Supplementary Material in Economics

8/14/2019 Supplementary Material in Economics

1/75

1

INTRODUCTORY MICROECONOMICSUNIT-IPRODUCTION POSSIBILITIES CURVEThe production possibilities (PP) curve is a graphical medium of highlighting the

central problem of

'what to produce'. To decide what to produce and in what quantities, it is first

necessary to know what

is obtainable. The PP curve shows the options that are obtainable, or simply the

production

possibilities.

What is obtainable is based on the following assumptions:

1. The resources available are fixed.

2. The technology remains unchanged.

3. The resources are fully employed.

4. The resources are efficiently employed.5. The resources are not equally efficient in production of all products. Thus if

resources are

transferred from production of one good to another, the cost increases. In other

words

marginal opportunity cost increases.

The last assumption needs explanation because it determines the shape of the

PP curve. If this

assumption changes, the shape changes.

Efficiency in production means productivity i.e. output per unit of an input. Let the

input be worker.Suppose an economy produces only two goods X and Y. Suppose a worker is

employed in

production of X because he is best suited for it. The economy decides to reduce

production of X

and increase that of Y. The worker is transferred to Y. He is not that efficient in

production of Y as

he was in X. His productivity in Y will be low, and so cost of production high.

The implication is clear. If the resources are transferred from one use to another,

the less and less

efficient resources will be transferred leading to rise in the marginal

opportunity cost which is

technically termed as marginal rate of transformation (MRT). What is

MRT?

Marginal Rate of Transformation (MRT)To simplify, let us assume that only two goods are produced in an economy. Let

these two goods be


2/75

guns and butter, the famous example given by Samuelson. The guns symbolize

defense goods and

butter, the civilian goods. The example, therefore, symbolizes the problem of

choice between civilian

goods and war goods. In fact it is a problem of choice before all the countries of

the world.Suppose if all the resources are engaged in the production of guns, there will be

a maximum amount

of guns that can be produced per year. Let it be 15 units (one unit may be taken

as equal to 1000, or

one lakh and so on). At the other extreme suppose all the resources are

employed in production of

butter only. Let the maximum amount of butter that can be produced is 5 units.

These are the two

extreme possibilities. In between there are others if the resources are partly used

for the productionof guns and partly for production of butter. Given the extremes and the in-

between possibilities, a

schedule can be prepared. It can be called a production possibilities schedule.

Let the schedule be:

2

Production Possibilities SchedulePossibilities Guns Butter MRT = Guns

(units) (units) Butter

A 15 0 -

B 14 1 1G : IB

C 12 2 2G : IB

D 9 3 3G : IB

E 5 4 4G : IB

F 0 5 5G : IB

In the table the possibility A is one extreme. The society devotes all the resources

to guns and

nothing to butter. Suppose the society wants one unit of butter. Since resources

are limited and fully

and efficiently employed, to produce one unit of butter some of the resources

engaged in production

of guns have to be transferred to the production of butter. Let the resources worthone unit of gun are

enough to produce one unit of butter. This gives us the second possibility with

MRT = 1G/IB. Now

suppose that the society wants another unit of butter. This requires transfer of

more resources from


3/75

the production of guns. Now we require transfer of resources worth 2 units of

guns to produce one

more unit of butter. The MRT rises to 2G/IB. MRT rises because now less

efficient resources are

being transferred. In this way MRT goes on rising.

We can now define MRT in general terms. MRT is the ratio of units of one goodsacrificed to produce

one more unit of the other good.

MRT = Units of one good sacrificed____ = Guns

More units of the other good produced Butter

Or, MRT is the rate at which the quantity of output of one good is sacrificed to

produce on more unit

of the other good.

Production Possibility CurveBy converting the schedule into a diagram, we can get the PP

curve. Refer to the figure I which is based on the PP schedule.Butter's production is shown on the x-axis and that of guns on the

y-axis.

We can measure MRT on the PP curve. For example MRT

between the possibilities C and D is equal to CG/GD. Between D

and E it is equal to DH/HE, and so on.3Diagrammatically, the slope of the PP curve is a measure of the MRT. Since the

slope of a concave

curve increases as we move downwards along the curve, the MRT rises as we

move downwards

along the curve.

CharacteristicsA typical PP curve has two characteristics:

(1) Downward sloping from left to rightIt implies that in order to produce more units of one good, some units of the other

good must

be sacrificed (because of limited resources).(2) Concave to the originA concave downward sloping curve has an increasing slope. The slope is the

same as MRT.

So, concavity implies increasing MRT, an assumption on which the PP curve isbased.

Can PP curve be a straight line.Yes, if we assume that MRT is constant, i.e. slope is constant.

When the slope is constant the curve must be a straight line. But

when is MRT constant? It is constant if we assume that all the

resources are equally efficient in production of all goods.


4/75

Note that a typical PP curve is taken to be a concave curve

because it is based on a more realistic assumption that all

resources are not equally efficient in production of all goods.

Does production take place only on the PP curve?Yes and no, both. Yes, if the given resources are fully and

efficiently utilized. No, if the resources are underutilized orinefficiently utilized or both. Refer to the figure 3.

