2.

Microeconomics and Macroeconomics - An Introduction

The terms microeconomics and macroeconomics were first coined and used by Ragnar
Frisch and have now been adopted by economists all over the world. Thus, the subject matter
Or economics have been divided into two parts - microeconomics and macroeconomics. The
economic behaviour at individual level is studied under microeconomics and the choice making
behaviour of the society as a whole is studied under macroeconomies.

2.1 Meaning of Microeconomics

The word, 'micro'has been derived from the Greek word 'mikros' meaning small. In this
context microeconomics deals with small partsofthe economy. Microeconomics studies behavior
ofsmall economic units economy like individual consumers, producers andresource owners
ofan
(factors ofprodhuction). In MICRO, the letter I' stands for individuals. Thus, microeconomics
studies the economic behaviour of individuals. Consumers decide how much of various
goods to purchase, producers decide how much output to produce. Every consumer allocates
his resources to the purchase of different goods to maximise his satisfaction. Similarly every
producer tries to allocate his resources in a manner that maximise his profits. Prices have their
important effects on these individual decisions. That is why, microeconomics is sometimes
called 'price theory.

SCOPE
Microeconomics deals with the following questions:
(a) How individual consumers distribute their money income on the purchase of various
goods and services i.e., theory of Demand.
(6) How producers use quantity of difierent factors ofproduction i.e., theory of production.
() dififerent factors of production
How producers
theory of cost.
use to minimise cost of production
i.e.,
(d) How prices of different goods are determined i.e., theory of product pricing.
(e How the produced output is shared or distributed among different factors of
production
i.e., theory of distribution.
( Whether resources are efficiently allocated to maximise output and welfare
economics.
i.e., welfare

Thus, the theory of product pricing and the theory of factor pricing (or the theory of
distribution) fall within domain of microeconomics.

2.2 Meaning of Macroeconomics

We now turn to explain the meaning oI macroeconomics. The term macro'has
been derived
fram aGreek word 'makros which means large. In the context of
macroeconomics large' means
aggregates or groups of entire economy. ln MACRO, the letter A' stands for aggresates.
 Introduction
Microeconomics and Macroeconomics-An
macroeconomics were first coined and used by Ragnar
Tne terms -

microeconomics and matter

the world. Thus, the subject
Frisch and have been adopted by economists all over
now
microeconomics and m a c r o e c o n o m i c s . The
of economics have been divided into two parts
and the choice making
behaviour at individual level is studied under microeconomics
economic
macroeconomics.
behaviour of the as a whole is studied under
society

2.1 Meaning of Microeconomics

word 'mikros' meaning small. In this
The word, 'micro'has been derived from the Greek
Microeconomics studies behaviour
Context microeconomics deals with small parts
of the economy.
and resource owners
like individual consumers, producers
of small economic units of an economy microeconomics
the letter T' stands for individuals. Thus,
(factors ofproduction). In MICRO,
how much of various
studies the economic behaviour of individuals. Consumers decide
allocates
decide how much output to produce. Every consumer
goods to purchase, producers
to maximise his satisfaction. Similarly every
his resources to the purchase of different goods
allocate his resources in a manner that maximise
his profits. Prices have their
producer tries to
sometimes
decisions. That is why, microeconomics is
important effects on these individual
called 'price theory'.

ScOPE
Microeconomics deals with the following questions:
How individual distribute their money income on the purchase of various
(a) consumers

goods and services i.e., theory of Demand.

(b) How producers use quantity of different factors of production i.e., theory of production.
(c) How producers use different factors of production to minimise cost of production i.e.,
theory of cost.
(d) How prices of different goods are determined i.e., theory of product pricing.

(e) How the produced output is shared or distributed among different factors of production
i.., theory of distribution.
().Whetherresources are efficiently allocated to maximise output and welfare i.e., welfare
economics.

Thus, the theory of product pricing and the theory of factor pricing (or the theory of
distribution) fall within domain of microeconomics.

Macroeconomics
2.2 Meaning of
We now turn to explain the meaning ofmacroeconomics. The term macro'has been derived
from a Greek word makros which means large. In the context ofmacroeconomics large' means
a0pregates or groups of entire economy. In MACRO, the letter A' stands for agqreoafas
Thus, macroeconomics studies the aggregates of an economy or economy as a whole e.g.,
gross domestic product, total employment, aggregate demand, aggregate supply, general price
level etc. It, thus, focuses on macroeconomic variables. That is why macroeconomics has also
been called "aggregative economics". According to Prof. Boulding "Macroeconomics deals
not with individual quantities as such but with aggregates of these quantities, not with individual
incomes but with the national income, not with the individual output but the national output".

SCOPE
Macroeconomics explains the following:
(1) It seeks to explain how national income (economy's total output of final goods and
services) is determined. Since the subject matter of macroeconomics revolves around
determination of the level of income and employment, it is known as "Theory of
Income and Employment'.
(ii) It explains the general price level. It explains why sometimes prices rise i.e., problem
of inflation, and why at other times general price level falls i.e., problem of deflation.
(iii) It also studies issues concerned with economic growth and development.
(iv) Further, it also describes issues relating to international trade and determination of

prices of different foreign currencies

Economics

Microeconomics Macroeconomics

Product|Factor Welfare
Pricing Pricing Economics

Theory of Theory of Economic Theory o

Income and
General Growth and
International

Price Level Trade

Employment Development
 Macroeconomics
DIstinction between Microeconomics and as under:
macroeconomics
microeconomics and
distinction between
We
may now sum up the MacroeconomiCS

Basis
Microeconomics
Macroeconomics
is the study of
is the study of | whole and its aggregates
1. Meaning Microeconomics

units of an economy as a
individual economic
as
national income, total
a |such
cconomy such
as a consumer,
consumption, general
price level etc.
producer etc. with|
Macroeconomics
is concerned
is primarily concerned |
2. Scope determination of aggregate output
Microeconomics

determination of relative the

with the
of goods and general price level in the economy
prices of goods (i.e., prices as a whole.
individually). and aggregate
of particular|Aggregate demand
3. Tools Demand and supply a
goods and services are the
commodity or factor of production |supply of
all
microeconomics. |main tools of macroeconomics.
are the main tools of in
There is limited amount of aggregation | There is high degree of aggregation
|4. Degree of microeconomics
macroeconomicS.

Aggregation | in
microeconomics. It should be
Macroeconomics should be carefully distinguished from
but not of the type with which
noted that microeconomics also deals with some 'aggregates',
of a product are aggregative
macroeconomics is concerned. Market demand and market supply
microeconomics. These aggregates are cofined to a single
concepts which are studied under
of all goods and
product or a single industry. But macroeconomics deals with aggregate output
services. Macroeconomics also examines the sub-aggregates of these large aggregates. For

example, the total production of consumer goods and total production of capital goods are the
two important sub aggregates of total production dealt in macroeconomics.

2.4 Interdependence between Microeconomics and Macroeconomics

From the above discussion, it becomes clear that microeconomics and macroeconomics
are two separate branches of economics. However, these two branches are not opposite to each
other. In fact, the study of one depends upon the study of other.

Examples
(1) Dependence of Macroeconomics on Microeconomics
) An economy is made of small economic units such as
individuals, firms and markets.
The aggregate demand of the economy depends upon the individual
demand of different
households.
ii) National income is the sum total of income of all the residents of the
economy.
(2) Dependence of Microeconomics on Macroeconomics
Micro variables also depend on the behaviour of macro variables.
i) Wage rate in a particular industry is attected by overall
wage rate in the economy.
i Tnvestment in one industry will depend upon the overall level of
in economy as a whole.
income and investment
 3. What is an Economy?
In economics, the word 'economy'
refers to production activities ofa well defined area or
region. It may be a village, a district, a state, a nation or the whole world. The sum total of all
production units ofa region like factories, farms, mines, offices, banks,
schools, colleges, shops,
transport system, railways, etc. collectively are called an economy. All these institutions help to
produce goods and services which directly and indirectly satisfy human wants. They produce a
variety of goods and services on one hand and provide employment to people on the other hand.
The size of an economy is determined by the level of
output of goods and services it produces.
Economy is a system by which people get a living (i.e., earning of income) and
satisfy their wants, 9

Economy is a system through which productive resources are utilised for satisfying
99
human wants.
For the survival of economy, people must earn income to spend it on goods and services.
For all economy must perform three basic activities namely
this
to
happen, production,
consumption and investment. These three economic activities are known as the essentials
or vital processes of an economy. Production is a process of creating goods and services or
increasing the value ofgoods already produced. Consumption is using up ofthe produced goods
and services which satisfy human wants directly. And investment implies addition to the capital
stock of a country that helps in further production. These three activities are interrelated. For
example, 1f there is no0 production there will be no consumption. And production is meaningless
without consumption. For further production investment is necessary.

Economy refers toeconomic activities of a particular area or region.

Production, Consumption and investment

are three basic activities of an economy.

The size of an economy is determined by the level of its output.

4. Economic Problem- Meaning and Causes

4.1 Meaning
All goods and services used to carry out production are called resources of an economy.
These are also referred to as factors of production. These are popularly classified as land,
labour, capital and entrepreneurship. But in comparison with unlimited human wants, the
resources required to satisfy such wants are limited. This gives rise to the problem orcno
wnich is called economic problem. Thus problem of choice means the problem of allocation o
resources to alternative uses.
 choices in the use of searce
of making
Economic problem is basically the problem 99
for the satisfaction of unlimited human wants.
resources

4.2 Causes
behind the economic problem are
The main causes
want is satisfiedmany
wants are unlimited. As one

(a) Unlimited human wants: Human than others.

also differ in urgency. Some wants are more urgent
other wants emerge. Wants
make choice among different wants in order of urgency.
This forces a man to a

a variety of goods
and services require resources.
: Production of
(b) Limited resources
and services, these resources
to the unlimited wants for various goods
However, compared for
that if all the available resources are fully employed
are scarce. It implies
even
wants can be satisfied.
various goods and services, only a small part of human
producing
choices arises. So scarcity of resources is
In view of limited resources, a need to make
an important reason behind the economic problem in any society.
not only limited but also have
(c) Resources have alternative uses : Resources are
resource can be put to more
alternative uses. Alternative use of resources means that a
alternative uses. For example,
than one use. Hence, choice has to be made for different
a piece of land can be used for farming, for a playground or for constructing a shopping
mall or residential flats. Its implication is that a resource can be used at a time for only
one purpose. This makes a resource all the more scarce because when it is used for one
purpose, it cannot be used for other purposes.

In short, scarcity and choice go together which means whenever there is question of scarce
resources, there arises a problem of choice. Therefore, an economy has to make a choice among
its available resources in the best possible manner. Making best use of the available resources
is known as the problem of economizing of resources.
The above explanation is summed up in the chart given below.

Economic Problem

Human Wants are Resources having

unlimited alternative uses are scarce

Problem of choice

Economising of Resources
5. Central (Basic) Problems of an Economy
Every economy has to face a choice problem which is called a central problem. The
allocation of resources or making choices among alternative uses of scarce resources is the
fundamental problem of an economy. Every economy (rich or poor, small or large) faces three
basic (central) problems. These problems are common to all economies, and hence, sometimes
are called economic problems. These problems are: what to produce, how to produce and for
whom to produce. In fact, these three problems come under the central problem of allocation
of resources. Allocation of resources refers to the problem of allocating the scarce resources
in such a manner that maximum wants of the society are fulfilled.

5.1 What to Produce and in What Quantities

This problem has two aspects: a) What goods to produce, and (b) How much to produc.
Every economy has to decide what commodities are to be produced and in what quantities.
This problem is faced because resources are limited on one hand and have alternative uses on the
other. In view of these features of resources, when we produce more of a commodity, it means
we will be able to produce less of another. Because more production of one commodity would
force us to withdraw resources from the production of the other commodity. So the economy
has to choose between consumer goods (like ghee, wheat, cloth, sugar, etc.) and capital goods
(like machines, equipments etc.). Similarly, choice has to be made between war goods like guns,
tanks etc. and normal goods like bread and butter, milk etc.
After deciding the goods to be produced economy has also to decide the quantity of output
of each chosen good.

5.2 How to Produce

The second basic problem that every economy has to face is that of deciding how to produce
the chosen goods and services. A particular quantity of a particular good or service can be
produced in many different ways. The economy must choose a particular way of producing the
specified amount of the good. This problem relates to the choice of technique of production
This becomes necessary for efficient production. Labour intensive techniques help to reduce
unemployment whereas capital intensive techniques are considered better for fast growth of
the economy. Therefore an economy must decide about the technique of production to be used
in a given industry.

Example
A given quantity of cloth can be produced either by using labour intensive technique
(handlooms) or by using capital intensive technique (modern machines). The guiding principle
here is to adopt that technique which minimise the per unit cost of production of thecommodiy
The goods and services should be produced efficiently.
5.3 For Whom to Produce
relates to the problem of
of allocation of resources
The third aspect of the central problem of production. In other
individuals or factors
the various distribution of final
distribution of the produce among
less. This is the problem of
who should get
words, who should get more or
goods and services.
The problem 'For Whom to Produce' has two aspects.
how the produced
distribution of income. It implies
(1) The first aspect relates to personal or households in the society.
should be distributed among individuals
output (or income) in the distribution of income.
the problem of inequality
This problem is concerned with
functional distribution
of income. How
relates to
(11) The second aspect ofthis problem viz. land, labour,
different factors of production
should production be distributed among
capital and entrepreneur.
are two
of allocation of resources, there
It is important to note that besides the problem
fuller and efficient utilisation
of resources,
(i) Problem of
more central problems namely of
of But these two problems go beyond the scope
and (i)Problem of growth resources.

our syllabus.

