Economics for Managers Sem-I

7/28/2019 Economics for Managers Sem-I

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ECONOMICS FOR MANAGERS

UNIT-I

The word economy comes from the Greek word for one who manages a house -hold.

We know that households and economies have much in common. A household faces manydecisions. It must decide which members of the household do which tasks and what each

member gets in return: Who cooks dinner? Who does the laundry? Who gets the extra desser

at dinner? In short, the household must allocate its scarce resources among its various

members, taking into account each members abilities, efforts, and desires.

Like a household, a society faces many decisions. A society must decide what jobs wil

be done and who will do them. It needs some people to grow food, other people to make

clothing, and still others to design computer software. Once society has allocated people (as

well as land, buildings, and machines) to various jobs, like a household, a society faces many

decisions. A society must decide what it needs some people to grow food, other people to

make clothing, and still others to design computer software. Once society has allocated people

(as well as land, buildings, and machines) to various jobs will be done and who will do them. It

needs some people to grow food, other people to make clothing, and still others to design

computer software. Once society has allocated people (as well as land, buildings, and

machines) to various jobs, it must also allocate the output of goods and services that they

produce. Scarcity means that society has limited resources and therefore cannot produce althe goods and services people wish to have. Just as a household cannot give every membe

everything he or she wants, a society cannot give every individual the highest standard o

living to which he or she might desire.

Economics is the study of how society manages its scarce resources. In most societies,

resources are allocated not by a single central planner but through the combined actions o

millions of households and firms. Economists therefore study how people make decisions: how

much they work, what they buy, how much they save, and how they invest their savings

Economists also study how people interact with one another. For instance, they examine how

the multitude of buyers and sellers of a good together determine the price at which the good

is sold and the quantity that is sold. Finally, economists analyze forces and trends that affec

the economy as a whole, including the growth in average income, the fraction of the

population that cannot find work, and the rate at which prices are rising.


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Although the study of economics has many features, the field is unified by severa

central ideas. But here we will concentrate on the ten principles of economics which help the

individual in decision making.

PRINCIPLE #1: PEOPLE FACE TRADEOFFS:

The first lesson about making decisions is summarized in the saying: There is no such thing as

a free lunch. To get one thing that we like, we usually have to give up another thing that we

like. Making decisions requires trading off one goal against another. Consider a student whomust decide how to allocate her most valuable resourceher time. She can spend all of he

time studying economics; she can spend all of her time studying accountancy; or she can

divide her time between the two fields. For every hour she studies one subject, she gives up an

hour she could have used studying the other. And for every hour she spends studying, she

gives up an hour that she could have spent napping, bike riding, watching TV, or working at he

part-time job for some extra spending money. When people are grouped into societies, they

face different kinds of tradeoffs. The classic tradeoff is between guns and butter. The more

we spend on national defense to protect our shores from foreign aggressors (guns), the less

we can spend on consumer goods to raise our standard of living at home (butter). Anothe

tradeoff society faces is between efficiency and equity. Efficiency means that society is getting

the most it can from its scarce resources. Equity means that the benefits of those resources

are distributed fairly among societys members. Efficiency refers to the size of the economic

pie, and equity refers to how the pie is divided. Often, when government policies are being


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designed, these two goals conflict and the government has to make decisions in such a way

that both are achieved equity as well as efficiency.

PRINCIPLE #2: THE COST OF SOMETHING IS WHAT YOU GIVE UP TO GET IT

We know that people face tradeoffs (sacrifice), and therefore making decisions requirescomparing the costs and benefits of alternative courses of action. In many cases, however

the cost of some action is not as noticeable as it might first appear. Consider, for example, the

decision whether to go to college. The benefit is intellectual enrichment and a lifetime o

better job opportunities. But there are many types of money costs i.e. the money you spend

on tuition, books, and room. But this total does not truly represent what you give up to spend

a year in college. The first problem here is that it includes some things that are not really costs

of going to college. Even if you quit school, you would need a place to sleep and food to eat

Room and board (housing facilities) are costs of going to college only to the extent that they

are more expensive at college than elsewhere. Indeed, the cost of room and board at your

school might be less than the rent and food expenses that you would pay living on your own

In this case, the savings on room and board are a benefit of going to college. The second

problem with this calculation of costs is that it ignores the largest cost of going to college

your time. When you spend a year listening to lectures, reading textbooks, and writing papers

you cannot spend that time working at a job. For most students, the wages given up

(sacrificed) to attend school are the largest single cost of their education. The opportunity cos

of an item is what you give up to get that item. When making any decision, such as whether to

attend college, decision makers should be aware of the opportunity costs that accompany

each possible action. In fact, they usually are. College athletes who can earn millions if they

drop out of school and play professional sports are well aware that their opportunity cost is

very high.

PRINCIPLE #3: RATIONAL PEOPLE THINK AT THE MARGIN

One of the important principles is that rational (sensible) persons think at margin. It

means that small adjustments that an individual makes in the existing plan of action. This help

in making good decisions. When exams are near, your decision is not between totally escaping

from them or studying 24 hours a day, but whether to spend an extra hour reviewing you

notes instead of watching TV. Economists use the term marginal changes to describe smal

incremental adjustments to an existing plan of action. Keep in mind that margin means

edge, so marginal changes are adjustments around the edges of what you are doing

Another example, consider an airline deciding how much to charge passengers who fly


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standby. Suppose that flying a 200-seat plane across the country costs the airline Rs. 100,000

In this case, the average cost of each seat is Rs. 100,000/200, which is Rs. 500. One might be

tempted to conclude that the airline should never sell a ticket for less than Rs.500. In fact

however, the airline can raise its profits by thinking at the margin. Imagine that a plane is

about to take off with ten empty seats, and a standby passenger is waiting at the gate willingto pay Rs.300 for a seat. Should the airline sell it to him? Of course it should. If the plane has

empty seats, the cost of adding one more passenger is very small. Although the average cost

of flying a passenger is Rs. 500, the marginal cost is merely the cost of the bag of peanuts and

can of soda that the extra passenger will consume. As long as the standby passenger pay

more than the marginal cost, selling him a ticket is profitable. As these examples show

individuals and firms can make better decisions by thinking at the margin. A rational decision

maker takes an action if and only if the marginal benefit of the action exceeds the margina

cost. In short if MR>MC, it is advisable for a firm to make this decision.