On point F, and for that matter on any point on the PP curve

AB, the resources are fully and efficiently employed. On point

U, below the PP curve or any other point but below the PP

curve, the resources are either underutilized or inefficiently

utilised or both. Any point below the PP curve thus highlights

the problem of unemployment and inefficiency in the economy.4

Can the PP curve shift?

Yes, if resources increase. More labor, more capital goods,better technology, all mean more production of both the goods.

A PP curve is based on the assumption that resources remain

unchanged. If resources increase, the assumption is broken, and

the existing PP curve is no longer valid. With increased resources

there is a new PP curve to the right of the existing PP curve.

It can also shift, to the left if the resources decrease. It is a rare

possibility but sometimes it may happen due to fall in population,

due to destruction of capital stock caused by large scale natural

calamities, war, etc.

5

UNIT-IICONSUMER'S EQUILIBRIUM_IntroductionA consumer is one who buys goods and services for satisfaction of wants.

The objective of a consumer is to get maximum satisfaction from spending his

income on various

goods and services, given prices.

We start with a simple example. Suppose a consumer wants to buy a commodity.

How much of it

should he buy? One of the approaches used for getting an answer to this

question is 'utility' analysis.Before using this approach, we would like to familiarize ourselves with some

basic concepts used in

this approach,_ConceptsThe term utility refers to the want satisfying power of a commodity. Commodity

will possess utility


5/75

only if it satisfies a want. Utility differs from person to person, place to place, and

time to time.

Marginal Utility is the utility derived from the last unit of a commodity purchased.

It can also be

defined as the addition to the total utility when one more unit of the commodity is

consumed.Total Utility is the sum of the utilities of all the units consumed.

As we consume more units of a commodity, each successive unit consumed

gives lesser and lesser

satisfaction, that is marginal utility diminishes. It is termed as the Law of

Diminishing Marginal Utility.

The following utility schedule will make the Law clear.

Units of a commodity Total (utils) Utility Marginal (utils) Utility

1 4 4 (=4-0)

2 7 3 (=7-4)

3 9 2 (=9-7)4 10 1 (=10-9)

5 10 0 (=10-10)

6 9 -1 (=9-10)

Here we observe that as more units are consumed marginal utility declines. This

is termed as the

law of diminishing marginal utility. The law states that with each

successive unit consumed the

utility from it diminishes.

AssumptionsThe utility approach to consumer's equilibrium is based on certain assumptions.61. Utility can be cardinally measurable, i.e. can be expressed in exact units.

2. Utility is measurable in monetary terms

3. Consumers income is given

4. Prices of commodities are given and remain constant.

Equilibrium(a) One commodity caseSuppose the consumer wants to buy a good. Further suppose that price of goods

is Rs. 3 per unit.

Lel the utility be expressed in utils which are measured in rupees. We are given

the marginal utilityschedule of the consumer.

Quantity Price Marginal Utility

1 3 8

2 3 7

3 3 5

4 3 3


6/75

5 3 2

When he purchases the first unit, the utility that he gets is 8 utils. He has to pay

only

Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because he gets more than

what he gives.

Similarly, we compare the utility received from other units with the price paid. Wefind that he will buy

4 units. At the 4th unit, MU equals price. If he buys the 5th unit, he is a looser

because the utility that

he gets is 2 utils and what he has to pay is Rs. 3. Therefore, the consumer will

maximize his satisfaction

by buying 4 units of this commodity. The condition for maximization of satisfaction

if only one

commodity is purchased then is:

MU = Price.

(b) Two commodities caseSuppose a consumer consumes only two goods. Let these goods be X and Y.

Given income

and prices (Px and Py), the consumer will get maximum satisfaction by spending

his income in such

a way that he gets the same utility from the last rupee spent on each good. This

is satisfied when

MUx = MUy = M.U. of a rupee spent on a good.

Px Py

We can show that in order to maximise satisfaction this condition must be

satisfied. If it is not satisfied

what difference will it make. Suppose the two ratios are:

MUx > MUy

Px Py7It means that per rupee MUx is higher than per rupee MUy. It further means that

by transferring one

rupee from Y to X, the consumer gains more utility than he looses. This prompts

the consumer to

transfer some expenditure from Y to X. Buying more of X reduces MUx, Px

remaining unchanged,

MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Pyremaining unchanged

it raises, per rupee MUy. The change continues till per rupee MUx becomes

equal to per rupee MUy.

In other words :

MUx = MUy = per rupee MU

Px Py


7/75

CONCEPTS OF DEMAND AND DEMAND SCHEDULEDemand for a good is the quantity of that good which a buyer is willing to buy

at a particular price,

during a period of time.

Demand schedule is a tabular presentation showing the different quantities

of a good that buyersof that good are willing to buy at different prices during a given period of time.Demand schedule of a commodityPrice (Rs. per unit) Quantity demanded (in units)

50 50

40 100

30 150

20 200

10 250

This schedule indicates that more is purchased as price falls. This inverse

relationship betweenprice and quantity demanded, other thing remaining the same is called the lawof demand.RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND ANDTOTAL EXPENDITUREAt this stage of learning it is sufficient to know the following about this

relationship:

1. When demand is elastic, a fall (rise) in the price of a commodity results in

increase (decrease)

in total expenditure on it. Or, when a fall (rise) in the price of a commodity results

in increase

(decrease) in total expenditure on it, its demand is elastic.2. When elasticity is unitary, a fall (rise) in the price of the commodity does not

result in any

change in total expenditure on it, or when a fall (rise) in price results in no

change in total

expenditure then its elasticity is unitary.