6. Production Possibility Curve

6.1 Meaning
in different ways
With the given amount of resources, it is possible to allocate the
resources

and thereby leading to different possible combinations of goods and services. The various possible
combinations of goods and services that can be produced with full and efficient employment
of resources and technology is called the production possibilities of an economy. When this
production possibility set is graphed, it is called production possibility curve or frontier (PPC
or PPF)
There is maximum limit (or boundary) to the amount of goods and services which an
economy can produce with full and efficient use of its available resources and given technology
That is why PPC is called production possibility frontier (boundary). Table 1.1 and Fig 1.1
indicate that if the economy decides to use all its resources in the production of cloth, it can
produce 5 thousand meters of cloth. And if it decides to use all its resources in the production
of wheat it can produce maximum 15 thousand quintals of wheat. There are also other possible
combinations of two goods that can be produced with full and efficient utilization of resources.
These combinations in the table and diagram are B, C, D and E. The economy has to choose out
of these various production possibilities. If more of the resources are used in the production of
cloth, less resources are available for the production of wheat and vice-versa.
Table 1.1 shows various production possibilities as A, B, C, D, E and F. By plotting all these
nroduction possibilities on a graph, we obtain a production possibility curve AF as shown in
Eia 11. All points on the PP curve indicate full and efficient utilization of resources. An
canomy has to make sure its production on the PP curve. Mind, PP curve only shows production
nassibilities, it does not say on which point the economy will actually operate.
 Production of possibility curve is also known as transformation curve as moving along
the curve implies transformation of one good into the other by transferring resoureces.

Table 1.1: Production Possibilities Schedule

Y

Production Cloth Wheat

18
Possibilities (in thds. (in thds.
15 A
meters) quintals) 14-
H
A 0 15
B 9
14
K
C 2 12
D 3 9
O
E 4 5 2 3 4 5

F 5 0 Fig 1.1 Cloth (Thousand Mts.)

Attainable and Unattainable Combinations of Output

Economywilloperate at anypoint (like A, B, C,Don PPC) when resources are fully and efficiently
utilised. But if resources are not fully and efficiently utilised, economy will operate at any point
(like K) inside the PPC. All combinations of output that lie on or inside the PPC are attainable
combinations. Thus, there can be two attainable options
) optimum utilisation of resources (if resources are best utilised) and
(ii) inefficient utilisation of resources (if there is wastage or inefficient utilisation of
resources).
All combinations that lie on or inside the PPC are called production possibilities set of
the economy.
An economy with the given amount of available resources economy cannot operate at any
point outside the PPC (like H) as it is not possible with the available resources and technology.
Such combinations are called unattainable combinations.

Thus, Production possibility curve can be defined as a curve which separates attainable
combinations from the unattainable combinations.

6.2 Assumptions
The concept of production possibility curve is based on the following assumptions

i) The resources available are fixed.

ii) The technology remains unchanged.
ii) The resources are fully and efficiently employed
of all goods.
(V The resources are not equally efficient in the production
 uilibsrin
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12
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16
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17.
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18.
 Ans Meaning of Demand. Demand for a commodity refers to the quantity of a

commodity which a consumer is willing to buy at different prices in a given period of

time. Thus demand involves three essential elements namely : (i) price of the commodity
(it) quantity of the commodity; and (ii) the period of time. It needs to be noted that demand
is not only with reference to the price of the commodity but also to the period of time.
Thus demand for a commodity is always expressed in relation to a particular price and
at a particular time. For instance, statement like a household's demand for milk is 2 litres
@20 per litre, is not correct and complete. The meaningful statement would be that

@ 20 per litre a household's demand for milk is 2 litres today, because it contains all the
three essential elements of demand.
Demand can be at two levels-individual demand and market demand.
Q.2.9. Explain the factors which determine individual demand for a commoditv.

State any two factors that affect a household's demand of a commoaity.

Ans. Following are the main factors (determinants) which influence/determine demand
for a commodity of the individual consumer (household).

Determinants of an Individual Demand

* * A A

Own price of Price of Income of Taste of

the good related good Consumer Consumer

) Price of commodity itself. It is generaly observed when price of the commodity falls,
its demand rises and when price rises, its demand falls, other things being equal. Thus there
is an iverse relationship between the price and the demand for commodity. It is discussed
in detail in next question titled law of demand.
(i) Price of related goods. Goods are said to be related when price of one
good
(say, x) causes change in demand for other good (say, y). A consumer's demand for a
particular good (say coffee) depends upon the price of its related good (say, tea). Related
goods are of two types-substitute goods and complementary goods.
(a) Substitute goods. Substitute goods are a pair of
in place of each other to satisfy a
goods which can be used (substituted)
given want. For example coffee, is substitute of
tea. If
price of coffee rises, demand for its substitute tea wil rise because
consumers will substitute
tea for coffee. Thus demand for a good (here tea) rises uvith a
rise in price of its substitute
(here coffee), i.e., there is direct relationship. good
(b) Complementary goods. These are a
a given want. For
pair of gooas wnich are used jointly to
example car and petrol.
price If of satisfy
demand for will fall. Thus in case
car
of
complementary good petrol rises,
for the other good rises, i.e., there is Inversecomplementary goods, if price of one good falls, demand
(ii) Income of the consumer. Relationship. T

The effect of change in income Higher the income, arger will be the demand
the good is normal or
on demand
inferior. A good whose depends upon the nature of the goodgenerally. whether
demand rises with rise in
income is called a
 i n c o m e is called
falls with rise in an
whose demand
8 O 0 d whereas a good for a normal good (like fullC
n c o m e of a c o n s u m e r goes
up, demand cream
(like tonea miik, jowar, coa mil
fine cloth) will rise but for an inferior good
a r s i

rse cloth
wneat, demand for a
n o r m a l good
will fall
t On the contrary with a fall in income,
Tall. but for
aninferior good will rise.
in taste for a po
and preference of consumer. A favourable change
aste
whereas an unfavourable change
in taste
(say, for su
also affects sweet
y eatable) increases its demand
a change in preference
ecreases its demand at the same price. Similarly,
and pens than utensils.
emand.
Or
instance a student may demand more of books
consumer's demand function.
2.10. What is demand function? State a
the demand for a
Ans. Demand Function. It explains the relationship between commod
modity
ana the factors determining demand. In a way it gives functional relationship (i.e., causa
and
effect relationship) between demand and its determinants. The above analysis is presented
as demand function in the form of the following equation.

D fP PR Y, T)
w

The equation shows that demand for commodity x (D-) is the function () of Price o
commodity x (P): Price of Related goods (PR); Income of consumer (Y) and Tastes of
Consumer (T).
A consumer's demand function for a
good gives the amount of the good that the consumer
chooses at different levels of its price when the other
things remain unchanged.
Let us first discuss the relationship between the
price and demand which is expressed in the
form of 'law of demand' and take up the
relationship
with other determinants afterwarde
Q. 2.11. . Explain law of demand with the help of a demand schedule.
Explain law of demand and the reasons behind it. Use
diagram.
Define demand schedule.
Ans. (a) Statement of law of demand. The Law of
Demand states "other thing
remaining unchanged, quantity demanded of a commodity is inversely related to the price of
commodity." In other words,
demnand for a commodity rises when price falls and its demand
71nhen vrice rises provided other factors remain fals
unchanged. Thus there is an inverse relationsnip
hetween price and demand. For instance, an individual
may demand one dozen of bananas
at 15 per dozen; he may, however, demand two dozens
if the price falls to 10 per
nThe law can be illustrated further with the 10per
help of hypothetical Demand Schedue
and Demand Curve based thereon.
Demand Schedule. A Demana Schedule is a tabular statement
auantities of commodity demanded at which shows differem
a
different prices, Let us
eehold for potatoes at ditrerent prices is as shown
in the demana of
suppose that the demand
following demand schedue
ule:
 DEMAND SCHEDULE YA
0
Price Quantity
per kg () demanded per (k9
w

10
8
DEMANDCCURVE
8 2
3

Note that quantity demanded is shown as

a function of price alone.
3 X
(c) Demand curve. A demand curve reflects O
QUANTITY DEMANDED

graphically the relationship between the Fig. 2.8

quantity demanded of a commodity and its
price. Thus graphical representation of demand has
at different levels of demand curve. The above imaginary demand schedule
price forms
been depicted as a demand curve in Fig. 2.8.
Curve generally slopes downward
Shape of Demand Curve (Negatively sloped). Demand which is derived from law of
from left to the right. It is called a negatively sloped curve
demand curve for a commodity is nothing but marginal
diminishing marginal utility. Clearly
utility curve of arn individual for that commodity.
of law of demand refer
(d) Assumptions or other things being equal. The assumptions
to the conditions under which law of
demand operates. The law is valid only when other
factors other than the price should not
things remain constant (unchanged) which means
related goods, (ii) income of the c o n s u m e r and
change. Thus, it is assumed that (i) price of called
etc. should renmain constant. These are
(iii) tastes and preferences of the consumer

demand.
assumptions of the law of
to the law of demand. Exceptions refer to situations when law of demand
(e) Exceptions
does not operate. Following are three such exceptions.
1. Inferior goods o r Giffen goods. In case of certain inferior goods (say, jowar, bajra)
when
their prices fal, their demand may not rise because consumers divert their extra purchasing
power (caused by fall in price) to purchase of superior goods (say, wheat, rice). As a result,
demand for such inferior goods whose price has fallen, also falls. Such inferior goods are
called Giffen goods because this fact was analysed first of all by Sir Robert Giffen. Mind,
Giffen goods are a special category of inferior goods whose price effect is positive (i.e., when price
falls demand also falls). Between two effects of price change (i.e., income and substitution
effect), the negative income effect is so strong that it outweighs the positive substitution
effect with the result that with a fall in price of the commodity, its quantity demanded also
falls. Mind, inferior goods are those goods whose income effect is negative.
2. Status symbol goods. This type of goods are purchased not because of their intrinsic
value but because of status or prestige value. The same jewellery when sold at low price
sells poorly but offered at five times the price, sells quite well. Similarly, demand for colour
 because of their status symbols in sni
Set, Video tape recorders has been rising pite of the
fact that their prices have also been rising continuousiy.
3. Goods expected to become scarce or costly in future are purchased by the h
n increased quantities even when their prices are soaring upwards. useholds
Fashion. The demand for goods which are in fashion does not fall even whe.
hen ther
prices increase.
Q2:12. .
Explain the causes behind law of demand.
the
why is there inverse relationship between price of commodity an
its
demandd?
Ans. According to Classical approach, the most important reason behind law of derman.
believe ncome
and
is lw of diminishing
marginal but the modern
utility' economists effect and and
substitution effect as the main causes. These are explained below:
1. Law of
diminishing marginal utility. Briefly, this law states that when a consumer
consumes more and more units of a commodity, marginal utility derived from
from successive
successive
units goes on decreasing. As for example, a hungry man gets maximum utility fron first
chapati, lesser utility from second chapati, still lesser from third chapati and so on. Demand
depends on utility or usefulness of a commodity to the consumer, i.e., if he gets more
satisfaction, he will pay more and if he gets less utility, he will buy at a lower price. Since
additional (or successive) units give him lesser utility, he will buy additional units only at lower
price. And this is Law of Demand which states that demand for a commodity is more at a
lower price and less at a higher price. Thus law of diminishing marginal utility explains the
downward slope of demand curve. Indeed demand curve is essentially the downward sloping
portion of the marginal utility curve.
2. Income effect. A change in quantity demanded as a result of change in real income
caused by change in price of a commodity is called income effect. Any change in the price
of a commodity affects the purchasing power or real income of the consumer although his
money income remains the same. When price of a commodity falls, less has to be spent on
purchase of same quantity of that commodity or sáme quantity can be purchased with less
money. With money thus saved, a consumer can purchase more quantity of the commodity
whose price This is called income effect of change in
has fallen. price of the
In short, a fall in price increases the real income (purchasing power) of a consumer
commodity.
with the result that he buys more quantity with the same money income. Similarly, a
rise
in price virtually amounts to fall in real income of the consumer leading to contraction of
his demand. This part of increase in demand is called income effect. Mind, income effect
is related to change in income caused due to change in price and not due to change in money
income.
3. Substitution effect. Substituting a cheaper commodity for the relatively expensive
commodity is called substitution effect., Alternatively, it refers to substitution of one
commodity in place of other commodity when it becomes relatively cheaper. How? A rise
in the price of a commodity, say coffee, also means that price of its substitute, say tea, has
fallen in relation to that of coffee even though price of tea remains unchanged. So people
]peopile
are induced to buy more of tea and less of coffee when price of coffee rises. In other
words, consumers will substitute tea for coffee. This part of increase in demand is calle

substitution effect.
 The effect operates reverse when the price of the commodity falls. A fall in the price of
acommodity induces the consumer to substitute other commodities with this commodity
aace Drice has fallen. This leads to rise in demand. Clearly substitution effect is based on
concept of relative prices of substitute goods.
Thus, according to modern economists, the combined operation of income effect and
effect causes increase in demand with a fall in price.
substitution
It may be noted that the combined effect of income effect and substitution effect is called
price effect.
Why inverse relationship between price and demand? We have read in Utility Approach
of consumer's equilibrium that a consumer buys only that much of a commodity at which
its marginal utility in money terms is equal to its price. Under such a situation suppose
price falls, it makes marginal utility greater than price. This induces the consumer to buy
more of the commodity. Clearly it shows inverse relationship
between price and demand.