PRINCIPLE #4: PEOPLE RESPOND TO INCENTIVES

Now we know that people make decisions by comparing costs and benefits and

therefore their behavior may change when costs and benefits change. That is people respond

to incentives. Incentives can be positive or negative. For example when the price of apple

rises, then people decide to substitute by eating more pears and fewer apples. This is because

the cost of buying apples is higher. Thus, it has positive effects on apple orchard owners. The

apple orchard owners hire more workers and harvest more apples as the benefit of selling

apples is higher.

Public policy makers should never forget about incentives as incentives change the cost

and benefits that people face and this will change their behavior. A tax on petroleum products

for example encourages people to drive smaller and more fuel efficient cars. It also

encourages the use of public transportation.

In short, people make decisions depending upon the incentives they receive.

PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF:

It is a fact that trade between the two countries can make each country better off. Trade

facilitates each country to specialize in their respective products. And as the result they enjoy

better variety of products and can buy the products at a cheaper rate. We know that china

U.S.A, U.K. is our competitors in the world market. But yet trade has made the countries

better off. India can produce agricultural products at a lower cost than U.S.A. whereas U.S.A


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can produce technology at a lower cost. When trade takes place, it makes both the countries

become better off. The idea of division of labour is based on trade. In an economy all familie

compete among themselves to buy goods at the cheapest price. But when the family isolate

itself from the market, it will have to make its own food, clothing and shelter. This will make

their life more difficult. Trade allows each person to specialize in the activities he or she doesbest, whether it is farming, sewing, or home building. By trading with others, people can buy a

greater variety of goods and services at lower cost.

PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC

ACTIVITY:

The fall down of communism in the Soviet Union and Eastern Europe has brought very

important changes in the world during the last half century. The communist country worked

on the assumption the Central planners were in the best position to guide the economic

activity. The planners (Government) decided important questions such as what to produce?

How to produce? For whom to produce? But today most of the countries have abandoned

this system and are trying market economies. In market economy the decisions are taken

collectively by millions of firms and households. In short, the market forces of demand and

supply makes the important decisions for the economy. In 1776, Adam Smith published a boo

called, An inquiry into the nature and cause of wealth of nations. In this book he has

mentioned that the Invisible hand that is the market forces will correct the problems of

market. According to him price mechanism works like magic which solves the problems of the

economy. Thus price is the instrument with which the invisible hand directs economic activity

The central planning system failed because they ignored the market economy or the invisible

hand. Thus, we conclude that markets are usually a good way to organize economic activity.

PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES:

We know that markets are usually a good way to organize economic activity but this rule has

many exceptions. There are two main reasons for government to intervene in the economy

One is to promote efficiency and another is to promote equity. We know that the invisible

hand helps markets to efficiently allocate its resources. But many a times this does not work

Economists term them as market failure. Market failure refers to a situation in which the

market on its own fails to allocate the resources efficiently. One of the reasons for market

failure is externality. An externality is the impact of one persons actions on the well being of

bystander (others). One very important example is pollution created by chemical factory. I

Government intervene this problem by imposing environmental regulation, then it can force

the chemical industry to undertake pollution abatement program. This will improve the


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market outcome. Another possible cause of market failure is market power (monopoly)

Market power refers to the ability of a single person (or small group of people) to unduly

influence market prices. In case of monopoly, the seller increases the price for self-interest

Government intervene the problem by regulating the prices, this can increase the marke

efficiency. The invisible hand is even less able to ensure that economic prosperity is distributedfairly. A market economy rewards people according to their ability to produce things that

other people are willing to pay for. The invisible hand does not ensure that everyone has

sufficient food, decent clothing, and adequate health care. A goal of many public policies, such

as the income tax and the welfare system, is to achieve a more equitable distribution o

economic well-being.

PRINCIPLE #8: A COUNTRYS STANDARD OF LIVING DEPENDS ON ITS ABILITY TO PRODUCE

GOODS AND SERVICES:

We have seen large changes in the standard of living in the citizens of the country. Also we

have come across large differences in the standard of living among the countries. The

explanation for these large differences in living standards is due to the differences in the

countries productivity. Productivity is the amount of goods and services produced from each

hour of workers time. It is observed that in nations where workers can produce more of goods

and services per unit of time enjoy higher standard of living. And in nations where workers are

less productive will have a lower standard of living. The growth rate of nations productivity

determines the growth rate of its average income. There is a positive relationship between

productivity and standard of living. The relationship between productivity and living standard

has also deep impact on public policy. The relationship between productivity and living

standards also has deep implications for public policy. To boost living standards, policymakers

need to raise productivity by ensuring that workers are well educated, have the tools needed

to produce goods and services, and have access to the best available technology.

PRINCIPLE #9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH MONEY:

In Germany in January 1921, a daily newspaper cost 0.30 marks. Less than two years later, in

November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy

rose by similar amounts. This episode is one of historys most spectacular examples of

inflation. What causes inflation? In almost all cases of large or persistent inflation, the culprit

turns out to be the samegrowth in the quantity of money. When a government creates large

quantities of the nations money, the value of the money falls. When government creates

money and circulates in the market through let us say government expenditure the incomes o


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the citizens increases which leads to increase in demand for goods and services. The supply of

goods may not increase in same amount as demand and therefore it causes scarcity, which

increases the price of the goods.

PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN INFLATION ANDUNEMPLOYMENT:

We know that inflation has many negative impacts on the society. The question is why does

policy makers find it difficult to get rid of this inflation. The reason this is that reducing

inflation often leads to temporary rise in unemployment. A very popular economist called A

W. Phillips explained the relationship between unemployment and inflation. The curve tha

explains the relationship between inflation and unemployment is known as Phillips curve. Thi

curve explains the inverse relationship between inflation and unemployment.

According to a common explanation, it arises because some prices are slow to adjustSuppose, for example, that the government reduces the quantity of money in the economy. In

the long run, the only result of this policy change will be a fall in the overall level of prices

That is, prices are said to be stickyin the short run. Because prices are sticky, various types of

government policy have short-run effects that differ from their long-run effects. When the

government reduces the quantity of money, for instance, it reduces the amount that people

spend. Lower spending, together with prices that are stuck too high, reduces the quantity o

goods and services that firms sell. Lower sales, in turn, cause firms to lay off workers. Thus, the

reduction in the quantity of money raises unemployment temporarily until prices have fully

adjusted to the change. The tradeoff between inflation and unemployment is only temporary

but it can last for several years. The Phillips curve is, therefore, crucial for understanding many

developments in the economy. In particular, policymakers can exploit his tradeoff using

various policy instruments. By changing the amount that the government spends, the amoun

it taxes, and the amount of money it prints, policymakers can, in the short run, influence the

combination of inflation and unemployment that the economy experiences.


