
MACROECONOMICS
CAPITAL MARKET AND IT'S REGULATION
The capital market provides the support to the system of capitalism of the country. The Securities and
Exchange Board of India (SEBI), along with the Reserve Bank of India are the two regulatory authority
for Indian securities market, to protect investors and improve the microstructure of capital markets
in India. With the increased application of information technology, the trading platforms of stock
exchanges are accessible from anywhere in the country through their trading terminals.
Capital Markets in India

✓ India has a fair share of the world economy and hence the capital markets or the share
markets of India form a considerable portion of the world economy. The capital market is vital
to the financial system.
✓ The capital Markets are of two main types. The Primary markets and the secondary markets.
✓ In a primary market, companies, governments or public sector institution can raise funds
through bond issues. Also, Corporations can sell new stock through an initial public offering
(IPO) and raise money through that. Thus, in the primary market, the party directly buys shares
of a company. The process of selling new shares to investors is called underwriting.
✓ In the Secondary Markets, the stocks, shares, and bonds etc. are bought and sold by the
customers. Examples of the secondary capital markets include the stock exchanges like NSE,
BSE etc. In these markets, using the technology of the current time, the shares, and bonds etc.
are sold and purchased by parties or people.
Broad Constituents in the Indian Capital Markets

✓ Fund Raisers are companies that raise funds from domestic and foreign sources, both public
and private. The following sources help companies raise funds.
✓ Fund Providers are the entities that invest in the capital markets. These can be categorized as
domestic and foreign investors, institutional and retail investors. The list includes subscribers
to primary market issues, investors who buy in the secondary market, traders, speculators,
FIIs/ sub-accounts, mutual funds, venture capital funds, NRIs, ADR/GDR investors, etc.
✓ Intermediaries are service providers in the market, including stock brokers, sub-brokers,
financiers, merchant bankers, underwriters, depository participants, registrar and transfer
agents, FIIs/ sub-accounts, mutual Funds, venture capital funds, portfolio managers,
custodians, etc.
✓ Organizations include various entities such as MCX-SX, BSE, NSE, other regional stock
exchanges, and the two depositories National Securities Depository Limited (NSDL) and
Central Securities Depository Limited (CSDL).
✓ Market Regulators include the Securities and Exchange Board of India (SEBI), the Reserve
Bank of India (RBI), and the Department of Company Affairs (DCA).
Page | 12
Role and Importance of Capital Market in India the capital market has a crucial significance to capital
formation. For a speedy economic development, the adequate capital formation is necessary. The
significance of capital market in economic development is explained below:
✓ Mobilization of Savings and Acceleration of Capital Formation: In developing countries like
India, the importance of capital market is self-evident. In this market, various types of
securities help to mobilize savings from various sectors of the population.
o The twin features of reasonable return and liquidity in stock exchange are definite
incentives to the people to invest in securities. This accelerates the capital formation in
the country.
✓ Raising Long-Term Capital, the existence of a stock exchange enables companies to raise
permanent capital. The investors cannot commit their funds for a permanent period but
companies require funds permanently.
o The stock exchange resolves this dash of interests by offering an opportunity to investors
to buy or sell their securities, while permanent capital with the company remains
unaffected.
✓ Promotion of Industrial Growth The stock exchange is a central market through which
resources are transferred to the industrial sector of the economy. The existence of such an
institution encourages people to invest in productive channels.
✓ Ready and Continuous Market The stock exchange provides a central convenient place where
buyers and sellers can easily purchase and sell securities. Easy marketability makes an
investment in securities more liquid as compared to other assets.
✓ Technical Assistance An important shortage faced by entrepreneurs in developing countries
is technical assistance. By offering advisory services relating to the preparation of feasibility
reports, identifying growth potential and training entrepreneurs in project management, the
financial intermediaries in capital market play an important role.
✓ Reliable Guide to Performance The capital market serves as a reliable guide to the
performance and financial position of corporate, and thereby promotes efficiency.
✓ Proper Channelization of Funds The prevailing market price of a security and relative yield
are the guiding factors for the people to channelize their funds in a particular company. This
ensures effective utilization of funds in the public interest.
✓ Provision of Variety of Services: The financial institutions functioning in the capital market
provide a variety of services such as a grant of long-term and medium-term loans to
entrepreneurs, provision of underwriting facilities, assistance in the promotion of companies,
participation in equity capital, giving expert advice etc.
✓ Development of Backward Areas Capital Markets provide funds for projects in backward
areas. This facilitates economic development of backward areas. Long-term funds are also
provided for development projects in backward and rural areas.
✓ Foreign Capital, Capital markets make possible to generate foreign capital. Indian firms are
able to generate capital funds from overseas markets by way of bonds and other securities.
The government has liberalized Foreign Direct Investment (FDI) in the country.
o This not only brings in the foreign capital but also foreign technology which is important
for economic development of the country.
THEORIES OF INFLATION AND EXPECTATIONS
Page | 13
Different economists have presented different theories on inflation. The economists who have
provided the theories of inflation are broadly categorized into two labels, namely, monetarists and
structuralists.
✓ Monetarists associated inflation to the monetary causes and suggested monetary measures
to control it.
✓ On the other hand, structuralists believed that the inflation occurs because of the unbalanced
economic system and they used both monetary and fiscal measures together for sorting out
economic problems.
1. Market-Power Theory of Inflation:

✓ In an economy, when a single or a group of sellers together decide a new price that is different
from the competitive price, then the price is termed as market-power price. Such groups keep
prices at the level at which they can earn maximum profit without any concern for the
purchasing power of consumers.
✓ For example, in the past few years, the prices of onion were very- high in India. The soaring
price of onions was the result of the group action of onion producers. In such a situation,
people in middle- and low-income groups reduced the consumption of onions. However,
onion producers earned high profits from higher income group.
✓ According to the advanced version of market power theory of inflation, oligopolists can
increase the price to any level even if the demand does not rise. This hike in price levels occurs
due to increase in wages (because of trade unions) in the oligopolistic industry.
✓ The increase in wages is compensated with the hike in prices of products. With increase in the
income of individuals, their purchasing power also increases, which further results in inflation.
✓ Apart from this, some economists concluded that fiscal and monetary policies are not
applicable in practical situations as these policies are not able to control rise in prices levels.
These policies would work only when prices rise due to an increase in demand.
✓ Moreover, these policies cannot be applied to oligopolistic rise in prices, which is due to
increase in the cost of production. Monetary policy can reduce the rate of inflation by raising
the interest rate and regulating the credit flow in the market. However, it would have no effect
on the oligopolistic price as the cost is transferred to the prices of goods and services.
2. Conventional Demand-Pull Inflation:

✓ The market power theory of inflation represents one extreme end of inflation. According to
this theory inflation exists even when there is no excess in demand. On the other end, the
conventional demand-pull theorists believed that the only cause of inflation is the excess of
aggregate demand over aggregate supply.
✓ In full employment equilibrium condition, when demand increases, inflation becomes
unavoidable. In addition in full employment condition, the economy reaches to its maximum
production capacity. At this point, the supply of goods and services cannot be increased
further while the demand of products and services increases rapidly. Due to this imbalance
between demand and supply, inflation takes place in the economy.
3. Structural Theories of Inflation:

Apart from the two extreme ends mentioned in the above, there is a middle group of economists
called structural economists. According to structural theory of inflation, market power is one of the
factors that cause inflation, but it is not the only factor. The supporters of structural theories believed
that the inflation arises due to structural maladjustments in the county or some of the institutional
features of business environment.
Page | 14
They have provided two types of theories to explain the causes of inflation:
Mark-up Theory:
✓ Mark-up theory of inflation was proposed by Prof Gardner Ackley. According to him, inflation
cannot occur alone by demand and cost factors, but it is the cumulative effect of demand-pull
and cost-push activities. Demand-pull inflation refers to the inflation that occurs due to excess
of aggregate demand, which further results in the increases in price level. The increase in
prices levels stimulates production, but increases demand for factors of production.
Consequently, the cost and price both increases.
✓ In some cases, wages also increase without rise in the excess demand of products. This results
in fall in supply at increased level of prices as to compensate the increase in wages with the
prices of products. The shortage of products in the market would result in the further increase
of prices.
✓ Therefore, Prof. Gardner has provided a model of mark-up inflation in which both the factors,
demand cost, are determined. Increase in demand results in the increase of prices of products
as the customers spend more on products.
✓ On the other the goods are sold to businesses instead of customers, then the cost of
production increases. As a result, the prices of products also increase. Similarly, a rise in wages
results in increase in cost of production, which would further increase the prices of products.
✓ So according to Prof Gardner, inflation occurs due to excess of demand or increases in wage
rates; therefore, both monetary and fiscal policies should be used to control inflation. Though,
these two policies are not adequate to control inflation.
Bottle-Neck Inflation:
✓ Bottle-neck inflation was introduced by Prof Otto Eckstein. According to him, the direct
relationship between wages and prices of products is the main cause of inflation. In other
words, inflation takes place when there is a simultaneous increase in wages and prices of
products. However, he believed that wage push or market-power theories alone are not able
to provide a clear explanation of inflation.
✓ After analysis of inflationary situation, Prof Eckstein says that the inflation occurs due to the
boom in capital goods and wage-price spiral. In addition, he also advocated that during
inflation prices in every industry is higher, but few industries show a very high price hike than
rest of the industries.
✓ These industries are termed as bottle-neck industries, which are responsible for increase in
prices of goods and services. In addition, Prof. Eckstein advocated that concentration of
demand for products of bottle industries results in inflation.
AUGMENTED PHILLIPS CURVE

The expectations-augmented Phillips curve introduces adaptive expectations into the Phillips curve.
These adaptive expectations, which date from Irving Fisher’s book “The Purchasing Power of Money”,
1911, were introduced into the Phillips curve by monetarists, specially Milton Friedman. Therefore,
we could say that the expectations-augmented Phillips curve was first used to explain the monetarists’
view of the Phillips curve.
✓ Adaptive expectations models led to an important shift in the perception of a government’s
ability to act. Under Keynes’ money illusion, changes in nominal variables (prices, wages, etc)
were accepted by agents as real despite overall purchasing power remaining stable.
✓ However, monetarism embraced the adaptive expectations theory to mean that people would
stumble once or twice on the same stone, but not a third. In this way, if the government
decided on an expansionist monetary policy, inflation would rise and unemployment would
Page | 15
fall, based on the Phillips curve. However, a second or third time around, agents would be
quick to associate higher inflation with rising salaries in a vicious circle, and adjust their
behaviour accordingly based on past experiences. They would anticipate that inflation would
drain their purchasing power accordingly, and monetary policy would have little effect. If we
see this graphically:
✓ Initially, unemployment and inflation are at point A. The government decides to embark on
an expansionist monetary policy, which floods the markets with inexpensive credit,
incentivising consumption. Expectations shift to point B along the Phillips curve:
unemployment is reduced through economic stimulus with a trade off in the form of inflation.
✓ However, after a short period, agents will begin to associate expansionist policies with
inflation, which means a drain on their resources, and they will push for higher wages. This
will stop the consumption stimulus and also disincentivise hiring. Eventually, agents will shift
their expectations curves to point C. A second time around, D will be achieved, leading more
or less rapidly to point E. This is why, in the long term, inflation has little effect on
unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with
no permanent effect on unemployment.
✓ In summary, monetarists sustained that the Phillips curve will hold up in the short term, but
not in the long term. In the long term, the Phillips curve is completely vertical and determines
the natural rate of unemployment, as Friedman puts it in his article “The role of Monetary
Policy”, 1968.
Real Business Cycles

Real business cycle models state that macroeconomic fluctuations in the economy can be largely
explained by technological shocks and changes in productivity.
✓ These changes in technological growth affect the decisions of firms on investment and
workers (labour supply). Hence changes in output can be traced to microeconomic and supply-
side factors.
✓ Real business cycle models either completely reject or play down the role of aggregate
demand in influencing the economic cycle.
✓ Real business cycle models suggest that government intervention to influence demand in the
economy is generally counterproductive and the optimal policy is to concentrate on supply-
side reforms which help the economy to be more efficient and flexible.
Page | 16
✓ Real business cycle models reject the Keynesian approach to the macroeconomy and also
reject monetarism. It tends to be associated with neo-classical economics and the Chicago
School of economics.
Aspects of Real Business Cycle

✓ The macro economy stems from individual microeconomic decisions. In particular, how do
individuals respond to a changing environment and technology in deciding what to produce
and how much to work? Thus according to real business cycle, economies have a strong basis
in microeconomic principles.
✓ Real business cycle models assume individuals are rational agents seeking to maximise their
utility. A basis for real business cycle theory is a simple neo-classical model of capital
accumulation where individuals seek to invest in capital, and the price of labour will be
determined by market forces. Thus under a broad set of conditions, work effort, investment
and output will converge to a steady rate.
Pareto efficiency and real business cycle

✓ Real business cycles generally assume that shocks to productivity lead to fluctuations in the
economy that are Pareto optimal. In others words, a temporary fall in output is an inevitable
consequence of fall in productivity and not a cause for concern. The fall in output is a way for
the economy to adjust to this new equilibrium and enable resources to find more productive
uses.
✓ This is similar to Joseph Schumpeter’s work on “Creative Destruction” – the idea that failure
of inefficient business is important for enabling productivity gains and economic growth.
Criticisms of Real Business cycle

✓ Evidence of major recessions Real business cycle appears more believable, if we use data from
the 1950s and 1960s, where economic growth was more stable. However, if we look at
the Great Depression (1929-34) and the Great Recession (2008-12), the length and extent of
the recession cannot be explained by supply-side shocks. There is a clear impact on aggregate
demand from a fall in confidence, a fall in money supply, a lack of bank lending. All demand-
side factors that have a direct influence on the economy.
✓ Liquidity traps Real business cycle argues higher government spending can cause crowding
out and be ineffective. However, in a liquidity trap, there is surplus saving and governments
can increase borrowing, spending without causing any crowding out.
✓ Wage rigidity Real business cycle theories assume flexible markets and output is always at
its real output. However, this ignores the role price and wage rigidity. Even neo-classical
economists argue that monetary policy can play a role in dealing with labour market
imperfections such as nominal wage rigidity.
✓ A clear link between interest rates and recession. If we look at the US recession of 1981-
82, we can see a clear link between higher interest rates and a sharp fall in demand. In the UK,
in 1991-92, there was a clear link with interest rates rising to 15%. The sharp fall in demand
and output has a clear link with a demand-side factor.
✓ Long-term nature of technological change. Technology takes time to diffuse into the
economy. There wasn’t a big bang moment for the use of the internet; it steadily increased its
scope in the global economy.
✓ Technological change may be influenced by the economic cycle. In a recession, firms
will cut back on investment and this will lead to a lower technological process. Therefore,
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rather than changes in technology causing the business cycle, it could be the other way
around.
STATISTICS & ECONOMETRICS

AUTOCORRELATION
Meaning: Error terms are correlated to each other
Auto-correlation can occur in any of the three types of data available for empirical analysis:
i. Time Series
ii. Cross Section
iii. Pooled data (combination of the above two)
 Note: Auto-correlation is most prevalent in Time-Series data analysis
AUTOCORRELATION IN TIME SERIES DATA (SERIAL CORRELATION)

✓ The relationship between the value of disturbance term (u) in one period and the value of the
same in any other previous periods (i.e., lagged by a number of time units)
✓ One of the basic assumptions in the regression model is that the value of disturbance term in
one period is independent of its value in any other period, so that
Cov (ut, us) = 0 for t ≠ s
E (ut, us) = 0 for t ≠ s
✓ This implies that the successive disturbance terms for different observations are statistically
independent. If this assumption is violated, that is, the value of u in any particular period is
correlated with its own proceeding value(s), it is termed as autocorrelation or serial
correlation of the disturbance term.
✓ Thus, the violation of the assumption cov (ui, uj) = 0 ; E(ui,uj) = 0 gives rise to autocorrelation
Several forms of autocorrelation are possible, the simplest one being the first order autocorrelation:
𝐮𝐭 = 𝛒𝐮𝐭−𝟏 + 𝐯𝐭
where, 𝛒 is the parameter that measures the correlation between ut and ut-1
vt is another random error term that is IID (i.e., not autocorrelated)
If 𝛒 > 0 → positive autocorrelation

𝛒 < 0 → negative autocorrelation
Example of a fourth-degree autocorrelation:

ut = ρ1 ut−1 + ρ2 ut−1 + ρ3 ut−3 + ρ4 ut−4 + vt
Two types of serial autocorrelation:

1. Pure Serial Correlation: The assumption that errors corresponding to different observations
are uncorrelated with each other. This assumption requires that-
E[ui uj ] = 0 and i ≠ j
When this assumption is violated, then the error term is said to be serially correlated. (Example: A
large external shock to the economy in one period may have an affect over several periods).
2. Impure Serial Correlation: Specification errors like omitted variables or incorrect functional
form can cause serial correlation.
AUTOCORRELATION IN CROSS SECTION DATA (SPATIAL CORRELATION)
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✓ In cross sectional studies, data are often collected on the basis of a random sample of cross
section unit such as household (consumption function analysis), firm (Investment function
analysis), so that there is no prior reason to believe that the error term pertaining to one
household or firm is correlated with the error term of another household or firm
✓ If by chance, such a correlation is observed in cross section, it is called spatial autocorrelation,
that is, correlation in space rather than in time.
✓ It is important to remember that in cross-section analysis, the ordering of the data must have
some logic for economic interest to make sense of any determination of whether spatial
correlation is present or not
POSITIVE AND NEGATIVE AUTOCORRELATION
Negative autocorrelation:
✓ Negative autocorrelation will show the error terms jumping from negative to positive
✓ It is indicated by an alternating pattern where the residuals cross the time axis more
frequently than if they were distributed randomly.
✓ There is some sort of cycle in the distribution of random errors
✓ In the figure positive values tend to be followed by negative ones and negative values by
positive ones. This is an example of negative autocorrelation. If auto correlation coefficient is
negative, it means that the return tends to switch Science from negative to positive and back
again for consecutive observations
Positive autocorrelation:
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✓ It will show the error terms moving gradually from positive to negative and back again in a
wave pattern.
✓ A plot of the residuals from our regression will tend to be positive for a number of
observations, then negative for several more and then back again.
✓ In the below figure, positive values tend to be followed by positive ones and negative values
by negative ones. Successive values tend to have the same sign. This is described as positive
autocorrelation.
✓ If auto correlation coefficient ρ is positive, it means that the error term tends to have the same
sign from one observation to the next.
CONSEQUENCES
1) The OLS estimators will be inefficient
2) This will no longer result in BLUE
3) The estimated variances of the regression coefficients will be biased and inconsistent
4) The Hypothesis testing will no longer be valid
5) In most cases, the r2 will be overestimated and the t-statistics will tend to be higher
TESTS FOR AUTOCORRELATION

1) Runs test
2) Durbin-Watson 'd' Test
3) Breusch-Godfrey (BG) test
SPURIOUS REGRESSIONS
A “spurious regression” is one in which the time-series variables are non-stationary and independent.
It is well known that in this context the OLS parameter estimates and the R 2 converge to functionals
of Brownian motions, the “t-ratios” diverge in distribution, and the Durbin–Watson statistic converges
in probability to zero. The regression is spurious when we regress one random walk onto another
independent random walk. It is spurious because the regression will most likely indicate a non-existing
relationship:
1. The coefficient estimate will not converge toward zero (the true value). Instead, in the limit the
coefficient estimate will follow a non-degenerate distribution
2. The t value most often is significant.
3. R 2 is typically very high
What causes the spurious regression?
Loosely speaking, because a nonstationary series contains
“stochastic” trend
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1. For a random walk yt = yt−1 + et we can show its MA

representation is yt = et + et−1 + et−2 + . . .
2. The stochastic trend et + et−1 + et−2 + . . . causes the series to appear trending (locally).
Spurious regression happens when there are similar local trends.
UNIT ROOTS
A unit root (also called a unit root process or a difference stationary process) is a stochastic trend in a
time series, sometimes called a “random walk with drift”; If a time series has a unit root, it shows a
systematic pattern that is unpredictable.
A possible unit roots. The red line shows the drop-in output and path of recovery if the time series has
a unit root. Blue shows the recovery if there is no unit root and the series is trend-stationary.
Because the autoregressive lag polynomial has one root equal to one, we say it has a unit root.
• Note that there is no tendency for mean reversion, since any epsilon shock to y will be carried
forward completely through the unit lagged dependent variable.
The Mathematics Behind Unit Roots
The reason why it’s called a unit root is because of the mathematics behind the process. At a basic
level, a process can be written as a series of monomials (expressions with a single term). Each
monomial corresponds to a root. If one of these roots is equal to 1, then that’s a unit root.
The math behind unit roots is beyond the scope of this site. All you really need to know if you’re
analysing time series is that the existence of unit roots can cause your analysis to have serious issues
like:
• Spurious regressions: you could get high r-squared values even if the data is uncorrelated.
• Errant behavior due to assumptions for analysis not being valid. For example, t-ratios will not
follow a t-distribution.
What is a Unit Root Test?
Unit root tests are tests for stationarity in a time series. A time series has stationarity if a shift in time
doesn’t cause a change in the shape of the distribution; unit roots are one cause for non-stationarity.
These tests are known for having low statistical power. Many tests exist, in part, because none stand
out as having the most power. Tests include:
• The Dickey Fuller Test (sometimes called a Dickey Pantula test), which is based on linear
regression. Serial correlation can be an issue, in which case the Augmented Dickey-Fuller (ADF)
test can be used. The ADF handles bigger, more complex models. It does have the downside of a
fairly high Type I error rate.
• The Elliott–Rothenberg–Stock Test, which has two subtypes:
• The P-test takes the error term’s serial correlation into account,
• The DF-GLS test can be applied to detrended data without intercept.
• The Schmidt–Phillips Test includes the coefficients of the deterministic variables in
the null and alternate hypotheses. Subtypes are the rho-test and the tau-test.
• The Phillips–Perron (PP) Test is a modification of the Dickey Fuller test, and corrects
for autocorrelation and heteroscedasticity in the errors.
• The Zivot-Andrews test allows a break at an unknown point in the intercept or linear trend.
Problems with Unit Roots

• Because they are not covariance stationary unit roots require some special treatment.
– Statistically, the existence of unit roots can be problematic because OLS estimate of the AR(1) coef.
ϕ is biased.
– In multivariate frameworks, one can get spurious regression results
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– So to identify the correct underlying time series model, we must test whether a unit root exists or
not.
INTERNATIONAL ECONOMICS
STOLPER-SAMUELSON THEOREM
The Stolper-Samuelson theorem is one of the central results of Heckscher-Ohlin theory, itself one of
the principal theories of international trade. It provides a definite answer to a central question in
applied economics: What is the effect of changes in the prices of goods, caused for example by
changes in tariffs, on the prices of factors of production? As first presented by Wolfgang Stolper and
Paul A. Samuelson (1941)
✓ It dealt with a very special framework with many restrictive Assumptions
o Most notably that the economy consists of only two broad sectors.
o One of the two trading countries, considered for analysis, produces two commodities—cloth
and steel, and employs only two factors—labour and capital.
o The production function for each of the two commodities is homogenous of first degree. It
implies that the production is governed by constant returns to scale.
o Both labour and capital are fully employed.
o The two factors of production are fixed in supply.
o The conditions of perfect competition exist both in the product and factor markets.
o The given country is labour-abundant and capital-scarce.
o The cloth is labour-intensive good while steel is capital-intensive good.
o The international terms of trade are fixed.
o Both the factors are mobile between two industries or sectors but these are not mobile
between the two countries.
o There is an absence of transport costs.
✓ However, subsequent theoretical work has shown that essential features of the theorem hold
much more generally. It has also been applied to a range of empirical issues, including the
effects of increased globalization on income distribution in developed countries, and the long-
run political allegiances of classes and interest groups.
Theorem
✓ Suppose that one sector produces exports and the other produces goods which compete
directly with imports. Suppose in addition that the import-competing sector is relatively
"labour-intensive," meaning that it uses a higher ratio of labour to capital than the export
sector.
✓ Now ask what will be the effect of a tariff or some other change, which raises the relative
price of the import-competing sector's output. Clearly this will encourage that sector to
expand. Provided that the economy is at or close to full employment of both factors, this
expansion must come at the expense of the export sector.
✓ The combined expansion of the relatively labour-intensive sector and contraction of the
relatively capital-intensive sector raises the aggregate demand for labour relative to capital,
and so puts upward pressure on the wage. Because the price of exports has not changed, a
higher wage must imply an absolute fall in the return to capital.
✓ This in turn implies that the wage must rise by even more than the price of imports. Thus,
when import-competing goods are relatively labour-intensive, wage earners gain and capital
owners lose, irrespective of which bundle of goods they consume. Put simply, in this case,
protection unambiguously raises real wages.
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✓ An increase in the price of a good will cause an increase in the price of the factor used
intensively in that industry and a decrease in the price of the other factor.
a 11 w + a21r = p1 … (1)
a12w + a22r = P2 … (2)
SST in Linear Model