6.2.13. Distinguish between 'Change in demand' and Change in quantity demanded

of a commodity'.
Ans. To simplify let us divide all the determinants of demand in two categories,
namely, 'priceof commodity itself in first category and 'factors other than the price of
the commodity, (such as price of related goods, income of consumer and taste of consumer)
in the second category.
i) Change in quantity demanded. When change (rise or fall) in demand for a commodity
is caused by change in its o w n price, it is called change in quantity demanded. It shows
It is expressed in
specific quantity of a commodity purchased against its specific price. is
the form of either extension o r contraction of demand. A change in quantity demanded
graphically represented in the form of movement along a given demand
curve.

other
(i1) Change in demand. When change (rise o r fall) in demand is caused by factors
than the own price of the commodity, it is merely called change in demand. It is expressed
in the form of either increase or decrease in demand. In fact, change (increase or decrease)
in demand is graphically represented by shift of a demand curve upuward or downward.
Comparison. 1. Change in 'quantity demanded' is caused by change in price of commodity
demand curve does not
(i.e., whereas 'change in demand' is caused by factors other
shift)
than the price i.e., demand curve shifts rightward or leftward.
2. Change in quantity demanded graphically implies movement along a demand curve
whereas change in demand graphically implies shift in demand' curve.

. 2.14. (a) Distinguish between extension of demand and contraction of demand with
the help of a diagram.
(b) What is 'movement along a demand curve'? Show it with the help of a diagram.
(c) What causes an upward movement along a demand curve ofa commodity?

Ans. (a) Extension and contraction of demand. Rise in demand due to fall in price of a
commodity itself, other things remaining the sane, is called extension of demnand. It results
in downward movement along a demand curve. On the other harid, fall in demand due to
rise in price of a commodity itself, other things remaining the same, is called contraction
It movement along a demand curve. The demand
of demand. results in upward
schedules and curve further clarify it.
following
 CONTRACTION OF DEMAND
EXTENSION OF DEMAND
Price per unit () Demand (units)
Price per unit ()
Demand(un
5
1 20
10
3 3 15
15
20 5 10

(b) Movement along a demand curve. A www

demand Y
curve showing change in demand due to MOVEMENT ALONG A
Channge DEMAND CURVE
im
price (i.e., extension and contractioin of
demand)

cONTRACTION EXTENSION
is graphically
called movement along8a
demand curve. In Fig. 2.9 when
price is OP,
demand is OQ. But when
price falls from OP
to OP2, demand
expands from 0Q to OQand
we move
downward along the demand curve.
When price rises from OP to
OP, demand
falls from OQ to OQ and
the demand curve. Thus a
we move upward
to
change in demand due
change in
price of the commodity graphically
means movement along the demand curve. Q
(c) Rise in price or fall in demand causes QUANTITY DEMANDED
an upward movement along a demand curve. Fig. 2.9
Q. 2.15. Distinguish between increase in demand and decrease in demand. (D
.

What is shift in demand curve?

Define change in demand and
represent the same graphically. State three factors
responsible for change in demand.
Ans. Increase and decrease in demand
(Shift in demand curve).
(a) Increase in demand. Rise in demand due to
of the
in change factors other than the price
commodity is called increase in demand.
Briefly it
price or same demand at a higher price. ln other words put refers to more demand at same
when
more quantity is demanded at
the same price or same
quantity at a higher price, it is called increase in demand as shown
in the following schedule.
Diagrammatically
(or upward) shift of demand curve as shown in
rise in demand is
represented in rightward
shifts rightward from its original position to new Fig. 2.10 in which demand curve DD
demand curve D,D2. Demand curve
showine its rightward shift indicates that the demand for D>D2
the commodity at the
has increased. same price
INCREASEIN DEMAND
(More demand at same price DECREASE IN DEMAND
(Lesser demand at same
Price ) Demand (units)
Price ) price
5 15 Demand (units www.

20 25

25 20
5 5
15
 (hDecrease in
demand. Fall in demand due to SHIFT IN DEMAND CURVE
YA
otiher than the price of the commodih
change infactors D D

is called decrease in demana. Briefly put, it refers

demand at
DEC
CREAS
at same price or same
to lesser demand
lower price. In other words, when less quantity is
demanded at the same price or same quantity at a
lower price, it is called decrease in demand as shown
in the above schedule. Diagrammatically decrease in EMA AND
demand is represented in leftward (or downward) b,D D
shift of demand curve as shown in Fig. 2.10.
In this figure, demand curve DD shifts leftward Q
from its original position to new demand curve D,D QUANTITY DEMANDED

Thus demand curve D,D showing its leftward shift Fig. 2.10
indicates that demand for the commodity at the same price has decreased
Factors responsible for change (increase and decrease) in demand are () Price of related
goods, () Income of consumer and (ji) Taste of the consumers. Remember that increase
or decrease in demand is graphically called shift in demand curve.
(c) Shift in demand curoe refers to the shifting of original demand curve to the right when
demand increases at the same price (curve DD shifts to curve DD, in Fig. 2.10) and to the left
when demand falls at the same price (curve DD shifts to curve D,D in Fig. 2.10). Mind, in a
shift a new demand curve is drawn.

Q. 2.16. (a) Distinguish between decrease in demand and contraction of demand.

b) Distinguish between increase in demand and extension of demand.

Distinguish between increase in demand and increase in quantity demanded of
a commodity.
(c) Differentiate between movement along a demand curve and shift in demand curve.
Ans. (a) Distinction between decrease in demand and contraction of demand. Both
indicate fall in quantity demanded but the reasons are different. (i) Decrease in demand is
at the same price due to change in factors other than the price (e.g., price of related goods,
income and taste of the consumer etc.) whereas contraction of demand is due to change
(rise) in the price of the commodity. (i) In case of decrease in demand, demand curve shifts
leftward (see Fig. 2.10) whereas in case of contraction of demand, we move up along the
demand curve (see Fig. 2.9).
(b) Distinction between increase in demand and extension of demand. Both reflect rise
in quantity demanded but the causes are different. (1) Increase in demand is at the same
caused in factors other than the price of the commodity (e.g., price of
by change
price
related goods, income and taste of consumer etc.) whereas extension of demand is caused
In case of increase in demand, demand
by change (fall) in price of the commodity. (i1)
whereas in case of extension of demand, we move
curve shifts rightward (see Fig. 2.10)
curve (see Fig. 2.9).
downward along the demand
factors other than the price (e.g., increase in income,
When rise in demand is caused by
it is called increase in demand. As against it
fall in price of complementary good etc.),
in Own price of the commodity, it
when rise in demand is caused by change (i.e., fall)
demanded of a commodity.
1s called increase in quantity
 4.1 Percentage Method

According to percentage method, price clasticity ofdemand (c,) 1S measured by taking ratio
of percentage change in demand to percentage change in price. This has been showning
hown by the
following formula :
Percentage change in quantity demanded
C
Percentage change in price

Change in Quantity (AQ) x 100

j00
Original Quantity ()
Change in Price (AP)
100
Original Price (P)
We can cancel out 100s to get
AQ
Q AQx - P AQP
; p
AP 4P AP Q
P
where e Price elasticity of demand
AQ =

Change in quantity demanded

AP= Change in price
P Initial price
Q=Initial quantity
If the result of the above equation is 1, demand is unitary elastic. And if the value of
comes to more than 1, demand is more elastic or elastic and when it is less than 1, demands
less elastic or inelastic. It may be noted that price and demand are inversely related.

NUMERICAL PROBLEMS
Problem 1. As the price of peanut packets increases by 5%, the number of peanut packes
demanded falls by 8%. What is the elasticity of demand of peanut packets ?
Solution: Here percentage changes in price and demand are given. So price elasticity ofdeman
can be calculated by using the following formula.

Percentage change in quantity demanded

Percentage change in price

1.6
Ans.
Problem 2. The quantity demanded of a commodity at a price ofR 8 per unit is 500 units. Io

price falls to 6 and as a result, its quantity demanded rises to 600 units Calculate its prie
elasticity of demand.

Solution : We are given absolute changes in price and demand.

 Given values are

AO=100 ( 600- 500), Q= 500 units, AP=-2 (6- 8), Q =600 units, P =78, P, =76
To calculate e. the following formula will be used:

AQ P
Cp AP Q
By putting the given values in the above formula, we get
100 8
2 500
-8%
= 1.6
5%
4
= 0.8 Ans.

Problem 3. At a price of R 30 per unit, the quantity demanded of a commodity is 300 units.
If price
falls by 10%, its quantity demanded rises by 60 units. Calculate its price elasticity of demand.
Solution: We are given percentage change in price and absolute change in demand. So first
of all we need to convert absolute change in demand into percentage change. Only then e, can
be calculated.
Percentage change in price = 10

60
Percentage change in demand x100 20 =

300
300
Precentage Change in Quantity Demanded
p Percentage Change in Price
20
=2
10
Ans.
Problem4. The demand for a good rises by 20 result of fall in its price. Its price
per cent as a
elasticity of demand is - 0.8. Calculate the percentage fall in price. (CBSE D 2015)
Solution
Given values: ep-0.8, % change in quantity demanded = 20%
Applying the formula
Price elasticity of demand (e,) = Percentage change in quantity demanded
Percentage change in price

20
0.8 =

Percentage change in price

Percentage change in price = 20/0.8

-25% Ans.
 4.3 Geometric (Or Point) Method
According to this method, elasticity of demand on any point on a straight line demand curves
measured by dividing the lower part of the demand curve by the upper part of the demand curve

Put in the form of an equation.

Lower Part of the Demand Curve

P Upper Part of the Demand Curve

at particular point on the demand curve is called point

Measuring the elasticity a

elasticity of demand.
of a straight line demand curve. This is
Price elasticity of demand is different at all points
and upper segment at each point of demand curve are
different. Price
because lower segment
under (refer Fig. 4.8)
elasticity can be worked out as
In Fig. 4.8, AB is a straight line
demand curve. Using the point method, we can find price
curve as under
elasticity at different points on demand
() Unit elastie (e,= 1)
3
oint P = =1, because P is the mid-point.
PA
i) More elastic demand (e,> 1)
B
e, at pointP, P, 1,because P,B is greater than P,A
=

(ii) Less elastic demand (e, < I)

P2B<1, because P,B is smaller than PA

(ep< 1)e,at point P= P2 A
(iv) Perfectly inelastic demand (e, = 0)

0
e, at point B= 0, because there is no lower part of demand curve. Any number
AB
multiplied by zero gives us zero.
P e r f e c t l y elastic demand (e, = )

AB
e at point A =
C,because there is no upper part of demand curve. Any number
0
dividing by zero gives us infinity.
Thus, we can say that at the mid-point on a straight
line demand curve, elasticity of demand will be equal to
one. At higher points (such as P, etc.) elasticity will be
greater than one and at lower points (such as P2 , etc.) Mid Point
the elasticity will be less than one. At points A and B the e,1
P
elasticity will be infinite and zero respectively.
A is that total expenditure
noteworthy point here Po e1
price x quantity) is maximum at the middle point on e,1
a linear demand B
curve.
e=0
Since, e,> 1 above the middle point, total o X
expenditure increases as we move downwards Quantity
along the demand curve. Fig 4.8
5. Factors Determining Price Elasticity
foraGood
on the following factors:
In general, the size (or value) of price elasticity depends
determinant of elasticity of demand for a
(1) Nature of the commodity : An important
itself. If the commodity is a necessity oflife
commodity is the nature of the commodity
its demand will not change much when its price changes.
Hence, the elasticity of demand
water etc. is nearly perfectly inelastic. The
will be low. For example, demand for salt,
sets etc.) on the other hand
demand for luxury items (e.g., ACS, big sized colour TV
some people may not purchase
is elastic. When the price of air-conditioners increases,
air-conditioners.
substitutes of a good are readily available,
(2) Availability of close substitutes : If close
its price elasticity of demand will more elastic. It is because an increase
in its price will
make consumers to shift over to other substitute goods easily. For example,
demand for
cold drinks e.g., coke, pepsi, limca etc. is highly elastic because of availability
of close
substitutes. On the other hand, demand for petrol, salt is inelastic as consumers have
no

option but to buy the given good.