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The firms shut down the business as less quantity of thegoods are sold and this makes the workers unemployed

At high prices but less amount of money people make lesspurchases

price level does not change immediately or the prices remain

sticky in the short run

Government takes policy measures to reduce price level byreducing the quantity of money


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UNIT-III

CONCEPT OF PRICE ELASTICITY

Q1. Define Price elasticity of demand and explain the methods of measuring price elasticity

of demand.

ANS: The law of demand explains that changes in price will cause changes in demand but it

does not tell us by how much the demand changes. Price elasticity of demand explains by how

the demand will change due to the change in price.

The proportion of change in demand due to the change in price is called price

elasticity. Some economists have defined price elasticity of demand in the following manner.

According to Alfred Marshall, Price elasticity of demand means the ratio of relative

change in quantity demanded to a relative change in its price.

According to Mrs. Joan Robinson, The proportion of changes in demand due to small change

in price is divided by the quantity of changes. The index thus derived at is called price elasticity

of demand.

According to Stonier and Hague, The proportion of change in demand that takes place

due to reduction in price is technically indicated through price elasticity is demand.

Methods of Measuring Price Elasticity

There are three methods of measuring price elasticity. They are explained below;

1. Point method: To find out the elasticity of demand at a single point on the demandcurve, we use the point method. The point method can be studied in two ways:

a. Mathematical method: The mathematical method to study price elasticity isexplained with the help of the following formula.


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Thus by rearranging the term we get,

This method is also known as the percentage method to measure price elasticity. The price

elasticity of demand range between 0 to , we can find out the price elasticity by using the

percentage method.

2. Arc Method: The arc method to measure elasticity can be used when there are twopoints on the demand curve. Elasticity of demand on a certain part of demand curve iscalled arc elasticity. Arc elasticity is the average elasticity; the diagram shows the use of

arc elasticity.

Y ARC ELASTICITY

Price

P1 A

P2 B

Q1 Q2 Quantity demanded X


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From the above diagram we find that there are two points on the demand curve A and B. A

point A we have price P1 and quantity Q1 and at point B, the price P2 and quantity Q2. Now

we determine the elasticity between the two points with the help of the following formula

Where ep = elasticity of demand

q = change in quantity demanded

p = change in price

q= original quantity

p = original price

But now to find arc elasticity, the average of both the quantities and prices are taken, which is

explained with the help of the following formula:

We also know that and p = p1-p2, now substituting this in the above equation

we get

The negative sing indicates the inverse relationship between price and quantity demanded bu

for simplicity purpose we ignore the negative sign.

3. Total Expenditure method: This method is used to measure the elasticity of demandaccording to this method we can determine the elasticity on the basis of tota

expenditure done by the consumer on a particular good. The explanation is given below

with the help of an example.

a. Unit elastic demand: (E = 1) When there is a change in the price of a good but the totaexpenditure done by the consumer remains the same or constant, it is called unit elastic

demand.


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From the above example, we conclude that whether the price rises or falls, the tota

expenditure remains constant. This indicates that the good has unit elastic demand.

b. Elastic demand: ( E > 1) When the price of the good falls and the expenditure rises orwhen price rises and expenditure falls, it is known as relatively elastic demand. Fo

example:

From the above table, the conclusion can be drawn that if price reduces and total expenditure

rises or if price increases and total expenditure falls, the demand for the good

is greater than 1. This indicates that the demand for the good is elastic in nature. Luxurious

goods have elastic demand.

c. Inelastic demand: ( E < 1) If the price reduces the total expenditure also reduces orwhen price increases the total expenditure rises on the good then the good will have

relatively inelastic demand. This is explained form the table below.

Price Quantity Demanded Total Expenditure

Rs.10 8 Rs.80

Rs.8 10 Rs.80

Rs.4 20 Rs.80


Rs.10 8 Rs.80

Rs.8 9 Rs.72

Rs.4 10 Rs.40


Rs.10 8 Rs.80

Rs.8 15 Rs.120

Rs.4 40 Rs.160


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From the above table we conclude that price and expenditure are rising or falling at the same

time. Therefore the goods will have inelastic demand. Necessaries will have inelastic demand.

This method is helpful to know whether the demand is elastic or inelastic but the exactmeasurement of elasticity cannot be done.

Q2. Explain the different types of elasticity of demand with the help of suitable diagram.

OR

The price elasticity of demand determines whether the demand curve is steep or flat-How?

You also need to explain all five cases of price elasticity. Remedial Exam (April-2010).

ANS: Price elasticity means the degree of responsiveness of quantity demanded to the change

in price of a good. Mathematically, it can be written as:

There are five types of elasticity of demand. They are explained below with the help odiagrams.

a. Perfectly inelastic demand, (e=0): With the change in price, if there is no change inquantity demanded, then elasticity is equal to zero. This means perfectly inelastic

demand. This is explained with the help a demand schedule and a diagram:

Price

(Rs.)

Quantity Demanded

(units)

5 1010 10

15 10

Y

Price

15 (e = 0, perfectly Inelastic demand)

10

5


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From the above diagram, we conclude that when e = 0, the demand curve is a vertical line.

This explains that with the change in price there is no change in demand.

b. Relatively Inelastic demand, (e


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From the above diagram, we conclude that the demand curve is downward sloping curve

which indicates that the price and quantity demanded changes in the same proportion. The

shape of the demand curve is downward sloping from left to right. It is a rectangular

hyperbola.

d. Relatively Elastic demand, (e>1): With a small change in price, if there is aproportionately larger change in quantity demanded, then the good will have elastic

demand. Luxurious goods such as expensive cars, televisions etc will have elastic

demand. The same can be explained with the help of a table and a diagram.

Price

(Rs.)

Quantity Demanded

(units)

5 10

10 5

Price

(Rs.)

Quantity Demanded

(units)

5 10

6 5

7 1

Y

Price

(e=1, unit elastic demand)

10

5

0 5 10 Quantity demanded X


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From the above diagram, we conclude that for elastic demand, the demand curve is

downward sloping but a flatter curve.

e.