3. When demand is inelastic, a fall (rise) in the price of a commodity results in a

fall (rise) in total

expenditure on it, or when a fall (rise) in the price of a commodity results in

decrease (increase)

in total expenditure on it, its demand is inelastic.8

Unit IIIPRODUCERS BEHAVIOUR AND SUPPLYMeaning of supplySupply means the quantity of a commodity which a firm or an industry is willing to

produce at


8/75

a particular price, during a given time period.

Law of supplyThis law states that 'other things remaining the same', an increase in the price of

a commodity

leads to an increase in its quantity supplied. Thus, more of a commodity is

supplied at higher pricesthan at lower prices.

This law can be explained with the help of a supply schedule and curve.

A supply schedule is a table which shows the quantities of a commodity supplied

at various

prices during a given time period.Supply Schedule Supply CurvePrice (Rs.) Supply (Units)

1 100

2 200

3 300As the price increases from Re. 1 to Rs. 3, the supply also rises from 100 units to

300

units, in response to the rising price. What is the basis of the law of supply?

Other things remaining

the same, an increase in price results in higher profits for the producer. The

higher the price of the

commodity, the greater are the profits earned by the firms and the greater is the

incentive to

produce more. Similarly when the price falls, profits decline, resulting in a

decrease in quantity

supplied of the commodity. Thus the price and quantity supplied of a commodity

are directly

related, other things remaining the same.

Change in supply versus change in quantity supplied(shift of supply curve versus movement along a supply curve)

The supply of a commodity depends on its own price and 'other factors' like input

prices,

technique of production, prices of other goods, goals of the firm, taxes on the

commodity etc.

Movement along a supply curve

The law of supply states the effect of a change in the own price of a commodityon its supply,

other things remaining constant. The supply curve also carries the same

assumption. Thus when

other factors influencing supply do not change, and only the own price of the

commodity changes, the9


9/75

change in supply takes place along the curve only. This is what movement along

a supply curve

means. A movement from one point to another on the same supply curve is

also referred to as

a change in quantity supplied.In figure 7, OQ is the quantity supplied at price OP. When the price risesto OP1 the quantity supplied increases to OQ1. Thus there is an upward

movement along the supply curve from point A to B. It is extension of

supply.

Similarly, when the price of a commodity falls from OP to OP2, there is a

decrease in quantity supplied from OQ to OQ2 and thus a downward

movement along the supply curve from A to C. It is contraction of supply.

Movements along the supply curve are caused by a change in the own

price of the good only, other things remaining the same.

Shifts of the supply curve

When supply changes due to changes in factors other than the own price of thecommodity, it

results in a shift of the supply curve. This is also referred to as a change insupply.An increase in supply means more of the commodity is supplied at the same

price. As a

result the supply curve shifts to the right.

In figure 8, at price OP the previous supply was OQ which

increased to OQ1. This also means that OQ units can now be supplied

at a lower price OP1 with the new supply curve S1S1.

An increase in supply can take place due to many reasons. Forexample, if the input prices fall or there is an improvement in technology,

it will enable producers to produce and sell more at the same price

resulting in a rightward shift of the supply curve.

A decrease in supply means less of the commodity is supplied at

the same price, than previously. As a result, the supply curve shifts

inwards to the left.

In figure 9, at price OP, previously OQ units were supplied which

decreased to OQ1. This also means that OQ units can now be supplied

at a higher price OP1 with the new supply curve S1S1.10Shifts of the supply curve of a good are caused by a change inany one or more of the'other factors' affecting supply, own price remainingunchanged. For example, if the inputprices fall or there is a decrease in the prices of other relatedcommodities, the producers


10/75

supply more at the same price resulting in a rightward shift ofthe supply curve.

PRODUCER'S EQUILIBRIUMThe primary objective of a producer is to earn maximum profits. Profit is the

difference between

total revenue and total cost. At that level of output, he is in equilibrium at whichhe is earning maximum

profit, and he has no incentive to increase or decrease his output. If he produces

less than this he

does not maximize total profits. Similarly, if produces beyond this, total profits

decline. Thus the

producer is in a 'state of rest' only at the level of output at which the difference

between the total

revenue and total cost of production is maximum i.e total profits are maximum.

(NOTE : How does a producer reach equilibrium under different market

conditions is not discussedat this stage of learning).

RELATIONSHIP BETWEEN MARGINAL COST (MC) ANDAVERAGE COST (AC)The relationship between marginal cost and average cost is an arithmetic

relationship. To understand

this relationship let us take a numerical example.

The table A shows the marginal costs, total costs and average costs at different

levels of output.

Table AOutput Total cost Marginal cost Average cost

(Units) (Rs.) (Rs.) (Rs.)

(1) (2) (3) (4)

1 60 60 60

2 110 50 55

3 162 52 54

4 216 54 54

5 275 59 55

Column 1 shows the level of output.

Column 2 shows the total cost of producing different levels of output.

Column 3 shows the increase in total cost resulting from the production of one

more unit of output.(It is called marginal cost. Thus MCn = TCn - TCn-1, where n and n-1 are levels of

output).