✓ These are zero-profit conditions. Here a11 is the amount of labour required to produce 1 unit
of cloth.
✓ a21 is the amount of capital required to produce 1 unit of cloth, w and r are the prices of two
factors (labour and capital) and p1 is the price of cloth. The same is the case with food. Eqn(1)
and (2) are the zero-profit conditions.
✓ Food- labour intensive, cloth- capital intensive.
✓ Rise in p2 that is price of cloth lead to fall in r and rise in w, the price of labour (the wage rate)
will rise, while price of the other factor, (capital) will fall.
✓ The SST states that if, say, the price of capital-intensive good rises r will not only rise but will
rise in greater proportion to the output price increase. The price of the other factor falls but
not necessarily in greater proportion to the rise in output price.
Stolper- Samuelson Theorem can be explained through Edgeworth Box
✓ Edgeworth box shows that the given country is labour-abundant and capital-scarce.
✓ A is the origin for labour-intensive goods—cloth and C is the point of origin for the capital-
intensive good—steel.
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✓ AC is the non-linear contract curve sagging below. In the absence of trade, production takes
place at R, which is the point of tangency of isoquant X0 of cloth, isoquant Y0 of steel and the
factor price line P0P0.
K-L Ratio in cloth at R = Slope of line AR = Tan α
K-L Ratio in steel at R = Slope of line RC = Tan β
✓ When trade commences, this labour-surplus country expands the production of cloth (L- good)
and reduces the production of steel (K-good).
✓ The production now takes place at S, which is the point of tangency of higher isoquant X1 of
cloth, lower isoquant Y1 of steel and the factor price line P1P1.
K-L Ratio in cloth at S = Slope of line AS = Tan α1
K-L Ratio in cloth at S = Slope of line SC = Tanβ1
✓ Since Tan α1 > Tan α and Tan β1 > Tan β, the K-L ratio rises in both the commodities in this
country. The factor price line P1P1 is steeper than the original factor price line P0P0. It signifies
that the price of labour rises relative to the price of capital.
IMPERFECT COMPETITION AND INTERNATIONAL TRADE

Trade Based on Product Differentiation
✓ A large portion of the output of modern economies today involves differentiated rather than
homogeneous products. Thus, a Chevrolet is not identical to a Toyota, a Volkswagen, a Volvo,
or a Renault. As a result, a great deal of international trade can and does involve the exchange
of differentiated products of the same industry or broad product group. That is, a great deal
of international trade is intra-industry trade in differentiated products, as opposed to inter-
industry trade in completely different products.
✓ Intra-industry trade arises in order to take advantage of important economies of scale in
production. That is, international competition forces each firm or plant in industrial countries
to produce only one, or at most a few, varieties and styles of the same product rather than
many different varieties and styles. This is crucial in keeping unit costs low.
✓ With few varieties and styles, more specialized and faster machinery can be developed for a
continuous operation and a longer production run. The nation then imports other varieties
and styles from other nations. Intra-industry trade benefits consumers because of the wider
range of choices (i.e., the greater variety of differentiated products) available at the lower
prices made possible by economies of scale in production.
✓ Several other interesting considerations must be pointed out with respect to the intra-
industry trade models developed by Helpman, Krugman, Lancaster, and others since 1979.
✓ First, although trade in the H–O model is based on comparative advantage or differences in
factor endowments (labour, capital, natural resources, and technology) among nations, intra-
industry trade is based on product differentiation and economies of scale. Thus, while trade
based on comparative advantage is likely to be larger when the difference in factor
endowments among nations is greater, intra-industry trade is likely to be larger among
industrial economies of similar size and factor proportions (when factors of production are
broadly defined).
✓ Second, with differentiated products produced under economies of scale, pre-trade relative
commodity prices may no longer accurately predict the pattern of trade. Specifically, a large
country may produce a commodity at lower cost than a smaller country in the absence of
trade because of larger national economies of scale. With trade, however, all countries can
take advantage of economies of scale to the same extent, and the smaller country could
conceivably undersell the larger nation in the same commodity.
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✓ Third, in contrast to the H–O model, which predicts that trade will lower the return of the
nation’s scarce factor, with intra-industry trade based on economies of scale it is possible for
all factors to gain. This may explain why the formation of the European Union and the great
post-war trade liberalization in manufactured goods met little resistance from interest groups.
✓ This is to be contrasted to the strong objections raised by labor in industrial countries against
liberalizing trade with some of the most advanced of the developing countries because this
trade, being of the inter- rather than of the intra-industry trade type, could lead to the collapse
of entire industries (such as the textile industry) and involve lower real wages and massive
reallocations of labor to other industries in industrial nations.
✓ Finally, intra-industry trade is related to the sharp increase in international trade in parts and
components of a product, or outsourcing.
✓ International corporations often produce or import various parts of a product in different
nations in order to minimize their costs of production (international economies of scale). The
utilization of each nation’s comparative advantage to minimize total production costs can be
regarded as an extension of the basic H–O model to modern production conditions. This
pattern also provides greatly needed employment opportunities in some developing nations.
✓ The tentative conclusion that can be reached, therefore, is that comparative advantage seems
to determine the pattern of inter-industry trade, while economies of scale in differentiated
products give rise to intra-industry trade.
✓ Both types of international trade occur in today’s world. The more dissimilar are factor
endowments (as between developed and developing countries), the more important are
comparative advantage and inter-industry trade.
✓ On the other hand, intra-industry trade is likely to be dominant the more similar are factor
endowments broadly defined (as among developed countries).
✓ As Lancaster (1980) pointed out, however, even in the case of intra-industry trade,
“comparative advantage is somewhere in the background.” One could say that inter-industry
trade reflects natural comparative advantage while intra-industry trade reflects acquired
comparative advantage.
Measuring Intra-Industry Trade
✓ The level of intra-industry trade can be measured by the intra-industry trade index (T):
T = 1 −|X − M|/X + M…….. (6-1)
where X and M represent, respectively, the value of exports and imports of a particular industry or
commodity group and the vertical bars in the numerator of Equation (6-1) denote the absolute
value. The value of T ranges from 0 to 1. T = 0 when a country only exports or only imports the good
in question (i.e., there is no intra-industry trade).
✓ On the other hand, if the exports and imports of a good are equal, T = 1 (i.e., intra-industry
trade is maximum).
✓ Grubel and Lloyd calculated the T index for various industries in 10 industrial countries for the
year 1967. They found that the weighted average of T for the 10 industrial countries ranged
from 0.30 for mineral fuels, lubricants, and related industries to 0.66 for chemicals, for an
overall or combined weighted average of T for all industries in all 10 countries of 0.48. This
means that in 1967 nearly half of all the trade among these 10 industrial countries involved
the exchange of differentiated products of the same industry. The value of T has also risen
over time. It was 0.36 in 1959, 0.42 in 1964, and 0.48 in 1967.
Formal Model of Intra-Industry Trade