Perfectly elastic demand, (e=): When there is an extremely small change in the pricebut infinitely large change in quantity demanded, then the elasticity is perfectly elastic

This is not practically possible in the real life but with the help of the following table and

a diagram, we can explain perfectly elastic demand.

Price

(Rs.)

Quantity Demanded

(units)

10 10

9.99

Y

Price (e=, perfectly elastic demand)

10

0 10 Quantity demanded X

Y

Price

7 (e>1, relatively elastic demand)

6 Flatter curve

5

0 1 5 10 Quantit demanded


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From the above diagram we conclude that for a perfectly elastic demand the demand curve is

a horizontal line parallel to X-axis and perpendicular to Y-axis.

Q3. Explain the main factors affecting elasticity of demand.

OR

Explain price elasticity of demand and income elasticity of demand. Also explain the

determinants of price elasticity of demand. (Feb-2011)

ANS: There are several factors which affect the elasticity of demand. These factors make the

demand for goods more elastic or less elastic. They are explained below:

1. Availability of substitutes: If the goods have close substitutes in the market then thedemand for the good concerned will have elastic demand. For examples commoditie

like butter, coca-cola, cars have close substitutes and therefore if the price of the good

changes, the demand for the product will change in greater proportion making the

demand more elastic. Where as, if the good has less substitutes or no substitutes then

the good will inelastic demand. For example demand for common salt is inelastic

because a good substitute for salt is not available.

2. Position of a commodity in consumers budget: The greater the proportion of incomespent on a commodity, the greater will be its elasticity of demand. The demand fo

goods such as salt, match-box, buttons etc tends to be inelastic because a householdwould spend only a small position of their income on them.

3. Nature of the need that a commodity satisfies: In general, luxury goods have elasticdemand where as necessaries has inelastic demand. This is due to the reason that

people cannot do without using necessaries where as one can postpone the use o

luxury goods. For example salt will have inelastic demand where as televisions wil

elastic demand.

4. Number of uses to which a commodity can be put: The more the possible uses of acommodity, the greater will be its price elasticity. For example milk has several uses. If

its price falls, it can be used for variety of purposes like preparation of curd, cream, ghee

and sweets. But if the price increases, its use will be restricted only to essential purpose

like feeding the children and sick persons. But if the product has one or less uses the

demand for the product may turn inelastic.

5. The time period: The longer the time period one has more completely one can adjustFor example, if the price of petrol increases then one can make fewer trips by car but in


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the long run the consumer can purchase a car which is more fuel efficient. In short

longer the time period faced by the consumer, elastic will be the demand for the

product.

6. Consumers habit: If a consumer has formed a habit of using a particular commoditythen with the change in the price the demand for the commodity will be inelastic.

7. Tied demand: The demand for the goods which are tied to the other goods wilgenerally inelastic. For example the demand for cement is tied with the demand for

buildings and construction. Therefore, if buildings are in demand, cement will be

definitely required. This makes the demand for cement inelastic.

8. Price range: Goods which are in very high price range or very low price range haveinelastic demand but those in the middle range will have elastic demand.

Q4.Explain the uses of elasticity of demand.

ANS: The concept of elasticity of demand is very useful in practice. Some of the important uses

are explained below:

1. Useful to government: The concept of elasticity of demand is very useful to the financeminister of the country. The finance department will consider the elasticity of demand

for every commodity while imposing taxes on goods. If the demand for the commodity

is inelastic, it can be necessity items, therefore government will imposes low tax rates

Whereas if the demand for the good is elastic in nature it may be luxurious goods, thus

government will impose high taxes.

2. Helpful to monopolist: A monopolist will analyze the elasticity of demand for theproduct before determining the price of the product. If the demand for good is inelastic

the monopolist can charge higher prices whereas if the demand for the goods is elastic

the monopolist can charge a lower price.

3. For international trade: The elasticity of demand will help to determine the prices othe goods to be exported. If the demand is inelastic in the international market, we can

charge a high price for exports. But if the demand for export is elastic, lower price can

be charged for exports to become more competitive. Devaluation of the currency is

done on the basis of elasticity of demand for imports and exports.

4. Helpful to producers of joint products: The producers who produce joint goods have todecide the price of joint products. The producer considers the elasticity of demand in

fixing the price of the joint products. For example, cotton and cotton seeds are join


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products, if the demand for cotton is inelastic the producer can charge a high price for

cotton and if cotton seeds have elastic demand, then he can charge lower price fo

seeds.

Thus, we conclude that elasticity of demand is of great importance in making

business decisions.Q5. Explain the income elasticity of demand with the help of suitable examples and

diagrams.

ANS: Income elasticity of demand means the degree of responsiveness of quantity demanded

of goods to the change in income of consumers. The formula for income elasticity is as under:

Where Ey= Income elasticity, q= change in quantity, y=change in income of the consumers.

Normally, income elasticity will have a positive sign because there is a positive relationship

between quantity demanded and change in consumers income. We know that higher the

income, higher is the quantity demanded, where as lower the income, lower is the quantity

demanded, assuming other factors remaining constant.

Positive income elasticity can be due to normal goods. Normal goods can be classified into

necessity items and luxurious items.

Types of income elasticity

The types of income elasticity are explained below:

1. Positive Income Elasticity: We know that as the income of the consumers increases thequantity demanded for the goods will also increase, that means there is a positive

relationship between quantity demanded and the income of the consumers. Generally

normal goods will have positive income elasticity. Normal goods are classified into two:

a. Luxurious goods: Income elasticity greater than 1 (ey>1): the demand increasesmore than the proportion of income, this income elasticity is greater than 1

Luxurious goods will have elastic demand.


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b. Necessity goods: Income elasticity less than 1, (ey


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demand lesser amounts of inferior goods Zero Income Elasticity: When income changes but

there is no change in the quantity demanded, then income elasticity is equal to Zero. (Ey=0)

The diagram below explains zero income elasticity.

Zero income elasticity will have a vertical straight line demand curve indicating that there is no

change in quantity demanded with the change in income.

Q6. Explain the concept of cross elasticity of demand with the help of suitable diagram.

ANS: Most of the goods are connected with other goods in the form of substitute goods orcomplementary goods. Tea and coffee, ink pen and ball pen are examples of substitutes

goods. Where as ink and ink pen, sugar and tea are examples of complementary goods.