is on a
(3) Proportion of total expenditure : Ifa very small proportion of income spent
gOod, its demand is likely to be inclastic. The demand for newspapers, match box, shoe
affect
polish etc. are examples of such goods. Price change of such goods does not 15
the budget of the consumer. On the other hand, if a large portion of the total income

spent on a good (e.g., petrol, clothing etc.), its demand will be more sensitive to
change. So, elasticity of demand is likely to be
a
price
high.
4) Habits : Habits also play a role in the
a person has developed the
determination of elasticities. For example, if
habit of drinking, he may not to be able to reduce his
consumption of Wine even when the price of wine goes up. His demand for wine will
then be inelastic.
(5) Number of uses: Good which can be put to several
etc.) will have more elastic demand in (such as electricity, milk
uses
comparison to a good only
example, when price of electricity rises its use will be made having limited use. For
for important uses
and the demand will contract.. On the other
less important uses and its demand will
hand, if its price falls it will be put to even
expand. Good having less number of alternative
ses (e.g.,tooth brush, school uniform etc.) will have inelastic demand.
(6) Income of the purchaser : The elasticity of demand is also influenced by the level
of income of the consumer. If the consumer is
rich, he will not bother much by small
changes in price. Such changes will leave his demand unaffected. A poor consumer,
on the other hand, will give
importance even to small changes in price. His demand,
therefore, will be price elastic.
(7) Postponement of consumption : If the use of a commodity cannot be postponed, its
demand is usually less elastic. For example, as the consumption of wheat or sugar cannot
be postponed, its demand is usually inelastic. On the other hand, if prices of cement rise
then people can postpone their plans to build a house. So, demand for cement is elastic.
(8) Period of time: If the price of a product rises, consumers will search for its cheaper
Substitutes. The longer period they have, the more likely they are able to find the one.
Demand will, therefore, be more price elastic in the long run. In the short period, on the
other hand, demand will be less elastic. The consumers may not be able to reduce the
consumption of a good immediately because they are habituated to that product.
52.INCOMEELASTIctY OF DEMAND)
Income elasticity of demand maybedefinedas the responsiveness
ofdemand
for a commodity to changes in income, otlher determinants remaining constant. In
brief,
Proportionate change inquantitydemanded
E Proportionate change in income
Symbolically,
E,= 4-9Y-Y: Aq Y
Or
Aq Y
Y AY AY
where, q and Y represent
original quantity and income respectively and q,
andY, denote new quantity and new income respectively.
Illustration. Suppose, a household demands 30 litres of milk when his
monthly income is Rs. 3,000. If the household's income increases to Rs. 5,000, his
demand for milk increases to 40 litres. The income
measured as follows:
of demand will elasticity be

Aq Y 10 3,000
E AY =0.5
2,000 30

Hence, household's demand for milk is income inelastic. Income

elasticity
ofdemand canbe of five ditferent types. Theses are tabulated in Table 39 below:
Table 39 :Types of Income Elasticity of Demand
Numerical of measure of
income elasticty of Verbal description
demand
1. Negative Demand for a
commodity falls as income
rises (e.g., inferior
goods).
2. Zero Demand for a commodity does not change
as income changes.
3. Greater than zero but Demand for a
less than one
comnmodity rises less than
in proportion to a rise in incone.
4. Unity Demand for a
commodity rises in the
same
proportion as rise in income.
5. Greater than unity Demand for a comodity rises in a
larger
proportion to rise in income.
The various of income
measures elasticity of demanddepicted can be
diagrammatically shownin Fig.3 20.
as

tion
In Fig.320, the curve represents relationshipbetween income and consump-
(demand). As income increases from OK to OM the level of con-
53.Cross Elasticity of Demand
The responsiveness ofdemand to a change in the prices of related commodi-
ties is called cross elasticity of demand. It is the responsiveness of demand for
commoditvXtoa change in price ofcommodity Yand is represented as follows:

Proportionate change in the quantity ofcommodityX

CProportionate change inthe price ofcommodity Y
Symbolically,
A4, P
E APy
The relationship between commodity Xand Ymay be substitutive (as in case
of tea and coffee) orcomplementary (as in case of ball-pens and refills), the main
features
ofcrosselasticity with theirdescriptions are tabulated in Table3-10:
Table 3-10: Cross Elasticity of Demand
Numerical measures
of cross elasticity Description
1. Infinity
Commodjty X is nearly a perfect substitute to
commodity Y.
2. Greater than zero is
but less than
Commodity X a substitute to commodity Y.
3. Zero
infinity
Commodity X and Y are not related.
4. Negative
Commodity X and Y are complementary.
(ii) b. Method for Measuring Arc Elasticity
For measuring
arc elasticity, instead of picking up any particular P and the Q associated with
it for the ratio P/Q, it is
customary to fix P =T2 (i.e., the average of the two end values Po 1.e,
original price and P i.e., changed price and similarly to fix Q=Q o (i.e., average of the two
2
end values.Qo i.e., the original quantity and Q1 i.e., changed quantity. Hence arc elasticity is
defined by the following expression:
= 4Q P
Are elasticity of demand
AQ Q
P+P
Q-Qo 2
P-P +Q
2

Q-Q , P+P
P-P Q+Q0
Let us illustrate the method for measuring arc elasticity with a simple numerical example.
Suppose, due to a fall in the price of a commodity from Rs. 10 to 8 per unit the quantity demanded
of it increases from 1000 units to 1500 units. What will be the value of arc elasticity in this case?
Let us translate these figures in symbols of the above expression.
According to the example Po 10, P = 8, Qo = 1500, AQ (i.e., Q - Q0)- 500 and AP

e., P-Po) =2.

Arc elasticity of demand Q - P +P
P-P Q-Q
500-1000 8+10
10-8 1500+1000

500 18
1.8.
2 2500
 Q. 3.35. Define supply.
Ans. Meaning of Supply. Supply of a commodity by a firm refers to the quantity of
commodity which the firm is willing to supply (sel) at a particular price and time. Like
demand, supply also has three elements, namely, quantity of commodity, particular price and
particular time. We cannot think of supply apart from price. For instance, at the price of
35 per kg. a seller may offer 100 kg of sugar for sale but @ 37 per kg, he may offer 200
kg of sugar. Similarly, he may offer different quantities for sale at different times. In short,
the quantity af a commodity which an individual firm (or producer) is ready to sell at a
particular price and time is called supply by the firm. It shows firm's willingness to sell
and not what it actually sells. Supply is a flow and expressed as the anmount
is, therefore,
of a commodity which is offered for sale per unit of time.

offers more quantity of commodity

for sale at a hi tne commodity. A producer usually supPly of the
ce and less quantity at a lower price. In other words,
whereas that of other
has not risen will not rise
whose price has
s D
directly will
relatod price
r y it means that other things being constant, supply of a commodit

of the commodity. This relationship

between price and
e oWn price most important factor
n the next section on 'law of supply'. Thus
affecting sunni
supply ofcommodity is its own price
a

erminants noted below are called 'factors other than the priCe
more proi echnology of production. Advance technology reduces cost leading to
increasess u s a change in technique of production which lessens cost ot production,
of# Supply of the commodity and shifts supply curve rightward. As against it, Supply
in costo d s which are being produced with old and inferior technology causingincreas
r production will fall and supply curve will shift leftward. That is why errorts are
marginal cot the producing units to evolve an efficient technology which reduces
L a cost of production. Under such conditions of falling marginal cost,
s htward (i.e., below the old supply curve). Hence it follows that asuppy curve
technological
progress increases the
supply and shifts the supply curve to the rigt.
e in price of inputs or factors of production. Change in prices of raw material
aremuneration of factors (rent, wages,
interest etc.) influences the cost of production of
Commodity and thereby
supply. An increase in the price of a factor of procuction may
ead to fall in production of a commodity shifting the
taproducer supply curve to the left. Contrary to
may supply more of a
commodity at given price if prices of factors tal!
shifting
the supply curve to the right.
a

4.
Change in excise duty (or tax
of good (eg, excise duty, custom dutyrate). Government levies various taxes on
etc.). Such taxes influence supply becauseproduetion
the marginal cost of it adds to
commodity production.
will increase
For example, increase in excise duty rate on
the left. In short, marginal cost leading to fall in supply and shift a
particular
higher tax rate results in decrease in supply curve to
to increase in
supply. supply whereas lower tax rate leads
Effect of subsidy on
supply. Effect of
government on production of good leads tosubsidy is opposite of indirect tax. Subsidy by
fall in price of the
revenue of the firm. Cost
remaining good. This increases sale and
unchanged profit rises. As a result
5. Price of other related
goods. Supply of a good is supply increases.
goods. How? also influenced
Suppose a firm produces two goods X and Y with its by prices of other
increase in the price of Y induces the firm to given resources. An
resources from production of X to Y. It is because produce more of Y good by diverting its
than producing X good. As a result producing Y good is now
more profitable-
supply of Y good increases and its
rightward whereas supply of X good decreases and its supply curve shifts=
price of related goods increases, the supPy ot the good supply curve shifts to leftward. Wher
in
selling other good (here y) is more profitable. question (here x) falls because=
imilarly if the other related good is substitute
by applying the same rice) of the
approach we can say, Mcrease in the pricegivena
(say good (say wheat)
production shifts the supply curve of the given good to the left." of substiute goo
goods ire
Ohiectives of the firm. Sometimes a firm may be
commodity not because it is more protaie dut Decause itsinduced to
increase supply of
supply is a source of status
at an
 SUPPLY SCHEDULE
Quantity supplied ()
ces of sugar per kg ()
50

16 40

12 30

8 20

4 10

3. Supply Curve. A supply curve reflects the

Y S
relationship between the price and quantity
supplied graphically what the supply schedule 20
shows arithmetically. Thus a supply curve is a
graphical representation of quantity suppliedat 16 SUPPLYcURVE
different price levels. The above supply schedule
has been depicted in the form of a supply curve. 12
Figure 3.24 shows clearly a positive relationshipP
between the price and supply of the commodity
because with rise in price, the rises 4
curve upward
from left to the right.
X
Shape of Supply curve (Positively sloped). It 10 20 30 40 50
should be noted that the supply curve of a firm is QUANTITY SUPPLIED
generally positively sloped, ie, it rises rightwards Fig.3.24
when price rises and it slopes leftwards when
price falls as shown in Fig. 3.24. Thus supply curve reflects direct relationship between price
and quantity supplied. (This is in sharp contrast to demand curve which reflects inverse
relationship between price and quantity demanded.) Again the above supply curve is a
straight line which need not be so always. It can be hyperbola
in shape depending
data of supply schedule. upon
4. Assumptions of Law of Supply (Other things being equal)
The phrase 'other things being constant used in the law of
of the law. The law of supply is based on the
supply shows the assumptipns
assumption that all the determinants of supply
except own price of the commodity should remain constant as shown below
(i) Cost of inputs/factors of production should remain. the same
(ii) Technology of production should not change.
ii) Taxation policy of the governmei snould not
change.
(io) Price of other related goods should not change.
(v) Goal (objectives) of the firm should not change.
Exceptions. There are some situations when law of supply does not
are: () Expectations of future changes in price and (7) Artistic operate. They
goods of high quality and
antiques.
a$ shown in Fig. 3.28. Here elasticity of supply
(es)= 0 because supply has not changed at all as Y G
30F
a result of 100% rise in price. This happens in case
like fish, milk
of perishable goods etc.
20 es 0

Price per kg () Supply (kg)

10 S
10 100
OL X
20 100 50 100 150 200
QUANTITY SUPPLIED

Less than unit elastic supply (es < 1). When

(ti) Fig. 3.28

percentage change in quantity supplied is less thaan ***********

** i *r*wresss***********************************************

the percentage change in price, supply is said to be

less than unit elastic (or less elastic) but greater than
zero as shown in the following supply schedule.
20

w
Price per kg
ww wwww w wWw wwww
Supply (k9
10 100 10

.
20 150 OL S
100 150
X
50

Here supply has increased by 50% in response to QUANTITY SUPPLIED

100% rise in price. Figure 3.29 shows a straight line Fig. 3.29

positively sloped supply curve which meets X-axis

when extended to the right of origin (point O). Alternatively it also means that es < 1 if supply

Curve starts from X-axis.

is said to be unit elastic (or
(ii) Unit elastic supply (es 1). Supply of a commodity
=

in
unitarily elastic) when percentage change in supply is equal to percentage change price
as shown below. Here supply has increased by 50% as a result of 50% increase in price.
In such cases, a straight line supply curve passes
********..*waanaa*********a****.***********************************************

through the point O as shown in Fig. 3.30. S

Price per kg K Supply (kg)

100 10
10
e s

15 150
45
Thus when es =
1, supply curve should start
50 X
from the point of origin as shown in this figure. 100 150
QUANTITY SUPPLIED
Alternatively it also means that es
=
1, if supply curve

starts from the origin (point of axes). Fig. 3.30

 io) More than unit elastic (es > 1). When percentage change in supply is mo more
Percentage change in price, supply is said to be more than unit elastie (or hik
elastic) but less than infinity as shown below. Here, supply has increased by 100% in
hly
response to 50% rise in price. In such a Situation
Positively sloped straight line meets Y-axis above
the 15
point O (point of origin) as illustrated in Es T

Fig. 3.31.
10
Price per kg () Supply (kg)
10 100
15 200
X
Alternatively it also means that es> 1, if supply curve 50 100 150 200
starts from Y-axis. aUANTITY sUPPLIED
Fig. 3.31
( ) Perfectly elastic supply (es = oo). Supply of a commodity is said to be perfectly elastic
when its supply expands (rises) or contracts (falls)
to any extent without any change or very little
change in price as shown below. In the following 30

hypothetical schedule, supply has gone up by 100% es

without an increase in price. S
20
Price per kg () Supply (kg) 10
20 100
20 200 OL
50 100 150 200X

QUANTITY SUPPLIED
Here es =
(infinity) and the supply curvve Fig. 3.32
becomes horizontal and parallel to X-axis as shown
in Fig. 3.32. It is an imaginary concept.