Column 4 shows the average cost at different levels of output (ACn = TCn )

n

11This table shows that :


11/75

1. Average cost falls only when marginal cost is less than average cost. Upto the

third unit of

output, the marginal cost is less than the average cost and average cost is falling.

When 2

units are produced the marginal cost is Rs. 50 which is less than the previous

average cost(Rs.60), now average cost falls from Rs. 60 to Rs. 55. When 3 units are

produced, the marginal

cost is Rs. 52 which is less than the average cost of 2 units (Rs. 55) so once

again the

average cost falls from Rs. 55 to Rs. 54.

2. Average cost will be constant when marginal cost is equal to average cost.

When 4 units are

produced, average cost does not change (It is Rs. 54 when 3 units are produced

and remains

Rs. 54 when 4 units are produced) because marginal cost (Rs. 54) is equal toaverage cost

(Rs. 54).

3. Average cost will rise when marginal cost is greater than average cost. When 5

units are

produced average cost rises from Rs. 54 to Rs. 55, because the marginal cost

(Rs. 59) is

greater than the average cost (Rs. 54).

This relationship between marginal cost and average cost is a generalized

relationship and holds

good in case of the marginal and average values of any variable, be it revenue or

product etc.

In the box a simple proof of the relationship is given : This is for reference only

For Reference only

Suppose AC falls. Then :

TCn < TCn-1

n n-1

Multiplying both sides by n we get,

TCn < TCn-1 x n

n-1

TCn < TCn-1 x (1 + 1 )

n-1TCn < TCn-1 + TCn-1

n-1

TCn - TCn-1 < TCn-1

n-1

Since the left hand side is MC, and the right hand side is AC, it proves that

MC < AC


12/75

Thus a fall in average cost means marginal cost is less than average cost. It can

similarly be proved

that a rise in average cost means, marginal cost is greater than average cost and

a constant average

cost means marginal cost is equal to average cost.

The relationship between marginal cost and average variable cost is similar to therelationship between

marginal cost and average cost because marginal cost is not affected by fixed

cost.

(For proof see box which is for reference only)12MCn = TCn - TCn-1

= [TFCn + TVCn] - [TFCn-1 + TVCn-1]

Since TFCn and TFCn are equal

MCn = TVCn - TVCn-1

LAW OF VARIABLE PROPORTION IN TERMS OF TP AND MPCURVES.(i) In terms of TPAs more and more units of variable factor are employed with fixed factor, total

product initially

increases at an increasing rate then increases at decreasing rate and ultimately

starts decreasing.13On the TP curve in the diagram, upto point A, TP is increasing at an increasing

rate. If more than 3

units of variable factor are employed, total product still increases till 7units are

employed but this

increase is at a diminishing rate. If beyond 7 units of variable factor are employed

then TP starts

falling. These are the three respective phases of the law.

(ii) In terms of MPMP increases upto 3 units. This is phase 1. MP falls after 3 units but is positive

upto 7 units.

This is phase 2. MP continues to fall but is negative after 7 units. This is phase 3.

Therefore, in

phase 1 the MP curve is upward sloping; downward sloping but above the X-axis

in phase 2; anddownward sloping but below the X-axis in phase 3.

(Note that TP is convex in phase 1; concave in phase 2; and downward sloping in

phase 3. This is

how we can identify the three phases.)

Returns to ScaleIntroduction


13/75

This topic is a part of study of production function. A production function is an

expression of

quantitative relation between change in inputs and the resulting change in output.

It is expressed as

:

Q = f (i1, i2 ......in)Where Q is output of a specified good and i1, i2 .in are the inputs usable in

producing this good. To

simplify let us assume that there are only two inputs, labour (L) and capital (K),

required to produce

a good. The production function then takes the form :

Q = f (K,L)

In microeconomics, conventionally, we study two aspects of relation between

inputs and output. One

aspect is : in what manner the change takes place in output of a good, if only one

of the inputsrequired in producing that good is increased, i.e. other inputs kept unchanged?

The manner of

change in output is summed up in the law of variable proportions which you have

already studied.

The second aspect is : in what manner the output of a good changes, if all the

inputs required in

producing that good are increased simultaneously and in the same proportion.

This aspect is

technically termed as returns to scale, and is the subject matter of this study. The

word 'return' refers

to the change in physical output. The word 'scale' refers to the scale of operation

expressed in terms

of quantum of inputs employed.

MeaningReturns to scale means the manner of change in physical output caused by the

increase in all

the inputs required simultaneously and in the same proportion. Elaborating,

suppose one unit of

capital and one unit of labour (1K + 1L), produce 100 units of output. Further

suppose that both the

14inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by

just 100%; by more

than 100%, or by less than 100%. There is no unique answer. All the three states

are possible. The

three states are respectively called Constant Returns to Scale (CRS), Increasing

Returns to Scale


14/75

(IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three

states and then explain

reasons.

Constant Returns to Scale (CRS)Suppose 1K+1L produce 100 units of output, and 2K+2L produce 200 units of

output. It is100 percent increase in inputs leading to just 100 percent increase in output. This

manner of change

in output is called CRS.

Increasing Returns to Scale (IRS)Suppose 1K+1L produce 100 units of output and 2K+2L produce 250 units of

output. It is 100

percent increase in inputs in leading to 125 percent increase in output. This

manner of change in

output is called IRS.