Cross elasticity of demand helps us to understand the relationship between two goods. Cross

elasticity of demand can be defined as, Cross elasticity of demand means the ratio of

percentage change in demand of substitute good or complementary goods as a result o

percentage change in the price of the commodity. The following is the formula to find out the

cross elasticity.

Types of cross elasticity

1. Positive cross elasticity: When two goods are substitute goods, the cross elasticity wilhave a positive sign. This can be explained with the help of an example. Let us assume

Y

Income (Zero income elasticity)

0 Quantit demanded X


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that there are 2 goods tea and coffee and changes in the price of coffee will lead to

changes in quantity demanded for tea.

The diagram for the same is explained on the next page.

From the above diagram and an example we conclude that there is a positive relationship

between quantity demanded of tea and price of coffee.

2. Negative cross elasticity: When two goods complimentary goods, the cross elasticitywill have a negative sign. This can be explained with the help of an example. Let u

assume that there are two goods ink and ink pen and changes in the price of ink wil

lead to changes for ink pens.

Tea

Quantity demanded

Coffee

Quantity demanded

Price of coffee

`

5 3 57 1 7

Ink

Quantity demanded

Ink pens

Quantity demanded

Price of Ink

`

2 3 10

1 2 15

Y

Price

Of coffee

7

5

0 5 7

Quantity demanded of Tea X


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From the above diagram we conclude that the demand curve for complementary goods is a

downward sloping curve.

3.

Zero cross Elasticity: When two goods are not related goods, then the cross elasticitywill be zero. For example there is no relationship between a ceiling fan and a car

Therefore the cross elasticity will be zero indicating that with the change in the price o

ceiling fans, there will be no change in the quantity demanded of cars. The demand

curve is a vertical line. This is explained with the help of a diagram.

Y

Price of

Ceiling

Fans

0 Quantity demanded of cars X

Y

(Negative cross elasticity)

(Complimentary goods)

10

5

0 2 3 Quantity demanded of ink pens X


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COST ANALYSIS

The term cost has wide variety of meanings in economics but the normal concept used is th

cost of production i.e. the expenditure incurred by the company on wages, salary, raw

power, light, fuel, transportation etc. Money cost therefore refers to money expenditure by

produce or sell a product. Business managers use this cost figures to determine prices of thepurchase of a new technology and profits for a firm.

Therefore, it is essential to know the different types of cost involved in a firm. Some importan

costs are recorded below:

1. Accounting cost and Economic cost2. Short run cost and Long run cost3. Incremental cost and Sunk cost4. Traceable cost and Common cost5. Fixed cost and Variable cost

1. Accounting cost and Economic cost: The cost incurred for accruing or producing good o

service is called accounting cost as these costs can be recorded in the books of accounts for

e.g. power, light, fuel, wages, salary, insurance, rent etc. These costs are also known as

Absolute costs or outlay costs. Where as opportunity cost is the revenue sacrificed by not

making the best alternative use. For e.g. a company can produce 1000 units of X, 900 units of

Y, and 800 units of Z. If the company decides to produce X, he makes a sacrifice of 900 units of

Y and 800 units of Z.According to the modern economist, opportunity cost is applicable to all factors o

production. While economic cost is a wide concept as it includes both the accounting

Cost as well the economic cost. i.e.

Economic cost = Accounting cost + Opportunity cost.

The accounting costs are important for managing the taxation needs as well as calculating

profit or loss for the firm where as economic costs relate to future. Since the only costs that

matter for business decisions are the future costs, economic costs are more used in decision

making.

A modern business firm should not only look at the accounting cost while making a

decision but also take into account the opportunity or implicit costs because

actual profitability of production can only be measured if the sacrifices actual costs are taken

into account.


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2. Short run and Long run Cost: In the short run, we know that to increase the level of output

a firm cannot purchase new factors of production like land, capital and set up a new enterprise

as it requires a long term planning. Therefore, in the short run certain factors remain constant

while labour can only be managed. The costs that change with the output or sales in the short

run are called short run cost. While in the long run i.e. (10 to 15years), after the long term

planning all the factors of production can be changed to produce more output. Therefore, al

the costs are variable in the long run. Long-term decisions can be regarding setting up of a new

plant. The cost involved in the long-term to expand the business is called the long-run cost.

3. Incremental (or, Avoidable or, differential) cost and Sunk cost: Incremental cost is the

additional cost, which arises due to the change in the business activity. The changes can take

place in several forms for e.g. addition of a new product line, replacing the old machine by a

new one, expansion of market etc. Incremental cost will not occur when new business is set

up. Incremental cost only arises when changes in the existing business takes place. In addition

incremental cost will be different in cases of different alternatives. These costs can be avoided

by not bringing about any change in the business activity; the incremental costs are also called

avoidable costs or escapable costs. On the other hand, sunk cost is the cost, which does not

change with the change in the level of business activity. It remains fixed or same irrespectiveof the alternatives selected. Thus to a manager incremental costs are more important than

sunk costs. Sometimes sunk cost is also known as fixed cost. For e.g. a manager has to make a

choice between hiring a machine and buying a machine. The costs associated with this

machine are as under:

(a)Acquisition cost.(b)Service and maintenance cost(c)Operating cost (labour, power, fuel).


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(d)Space occupancy. (Depreciation, taxes, insurance)From this we realize that acquisition cost and service and maintenance cost is

incremental cost as they change with the decision while operating cost and space

occupancy are sunk cost.

2.Traceable and common cost: A direct or traceable cost is one, which is easily identified witha unit of operation for e.g. the salary of the divisional manager is the direct cost when the

division is the costing unit. In other words, direct costs are the ones that have direct

relationship with the unit of operation like a product, a process, or a department of the firm

Since all the costs are linked to a particular product, process or department they vary with the

changes in them and therefore direct cost is variable costs. Traceable costs are important

when a company is engaged in multiple products. On the other hand, indirect costs or the non

traceable may or may not be variable. Common costs are the indirect cost that are not

traceable with the final product for e.g. electric power for operating machine, raw material

labour are the traceable costs while salary of the administrative department, electricity bill

interest, and insurance are common costs.

A rational producer will try to find out the different types of cost incurred by the

firm especially if it is a multi-product firm. The knowledge of different types of cost can give

the idea to the manager on how to maximize the production and profit by making some

changes in the costs. Thus, the traceability of the costs is quite important in decisions involving

additions and subtraction from a product line, product pricing, product marketing, changes inprocesses etc.