✓ Figure below presents a formal model of intra-industry trade. In this Figure, D represents the
demand curve faced by the firm for the differentiated products that it sells. Since many other
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firms sell similar products, the demand curve faced by the firm is fairly elastic (i.e., D has a
small inclination). This means that a small price change leads to a large change in the firm’s
sales. The form or market organization where (as in this case) there are many firms selling a
differentiated product and entry into or exit from the industry is easy is called monopolistic
competition. Because the firm must lower the price (P) on all units of the commodity if it wants
to increase sales, the marginal revenue curve of the firm (MR) is below the demand curve (D),
so that MR < P.
✓ For example, D shows that the firm can sell 2 units at P = $4.50 and have a total revenue of $9
or sell 3 units at P = $4 and have a total revenue of $12. Thus, the change in total revenue or
MR = $3, compared with P = $4 for the third unit of the commodity sold.
✓ By producing only one of a few varieties of the product, the firm also faces increasing returns
to scale in production, so that its average cost curve (AC) is also downward sloping (i.e., AC
declines as output increases). As a result, the firm’s marginal cost curve (MC) is below the AC
curve. The reason for this is that for AC to decline, MC must be smaller than AC. The best level
of output for the firm is 3 units and is given by point E, where the MR and MC curves intersect
(see Figure below). At a smaller level of output, MR (i.e., the extra revenue) exceeds MC (i.e.,
the extra cost) and it pays for the firm to expand output.
o D is the demand curve for the product sold by a firm, while MR is the corresponding marginal
revenue curve.
o D is downward sloping because the product is differentiated. As a result, MR < P. The best
level of output for the monopolistically competitive firm is 3 units and is given by point E, at
which MR = MC. At Q = 3, P = AC = $4 (point A) and the firm breaks even (i.e., earns only a
normal return on investment in the long run).
o AC is the average cost curve of the firm. AC is downward sloping because of economies of
scale.
✓ On the other hand, at an output greater than 3 units, MR < MC and it pays for the firm to
reduce output. Thus, the best level of output (Q) is 3 units. The firm will then charge the price
of $4, shown by point A on the D curve. Furthermore, since more firms are attracted to the
industry in the
long run whenever firms in the industry earn profits, the demand curve facing this firm (D) is
tangent to its AC curve, so that P = AC = $4 at Q = 3.
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✓ This means that the firm breaks even (i.e., it earns only a normal return on investment in the
long run). We can now examine the relationship between inter-industry and intra-industry
trade.
✓ To do this, suppose that Nation 1 has a relative abundance of labor and commodity X is labor
intensive, while Nation 2 has a relative abundance of capital and commodity Y is capital
intensive. If commodities X and Y are homogeneous, Nation 1 will export commodity X and
import commodity Y, while Nation 2 will export commodity Y and import commodity X, as
postulated by the Heckscher–Ohlin theory. This is inter-industry trade and reflects
comparative advantage only.
✓ On the other hand, if there are different varieties of commodities X and Y (i.e., commodities X
and Y are differentiated), Nation 1 will still be a net exporter of commodity X (this is inter-
industry trade, which is based on comparative advantage), but it will also import some
varieties of commodity X and export some varieties of commodity Y (this is intra-industry
trade, which is based on product differentiation and economies of scale).
✓ Similarly, while Nation 2 will still be a net exporter of commodity Y, it will also import some
varieties of commodity Y and export some varieties of commodity X. The net exports of X and
Y by Nations 1 and 2, respectively, reflect inter-industry trade, which is based on comparative
advantage. On the other hand, the fact that Nation 1 also imports some varieties of
commodity X and exports some varieties of commodity Y, while Nation 2 also imports some
varieties of commodity Y and exports some varieties of commodity X (i.e., the fact that there
is an interpenetration of each other’s market in each product) reflects intra-industry trade,
which is based on product differentiation and economies of scale.
✓ Thus, when products are homogeneous, we have only inter-industry trade. On the other hand,
when products are differentiated, we have both inter- and intra-industry trade. The more
similar nations are in factor endowments and technology, the smaller is the importance of
inter-relative to intra-industry trade, and vice versa.
✓ Since industrial nations have become more similar in factor endowments and technology over
time, the importance of intra-relative to inter-industry trade has increased. As pointed out
earlier, however, a great deal of intra-industry trade is also based on differences in
international factor endowments (when factors are defined less broadly and in a more
disaggregated way).
Another Version of the Intra-Industry Trade Model

✓ We now examine intra-industry trade from a different perspective with the aid of Figure
below.
✓ The horizontal axis in the Figure measures the number of firms (N) in a monopolistically
competitive industry, while the vertical axis measures the product price (P) and the average
or per unit cost of production (AC). All firms sell at the same price even though their product
is somewhat differentiated. This will be true if all firms in the monopolistically competitive
industry are symmetric or face identical demand and cost functions or conditions.
✓ In the Figure, curve P shows the relationship between the number of firms in the industry and
the product price. Curve P is negatively sloped, showing that the larger the number of firms in
the industry the lower is the product price because competition is greater or more intense
with more firms in the industry.
✓ For example, P = $4 when N = 200 (see point F in the figure), P = $3 when N = 300 (point E),
and P = $2 when N = 400 (point E’). Curve C, on the other hand, shows the relationship
between the number of firms in the industry and their average cost of production for a given
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level of industry output. Curve C is positively sloped, showing that the larger N is, the greater
their AC is.
✓ The reason is that when more firms produce a given industry output, each firm’s share of the
industry output will be smaller, and so each firm will incur higher average costs of production.
For example, AC = $2 when N = 200 (point G in the figure), AC = $3 when N = 300 (point E),
and AC = $4 when N = 400 (point H).
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o Curve P shows the negative relationship between the total number of firms in the industry (N)
and product price (P), while curve C shows the positive relationship between N and their
average cost of production (AC) for a given level of industry output.
o Equilibrium is given by the intersection of the P and C curves at point E, where P = AC = $3 and
N = 300.
o Trade causes curve C to shift down to, say, curve C’ and defines new equilibrium point E’,
where P = $2 and N = 400.
✓ The intersection of curve P and curve C defines equilibrium point E, at which P = AC = $3 and
N = 300 and each firm breaks even (i.e., makes zero profits). With 200 firms, P = $4 (point F),
while AC = $2 (point G). Since firms will then be earning profits, more firms will enter the
industry until long-run equilibrium point E is reached.
✓ On the other hand, with N = 400, P = $2 (point E’), while AC = $4 (point H). Since now all firms
incur losses, some firms will leave the industry until long-run equilibrium point E is reached.
✓ By opening up or expanding international trade and thus becoming part of a much larger
integrated world market, firms in each nation can specialize in the production of a smaller
range of products and face lower average costs of production.
✓ Mutually beneficial trade can then take place even if nations are identical in factor
endowments and technology.
✓ Consumers in each nation would benefit both from lower product prices and from the larger
range of commodities. This is shown by the downward shift of curve C to curve C’ in the Figure.
✓ Curve C shifts down to curve C’ because an increase in market size or total industry sales
increases the sales of each firm, for any given number of firms in the industry, and lowers the
average production cost of each firm. The downward shift in curve C to curve C’ leads to new
long-run equilibrium point E’, P = AC = $2 and N = 400, as compared with original equilibrium
point E (with P = $3 and AC = $3). Note that the increase in total industry sales does not affect
the P curve (i.e., the P curve does not shift).
PUBLIC ECONOMICS
COASE THEOREM
INTRODUCTION
British American economist Ronald Coase developed the Coase theorem in 1960, and, although not
a regulatory framework, it paved the way for incentive-driven, or market-based, regulatory systems.
✓ Theorem states “that when there are conflicting property right, bargaining between the
parties involved will lead to an efficient outcome regardless of which party is ultimately
awarded the property rights, as long as the transaction costs associated with bargaining are
negligible.”
✓ In the face of market inefficiencies resulting from externalities, private citizens (or firms) are
able to negotiate a mutually beneficial, socially desirable solution as long as there are no costs
associated with the negotiation process. The result is expected to hold regardless of whether
the polluter has the right to pollute or the average affected bystander has a right to a clean
environment.
EXPLANATION
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✓ Consider the negative externality example, in which parents face soaring health care costs
resulting from increased industrial activity. According to the Coase theorem, the polluter and
the parents could negotiate a solution to the externalities issue even without government
intervention.
✓ For example, if the legal framework in society gave the firm the right to produce pollution, the
parents with sick children could possibly consider the amount they are spending on medical
bills and offer a lesser sum to the firm in exchange for a reduced level of pollution. That could
save the parents money (as compared with their health care costs), and the firm may find
itself more than compensated for the increased costs that a reduction in emissions can bring.
✓ If it is the parents instead who have a right to clean, safe air for their children (this is more
typically the case), then the firm could offer the parents a sum of money in exchange for
allowing a higher level of pollution in the area. As long as the sum offered is less than the cost
of reducing emissions, the firm will be better off. As for the parents, if the sum of money more
than compensates the health care costs they face with higher pollution levels, they may also
find themselves preferring the negotiated outcome.
✓ Unfortunately, because the Coase theorem’s fundamental assumption of costless negotiation
often falls short, the theorem is not commonly applicable as a real-world solution.
Nevertheless, the Coase theorem is an important reminder that, even in the case of complex
environmental problems, there may be room for mutually beneficial compromises.
✓ Coase's main point, clarified in his article 'The Problem of Social Cost,' published in 1960 and
cited when he was awarded the Nobel Prize in 1991, was that transaction costs, however,
could not be neglected, and therefore, the initial allocation of property rights often mattered.
As a result, one normative conclusion sometimes drawn from the Coase theorem is that
liability should initially be assigned to the actors for whom avoiding the costs associated with
the externality problem are the lowest.
✓ The problem in real life is that nobody knows ex ante the most valued use of a resource, and
also that there exist costs involving the reallocation of resources by government. Another,
more refined, normative conclusion also often discussed in law and economics is that
government should create institutions that minimize transaction costs, so as to allow
misallocations of resources to be corrected as cheaply as possible.
When faced with an externality, the same efficient outcome can be reached without any
government intervention as long as the following assumptions hold:
i. Property rights must be clearly defined
ii. There must be little to no transaction’s costs
iii. There must be few affected parties (or else the transactions costs of organizing them gets to be
too great).
iv. There must be no wealth effects. The efficient solution will be the same, regardless of who gets
the initial property rights.
KEY TAKEAWAYS
✓ The Coase Theorem argues that under the right condition’s parties to a dispute over property
rights will be able to negotiate an economically optimal solution, regardless of the initial
distribution of the property rights.
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✓ The Coase Theorem offers a potentially useful way to think about how to best resolve conflicts
between competing business or other economic uses of limited resources.
✓ In order for the Coase Theorem to apply fully, the conditions of efficient, competitive markets,
and most importantly zero transactions costs, must occur.
How Does It Work in Practice?