Decreasing Returns to Scale (DRS)Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of

output. It is

100 percent increase in inputs leading to only 80% increase in output. This

manner of change in

output is called DRS.

Which of the above states actually results depends to a great extent on the type

of technology

used. There are technologies which result in IRS from the beginning and

continue upto a large output

level. Similarly, there are technologies leading to CRS almost throughout. There

can also be

technologies leading to DRS from the very beginning.

Besides, it is also possible that a technology is such that it gives IRS in the

beginning, followed

by CRS and then DRS. For example:

Returns to ScaleInputs %change Output %change Returns to scale

1K+1L - 100 - -

2K+2L 100% 250 125% IRS

3K+3L 50% 375 50% CRS

4K+4L 33.3% 450 20% DRSWhy do IRS arise?There are two possible reasons:15

1. More division of labourDivision of labour means subdividing a task into many small sequential

operations, with each


15/75

worker (or a group of workers) assigned each operation. A single worker, instead

of doing all the

operations, concentrates on only one operation and specializes. This raises

efficiency of the worker.

Returns to scale means increasing the number of workers along with other

inputs. Moreworkers mean more division of labour. If one task can be divided into 20 small

operations, with each

worker assigned only one operation, the worker becomes an expert in the

operation he is assigned.

Efficiency increases and so the production. In business circles, the division of

labour type production

is called assembly line production.

2. Use of specialized machinesMore capital means more capital goods and bigger capital goods. Fully automatic

machinescan replace the semi-automatic or the hand operated machines. Bigger machines

can be used in

place of small machines. Bigger capital goods can be used in place of smaller

capital goods. It is

a common knowledge that a double size capital input may produce more than

double the output.

Let us take an interesting example.

Suppose a firm needs a wooden box to store goods. Suppose initially the firm

goes in for

1'x1'x1' (LxBxH) size box. Let us see the input requirement and the resulting

output. Let the wood

be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of wood

(=1'x1'). Then

the input requirement = 1'x1'x6 = 6 sq.ft.

The storing capacity of the box is measured by its volume. Then :

Output of the box : 1'x1'x1' = 1 cubic ft.

Let us now see what happens when the size of the box is increased to 2'x2'x2'.

Input requirement = 2'x2'x6 = 24 sq.ft.

Output = 2'x2'x2' = 8 c.ft.

Now compare. Input of the box rises from 6 sq.ft. to 24 sq.ft. i.e. by 300%. Output

of the boxrises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns to scale arise.

Remember that it may not go on for ever, i.e. we go on increasing the size and

continue to get

IRS. A stage may reach when IRS may give way to CRS or DRS.

Why do DRS arise?


16/75

Economists do not find any specific reason. DRS is a puzzle. Why output rises in

a smaller

proportion when all inputs are increased? The probable explanation is that the

firm finds it difficult

to manage and coordinate the activities arising out of larger scale. The difficulties

may lead to wastage,inefficiency etc. and cause DRS.16

EQUILIBRIUM PRICE UNDER PERFECT COMPETITIONMeaning of equilibriumEquilibrium, in general terms. implies (a) a balance between the opposite forces

and (b) a

state of rest or a situation that has a tendency to persist. Let us take examples to

show the application

of these meanings in microeconomics.

Let us take a market situation in which buyers and sellers are negotiating to buyand sell a

good. Both have different prices to offer. But the good will be sold only when both

agree to a common

price and a common quantity at that price. If both agree, a market equilibrium is

said to emerge.

Note that buyers and sellers have opposite interests. The buyers will like to pay

as low a price as

possible. The sellers will like to charge as high a price as possible. Agreement on

a common price

and quantity creates a balance between the two opposite interests. This

equilibrium price and quantity

has a tendency to persist.

Equilibrium priceEquilibrium price is the price at which the sellers of a good are willing to sell the

same quantity

which buyers of that good are willing to buy. We can explain this meaning with

the help of market

demand and supply schedule of a good, given below :

Price per unit Market demand Market supply Equilibrium

(Rs.) (units) (units)

1 1000 200 Excess demand2 800 400 Excess demand3 600 600 Market Equilibrium4 400 800 Excess supply

5 200 1000 Excess supply

Refer to the schedule. The market equilibrium is established at a price of Rs. 3

per unit,


17/75

because at this price both the market demand and market supply are equal. This

is the price

which has a tendency to persist.

Why is not any other price an equilibrium price?Take, for example, a price less than the equilibrium price. Suppose it is Rs. 2 per

unit. Atthis price market demand is greater than market supply. It is called an excess

demand situation. But

this price cannot persist. It will change. Why?

It is because the buyers will not be able to buy all what they want to buy. The

pressure of

excess demand will push the market price up. This will have two effects. Supply

will go up because

the producers are willing to supply more at a higher price. Demand will go down

because the buyers

are willing to buy less at a higher price. In fact, this is what is required to restoreequilibrium. The

tendency of supply going up and demand going down will continue till market

supply becomes equal17to market supply once again and the excess demand becomes zero. This is

achieved at Rs. 3 per

unit. The equilibrium is restored.