DEGREES OF ELASTICITY OF SUPPLY

Coefficients of es Nature of es Relationship between price and supply
es = 0 Perfectly inelastic Quantity supplied does not change with
change in price.

es1 Less than unit %change in supply is less than that in

elastic price.

es = 1 Unit elastic % change in supply is equal to that in

price.
es 1 More than unit % change in supply is more than that
elastic in price.

es Perfectiy elastic Supply changes infinitely without

change in price.
 Simply put, Flatter thhe
supply curve, thie
responsive (elastic) is the supply. more
Supply curves showing different
The Fig. 3.33 showS elasticitles
with different degrees ot graphically supply curves S

ho infinity. Simply put (1) If elasticity ranging from O

supply curve is a vertical
straight line, es is zero. (i7) If supply curve is
to X-axis, es is infinite.
(11) It supply curve parallel
straight line passing through the is a
(iv) If supply curve is a straight line origin (O), es=1.
es1. (v) It supply curve is a cutting Y-axis, QUANTITY SUPPLIED

X-axis, es 1. straight line intersecting Fig. 3.33

(b) (i) When percent change in

supply is than percentage change in price.
(i) When supply expands or contracts togreater
any extent without any change or very
change in price. ittle

ii) Elasticity at any point on a positively

sloped
es1if it touches (or passes through) the originstraight
line supply curve is 1 Le.,
when extended; es>1 if it touches
Y-axis when extended and es < 1 if touches X-axis when extended.

MEASUREMENT OF ELASTICITY OF SUPPLY

Q. 3,47, Explain percentage method of measuring price elasticity of supply.
(D 2000)
State formula of measuring price elasticity of
Ans. Price elasticity of supply (es) can be measured
supply. (A 2000)
and Geometric Method-as explained below.
by two methods-Percentage Method
Percentage Method
Price elasticity af supply is measured
by percentage method in the same as the
elasticity of demand. We measure elasticity of supply as the ratio of percentageway
change in
quantity supplied of the commodity to percentage change in its price. In other words, es is
measured by dividing the percentage change in quantity supplied of a commodity by the
percentage change in price of the commodity. Expressed in the form of an equation:

Elasticity of supply Percentage changein quantity supplied

Percentage change in price
By simplifying, this can be converted into the following formula:

es
In which es stands for of supply
Elasticity
Aq stands for change in quantity supplied
Ap stands for change in price
q stands for original quantity
p stands for original price
 ghly elact:te above equation is 1, supply is elastic; it more than 1, Suppluwith the
1f the
result of the above can be further
clarified,O
or highly elastic; if less elastic. This
helpof
less than
supply isi less
1, supply
tollowing examples.
Note: Since generally in the
same
direction, elasticity of suppi wil alngys
be price anduan
qu tity supplied move
positize. Then
POsitive There is no confusion
regarding sIg fes
R 18 per KG the quantity sun
CApands from 100 ke tosugar
rises from 16 per kg to
150 kg. What is elasticity ofsupply of sugar?
Supplied
Solution. Aq =
50 kg (150 100)
Ap 2 (18 16)
100 kg
p = 7 16

es Ap
- 1004
16

Here 4 is called coefficient of elasticity of supply. Supply in tns case 1s nore than unit
elastic or
supply of sugar is more elastic.
(Geometric method of measuring price elasticity of supply is explained n 9.
3.20)|
Q. 3.48. NUMERICAL SUMS ON ELASTICITY OF SUPPLY
(D 2003, 2004, 06, 06C, 07C, 09, 09C, 10; A 2004, 06, 09, 10)
1. Calculate
elasticity of supply when price falls from 6 toR 4 per unit.
Price (per unit) Supply (units)
5000
4000

3500
3 2000

Ans. Ag = 1500 (5000 3500)

Ap = 2 (6 - 4)

4 5000
P 6

es

1500 6 9
2 5000 10 0 . 9
 2. When price of a commadity increases from 10 to 7 12 per unit, its p 6oes up
from 100 units to 140 units. Calculate elasticity of supply.
P
ns esApX
40(140-100) 10
2(12-10) 100
2
3. A seller of potatoes sells 80 qtls. a day when the price of potatoes is *P
of
The price elasticity of supply of potatoes is known to be 2. How mucn yu
(D 96)
potatoes will the seller supply when the price rises to 5 per kg

Ans. es A
Aq 4
2 15-4 x
80
or Ag 40
Seller will supply 120 (80 + 40) qtls.
when price rises
4. From the following table, calculate the price elasticity of supply (NCERT)
from 2 to F 3.

Prlce(inper kg) 3 4

Supply by Firm 35 37 40 44 48

Ans. esAp
T3-2 x 0.16
is 3. A seller supplies 20 units
5. The coefficient of elasticity of supply of a commodity
How much quantity of this commodity
of this commodity at a price of 8 per unit. (A 98)
unit?
will the seller supply when price rises by? 2 per

Ans.

3 -4
Aq 15

Quantity supplied 3 5 (20 +15) units of good at a

of a good is 5. A producer sells 500
6, Price elasticity of supply to sell at the price of 6 per
How much will he be willing
price of 75 per unit. (D 99/1)
unit?

Ans. es
9-500 5
or 516-5) 500
 t Of Production .
1. The Concep t'ng vari ous goo ds and serv ices which a
By production we mean th e pro cessIt of crea 1
is to be emp hasi sed that goo d s and serv~.ces are not re
consumed by the peop .
le of the cou~try.
d • is a process m . whi ch inpu ts are tran sfor med mto output
d out of nothing. Pro uction . ·
ereate . d t' process 1s .
ca
lled an inpu t (or a fact or of productio n) and
Whatever is used m the pro uc ion. . .
t Prod ucti on, thus , mea ns tran sfon nmg
. • d · th oces s 1s an outp u · mputs
whatever is obtame 1~ e pr lt of the prod ucti on proc ess.
into output and output is the end resu

2 Meaning of Production Function

• .
. • t nd phy sica l outp ut is call ed a product10n funct
The relation between physica1 mp: s a tity of each ion.
inpu t i's requ ired to produce a given
Production function shows hhow mudc q;a~ ed is goo
output of a good. Suppose, t e goo pro u d X. The n, mat hem atic ally , a production
function is expressed as follows :
Q = f (x 1, x 2 ...... ..... xJ
where Q is physical quantity produced per time peri
od.
x , x ....... .... x are the physical quantities of vari ous
1 2 0 inpu ts, and f is func tion of or depends
upon.

"Production function is an expression whi ch stat

es the mat hem atic al relation
between physical inputs used in production of a goo . l out put of that d"
d and phy sica goo ·
Note that from the same amount of the inputs, the
mor e effic ient prod ucer will produce
more and the less efficient producer will prod uce less
. In this case , the prod ucti on function is
meaningless because we do not know the exac t valu
e of outp ut eve n if we kno w the value of
inputs. For this reason while writing a production func
tion , we assu me that prod ucti on is efficient.
Given the values of inputs, the max imu m level of outp
ut that can be obta ined from these inputs
is to be taken as the level of output. Thu s the prod
uction func tion of a firm may be de.fined as
a technological relation that tells the maximum levels
of outp ut from diffe rent combinations of
inputs. In any production function, only tech nica lly
effic ient com bina tion s of inputs are used
so that max imu m level of output is obtained from a
give n qua ntity of inpu ts. Wit h the advance
in technolo~y, more can be p~oduced with the sam
e set of inpu ts or the sam e output can be
produced with less amount of mputs. We, then, hav
e a new prod ucti on func tion .
Features of Production Function
The mai n features of a prod ucti on function are as
follo ws:
(a) It is physical technical relation : Production functi·
. . . th t hn. cal relation (not
econ omi c relation) betw een inputs and outp uts It ·0 n exp ress es e ec 1 .
· . 1s pure1y a p h ys1c. a t hni·cal relati00·
1 ec
 It has n?thing to do with the money value of output produced and prices of factors of
production used.
(b) It is determined by the state ~f tec~nology : The quantity of factors of production to
be employed and the ~anner m _which the~ shall be combined depend upon the state
of technology.. Production function takes mto account the most efficient technology
available at a time.
(c) Period of time : A production function is expressed with reference to a particular period
of time because production is a flow, that is, it is so many units of output per period of
time say per day, per month etc.

3. Short Run and Long Run

The functional relationship between change in output due to change in inputs is studied in
two time periods- Short run and Long run.

3.1. Short Run

Short run refers to a period in which output can be changed only by changing the quantity
variable factors. During the short run, the quantity of fixed inputs like plant, machinery, building
etc. cannot be changed. It remains the same (fixed). It means production can be raised only by
increasing the quantity of variable factors. But it will be possible upto the extent of capacity of
fixed factors.
For example, if a producer wants to increase output in the short run, then he can do so only by
using more of raw materials and labour with the existing factory building, plant and equipment.
He cannot immediately expand factory building, install additional plant and equipment in the
short run.

3.2. Long Run

Long run refers to a period in which output can be changed by changing all factors of
th
e production. In the long run all factors (inputs) are variable. Firm can change its scale of
Prod · shift
.. uctton, · to new techniques
' of production purchase new machmery · etc. Therefore, the
dist · ' . .
mctton between fixed factors and variable factors disappears m the long run. We may now
sum up the difference between short run and long run as under :

Basis Short run Long run

I. Meaning
Short run refers to a time periodLong run refers to a time period
in which output can be changed in which output can be. changed
only by changing the quantity of by changing the ~uantlty of all
vruiable factors. factors of production.
Classification of
factors f
0
Here, factors of production are Here, all factors of production
production classified into fixed and vru·iable are variable.
factors.
~
r
I 4. Fixed Factors and Variable Factors
.
Factors of production are c1asst'fied 1·nto two categories :
1. Fixed Factors
2. Variable Factors

4.1. Fixed Factors

Fixed factors refer to those factors of production which cannot be changed during short
run. These are used in a fixed quantity in the short run. These factors can be changed only in
i' .
the long run. These factors are not directly related to the level of output. In fact, fixed factors
have to be employed even before the output actually starts. Land, plant and machinery, factory
building, top management are examples of fixed factors.

4.2. Variable Factors

Variable factors are those factors ofproduction which can be changed during short period.
The quantity of variable inputs varies according to the level of output. Labour, raw material,
fuel, power, etc. are examples of variable factors.

Differenc e between Fixed factors and Varlable Factors

Basis Fixed Factors Variable Factors

1. Meaning Fixed factors refer to those factors Variable factors are those factors
the quantity of which cannot be the amount of which can be
changed in the short run. changed in the short run.
2. Relation with Output They are not directly related to They are directly related to
output. output.
3. Examples (i) factory building, (i) raw material,
(ii) plant and machinery (ii) casual labour
(iii) pennanent staff (iii) fuel -

5. Types of Production Function

~co~omists distinguish between two basic relationships of inputs and outputs. First, _the
apphcat10n of one or more factors is kept constant while the application of one factor is vaned.
The resulting behaviour of output is termed as 'returns to a factor., Second the application of
all the factors is changed simultaneously and in the same proportion. The r~sulting behaviour
of output is tenned as 'returns to scale'.