✓ Why is this? Let's say that it's efficient to have the turbines operating in the area, i.e., that the
value to the company of operating the turbines is greater than the cost imposed on the
households. Put another way, this means that the turbine company would be willing to pay
the households more to stay in business than the households would be willing to pay the
turbine company to shut down. If the court decides that the households have a right to quiet,
the turbine company will probably compensate the households in exchange for letting the
turbines operate. Because the turbines are worth more to the company than quiet is worth
to the households, some offer will be acceptable to both parties, and the turbines will keep
running.
✓ On the other hand, if the court decides that the company has the right to operate the turbines,
the turbines will stay in business and no money will change hands. This is because the
households aren't willing to pay enough to convince the turbine company to cease operation.
✓ In summary, the assignment of rights in this example didn't affect the outcome once the
opportunity to bargain was introduced, but the property rights did affect the transfers of
money between the two parties. This scenario is realistic: In 2010, for example, Cathines
Energy offered households near its turbines in Eastern Oregon $5,000 each not to complain
about the noise that the turbines generated.
✓ It's most likely that in this scenario, the value of operating the turbines was greater to the
company than the value of quiet was to the households, and it was probably easier for the
company to proactively offer compensation to the households than it would have been to get
the courts involved.
Problems with Theorem

✓ Difficulty in Assigning Property Rights: It is extremely difficult to determine who may be
responsible for the externality as well as who is actually affected by it. Take the case of a
polluted river that reduces the fish population. People cannot easily translate their
experiences to monetary values, and they are likely to overstate the harm they have suffered.
At the same time, the polluters would likely underestimate the proportion of the externality
that they are responsible for.
✓ Holdout Problem: Imagine that we have found a way to overcome the assignment problem;
we will likely be met by another difficult challenge. If the fisherman is assigned the property
rights, the textile mill cannot dump unless all the fisherman give permission. If there are 10
fishermen on the lake and nine have given permission, the 10th has an incentive to demand
more money to give his permission.
✓ The Free Rider Problem: Suppose there are 10 fishermen who would each have to pay $10 to
get the mill to reduce dumping by 10 units (suppose this is socially efficient). However, once
eight have paid the $10, the mill will reduce dumping by eight units which is "almost" as good
as the efficient 10-unit reduction. Because the benefits of pollution reduction are enjoyed by
all fishermen (dumping reduction is a public good) the cost (in lower fishing output) of
Page | 31
underinvestment is spread across all 10 fishermen. In other words, because the marginal
benefit of individual investment is low compared to cost, there is an incentive for the two
remaining fishermen to free ride off the other eight's investment. This can lead to a vicious
cycle, when the other fishermen realize that others are coasting on their efforts. So, they start
to under-invest as well.
✓ "Higher than Zero" Transaction Costs: When there are a large number of people involved,
coordination is typically difficult. Imagine the difficulty of getting all 10 fisherman and the mill
operator together to negotiate; even if the only "cost" is time, it is important to remember
the opportunity costs associated with time spent. It is also important to remember that our
example may be overly simple compared to the "real world" in terms of time and travel costs;
the costs would be much higher than negligible to organize negotiation. There is also
information asymmetry where that neither the polluting firms nor those hurt by pollution
know what each other's cost are. The firm doesn't know what the marginal damage is to
individuals and other businesses, and these harmed entities don't know the production and
abatement costs of the polluting firms. This incomplete information can lead to strategic
behaviour by both sides in the negotiations, and ultimately, an inefficient solution.
Where the Coase Theorem May Work?

✓ In situations where there are only a few parties involved and assigning property rights is
possible, we will likely see a solution similar to the one Coase has suggested.
✓ For example, my neighbor’s property has a steep hill perfect for rock climbing. But, because
my neighbour is worried about being liable if someone is injured on his hill, he has built a tall
fence. Now, with no access to the rock, the climbers receive no benefit from climbing; this
may not be socially efficient. There may be room for negotiation; the rock climbers may be
willing to pay my neighbour to allow them to rock climb. In turn, my neighbour may be willing
to accept this payment to hedge his risk if a climber is injured and my neighbour is found liable.
✓ A similar Coasian solution is reached if the neighbours sign a 'no-liability contract' with the
owner of the hill. They are exchanging something in value- their ability to sue- in order to gain
the benefit of climb the rock.
✓ In cap - and - trade markets for dealing with the negative externalities created by pollution,
we can see the permits as the assignment of property rights; in this type of market we may
see Coasian outcomes. However, full participation in these markets is difficult to achieve.
✓ For example, India, The United States, and China, some of the world's top polluters, do not
participate in the Kyoto Treaty (there are a variety of reasons for this). The United States is
not a member and India and China are exempt as "developing nations".
PUBLIC & PRIVATE GOODS

BASIS PUBLIC GOODS PRIVATE GOODS
Meaning Public goods are the ones Private goods are the ones which
which are provided by the are manufactured and sold by
nature or the government for the private companies to satisfy
free use by the public. the consumer needs and wants.
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BASIS PUBLIC GOODS PRIVATE GOODS
Provider Nature or government Manufacturers i.e. entrepreneurs
Consumer Rich and poor are treated Preference to rich consumers

equality equally
Availability Readily available to all Reduces with each consumption
Quality Remains constant Varies with ability to buy
Decision Social choice Consumer's decision
Objective Overall growth and Profit earning

development
Traded in No Yes
Free Market
Opportunity No Yes
Cost
Free riders’ Yes No

problem
Rivalry Non-rival Rival
Excludability Non-excludable Excludable
Demand Horizontal Vertical

Curve
Examples Police service, fire brigade, Clothes, cosmetics, footwear,

national defence, public cars, electronic products and
transport, roads, dams and food
river
Page | 33
INDIAN ECONOMY
TAX REFORMS-GOODS AND SERVICES TAX
First Indirect Tax Reform occurred in India when the Modified Value Added Tax (MODVAT) was
introduced for selected commodities in 1986 to replace the Central Excise Duty. It was gradually
extended to all commodities through Central Value Added Tax (CENVAT). The states also followed the
suit and enacted the VAT acts to replace the sales tax with Value Added Tax. Following are the key
indirect tax reforms done.
✓ Reduction in Custom Duties: In 1990, the custom duty on non-agricultural products was
around 128%. It was brought down gradually. Currently, the average custom duties are 11-
12%, however, they range from 0 to 150%.
✓ Central Excise: Central Excise duties were first replaced with MODVAT and now CENVAT is
applicable. The number of different types of duties was cut down.
✓ Service Tax: Service tax was first introduced on some limited services in 1994-95 at 7%. The
rate was gradually increased and so was the number of taxable services. Currently, we pay
14% service tax on around 100 services.
✓ Goods and Services Tax: The Goods and Services Tax (GST) is so far the biggest tax reform in
the country. At present, the GST-Bills have been passed and it is expected to come into force
from July 1, 2017.
Goods and Services Tax (GST)