Let us now take a price higher than the equilibrium price. Suppose it is Rs. 4 per

unit. At this

price now the market supply is greater than market demand. It is called an excess

supply situation.

Even this price cannot persist. It is because the sellers will not be able to sell all

what they want to sell.

The excess supply pressure will push the price downwards. This will have two

effects. Supply will go

down and demand will go up. The tendency will continue till market demand

becomes equal to

market supply once again, and the price settles at Rs. 3 per unit.

To sum up, the equilibrium price is the price at which market demand equals

market supply.

This price has a tendency to persist. If at a price the market demand is not equalto market supply

there will be either excess demand or excess supply and the price will have

tendency to change until

it settles once again at a point where market demand equals market supply.

Graphic PresentationThe equilibrium is at E the intersection of supply and


18/75

demand curves representing the two schedules given above.

The equilibrium price is Rs. 3 and equilibrium quantity 600 units.

The price higher than Rs. 3, creates excess supply and ultimately

returns to Rs. 3 on account of the effects explained above. The

arrows indicate the tendencies. The price below the equilibrium

price creates excess demand and has a tendency to return toRs. 3 per unit on account of the effects explained above and

indicated by the arrows.

Can the equilibrium price change?Yes, when demand or supply or both increase or decrease. 'Increase', as you

know, means

rise in demand or supply due to factors other than the own price of the good.

Similarly the term

'decrease' is defined. Graphically, it means shift of demand curve, or supply

curve or both. You are

familiar with these terms. You are expected to study the chain effects of shifts indemand and supply

on equilibrium price and quantity.

18UNIT IV

FEATURES OF PERFECT COMPETITIONIntroductionPerfect competition is a state of a market. Anything which facilitates contact

between buyers

and sellers constitutes a market. It may be a face to face meeting at some place

or simply verbal

negotiations through telephone, internet, etc.

Conventionally, in microeconmoics the markets are classified into these states:

perfect

competiton, monopoly, monopolistic competition and oligopoly. There are many

criteria of

classification, the number of sellers, similarity of products, availability of

information, mobility of firms

and the inputs engaged in the firm, etc. Whatever the criteria the end result is

reflected in one thing :

how much influence an individual seller, on his own, is able to exercise on the

market. Lower theinfluence more the competitive nature of the market it indicates. If the influence of

an individual seller

is zero, or virtually zero, the market is said to be perfectly competitive.

MeaningPerfect competition can be defined either in terms of its characteristic features, or

in terms of


19/75

the unique end result of these characteristics. Unique in the sense that it is

specific to a perfectly

competitive market. In terms of its features, a perfectly competitive is a market

where there are

large number of buyers and sellers, the firms produce homogeneous products,

the buyers and sellershave perfect knowledge and the firm are free to entry or make an exit in and out

of industry. In terms

of the end result of these features which is unique to this market, a perfectly

competitive market is

one in which an individual firm cannot influence the prevailing market price of the

product on its own.

Features and their implicationsA perfectly competitive market has the following features:

1. Large number of sellers and buyers

Note that 'large number' is not a specifically defined number. However, it has aspecific

implication. Let us talk about the large number of sellers first. The words 'large

number' imply that

the number of sellers is large enough to render a single seller's share in total

market supply of the

product insignificant. It has a further implication. Insignificant share means that if

only one individual

firm reduces or raises its own supply, the prevailing market price remains

unaffected. The prevailing

market price is the one which was set through the interaction of market demand

and market

supply forces, for which all the sellers and all the buyers together are responsible.

One single

seller has no option but to sell what it produces at this market determined price.

This position of

an individual firm in the total market is referred to as price taker. This is a

unique feature of a

perfectly competitive market.

Similarly, the 'large number' of buyers also has the same implication. A single

buyer's

share in total market demand is so insignificant that the buyer cannot influencethe market price

on his own by changing his demand. This makes a single buyer also a price

taker.

19To sum up, the feature 'large number' indicates ineffectiveness of a single seller

or a


20/75

single buyer in influencing the prevailing market price on its own, rendering him

simply a price

taker.

2. The products of all the firms in the industry arehomogenous

It means that the buyers treat the products of all the firms in the industry ashomogenous. The

products produced by the firms are identical, or treated as identical, or perfectly

standardized. The

buyers do not distinguish the output of one firm from that of the other.

The implication of this feature is that since the buyers treat the products as

identical they are

not ready to pay a different price for the product of any one firm. They will pay the

same price for the

products of all the firms in the industry. On the other hand, any attempt by a firm

to sell its product ata higher price will fail.

To sum up, the 'homogenous products' feature ensures a uniform price for the

products of all

the firms in the industry.

3. Perfect knowledge about markets for outputs andinputs.The firms have all the knowledge about the product market and the input

markets. Buyers

also have perfect knowledge about the product market.

Let us take the product market first. The implication of perfect knowledge aboutthe product

market is that any attempt by any firm to charge a price higher than the prevailing

uniform price will

fail. The buyers will not pay because they have perfect knowledge. There is no

ignorance factor

operating in the market. The sellers do not charge a lower price due to ignorance.

The buyers do not

pay a higher price due to ignorance. A uniform price prevails in the market.

As regards the knowledge about the input markets, the implicit assumption is that

each firm

has an equal access to the technology and the inputs used in the technology. Nofirm has any cost

advantage. Cost structure of each firm is the same. All the firms have a uniform

cost structure.