(Q).Explain the cost output relationship in the short run.

Cost and output are correlated. If the producing unit increases the level of output, the cost wil

also be affected. The study of cost is divided into two:

(a)The cost output relationship in the short run.(b)The cost output relationship in the long run.

(a)The cost output relationship in the short run: In the short run if a firm decides to produceand sell more output in the market, the only thing it can do is adjust the labour to increase

the level of output. This is because in the short run it is not possible to for the firm to buy

or introduce new plant, machinery, land, capital etc. Therefore, in the short run certain cos

is fixed while some are variable. The cost incurred on land, plant, machinery is fixed while

that on labour is variable. In the short run total cost of production will be

Total cost = Total fixed cost + Total variable cost.


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TC = TFC + TVC.

The cost output relationship in the short run can be studied in terms of

1. Average fixed cost.2. Average variable cost3. Average total cost.4. Marginal cost

Average total cost = Average fixed cost + Average variable cost

ATC = AFC + AVC

1. Average fixed cost: As the total fixed cost remains constant or fixed, with the change in the

in output average fixed cost will fall with the increase in output for e.g.No. of units TFC AFC

100 5000 50

200 5000 25

500 5000 10

From the above table we mark that greater the level of output, lower will be the fixed cost

The shape of the average fixed cost curve will be downward sloping because there is aninverse relationship between total number of units and average fixed cost.

AFC

50

(Downward sloping AFC Curve)

25

10

0 100 200 500

UNITS


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2. Average variable cost: Average variable cost will first rise then fall as more and more units

are produced. This is because in the short run law of variable proportion is applicable i.e. til

the time we have underutilized capacity the output will rise but the cost will fall but once the

capacity is fully utilized extra output can be increased only at an extra cost i.e. if more output

is produced by hiring more and more labour the laborers will be more in number then themachines and the cost would rise sharply.

3. Average total cost: Average total cost is the total cost of production i.e. the sum of average

fixed cost and the average variable cost. The ATC curve is a U shaped curve because it is

affected by both AVC and AFC curves. Initially both the curves are falling and therefore wil

slope downwards further AFC curve fall but AVC curve rises, the rise in the AVC curve is more

Units TVCAverage Variable Cost

(AVC=TVC/Q)

100 500 5

200 750 3.75

400 800 2

500 1500 3

AVC

Average Variable cost U shaped

5

3.7

5

3

2


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powerful than the fall in AFC curve. The shape of the ATC curve will be affected by the AVC

curve and therefore the AVC curve shoots up suddenly. This is explained in the diagram below

4. Marginal cost: Marginal cost is the addition made to the total cost by producing one more

of output. The law of variable proportion in the short run also affects the marginal cost. How

marginal cost is independent of the fixed cost. The marginal cost curve first falls down and larises steeply and it intersects the average variable cost curve at its minimum point. This ca

explained with the help of a table and diagram.

Units AVC AFC ATC=AVC+AFC

100 5 50 55

200 3.75 25 28.75

300 2 16.66 18.66

500 3 10 13

600 8 8.33 16.33

ATC

Average Total Cost U shaped55

28.75

18.66

16.33

13

100 200 300 400 500 600 units


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The above table explains the relationship between fixed cost variable cost and margina

cost. It states that:

(a)Fixed cost remains same or constant i.e. it does not change with the level ofoutput. Therefore the average fixed cost falls down with the increase in the in the

output.(b)Variable cost increases with the level of output but not proportionately.(c)Marginal cost is the cost of an additional unit produced. This cost also falls down

as the output level increases.

Y

MC

Units X


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Relationship between Average and Marginal Cost and Output

The relationship between average, marginal and output are explained in the diagram below. I

states that

(1) As the result of increase in output the average cost falls, marginal cost is less than average

cost. (MC < AC)

(2) As the result of increase in output the average cost is at its minimum, marginal cost is

equal to average cost. (AC = MC)

(3) As the result of increase in output the average cost is increasing, marginal cost is more than

average cost. (AC>MC)

DIAGRAM

0 A F I OUTPUT

ATC/MC

B

C

E

G

H


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Q)Explain the Cost output relationship in the long run.

In the long run all the cost are variable because to increase the output in the long

run we can change all the factors of production. In the long run, the producer can

Change or construct a new plant size to suit to the level of output. To explain this let u

assume three plants of different sizes. Corresponding to this plant size, we will have three

average short run cost curves, SAC 1, SAC2, SAC3, respectively. Where plant 1is a smal

plant, plant 2 is a medium sized plant, while plant 3 is a large sized plant.

This can be explained with the help of a diagram.


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Now if the producer wants to produce OA, it should select plant size 1 as the cost of

production on plant size 1 is less than the cost of production on plant size 2, similarly

If he wishes to increase the output to OB, he should select plant size 2 and for OC level of

output plant size 3 is the best choice.

To derive a long run average cost curve (LAC curve), a tangential line should be passed

through various SAC curves. This will give an envelope shaped LAC curve and the optimum

level of output for a firm is ON because the cost of production at this point is minimum. If a

producer produces more than ON level of output, the cost of production rises as the plant is

over utilized and if the producer produces less than ON, the plant in the long run will be ove

utilized. This is shown in the diagram.


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DIAGRAM

N

Now if the producer wishes to produce less than ON level of output i.e. OMthen he underutilizes his plant size and the cost of production increases toEM and if he produces more than ON level of output i.e. OP level of output thecost of production increases to GP and therefore a rational producer willproduce at minimum cost in the long run and therefore he will select ON level

of output. Thus, we derive a long run average cost curve with the help of theshort run average cost curve.

CHARACTERISTICS OF LONG RUN AVERAGE COST CURVE

i. LAC Curve is U shaped;ii.The LAC covers all the SACs;iii.The LAC is tangential to all the SACs; that is LAC can never intersect the

SACs;

SAC1

SAC9

SAC2

SAC3

SAC5

SAC6

SAC7

SAC8

A

B

C

D

E

G

H


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iv.The LAC is also known as Envelope Curve as its arms envelope all theSACs.

v. LAC shows minimum cost of any level of output. Hence, no SAC can cut andlie below LAC.

vi. When LAC is falling, it touches the descending portion of SAC and when it isrising, it touches the ascending portion of SAC.

vii.The LAC curve is also known as Planning curve as it helps management inplanning its business operations.