5.1. Short Run Production Function

.
In short run, supp IY of some mputs ' · e the
is vanable while that of other remains fixed. nl
vve us . I
simplified production function with only two inputs - (a) labour which is variable and (b) capita
which is fixed.
--- ---- - --- ---- ---- ---- ---- ---
-
--
A-One Introduc tory Microeconomics
Ei:ample:
Production function in the sho rt run can be
exp ress ed as follows :
Q= (L, K)
where, Q = Quantity of out put of a giv en
com mo dity ; L = Lab our ; K = Fix ed cap
ital
In short, output (Q) depends upo n phy sica
l inp uts Lan d K. Sin ce K is constant and
the proportion betw een K and L cha nge s as L changes,
out put is inc rea sed .
Short run production can be illu stra ted wit
h the hel p of an exa mp le. Sup pos e, the
K is constant at 2, whi le L = 3 uni ts. Fur the valu e of
r, sup pos e tha t the ma xim um quantity of
good X that can be pro duc ed is 20, the n pro out put of
duc tion fun ctio n can be wri tten as :
20 x = f ( 3L, 2K )
If the amount of variable factor (L) inc rea ses
from 3 to 4 uni ts and ma xim um pos sibl
of good X is 25 units then , pro duc tion fun e out put
ctio n is exp ress ed as und er :
20 x= f(4 L , 2K )
5.2. Long Run Pro du ctio n Fu nct ion
On the other hand, in the lon g run , all fact ors
are variable. The refo re, scale of pro duc tion
changed in the long run. Lon g run pro duc can be
tion fun ctio n exp lain s the beh avi our of
the quantities of all factors of pro duc tion out put whe n
are inc rea sed in a fixed pro por tion .
With the given tech nol ogy, lon g run pro duc
tion can b e exp ress ed as und er :
Qx = f (L , K )
Where Qx = max imu m pos sib le out put of
goo d X ; f = function ; L= labo ur ; K = Cap
ital
Example:
Suppose L = 4 and K = 3 the n Pro duc tion
is exp ress ed as :
30 = f (4L , 3K)
which implies that by 4 uni ts of lab our and
3 uni ts of cap ital , ma xim um pos sibl e pro
30 units. duc tion is
Now suppose the am oun ts of lab our and
cap ital are dou ble d whi le kee pin g the
proportions constant, the pro duc tion fun ctio factor
n tak es the foll owi n g form :
50 = f (8L , 6K)
whi~h implies that the out put rise s from 30
uni ts to 50 uni ts, wh en the am ounts of
capital are doubled. labour and

6
· Tftue Co~cepts of Prroduct
I
' 1\1
 6.1 Total Product
Total product refers to the t~tal_ quantity .of
a ~oo d pro duc ed by. a fir":- with the give
quantity of a variable input. It sigmfies rela tion ship betw een the van able mpu t and
keeping all other inputs constant. outpunt
We can illustrate it with the help of an exam ple.
Ifla bou r (L) and cap ital (K) are the va . b
1:
and fixed factors respectively and . 5 umt. s ofL
and if their contribution to output is 2, 3, 4,
d( 1
are ~se a o~g with . na le
som e fixe d amount ofK)
3, 2 umt s resp ecti vely, then TP = 14 ( 2 +
3 + 2) units of the commodity. TP is the sum 3+ ~
tota l of outp ut of eac h unit of the variable 4
used in the process of production. factor
Total product is also called total retu rn or
tota l phy sica l pro duc t of the variable input.
Physical product means production (or outp
ut) mea sure d in phy sica l unit s of the good
.
Table 5.1 TP, MP & AP of a Var iabl e Fac
tor
Units of labour Total Product Ave rag e Pro duc t Mar gina l Product
(Variable Factor) (units) (un its) (units)
(1) (2) (3) (4)
1 2 2 2
2 5 2.5 3
3 9 3 4
4 12
5 3 3
14 2.8
6 2
15 2.5
-

7 1
15 ~

Two features of total pro duc

14
2.14
1.75
0
1
-----
dep end s on the quantity of the varita~~: d t 0 b . ut
e men tion ed here . Fir st, the qua ntit y of total
the actual output. It shows t: ·
hav e different level of outp t S

e max
Ieve ls of emp loym ent of variabl . imu m
fact or emp loye d. For eac h leve l of emp loym
ec_o nd' total prod uct imp lies pos sibl e/pr oba
amo unt 0 f h.
outp ut w ich can be obta me
ble
. d fr
outp ut
ou:i
ent, we t
ao<l
ll
00
differen1
e mput. om
6.2 Average Product
Average product is defined as th
e output per
unzt· oif vari able inpu t. We calc ulat e i·t as··
AP = TP
Wh ere L is the leve l of emp loym ent f Lh
0 .
In tabl e 5 .1 we hav e repr odu c d h t e van abl ·
e e mpu t, TP den otes tota 1 pro duct · ve
t
corr esp ond ing valu es of aver age prod uct Ite tota l
h pro duc t sch e ba
. edu le. In colu mn 3, w tpllt
at 2 units of labo ur AP 1s 2.5 unit s outp.ut s ows that . of ou '
and at 1 unit ofla bou r, AP is 2 UOit
phy sical product (APP). so on A .
s ,age
· vera ge pro duc t 1s also calied a"e

iJlj A-One Introductory Microeconomics -

y

a1arg1nal product
6,.11
11
1• ll ed marginal p .
'(Jinal pro duc t ( a 1so ca h y s ic a l p r o d u .
MO'o h ,nplo +a c t) o f a n zn .
ymen 0'J n a d d it io n a l u m.t o f labou
t
ut by t e e put zs d e fi n e d
ill ot1tP . and lt total o u tp u .
r. T h u s , if a s th e c h a n g
as a re t in c re b A a m o u n .
t o f la b o u r in e
b1N, i.unts su , a s e s y u 'T P . M c
u n it s . . l
a rg in a p ro d re ases
~T P
. .
u c t is g iv e n b y
MPL = ~Q
TP represents c
hange in o u tp
\\fhere ti Margin ut and ~L de
input labour. al product c a n n o te s c h a n g e
also b e c a lc u in th e a m o u
la te d in th e fo n t o f v a ri a b le
ll o w in g w a y
:
M P L = T P L-
TPL- l
Here L stands for
number o f u n
acertain level of e it s o f th e v a ri
mployment o f a b le fa c to r a
th e v a ri a b le fa n d T P L s ta n d
Example (using c to r. s fo r to ta l p r
Table 5 .1) oduct at
TP at 3 units of la
bour is 9 u n it s
TP at 2 units o f la o f o u tp u t
bour is 5 u n it s
Then o f o u tp u t
 == 9 0 - ~u = o

7• The Law of Varia ble Proportions

The law of variable propo rtions explai ns the effect ·of an increa se in the
amou nt of a
variable factor on the total output. If there are only two factors namel y labou r
(varia ble factor)
and land (fixed factor), a firm can chang e its outpu t by chang ing only the amou
nt of variab le
factor (say labour) while other factors remai ning uncha nged. In this case, the factor
propo rtion
fixed factor ) will gradually fall with an increa se in the amoun t of labour. So,
( variable factor this law is
known as the law of variable propo rtions .

7.1 Statement of the Law

According to this law, as the quant ity of variab le input is increa sed, keepi ng
other factors
fixed, initially total produ ct increa ses at an increa sing rate, then increa ses at a
decrea sing rate
and finally it (TP) starts falling.
Expressed in terms of marginal product, the law states that if more and more units
of variable
inputs are applied with the given quantity of fixed factors, initially the marginal produ
ct increases,
then it decreases to zerd but remai ns positi ve and finally while declin ing it becom
es negative.
7.2 Explanation
The law of variable propo rtions outlines 3 stages (or phase s) of returns to a variab
le factor.
!hese stages help a firm to decide the amou nt of the variab le input it should
rt8 fi use to maximise
pro t. These stages are : .
 (i) Increusing returns
(ii) Diminishing !'~turns
(iii) Negative rctums · I ,· k ,
vurlubh., ru ctot' of p1·0< ucl,1011 , CoJ)111g
Stage I. In this stugc, whon u llrm lncn.,usml 011 1.Yt'"c t1rlubl o JiHilOI' 1·i1-1cH11ml totul p1·0<111ct
other factors unchanged, lluJ nwrginul Prod ulit oJ ' vi 1 i1-1 till L ~ j, W1J cull il h1crctrni11u
10
. . . l ., l lu 5 2 this Hlugc HJ l ' ) , l I r,
mcreases at un llH.m.msmg rutc. n ~u :, · . •olunl n ,h1n11'.1 01· nUll'K 1111 produc:t,
returns to the varinblc fodor. H.charns lu.,rc lmplllls uuu"'
Thus marginal product is incruusing in thi s stugu.
'l 'hl't~ti Sh•f'('N
'1)1blc 5.2 H.durns fo n 1i•n(101
.~ · ·
• •

'l,,~h,l Mnrglnnl StH~CH

Fixed factor Unit's of • 1., rodud·
Vnrinblc Prntlud
1rnct'or (Units) (Units) (lJnUs)
~ - -- - --+---- - -~ - -~--=- ......
4 Stage I
Units ofL:md 1 4 ,,Ii
1------- -,- - - - lncrcmiing I
,I

( 2 Acres) 2 10 RulurnK .v
I
1 - - - - -- -1~--- ~ • l •~ --
'l
3 IX H ,/
',
4 24 6 8tagc II "r
~-----~1-------1- ~ Diminit-1hing
5 28 4 Rulurn.H
-----1-- -
6 30 2
1 - - - - - - -- t - - - - - ~ ~ ·- ---·~
7 30 0
1------ - - t - - - - - -
8 2H -2 . Stage Ill
Product (Unit8)

In Fig. 5.1 MP tends to rise till OL 1 units of labour corresponding to incrcal)ing MP, TPtcnds
to Iise at the increasing rate from point O to L1 in the Part A of the diagram.
It is the point from where slope o:f TP changes. Upto this point TP incrcasci; at increasing
rate and from this point onwards TP increases at decreasing rate (ending of the 1st stage and
beginning of the 2nd stage). In the figure point K is the point of inflexion. TP changes its shapes
fro111 this point.
Stage II. In this stage, increase in the input of variable factor (labour) is leads to decrease
in MP but it remains positive. TP increases at decreasing rate. In the diagram between L,L2
units of labour, MP tends to fall but remains positive from point R to L2 and TP increases at
decreasing rate from point K to T.
Stage III. In this stage, increase in the units ol' variable input results in negative MP and
TP sta1is declining. In the .figure, when labour is c111ploycd beyond OL2 units, MP becomes
negative i111plying .a fall in TP (beyond point T). 1
 y
stage of operation . .
i) A profit-maximising firm wil! never operate m TP is Maximum
( stage III. It is becau~e, by entermg stage III, a ~TI? 32 I
will have to incur higher cost on one hand (as 1t 1s t5
:::, 28 ·
hiring more of the variable input) and at the same °8,_ 24
TP
time will get less revenue in the product ma~ket a.. 20 K
as total output is falling. In this stage marg~nal .$ 16 Stage II Stage Ill
0
F 12
product of each variable factor becomes negative.
8
(ii) A profit maximising firm will also not operat~ in 4
stage I because it is getting increasing margmal o ~ ~ --4---+-+---+---+--+--~ X
1 2 L,4 5 6 L, 8
returns. In this stage each increase in the quantity
Variable Factor (Units)
of variable factor gives more and more output.
(iii) This leaves out only stage II, in which the marginal y
returns to the variable input are positive but
diminishing. From the view point of the operation
of the firm, this is the most relevant stage. t5
:::,
"C
0
,_ Stage I Stage II Stage Ill
Fig. 5.1 a..
• Stage I: Between OL 1, TP increases at an increasing -a; MP is
C:
rate and MP increases. ·e, Maximum

• Stage II : Between L 1 L2, TP increases at a diminishing

rn
~
8
RI
rate and MP decreases. 4
"--lf---l---+--+--+~----1--- - X
• Stage III : Beyond point L 2, TP starts declining and O 1 2 3 4
MP becomes negative.
. MP is Zero
• K is the point of inflexion. At this point TP changes its Variable Factor
Fig 5.1
shape from increasing rate to decreasing rate.
7.3 Assumptions of the Law
The law is based upon the following assumptions:
(i) The firm operates in the short run. This means that only one factor of production is
variable while all other factors are constant.
(ii) The technique of production does not change.
(iii) All units of the variable factor are equally efficient. This implies that output does not
change because one unit oflabour is more efficient than another. All units take the same
time and effort to do the job.
7.4 Causes of Operation

(1) Causes of Increasing Returns to a Factor

The main causes responsible for increasing returns in the first stage are as follows:
· 1 · this stage
(1') Better-utilization of fixed factors : The amount of fixed factor avatlab em . f
.18 d more units o
much more than the availability of variable factor. When more an .
· b . d re effective1Y·
vana le factor (labour) are apphed, the fixed factor will be use mo
_ _ -1 •• ,,..#-inn Function II 'i
 (ii) Specialisation and division of labour : As the number of labour is incre
labour specialises in a particular activity and thus adding to the average anda:! e_ach
products. gllla!
(iii) Indivisibility of fixed factors : Generally fixed factors are indivisible. Such 1e:
• d actor
cannot be used in smaller units. Therefore, a deli non to more an more units ofvari b
factor improves the utilisation of fixed factor. Increasing returns tend to occur so let
as optimum level of combination between fixed factor and variable factor is achiev:~~
(2) Causes of the Diminishing Returns to a Factor
There are two main reasons behind the operation of diminishing returns to a factor. These are .
(i) Optimum capacity : When the optimum combination of fixed and variable factors is
reache~ then further increases in the amount of variable factor lead MP to decline. It
is because the fixed factor now becomes inadequate relative to the quantity of variable
factor.
(ii) Lack of perfect substitutability between factors : Diminishing returns occur because
the factors of production are imperfect substitutes for one another. For example, more
labour can be applied in place of capital. But labour cannot be continuously used in
place of capital. This reduces MP of the variable factor.
(3) Causes of Negative Returns
The third stage i.e., the stage of negative returns can be explained in terms of the following
reasons:
(i) Overcrowding: If more and more units of variable factor are applied on a given quantity
of fixed factor, this will lead to overcrowding on the fixed factor. There will be lower
availability of fixed factor per worker. Moreover, if there are too many workers on a
given amount of fixed factor, they will come in each other's way and disturb others. All
this leads to a fall in total output.
(ii) Management problem : When there are too many workers, it becomes difficult to
manage them. The labourers can avoid work.