Since there is uniform price and uniform cost in case of all firms, and since profits

equals cost

less price, all the firms earn uniform profits.


21/75

4. Freedom to firms to enter or to leave the industry inthe long runFreedom of entry means that there are no artificial barriers and natural barriers in

the way of

a new firm wishing to enter into industry. The artificial barriers may take the form

of patent rights,legal restrictions, etc. The natural barrier may take the form of huge capital

expenditure required to

start a new firm, which the firm wishing to enter is not able to arrange.

Freedom of exit means no barriers in the way of a firm deciding to leave the

industry.

Government rules, labour laws, loss of huge fixed capital etc. do not come in the

way.

The freedom of entry and exit of firms has an important implication. This ensures

that no

firm can earn above normal profits in the long run. Each firm earns just thenormal profits, i.e.

minimum necessary to carry on business. In Microeconomics, normal profits is

treated as an20opportunity cost, and therefore, counted in calculation of total cost. Since profit

equals total revenue

minus total cost, normal profit means zero economic profit. Why? Let us explain.

Suppose the existing firms are earning above normal profits, i.e. positive

economic profits.

Attracted by the positive profits, the new firms enter the industry. The industry's

output, i.e. market

supply, goes up. The price comes down. New firms continue to enter and the

price continues to

fall till economic profits are reduced to zero.

Now suppose the existing firms are incurring losses. The firms start leaving. The

industry's

output starts falling, price starts going up, and all this continues till losses are

wiped out. The remaining

firms in the industry then once again earn just the normal profits.

Only zero economic profit in the long run is the basic outcome of a perfectly

competitivemarket.

Average Revenue and marginal revenue curves of aperfectly competitive firmThe forces of market supply (i.e. supply by industry) and market demand

(demand by all the


22/75

buyers) determine the market price. The firm, being a price taker, adopts this

price and is free to sell

any quantity it likes at this price. The price taker feature determines the shape of

the firms AR and

MR curves. Refer to the figure -12 b

The figure 12a shows the intersection of demand and supply curves at Edetermining the

price OP. The figure 12b shows the adoption of price by the price taker firms who

are free to sell any

quantity, at this price. This makes the AR curve perfectly elastic and thus parallel

to the

X-axis. As per the average marginal relationship, when AR is constant, MR must

be equal to AR.

Therefore, AR curve is also the MR curve of the firm.

1

PART B : INTRODUCTORY MACROECONOMICSUNIT 6 - NATIONAL INCOME AND RELATED AGGREGATESSOME CONCEPTSCONCEPT OF ECONOMIC TERRITORY

INTRODUCTIONNational income accounting is a branch of macroeconomics of which estimation

of national

income and related aggregates is a part. National income, or for that matter any

aggregate

related to it, is a measure of the value of production activity of a country. But,

production activity

where and by whom? Is it on the territory of the country? Or, is it by those who

live in the

territory? In fact it is both. This raises further question. What is the scope of

territory? Is it simplypolitical frontiers? Or, is it something else? Who are those who live in the

territory? Is it simply

citizens? Or, it is something else. The answer to these questions leads us to the

concepts of (i)

economic territory and (ii) resident. The two have an important bearing on the

estimation of

national income aggregates. How? We will explain it a little later.


23/75

DefinitionThe first thing to note is that economic territory of a country is not simply political

frontiers

of that country. The two may have common elements, but still they are

conceptually different. Let

us first see how it is defined. According to the United Nations :Economic territory is the geographical territory administered by a

government within which persons, goods and capital circulate freely.

The above definition is based on the criterion freedom of circulation of persons,

goods and

capital. Clearly, those parts of the political frontiers of a country where the

government of that,

country does not enjoy the above freedom are not to be included in economic

territory of that

country. One example is embassies. Government of India does not enjoy the

above freedom inthe foreign embassies located within India. So, these are not treated as a part of

economic

territory of India. They are treated as part of the economic territories of their

respective countries.

For example the U.S. embassy in India is a part of economic territory of the

U.S.A. Similarly, the

Indian embassy in Washington is a part of economic territory of India.

ScopeBased on freedom criterion, the scope of economic territory is defined to cover:

(i) Political frontiers including territorial waters and air space.

(ii) Embassies, consulates, military bases, etc located abroad,but excluding those

located

within the political frontiers.

(iii) Ships, aircrafts etc, operated by the residents between two or more countries2

(iv) Fishing vessels, oil and natural gas rigs, etc operated by the residents in the

international

waters or other areas over which the country enjoys the exclusive rights or

jurisdiction.Implication

National income and related aggregates are basically measures of productionactivity.

There are two categories of national income aggregates : domestic and national,

or domestic

product and national product. Production activity of the production units located

within the economic


24/75

territory is domestic product. Gross domestic product, net domestic product are

some examples.

We will learn more about the implications after studying the concept of resident.CONCEPT OF RESIDENTIntroduction

Note that citizen and resident are two different terms. This does not mean that acitizen is

not a resident, and a resident not a citizen. A person can be a citizen as well as a

resident, but it is

not necessary that a citizen of a country is necessarily the resident of that

country. A person can be

a citizen of one country and at the same time a resident of another country. For

example a NRI,

Non-resident Indian. A NRI is citizen of India but a resident of the country in

which he lives.