MANAGERIAL USES OF LAC CURVE

The firm is interested in producing the given level of output at minimum cost

and not interested in getting the minimum cost output in a given plant. The

LAC curve helps a firm to decide to buy that level of plant size for a given level

of output to minimize the cost. If the plant is underutilized then the cost

increased because the business manager has to incur maintenance charge tokeep the machine in running condition. It is observed that if a firm wishes to

produce little less output compared to optimum level then it is economical to

under use a slightly bigger plant operating at less than its minimum cost

output then to overuse a smaller plant. On the other hand, at output beyond

the optimum level that is when the firm experiences decreasing returns to

scale it is more economical to overuse a slightly smaller plant than to

underuse a lightly larger one.

Q) Discuss the Factors Affecting Cost.

Cost of any product is a function of many variables. In other words, cost is

determined by many factors they are also known as determinants of cost.

Symbolically it can be expressed as:

CX = F (OX, T, I, Q, G)

OX = output of product x

T = Technology

I = Input prices

Q = Input Quality

G = Government Policy


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1.Output of X: Cost of production depends upon the level of output, higher thelevel of output lower will be per unit cost because the fixed cost is dividedbetween many units. Thus the we can say that the fixed cost such as rent,insurance premium, interest payment etc can be among many units.

2.Technology: Technology is another important determinant of cost. A firm toreduce the cost of production and improve the quality of the product thoughthe cost of installation may be high adopts usually new technology.

3.Input Prices: The inputs like raw materials of various prices, labourtransport, insurance, capital etc. are required to produce goods. If the cost ofsuch goods increases the total cost of production increases and if the inputprices are lower than the cost of production decreases.

4.Input Quality: It the quality of input is poor or inferior in nature then thecost of production will increase because of loss of raw material duringproduction. Where as the better quality of the raw materials reduce the cost

of production.5.Government policy: Nowadays government controls and regulates the

business and industry. Government policy pertaining to taxation, subsidy,wage fixation, export-import, licences etc. affects the cost structure ofindustry largely. If the tax rates were high, cost of production would swell tothat extent.

6.Location: According to Dr.Vishweshvaria, the firm should take intoconsiderations the nine Ms before making any decisions with respect to anydecision regarding location of a new unit. The Nine Ms are men, material,market, machinery, motive power, management, means of transportation,money etc. The success of a firm depends up on the selection of a suitablesite.

7.Transportation: Every manufacturing industry requires cheap and efficientmeans of transportation for the movement of both raw materials from thesource of supply to the factory and finished products from the factory to themarkets or the centers of consumption. The location of the plant, shouldtherefore, be at a place where adequate transport facilities are available atcheaper rate.

8.Finance: No productive activity is possible without the availability ofadequate capital. Banks, stock exchange and other similar institutions helpin capital formation and expansion of industry by providing financial help toit from time to time.

9.Size: The success and efficiency of the firm also depends on its suitable size.The size of the firm should be optimum as to ensure maximum profitability.The optimum size of the firm is that point which results in the lowestproduction cost and maximum efficiency. This optimum size of the firm keepson changing from time to time depending upon the improvement made by thefirms in production techniques and managerial expertise.


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0.Climatic conditions: Certain industries require a special type climate. Fore.g. cotton, textile industries require humid climate while the photographicclimate require dry climate. Climatic conditions also require affect theworking capacity.

No. of unitsTVC

AVC

100 100 1

200 150 0.75

300 300 1

400 800 2

500 1500 3

No. of units AFC AVC TC

100 50 1 51

200 25 0.75 25.75

300 16.66 1 17.66

400 12.5 2 14.50

500 10 3 13


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UNIT-III


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MEASURING NATIONAL INCOME

Q) Describe the four components of GDP and give examples of each.

ANS: We know that one of the most important things in macro economics is the measurement of national income. GDP

is one of the ways of estimating national income. GDP is the most closely watched statistics as it is considered as the

best single measure of societys well-being. Economy as a whole is the collection of many households and firms

interacting in the markets. It is known facts that total expenditure is equal to the total national income and tota

national production.

Total national income= Total national expenditure= Total national production

This is because one mans expenditure is equal to another man income is equal to the market value of total nationa

production. Gross domestic product (GDP) is the market value of all final goods and services produced within a countr

in a given period of time. This definition might seem simple enough. But, in fact, many subtle issues arise whe

computing an economys GDP. Lets therefore consider each phrase in this definition with some care.

GDP is the market value: It means that GDP adds together many different kinds of products into a single measure of the

value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are

willing to pay for different goods, they reflect the value of those goods.

Of all goods and services: It includes all goods and services produced in the economy. It is a comprehensive measure

GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, i

uses market prices. Because market prices measure the amount people are willing to pay for different goods, the

reflect the value of those goods. GDP excludes items produced and sold illicitly, such as illegal drugs. It also excludes

most items that are produced and consumed at home and, therefore, never enter the marketplace. Vegetables you buy

at the grocery store are part of GDP; vegetables you grow in your garden are not.

Final: The word final goods and services mean that it includes the value of only final finished product and not the value

of intermediate or semi-finished goods or services. For example the value of cotton, yarn, and textile would already be

included in the market value of ready-made shirts. So if intermediate goods are taken into consideration then there

would be problem of double counting. An important exception to this principle is when an intermediate good i

produced and, rather than being used, is added to a firms inventory of goods to be used or sold at a later date. In this

case, the intermediate good is taken to be final for the moment, and its value as inventory investment is added to

GDP. When the inventory of the intermediate good is later used or sold, the firms inventory investment is negative, and

GDP for the later period is reduced accordingly.

GOODS AND SERVICES: GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts

housecleaning, and doctor visits). When you buy a CD by your favorite singing group, you are buying a good, and the


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purchase price is part of GDP. When you pay to hear a concert by the same group, you are buying a service, and the

ticket price is also part of GDP.

PRODUCED: GDP includes goods and services currently (In that financial year) produced. It does not include transactions

involving items produced in the past. When General Motors produces and sells a new car, the value of the car is

included in GDP. When one person sells a used (second hand) car to another person, the value of the used car is no

included in GDP.