8 . Relation Between TP, MP and AP

8 .1 Relationship between TP and MP

Fixed Factor
(Land)
Table 5.3 : Relation between TP and MP

(Labour)
Variable Factor
TP
(Units)
MP
(Uni~
---
1 1 10 10-----
I 2 30 20 -----
3 60 30
1 \

I
\
-
~
1 4
5
80 20 l

-- 1
1 6
90
90
10
0
1 7 80 (-) 10
1 8 60 (-)2 0
-
Table 5.3 and Fig. 5.2 show the relationship bet y
wee n
TP and MP as under : ~ TP is
90 maximum
(i) So long as TP rises at an increasing rate, MP
rises. 80
This happens upto 3rd unit of variable factor). 00 10
~ 60
(ii) 'When TP rises at a diminishing rate, MP 2, 50
falls but
is positive. It is happening between 3 units a.. 40
to 5 ~ 30
units of the variable factor. o6
a..
I-
20 Q
(iii) When TP is maximum, MP is zero . It 10 MP is zero
happens 0 ~-- 1-- -1- --+ --~ ~-+ -- __. X
when 6th unit of labour is employed.
-10
(iv) When TP falls, MP becomes negative. -20
It starts MP
happening from 7th unit of variable factor. Units of Vari able Fac tor
Fig 5.2

8.2 Relation bet we en AP an d MP

The relationship between AP and MP is exp
lain ed with the help of following table and
diagram:

Table 5.4 : Rel atio n between AP and MP

Fixed Fac tor Var iab le TP AP MP

(Land) Fac tor (Units) (Un its) (Un its)
(La bou r)
1 1 10 10 10
1 2 30 15 20
1 3
~

60 20 30
1 4
~

80 20 20
- 1 5 90 18 10
-- 1
1
6 90 15 0
r- -- 7 80 11.4 (-) 10
1
8 60 (-)2 0
7.5
 Table 5.4 and Fig. 5.3 show
the relationship between y
AP and MP as under :
(i) A s long as MP is grea 35 - AP = MP
ter than AP, AP rises. It is 2 30
at maximumpoint
happening till 3rd unit of va ·2 25 / of AP curve
riable factor.
(ii ) W he n MP is equal to 2 20
AP, AP is its maximum. At ~ 15
4th unit of the variable facto
r AP = MP. Thus MP o6 10
AP
curve passes through the m a. 5
aximum point of AP. <( 0 l-- l--1 --- +- ~- 1---1-- 11 -~
X
(ii i) W he n MP is less th - 5 ·- 1 2 3 4
an AP, AP falls. It happens
from 5th unit onward of the - 10
variable factor. - 15
(iv ) MP m ay be ze ro or - 20 · MP
negative but AP always
remains positive. At 6th un Fig 5.3 Units of Variable Factor
it of
MP is zero and thereafter MP be variable factor,
comes negative.
1·

.
TP increases at an increasing rate and MP also mcreases upto
3 .
umts. Therefore, 1st ha
r1n
d
ends when 3 units of variable input are employe • P st ~' t
10. Returns to Scale t
~
/ So far we have studied the short-run production function or different aspects of
factor of production where there was only one variable
. fu factor
. andhall.other factors wererefiturns
Xed (to
constant). Now, we will study long-run production ncl!on or t e mput-output relation wh or
all the factors of production are simultaneously changed. Cit

10.1 Meaning of Returns to Scale

Returns to scale refers to the increase in output when all inputs are increased in th
proportion. Hence, to increase production, a firm has to increase all the factors such e sa,,,.
th
factory premises, machinery, Jabour, capital, organisational capacity, etc. in ord;r to sa:fy- e
Jong-run demand for a commodity. the
When all inputs
. are changed in the sameh proportion,
d we call this
. as change in scale (o r input
•
scale) of pro duct1on. The way total output c anges ue to change zn the scale ofproductio ('
scale inputs) is known as the 'law ofreturns to scale '. n i.e.,

10.2 Types of Returns to Scale

. W~en all the inputs increase in the. same . . h'proportion, total product may increase at an
mcreasmg rate, at a constant rate or at a d1mm1s mg rate. Accordingly, there may be three typ
ofretums to scale: ei

( i) Increasing returns to scale

(ii) Constant returns to scale, and
(iii) Diminishing returns to scale.

10.3 Explanatlon
The law of returns to scale also has three stages which are shown as under :

Table 5.5 : Production Function : Returns to Scale

-

E
Scale of Inputs Output Returns to Scale
Units of Labour TUP its
Land (in Acres)
MP -

A 2 1 5 5
B 4 2 11 6 Increasing

C 6 3 18 7 -
 4 26 8
5 34 8 Consta nt
6 42 8
7 49 7
Dimin ishing
8 55 6

es of retmns to scale are shown as under :

Three typ
, Increasing Returns_ to Scale : The law_ of increasing returns to sc~le opera~es when
centage increase m the total product 1s more than the percentage increase m all the
i:;tor inputs employed in the same proportion. For example, if labour and capital are
increased by 100 per cent and the total product increases by 120 per cent, the law of
increasing returns to scale operates. .
In table 5.5, from A to D there are increasing returns to scale. For example, in combi
nation
A 2 units of labour and 1 acre of land produce 5 units of output. Compared to
A, the
c~mbination B has double the amount of each input, but output (equal to 11 units)
is
more than double of the output at combination A.
Similarly from B to C, inputs increase by 50% but output increases by more than 50%
as
18 is more than 50% higher than 11. Increasing returns to scale occur upto combination
D.
, Constant Returns to Scale : The law of constant returns to scale operates when a given
percentage increase in all factor inputs in the same proportion causes equal percentage
increase in total output. For example, 50 per cent increase in all factor inputs leads
to
50 per cent increase in total output, it is called a situation of constant returns to scale.
Between Combinations D to F, there are constant returns to scale. If the input scale
is
increased from D to F, marginal returns remain constant. When inputs are increased
by
the same proportion, the marginal returns from them remain at the same level at 8 units.
• Diminishing Returns to Scale : The law of diminishing returns to scale occur
when
a given percentage increase in all factor inputs in equal proportion causes less than
percentage increase in total output. If a 20 per cent increase in all factor inputs causes only
10 per cent increase in total output , it is called a situation of diminishing returns to scale.
In the third stage (combination E onward), if the scale of inputs increases, then total
returns increases only at a diminishing rate.
 ' ~\ ' R.t-'-!, -i$
:~ $ ,:;..~":? ~..,'\ ~