Goods and Services Tax (GST) is a comprehensive indirect tax on manufacture, sale, and consumption
of goods and services throughout India. GST would replace respective taxes levied by the central and
state governments.
✓ It is a destination-based taxation system.
✓ It has been established by the 101st Constitutional Amendment Act.
✓ It is an indirect tax for the whole country on the lines of “One Nation One Tax” to make India
a unified market.
✓ It is a single tax on supply of Goods and Services in its entire product cycle or life cycle i.e.
from manufacturer to the consumer.
✓ It is calculated only in the “Value addition” at any stage of a goods or services.
✓ The final consumer will pay only his part of the tax and not the entire supply chain which was
the case earlier.
✓ There is a provision of GST Council to decide upon any matter related to GST whose chairman
in the finance minister of India.
Taxes at center and state level are incorporated into the GST
State Level:
✓ State Value Added Tax/Sales Tax
✓ Entertainment Tax (Other than the tax levied by the local bodies)
✓ Octroi and Entry Tax
✓ Purchase Tax
✓ Luxury Tax
✓ Taxes on lottery, betting, and gambling
Central level
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✓ Central Excise Duty

✓ Additional Excise Duty
✓ Service Tax
✓ Additional Customs Duty (Countervailing Duty)
✓ Special Additional Duty of Customs
Benefits of GST
For Central and State Governments:
✓ Simple and Easy to administer: Because multiple indirect taxes at the central and state levels
are being replaced by a single tax “GST”. Moreover, backed with a robust end to end IT system,
it would be easier to administer.
✓ Better control on leakage: Because of better tax compliance, reduction of rent seeking,
transparency in taxation due to IT use, an inbuilt mechanism in the design of GST that would
incentivize tax compliance by traders.
✓ Higher revenue efficiency: Since the cost of collection will decrease along with an increase in
the ease of compliance, it will lead to higher tax revenue.
For the Consumer:

✓ The single and transparent tax will provide a lowering of inflation.
✓ Relief in overall tax burden.
✓ Tax democracy that is luxury items will be taxed more and basic goods will be tax-free.
For the Business Class:

✓ Ease of doing business will increase due to easy tax compliance.
✓ Uniformity of tax rate and structure, therefore, better future business decision making and
investments by the corporates.
✓ Removal of cascading effects of taxes.
✓ Reduction in transactional cost will lead to improved competitiveness.
✓ Gain to the manufacturer and exporters.
✓ It is expected to raise the country GDP by 2% points.
GST Council
✓ It is the 1st Federal Institution of India, as per the Finance minister.
✓ It will approve all decision related to taxation in the country.
✓ It consists of Centre, 29 states, Delhi and Puducherry.
✓ Centre has 1/3rd voting rights and states have 2/3rd voting rights.
✓ Decisions are taken after a majority in the council.
Supporting Laws to implement GST

For the implementation of GST, apart from the Constitution Amendment Act, some other statutes are
also necessary. Recently 5 supporting laws to the GST were recommended by the council. 4 for the
bills should be passed by the parliament, while the 5th one should be passed by respective state
legislatures. The details are given below.
✓ The Central Goods and Services Tax Bill 2017 (The CGST Bill).
✓ The Integrated Goods and Services Tax Bill 2017 (The IGST Bill).
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✓ The Union Territory Goods and Services Tax Bill 2017 (The UTGST Bill).
✓ The Goods and Services Tax (Compensation to the States) Bill 2017 (The Compensation Bill).
✓ And a state GST will be passed by the respective state legislative assemblies.
o Tax slabs are decided as 0%, 5%, 12%, 18%, 28% along with categories of exempted and
zero rated goods for different types of goods and services.
o Further, a cess would be levied on certain goods such as luxury cars, aerated drinks, pan
masala and tobacco products, over and above the rate of 28% for payment of
compensation to the States.
o However, which goods and services fall into which bracket is still an enormous task to be
completed by the GST council.
o Highest tax slab is pegged at 40%.
Process of GST:
✓ The Centre will levy and collect the Central GST.
✓ States will levy and collect the State GST on the supply of goods and services within a state.
✓ The Centre will levy the Integrated GST (IGST) on the interstate supply of goods and services,
and apportion the state’s share of tax to the state where the good or service is consumed.
✓ The 2016 Act requires Parliament to compensate states for any revenue loss owing to the
implementation of GST.
Issues Arisen OR Unresolved:

✓ Not all items are covered: Taxation for certain items such as Alcohol, Tobacco etc. are still not
under the GST domain. States argue that including them would hamper their revenue and
they would suffer a huge resource. However, some experts say that the real reason is the
nexus of politicians with some business class and high profile lobbying.
o Further, the Finance minister of India has said in the parliament that the consensus to
include alcohol and tobacco under GST regime is possible in foreseeable future.
✓ Decision criteria for the tax bracket: There are apprehensions that how to decide about the
items and the criteria that which item will fall into which tax bracket. It may lead to lobbying.
To this, the Finance minister has said that the decision will be taken by the GST Council only
and after due diligence and most probably by the consensus.
✓ Multiple tax rates and brackets: The philosophical idea that GST means “One Nation one Tax”
is currently diluted due to multiple tax rates and brackets. To this, the Finance minister has
said that since the target consumer of goods and services have different capabilities and
therefore there must be a system similar to the democratic lines where higher value
consumer pays more taxes.
✓ Power to impose tax taken away by Central Government from the Parliament: The Central
GST Bill, 2017 allows the central government to notify CGST rates, subject to a cap. This implies
that the government may change rates subject to a cap of 20%, without requiring the approval
of Parliament.
✓ Under the Constitution, the power to levy taxes is vested in Parliament and state legislatures.
Though the proposal to set the rates through delegated legislation meets this requirement,
the question is whether it is appropriate to do so without prior parliamentary scrutiny and
approval.
Page | 36
✓ Confusion regarding the location of consumption: Under GST, both state and Centre can tax
the services based on their location of consumption. Now the confusion arises since the
general rule to determine the location of the recipient is his location or address on record;
there are specific rules for various services such as telecom, property, transportation, etc.
o This means that while a service may be consumed across multiple states, the tax revenue
would be attributed to the state where the recipient is registered or his office is
located. This could lead to higher tax attributed to states that have more registered
offices.
o For example, suppose a company is located in Bangalore and advertises its products in
the Kolkata edition of a newspaper, which has its registered office in Delhi. In this case,
one may argue that the service is being finally consumed in Kolkata. However, as the
recipient of services is in Bangalore, the tax would accrue to Karnataka.
✓ Anti-Profiteering Clause: The government is planning to set up an authority to see if any
reduction in tax rates after GST is passed on to the consumer by companies or not. The
industry and businesses are not taking this idea kindly and they see it as a backdoor entry of
inspector raj. Experts say that prices should be market determined and no government
authority has the business of deciding prices for goods and services.
✓ Confusion regarding the control over taxation: To avoid dual control, the GST council has
reached a compromised formula. 90 percent of tax assesses with an annual turnover of Rs 1.5
crore or less, will be assessed by states and the rest by the Centre. For those with a turnover
of over Rs 1.5 crore, the states and the Centre will share it equally. However, this ‘solution’
has its own set of issues.
o For example, if an entity with a turnover of less than Rs 1.5 crore in one year, posts a
turnover of Rs 1.5 crore in the following financial year, who would be the new authority
to take over the assessment? And, how will the existing investigations, if any, against the
entity be addressed, and by whom? “There are a lot of procedural issues, and if these
issues are not addressed properly, they would lead to litigations.
✓ The issue of casual taxable person: If a person registered in one state moves to another state
for a short period for some business transaction – say to participate in a fair or exhibition,
then that person would have to get himself registered in that state for that period.
What is GSTN?
✓ GSTN is registered as a not-for-profit company under the companies Act.
✓ It has been formed to set up and operate the information technology backbone of the GST.
✓ While the Central (24.5%) and the state (24.5%) governments hold a combined stake of 49%,
the remaining 51% stake is divided among five financial institutions—LIC Housing Finance with
11% stake and ICICI Bank, HDFC, HDFC Bank and NSE Strategic Investment Corporation Ltd
with 10% stake each.
✓ GSTN had awarded Infosys Ltd the contract to develop the hardware and software for GST.
✓ The idea behind GSTN was to set up an entity that is equidistant from both the Central
government and the state governments, as it will advise both the Centre and the states on the
information technology network.
Page | 37
ISSUES OF GROWTH AND EQUITY