WITHIN A COUNTRY: GDP measures the value of production within the geographic confines of a country. When a

Canadian citizen works temporarily in the United States, his production is part of U.S. GDP and therefore it is recorded

When an American citizen owns a factory in Haiti, the production at his factory is not part of U.S. GDP. (It is part o

Haitis GDP.) Thus, items are included in a nations GDP if they are produced domestically, regardless of the nationality

of the producer.

IN A GIVEN PERIOD OF TIME: GDP measures the value of production that takes place within a specific interval oftime

Usually that interval is a year. GDP measures the economys flow of income and expenditure during that interval. It

should be apparent that GDP is a sophisticated measure of the value of economic activity. In advanced courses in

macroeconomics, you will learn more of the subtleties that arise in its calculation. But even now you can see that each

phrase in this definition is packed with meaning.

COMPONENTS OF GDP

Now we know that total expenditure of the economy is equal to total national income of the economy. So the

statistician measures the total national expenditure of the economy. GDP includes all of these various forms of spending

on domestically produced goods and services. To do this, GDP (which we denote as Y) is divided into four components

consumption (C), investment (I), government purchases (G), and net exports (NX):

Y = C+I+G+NX

Consumption spending: It is the spending by households on goods and services, with the exception of purchases of new

housing. The circular flow in income as shown below explains how households spend on various goods and services to

satisfy their wants. The households may buy food, clothing, shelter and various other things of comforts and luxuries

and this all is included in consumption spending. C (consumption) is normally the largest GDP component in the

economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditure

fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent

jewelry, gasoline, and medical expenses but do not include the purchase of new housing.
http://en.wikipedia.org/wiki/Household_final_consumption_expenditurehttp://en.wikipedia.org/wiki/Durable_goodshttp://en.wikipedia.org/wiki/Durable_goodshttp://en.wikipedia.org/wiki/Household_final_consumption_expenditure


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Investment spending: Firms as well as household do for investment spending. Investment spending on capita

equipment, inventories, and structures, including household purchases of new housing is included in this category.

(investment) include business investment in equipments for example and do not include exchanges of existing assets

Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a

factory. Spending by households (not government) on new houses is also included in Investment. In contrast to its

colloquial meaning, 'Investment' in GDP does not mean purchases of financial products. Buying financial products is

classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in a company, and the

company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the

company spends the money on those things; to also count it when one gives it to the company would be to count two

times an amount that only corresponds to one group of products. Buying bonds or stocks is a swapping of deeds, a

transfer of claims on future production, not directly an expenditure on products.

Government purchases: It is the spending on goods and services by local, state, and Central governments. G(government spending) is the sum ofgovernment expenditures on final goods and services. It includes salaries ofpublic

servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include

any transfer payments, such as social security or unemployment benefits.

Net exports spending: Spending on domestically produced goods by foreigners (exports) minus spending on foreign

goods by domestic residents (imports)
http://en.wikipedia.org/wiki/Mininghttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Savinghttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Deedhttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Final_goodshttp://en.wikipedia.org/wiki/Public_servantshttp://en.wikipedia.org/wiki/Public_servantshttp://en.wikipedia.org/wiki/Transfer_paymenthttp://en.wikipedia.org/wiki/Social_securityhttp://en.wikipedia.org/wiki/Unemployment_benefitshttp://en.wikipedia.org/wiki/Unemployment_benefitshttp://en.wikipedia.org/wiki/Social_securityhttp://en.wikipedia.org/wiki/Transfer_paymenthttp://en.wikipedia.org/wiki/Public_servantshttp://en.wikipedia.org/wiki/Public_servantshttp://en.wikipedia.org/wiki/Public_servantshttp://en.wikipedia.org/wiki/Final_goodshttp://en.wikipedia.org/wiki/Government_spendinghttp://en.wikipedia.org/wiki/Deedhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Savinghttp://en.wikipedia.org/wiki/Financial_markethttp://en.wikipedia.org/wiki/Mining


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Q) Difference between Real and Nominal GDP.

Q) Why do economists use real GDP rather than nominal GDP to gauge economic wellbeing?

ANS: We now know that GDP measures the total spending on goods and services in all markets in the economy. If tota

spending rises from one year to next, then two reasons are responsible.

a. The economy is producing a larger output of goods and services. Or

b. Goods and services are being sold at higher prices.

We can separate these two effects, when we want to understand the changes over time. In particular, we want a

measure of the total quantity of goods and services the economy that is produced is not affected by changes in the

prices of those goods and services. To do this economists use the Real GDP. Real GDP answers a hypothetical question

What would be the value of the goods and services produced this year if we valued these goods and services at the

prices that prevailed in some specific year in the past (current year and base year)? By evaluating current production

using prices that are fixed at past levels, real GDP shows how the economys overall production of goods and services

changes over time.

To sum up:Nominal GDP uses current prices to place a value on the economys production of goods and services. Rea

GDP uses constant base-year prices to place a value on the economys production of goods and services. Because rea

GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced. Thus

real GDP is a measure of the economys production of goods and services. Our goal in computing GDP is to gauge how

well the overall economy is performing. Because real GDP measures the economys production of goods and services, it

reflects the economys ability to satisfy peoples needs and desires. Thus, real GDP is a better gauge of economic wel

being than is nominal GDP. When economists talk about the economys GDP, they usually mean real GDP rather than

nominal GDP. And when they talk about growth in the economy, they measure that growth as the percentage change in

real GDP from one period to another.


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THE GDP DEFLATOR

As we have just seen, nominal GDP reflects both the prices of goods and services and the quantities of goods and

services the economy is producing. By contrast, by holding prices constant at base-year levels, real GDP reflects only the

quantities produced. From these two statistics, we can compute a third, called the GDP deflator, which reflects the

prices of goods and services but not the quantities produced.

The GDP deflator is calculated as follows:

GDP deflator =

Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals

100. The GDP deflator for subsequent years measures the rise in nominal GDP from the base year that cannot be

attributable to a rise in real GDP. The GDP deflator measures the current level of prices relative to the level of prices in

the base year. To see why this is true, consider a couple of simple examples. First, imagine that the quantities produced

in the economy rise over time but prices remain the same. In this case, both nominal and real GDP rise together, so the

GDP deflator is constant. Now suppose, instead, that prices rise over time but the quantities produced stay the same. Inthis second case, nominal GDP rises but real GDP remains the same, so the GDP deflator rises as well. Notice that, in

both cases, the GDP deflator reflects whats happening to prices, not quantities.

Documents

Economics for Managers Sem-I