---►

10.4 cau54l5 Behind Rehlrns to Sc.ale

tacreaslng Rehlms to kale
- rurn · ,,, - ' ·)l ""-- -~N
h":U~;l.._~ft~ re ,~ ,,.,. ~~'~' ~~
1.'r~unN
~
uuc t1.1 foll0\Y:in~
- ~~ilit.$ :
(!'I lnd'h~s.ibility ofFsctors: S0mc fu~t0!'$ ~ inJi,i s~?l~ 1.1uet0,:~~:clitt~y ,:·.~:::ri::-i::~
in p:a1:s.. In me ~ginning. these fa~t0rs ~~ :11.."t cm~1~ntly u~hs~ °B'.:-i 0:1 :::i~
-,~l.,. .,\.,_,,_. .,. ·"~;,1·, 1·b1.=- ~~.'t0~
~~~ U4C-~\i.. 1 lt\..U ..... - 1 ~- ....
m u.se-J ero~1c1nk •
~J thmt0.re ir.~~~~,:,-~~-
......__~ - , ~ :
-.

~';.tle .!re 01't.lir•.:-J.

~m Dh·is.ion ofLsbour: ·DiY:iS.il"'-1~ c1fL.1{.''-"'ur· is S.Ill"'tn.:- r rnJin '-~use 0fil:~~f~
tu ~j.J.c. It i-r•.:.re~cs eftkicn~y whid1 ulrim:m.~ly 1.:-~!Js t1.1 ir.~~'-1:lf ~=--~ :.) ~

Constant Retums to Scale

Oa in.:.re-..L'1tlg pr0<lu~ticn. ~0fo.m1ics 0f s~~c mer ~1 limit cll~'1~ ir.:-0 t ~~n~i
~~e, _-\s ~'ale ~f pr0u¾i~ti0n is in.:.reJ.SN. ~0n1."'mi.:-s 1.1f s~~1c 1'-'X'0.n:c ~d :.". ..::~.:-..1:1..'Ul:;!:
of s.c;!J.e. This C'~Jiti011 is csllN ·cm:s:.:1:1 R,._~;::n;.s ;._) S:·..:.\ .~·_ C\~nsr-.:.nt f.:'n:1~s :~ s..".t.~~--=
K"lf :i shun rim~ ma-whiclt diminishing remms t'-"' s~Af~ '-"- ~ur.
Dlmlnlshlng Retums to Seale
Dimirri,hing returns tu s~sl~ sre C3USN by the foll0\\ing fa ~tl'i'S :
(:) ~IanagerfalProblems: In the third s1'. 1 ~e. wh.:-:n s.~~ e 0fcr~¾!~ri0n ~'\.'\1::1~\';~d~~
- ~
mJ.njgcri:.ll pn~blc.rns tend t0 mse. ~fan~g~ri31 pr\A~~ t:'~'-"'::l~ ir.~rr. .."-:~t.
Fu.eel Supply of Some ~stura.l Factors : Diminishin~returns T1." ~..~~ i~" ~. ~ .
the supply l1f s0111e n3tural fa~tors is fixC'd. F'--rr cx;;.nt'k if &.e 3..-:~0:=.t d:)."lS~··
~~$.:
pR".lU~ti<."Il is d0uMe-J.. c031 pl\.'l.iu~ti011 \\ill n0t in~~e pr1.'P.."-rt:0~:~~--

---------------- -------------
10·5 Distinction between Returns to Variable Factor and Ret urns t o Scale

Basis Returns to a Variable Factor Returns to Scale

1. Meaning Returns to a factor means the change Returns to scale means change in
in output when quantity of one factor output when quantity of all the factors
is changed, other inputs remaining is increased simultaneously and in the
fixed. same proportion.

2. Time It is a short run phenomenon. It is a long run phenomenon.

Period
3. Factor Under it, factor proportion goes on Under it, factor proportion remains
Proportion changing as more and more units of unchanged.
the variable factor are applied.

y y
JI'
'" s

---
~

-ro
·o..
ro
(.)
K
a b C
·-
ro
o..
ro
(.)

Q L - - L - - . __ ._ _----p~ X
Lo L1 L2
Labour (L)
Fig 5:5 I Fig 5.6 I
In the figure, the amount of capital is In the figure, both labour and capital
fixed at OK. As the amount of labour increase in the same ratio along the
is increased from OL0 to OL 1 and OS line. So the factor ratio remains
from OL 1 to OL2, then the ratio of constant.
capital compared to labour goes on That is,
decreasing.
For example:
OK OK OK
-<-<-
OL2 OL1 OL 0

4. Scale of No change in scale of production. Scale of production changes.

Prodµction
 ~ - - --- -,-- - - - - - - - - - - - -,-- -- -- - - ---
5. Diagram y
y
Increa sing
Return s to ~ Constant
t5 Scale Returns to
::,

ea.. \ b _ _ _, c Scale

m
C
·e,
m
a Jd
~ Diminishing
Returns to
Scale
0 .....___ _ _ . _ _ _ . . 1 . __ _ _ ... X
A B
Variable Factor
Scale of Inputs
Fig 5.7 (Units) Fig 5.8

6. Cause of Phase I Phase I

Operation (i) Better utilization of fixed factor. (i) Indivisibility of some factors.
(ii) Division of labour and (ii) Division of labour and
specialisation. specialisation.
Phase II Phase II
(i) Ideal facto r comb inati on is (i) Econ omie s of scale become :
disturbed. equal to diseconomies of scale. I
(ii) Fact ors of prod ucin g are I
imperfect subst itutes of each
other.
Phase Ill Phase III
(i) Heavy pressure on fixed factors. (i) Managerial difficulties.
(ii) Eme rgen ce of man ager ial (ii) Fixed supply of fixed factor.
problems. (iii) Diseconomies of scale.

• Economies of Scale
Econ omie s of scale refers to the situation in which on increa
sing the scale of production, unit co 5t of I
produ ction reduces or decreases and output per unit of
are class ified as :
factor inputs increases. Economies of scale I
(a) Internal Economies,
(b) Exter nal Economies. , .
Internal Economies are firm specif. ic: They occur with the expansion
.
. ~~-
affirm , i.e., 1~ternal e~oduction
. 'de the firm. Internal economies are a function of the
size of firm. As size of P result
~ccu r ,nsl a firm uses its factors of produ?tion more efficie
ntly. Internal economies occur as a
mcre as~s: _ . nd division of labour which decreases long-run average cost.
of spec1allsat1on a · _ · .
 ---= ==~ ==.:=::= =:== === =-- ~= =~ ~--
occu r
--=
due to
-=-
expa
'- of in=:d=us=t==,t=
nsion
·----------==-
== ==
j xt nal Economies of Scale : Thes e economie s
e include the follo:~gs:benefits are
~ot :~ite d to one or two firm , but to all firms in the industry. Thes
(i) Availability of efficient labour at cheap rate .
\\
(ii) Development of transport and communication facility.
of cheaper credit. \
(iii) Development of financial institutions, and hence, availability
\
(iv) Easy availability of raw material. 1
by impa rting traini ng. :·.
(v) Increase in efficiency of labourers
(vi) Obtaining information related ~conomies by publication of inves
tigation and busin ess magazines .
1
i
• Oiseconomies of Scale
omie s of scale are converted to
If the production is increased after a certain limit, then econ
'diseconomies of scale'.
Diseconomies of scale are of two types :
1. Internal Diseconomies,
2. External Diseconomies.
Internal Disec onom ies
of production of a firm, if its scale
Internal diseconomies refer to those factors which raise the cost
ing :
of production is increased beyond a point. These include the follow
(i) Management problems
(ii) Technical difficulties
External Disec onom ies
industry of which the indiv idual
External diseconomies·ar e the result of excessive growth of the entire
:
firms are the members. This may lead to the following problems
(i) Rise in input prices
(ii) Higher wages
(iii) Costlier transport
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8.3 TYPES OF INFLATION
Phe persistent rise in prices may be of various magnitudes. Accordingly, inflation
can be of different types, depending uporn the rate of increase in prices. On the basis of
rate of inflation, inflation can be follorwing types:
1. Creeping or Mild Inflation: It occurs when the price level rises at a very slow
rate (less than 3% per annum).
2. Walking or Trotting Inflation: It occurs when the price level rises at an
intermediate range of 3% to 6 per cent per annum.
.The annual inflation rate is of a single digit.
I t is a warning signal for the government to control it before it
turiis into
running inflation.
3. Running Inflation: It Occurs when the sustained rise in prices is over 8% and is
generally around 10% per annum.
It normally shows two-digit inflation.
.It affects the poor and middle classes
adversely.
Tts control requires strong monetary and fiscal measures,
to galloping inflation. otherwise it leads
4. Galloping Inflation: It occurs when the price rises
imflation rates. It means, it prices rise by more by double or triple digit
than 10% but less
annum, then galloping intlation occurs. than 1000% per
J t is also referred as
Jumping inflation.
 India has been
.
Witnessing galloping inflation since the second five year
plai
period.
.Hvperinflation
5. Hyperinfla Inflation: It refers to a situation when the prices rise at an
alarming high rate. The prices rise so fast that it becomes very difficult to measure
its magnitude.

.In quantitative terms, when prices rise above 1000% per annum, it is termed
as Hyperinflation.
.Hyperinflation is an indication of the highest degree of abnormality in the
monetary system of a country.

4 DEMAND-PULL INFLATION AND cOST-PUSH INFLATION

Demand-Pull Inflation
Demand-pull inflation OcCurs when the aggregate demand of goods and services exceeds
the aggregate supply of goods and services at the existing prices, ie., when there is
excess demand for goods and services. Demand-Pull inflation is a phenomenon of Too
much money chasing too few goods'.
I t is also known as "Excess Demand Inflation".
Excess demand pulls up the price level and leads to emergence of inflation.
and services occurs
Causes of demand-pull inflatiom: This excess demand for goods
due to:
i) Exploding Population
(i) Rising Money Incomes
(ii) Expansion in Money Supply
(iv) Rising Volume of Black Money
(v) Increase in Public Expenditure
(vi) Increase in Investment
Cost-Push Inflation without the
occurs due to increase in cost of production
OS-PuSh Inflation
Corresponding increase in the productivity. from the supply side or
the
o c c u r s due to
forces operating
Lnis type of inflation of inflation.
supply or cost theory
Cost side. So, it is also
known as

caused due to:

Causes of cost-push inflation: It is
i) Increase in the wages
(i) Increase in profit margin
ii) Higher taxes
(v) Fall in the availability of basic inputs
v) Administered higher prices of inputs
8.5 CAUSES OF INFLATION
There are many factors or reasons which lead to inflation. Some of the main causes
are:

1. High Growth rate of Population: In India, population is increasing

very at a
high rate and it is putting heavy pressure on the aggregate demand and on the
price level of the country.
2. Increase in Public Expenditure: Government expenditure has been steadily and
Continuously increasing over the vears. Continuous increase in the Goverrnment
expenditure puts large money incomes in the harnds of general public as
expenditure of the Government becomes income for the people. It leads to
growing public demand for goods and services and consequent rise in prices.
3. Increase in Money Supply: There has been
persistent increase in the supply of
money since the second five year plan, without any equivalent increase in the
Gross Domestic Product
(GDP). It has increased the purchasing power of public,
which in turn, raises the demand for
goods.
4. Deficit
Financing: Deficit financing refers to printing of currency by Reserve
Bank of India to meet deficit
(shortage) of money in the Government budget.
The rising expenditure of the
government is responsible for adopting deficit
financing as a method of financing economic
development. Printing of new
currency increases the money supply, which raises the
goods and services. aggregate demand for

5. Growth of Black Money: Black

money refers to that
money which is acquired
after evading taxes. Black money is
generally
activities like investment in real estate,
used for financing non-productive
purchase of gold, hoarding and black
marketing of essential goods, etc. All these
give rise to inflation.
6. Increased Taxation: With every budget, the
of Indirect taxes (taxes on government increases the amount
goods and services). It gives an
trading classes to raise the prices (often more
than the
opportunity to the
are responsible for rate of taxes). Such taxes
pushing up the price level in the
country.
7. Hoarding of Essential Commodities: At the
time of
a tendency on the
part of traders and merchants to shortage of goods, there is
for making huge
profits. Such a hoarding creates hoard essential commodities
leads to still greater rise in
prices. scarcity in the market and
8. Wage and Cost spiral: in modern
ccessful in increasing the wages of times, strong trade unions are
their
productivity. Such a rise in wages pushes workers without an equal increase generally
push up the prices. up the i
production costs, which in turn
 asy Finance Facilities: Easy availability of
9. Eas credit for the purchase of consume
ds has significantly raised the level of aggregate demand
goods
in India, which ina
ktrn, pushes the
up price level in the country.
Rise in Administered prices: Price level in the country is also increasing due to
ontinuous upward revision of several administered prices such as those of petrol,
diesel, coal, etc.

aA ADVERSE EFFECTS OF INFLATION

(PROBLEMS DUE TO INFLATION)
tnflation has caused certain serious imbalances in the Indian economy. The main

harmful effects of inflation are as follows:

1 Creates Business Uncertainty: Unless price rises are predictable, they introduce
an element of uncertainty into the economy. Production is adversely affected on
account of business uncertainty. Persistent rise in price level discourages the
entrepreneurs from taking risks involved in productiorn.
2. Adverse effect on Balance of Payment: Inflation often leads to increased import
and/or reduced export. This results in defiit in the balance of payments, which
in turn causes a drain on the foreign exchange reserves.
Rise in Inequalities in Income: During inflation, speculators and profiteers gain
without any effort on their part. Thus, inflation gives rise in disparities in the
distribution of income and wealth.
4. Leads to hoarding and Black marketing: During inflation, the traders hoard
essential goods with the aim of getting higher profits. The buyers also hoard
essential goods for the fear of paying higher prices in future. Thus, inflation
leads to growth of black marketing.
in price level reduces
. Adverse effects on savings and investment: Persistent rise
the value of money, which reduces the purchasing power. It leads to fall in savings

and investment.
attects
Adverse effect weaker sections: The continuous rise in prices adversely
on
not
of the population as they
are
the consumption of the weaker sections
Compensated for the rise in prices.

8.7POLICIES TO cONTROL INFLATiON

important that inflation
EW Ot the serious adverse effects of inflation, it is very
starts threatening
the very existence o
effectively controlled before it
De can be used
The measures, which
C and political system of the country.
O
ntrol inflation are broadly categorised as:

Monetary Policy
Fiscal Policy
Other Measures
Monetary Policy
Monetary Policy is the policy of Central Bank to control money supply and credit creation in
the economy. India's Central Bank is the Reserve Bank of India (RBI). Following two
instruments of monetary policy are used by RBI to control inflation:

Quantitative Instruments
These imstruments aim to influence the total volume of credit in circulation. Major
instruments or measures are:
nerease in Bank Rate: The term Bank Rate' refers to the rate at which central
bank lends
money to commercial banks as the lender of last resort. During inflation,
central bank increases the bank rate, which raises the cost
of borrowings from the central
bank. It forces the commercial banks to increase their
lending rates, which
discourages borrowers from taking loans. It reduces the availability of credit in
the economy and
helps to correct inflation.
2Open Market Operations (Sale of securities): Open market operations refer to
sale and purchase of securities in the open market by the central bank. It directly
influences the level of money
supply in the economy. During inflation, central bank
offers securities for sale. Sale of securities reduces the reserves of commercial banks.
It adversely affects the bank's
ability to create credit and helps to control inflation.
3increase in
Legal Reserve Requirements (LRR): Commercial banks are obliged
to maintain legal reserves. There are two
components of legal reserves:
(i) Cash Reserve Ratio (CRR): It is the
minimum percentage of net demand and
time liabilities,
to be kept by commercial banks with the central bank.
(ii) Statutory Liquidity Ratio (SLR): It refers to minimum
and time liabilities, which commercial percentage of net demand
bankS are
required maintain with
to
themselves.
To correct inflation, the central bank increases
CRR or/and SLR. It
of effective cash resources of commercial reduces the amount
banks and limits
power. It ultimately helps in their credit creating
controlling inflation in the economy.
Qualitative Instruments
These instruments aim to regulate the direction
of credit.
or measures are: Major qualitative instruments
1. Increase inMargin Requirements: Margin
the market value of security offered andrequirement refers to difference between
the value of
economy is suffering from intflation, central amount lent. When the
the credit creating bank increases
power of banks. Borrowers tind it the margin,
and it helps to control less which restricts
inflation. attractive to borrow money
2. Moral Suasion (Advise to
and pressure that CentralDiscourage Lending): This is a
in a manner, in line with its
Bank
applies on other bankscombination
in
of persuasio
policy. Moral order to get them
suasion is exercised act
through
bugB discussions,
 SDeeches and hints to banks. During inflation, the central bank advises, requests
letters
. nersuades the commnercial banks not to advance credit for speculative or non-essential
o rp e r s u a d e s

activities. It helps to control inflation.

activit

3. Credit Controls (Introduce Credit Rationing): It refers to a method in

Selectio Credit
Selective
3hich the central bank gives directions to other banks to give or not to gtive
whio

eredit for certain purposes to particular sectors. During inflation, the central bank
introduces rationing of credit in order to preventexcessive flow of credit, particularly for
neculative
Spe
activities. It helps to wipe off the excess demand and helps in
intlation in the economy.
controlling

Fiscal Policy
to the policy of central government to control the situation of
Fiscal policy refers 'Revenue and Expenditure Policy
in the economy. It is also known as
money supply The main constituents or
can control inflation through its fiscal policy.
Government
of Fiscal Policy are:
tools or instruments Government spends huge
in Government Spending):
1. Expenditure Policy (Decrease administrative activities. To control the situation
infrastructural and
amount on maximum possible
reduce its expenditure to the
Government should
of inflation, on defense and
extent. More emphasis should be placed to reduce expenditure Decrease in
in growth of a country.
unproductive works
as they rarely help demand in the economy
and helps

Government spending will

reduce the level ofaggregate
in the economy.
to correct inflationary pressures is expressed in
(Increase in taxes):
Revenue policy of the government indirect taxes
2. Revenue Policy different kinds of direct and
Government imposes of taxes and e v e n
terms of taxes. increases the rates
inflation, government expenditure
on public. During
the
to decrease in the
level of aggregate
leads
n e w taxes. It
mposes s o m e inflation.
and helps to control borrows money from
in the economy Government
borrowings): borrows
(lncrease in inflation, government
Borrowings
deposits. During
Public
them. It helps to
form of public by held
in the
public withdraw
excess money inflation.
to in controlling
from the public and helps
money the economy increases
the money
supply in i.e. printing of currency
reduce
Deficit financing, avoids deficit
(Decrease): government
inflation,
D e f i c i t Financing During
the economy.
in
ne supply of money increase of money supply
prevent
uancing to
inflation.
control
to
Other Measures
undertaken

which can be
m e a s u r e s
also,
Ihere are c e r t a i n other
are
below: to ensure
that wages,

These measures a r e
discussed
income policy is productivity.
objective
of increase in
primary with
1. Policy: The in tune productivity,
come increase
rise in
should with the
incomes consistent
other be
claries and factor
should
of any
rise in i n c o m e
 in order to control inflation. However, it is difficult to implement such a policy,
especially in case of wage incomes due to pressure of trade unions.
2. Price Control of Essential Items: Under
price control policy,
the government
fixes the maximum price at which certain commodities could be sold. Prices of
essential goods need to be controlled in
order to ensure their availability to all
sections of the society.
3. Improvement in Public Distribution System: Price control policy needs to be
accompanied by rationing. Under rationing, specified quantity of goods is given
to consumers at the controlled
price through Public Distribution System (PDS).
Government should take reasonable steps to improve PDS so that
essential
commodities can be made available to the weaker sections at the controlled
4.
prices.
Increase inavailability goods: The problem of inflation can be controlled to
of
a great extent by increasing the availability of goods in the economy. It needs
two measures:
(a) Increase in Domestic Production: The domestic
production should be increased
by allocating more resources, providing subsidies and removing bottlenecks
which obstruct the production of these
goods.
(b) Import Goods: If domestic production falls short of demand, then
government
should go for import of essential items, so as to minimise
inflationary pressures
5. Population Control Measures: Effective population control measures will help
a lot in reducing excess demand and
controlling inflation.
 ~:8LAN@i :: 'ft,yHfJ/1
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