Economic growth has raised living standards around the world, but modern economies have lost sight
of the fact that the standard metric of economic growth, gross domestic product (GDP), merely
measures the size of a nation’s economy and doesn’t reflect a nation’s welfare. Yet policymakers and
economists often treat GDP as an all-encompassing unit to signify a nation’s development, combining
its economic prosperity and societal well-being.
✓ The debate between growth and equity and redistribution is one of the oldest in economic
development. The common citizens of any country care more about the real impact of growth
in terms of improvement in their standard of living, provision of basic facilities such as
electricity, drinking water, healthcare systems etc.
✓ Focusing exclusively on GDP and economic gain to measure development ignores the negative
effects of economic growth on society, such as climate change and income inequality. It’s time
to acknowledge the limitations of GDP and expand our measure development so that it takes
into account a society’s quality of life.
Fallacy of GDP growth as indicator national progress:

✓ Ineffective trickle down of benefits earned from economic growth. There is increasing
disconnect between economic growth and social development. As per popular development
economist Jean Dreze, India’s high economic growth has failed to bring about any significant
improvement in the quality of life of the common people.
✓ GDP cannot differentiate between an unequal and an egalitarian society if they have similar
economic sizes. As rising inequality is resulting in a rise in societal discontentment and
increased polarization.
✓ Despite the high growth rates in India, almost half of the children younger than 5 years are
stunted due to improper nutrition and sanitation. As of 2018, more than 163 million Indians
do not have access to safe drinking water. Over the decade ending 2011, water availability
reduced by 15% and it is estimated that India will become water-scarce by 2050. As per the
Tendulkar methodology, 22% of Indians live on less than $1.25 a day.
✓ Economic growth of lower strata should be faster than the affluent class; however, India has
experienced one of the highest rates of growth of inequality. As per OXFAM survey India’s
richest 1% holds four times of the wealth held by 70% of bottom population which is around
1 billion. Certainly, in GDP growth fails to account pie of growth of shared by different sections
of society which makes it ineffective indication of national progress.
Though, it is necessary to generate wealth in the first place to redistribute it, however overemphasis
on high growth rate may create huge inequality and disparity.
✓ Labour reforms: Time of the crisis is often used by rulers as opportunity to push unpopular
policy decisions in democratic countries. Recent labour reforms pushed by UP, MP may create
inequality faster than growth. It reduces the bargaining power of labour via different
conditions like contract labour, ability to hire and fire, relaxation on working hours, lesser
inspection from government officials for working conditions ultimately making lives of
unskilled and lower skilled population worse for high economic growth for so called stress on
cheap labour as ease of doing business indicator.
✓ Regressive tax system: Where rich pay lower taxes as compared to poor. Increased efficiency
of indirect taxes with the coming of GST which is burdened by larger base rather than stress
Page | 38
on improving direct tax efficiency. Higher proportion of indirect taxes in overall tax collection,
absence of wealth tax or inheritance tax indicates regressive taxation.
✓ Lack of universal education and Health: Lack of universal free college education makes it
impossible to generate equal opportunity for students from poorer section to achieve high
skill set in new technologically advanced economic models and journey towards industrial
revolution 4.0. Out of pocket expenditure on health is one of the major reasons for chronic
poverty in India, despite of which high economic growth has failed to improve health
infrastructure or provide universal healthcare.
✓ Financial sector reforms: Privatisation, increased focus on fiscal consolidation, more scrutiny
of loans for lower sections like farmers, labourers. Financial sector reforms often designed in
way to squeeze cash from lower section to higher level of pyramid.
Overemphasis on GDP growth ignore account of inequality

✓ India’s National Indicator Framework Baseline Report, 2015-16 for measuring progress
towards Sustainable Development Goals shows India has not developed most of the indicators
required to measure and mitigate inequality.
✓ The National Indicator Framework Baseline Report reveals that India does not have data to
measure growth rates of household expenditure per capita among the bottom 40% of the
population or the total population.
✓ The government of India has no data on the proportion of people living below 50% of median
household expenditure. The report further reveals that no national indicator has yet been
developed to ensure equal opportunity and reduce inequalities of outcome.
India need alternative metrics to complement GDP in order to get a more comprehensive view of
development and ensure informed policy making that doesn’t exclusively prioritize economic growth.
Bhutan’s attempt to measure Gross National Happiness, which considers factors like equitable socio-
economic development and good governance, and UNDP’s Human Development Index (HDI), which
encapsulates health and knowledge apart from economic prosperity.
As a step in this direction, India is also beginning to focus on the ease of living of its citizens. Ease of
living is the next step in the development strategy for India, following the push towards ease of
doing business that the country has achieved over the last few years.
Measures Taken India to Achieve Inclusive Growth

✓ Several schemes are being implemented by the government for inclusive growth which
includes the following:
o Mahatma Gandhi National Rural Employment Guarantee Act Scheme (MGNREGA)
o Prime Minister’s Employment Generation Programme (PMEGP)
o Mudra Bank scheme
o Pt. Deen Dayal Upadhyaya Grameen Kaushalya Yojana (DDU-GKY)
o Deendayal Antyodaya Yojana- National Urban Livelihoods Mission (DAY-NULM)
o Sarva Siksha Abhiyan (SSA)
o National Rural Health Mission (NRHM)
o Bharat Nirman
o Swachh Bharat Mission
o Mission Ayushman
Page | 39
o Pradhan Mantri Jan Dhan Yojana

✓ Government is working with NGOs and International groupings in policy making eg:
o DISHA Project is being implemented in partnership with UNDP for creating employment
and entrepreneurship opportunities for women in India.
✓ NITI Aayog's Strategy for New India @75 has the following objectives for the inclusive growth:
o To have a rapid growth, which reaches 9-10% by 2022-23, which is inclusive, clean,
sustained and formalized.
o To Leverage technology for inclusive, sustainable and participatory development by 2022-
23.
o To have an inclusive development in the cities to ensure that urban poor and slum
dwellers including recent migrants can avail city services.
o To make schools more inclusive by addressing the barriers related to the physical
environment (e.g. accessible toilets), admission procedures as well as curriculum design.
o To make higher education more inclusive for the most vulnerable groups.
o To provide quality ambulatory services for an inclusive package of diagnostic, curative,
rehabilitative and palliative care, close to the people.
o To prepare an inclusive policy framework with citizens at the centre.
Page | 40
ECOHOLI
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WHAT ARE INDIFFERENCE CURVES?

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Table: Two indifference schedules

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MARGINAL RATE OF SUBSTITUTION

Now, how to measure marginal rate of substitution on indifference curve?

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PRINCIPLE OF DIMINISHING MARGINAL RATE OF SUBSTITUTION

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✓ Slope of the tangent GH is equal to OG/OH

Factors responsible for diminishing marginal rate of substitution:

PROPERTIES OF INDIFFERENCE CURVES

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Property II. Indifference curves are convex to the origin.

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Property III. Indifference curves cannot intersect each other.

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INDIFFERNCE CURVES OF PERFECT SUBSTITUTES AND PERFECT COMPLIMENTS

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NOTE: Budget line is also known by the names-

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Capital Markets in India

Broad Constituents in the Indian Capital Markets

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THEORIES OF INFLATION AND EXPECTATIONS

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1. Market-Power Theory of Inflation:

2. Conventional Demand-Pull Inflation:

3. Structural Theories of Inflation:

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AUGMENTED PHILLIPS CURVE

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Real Business Cycles

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Aspects of Real Business Cycle

Pareto efficiency and real business cycle

Criticisms of Real Business cycle

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STATISTICS & ECONOMETRICS

AUTOCORRELATION IN TIME SERIES DATA (SERIAL CORRELATION)

If 𝛒 > 0 → positive autocorrelation

Example of a fourth-degree autocorrelation:

Two types of serial autocorrelation:

AUTOCORRELATION IN CROSS SECTION DATA (SPATIAL CORRELATION)

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POSITIVE AND NEGATIVE AUTOCORRELATION

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TESTS FOR AUTOCORRELATION

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1. For a random walk yt = yt−1 + et we can show its MA

Problems with Unit Roots

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Ecoholics is committed to help you.