Citizenship is basically a legal concept based on the place of birth of the personor some

legal provisions allowing a person to become a citizen. On the other hand

residentship is basically

an economic concept based on the basic economic activities performed by a

person.

DefinitionA resident is defined as follows:

A resident, whether a person or an institution, is one whose

centre of economic interest lies in the economic territory of the country

in which he lives.

The centre of economic interest implies two things: (i) the resident lives or islocated

within the economic territory and (ii) the resident carries out the basic economic

activities of

earnings, spending and accumulation from that location

ImplicationsProduction activity of the residents of an economic territory is national product.

GNP, NNP,

are some examples. National product includes production activities of residents

irrespective of

whether performed within the economic territory or outside it.In comparison, domestic product inludes production activity of the production

units located

in the economic territory irrespective of whether carried out by the residents or

non-residents.3

Relation between national product and domestic product


25/75

The concept of domestic product is based on the production units located within

economic

territory,operated both by residents and non-residents. The concept of national

product is based

on residents, and includes their contribution to production both within and outside

the economicterritory.Normally, in practical estimates, domestic product is estimated first.

National product is

then derived from the domestic product by making certain adjustments.Let us see

how?

National product is derived in the following way:

National product = Domestic product

+ residents contribution to production outside the economic

territory

- non-residents contribution to production inside the economic

territoryIn practical estimates the residents contribution outside the economic territory is

called

factor income received from abroad. The non-residents contribution inside the

economic territory

is called factor income paid to residents. Therefore,


+ Factor income received from abroad

- Factor income paid to abroad.

Factor income received from abroad is added to domestic product because this

contribution

of residents is in addition to their contribution to domestic product. Factor income

paid to abroad

is subtracted because this part of domestic product, does not belong to the

residents. By subtracting

factor income paid from factor income received from abroad, we get a net

figure Net factor

income from abroad popularly abbreviated as NFIA.


+ Net factor income from abroad

= Domestic product + NFIA

INDUSTRIAL CLASSIFICATIONIntroductionIt means grouping production units into distinct industrial groups, or sectors. This

is the

first step required to be taken in estimating national income, irrespective of the

method of


26/75

estimation. It is statistically more convenient to estimate national income

originating in a group of

similar production units rather than for each production unit separately.4

It is now a matter of general practice to group all the production units of the

economicterritory into three broad groups : primary sector,secondary sector and tertiary

sectors. Each of

these sector can be further subdivided into smaller groups depending upon the

requirement. Let

us now explain each sector.Primary SectorPrimary sector includes production units exploiting natural resources like land,

water, subsoil

assets,etc. Growing crops, catching fish, extracting minerals, animal husbandry,

forestry, etc.are some examples. Primary means of first importance. It is primary because it is

a source of

basic raw materials for the secondary sector.

Secondary SectorSecondary sector includes production units which are engaged in transforming

one good

into another good. Such an activity is called manufacturing activity. These units

convert raw

materials into finished goods. Factories, construction, power generation, water

supply are the

examples. It is called secondary because it is dependent upon the primary sectorfor raw materials.

Tertiary SectorTertiary sector includes production units engaged in producing services.

Transport, trade

education, hotels and restaurant, finance, government administration, etc are

some examples.This

sector finds third place because its growth is primarly dependent onthe primary

and secondary

sectors.

NATIONAL INCOME AGGREGATESThere are many aggregates in national income accounting. The basic among

these is

Gross Domestic Product at Market Price (GDPmp). By making adjustments in

GDPmp, we can

derive other aggregates like Net Doemstic product at Market Price (NDPmp) and

NDP at factor


27/75

cost (NDPfc).

Net Domestic ProductWhy is GDPmp called gross? GDPmp is final products valued at market price. This

is what

buyers pay. But this is not what production units actually receive. Out of what

buyers pay theproduction units have to make provision for depreciation and payment of indirect

tax like excise,

sales tax, etc. This explains why GDPmp is called gross. It is called gross

because no provision

has been made for depreciation. However, if depreciation is deducted from the

GDP, it becomes

Net Domestic Product (NDP). Therefore,

GDPmp - depreciation = NDPmpDomestic product at Factor Cost

Why is GDPmp called at market price ?Out of what buyers pay, the production units have to make payments of indirect

taxes,if5

any. Sometimes production units receive subsidy on production. This is in

addition to the market

price which production units receive from the buyers. Therefore what production

units actually

receive is not the market-price but market price - indirect tax + subsidies This

is what is actually

available to production units for distribution of income among the owners of

factors of production.Therefore,

Market price - indirect tax (I.T.) + subsidies = Factor payments (or factor costs)

By making adjustment of indirect tax and subsidies we derive GDP at factor cost

(GDPfc)

from GDPmp..

GDPmp - I.T. + subsidies = GDPfc

or GDP - net I.T. = GDPfcNet Domestic Product at Factor CostIf we make adjustment of both the net I.T and depreciation (also called

consumption offixed capital) we get one more aggregate called Net Domestic Product at Factor

Cost (NDPfc)

GDPmp - I.T. + Sub-depreciation = NDPfc.

or NDPfc+ I.T. - Sub+depreciation = GDPmpNet National Product at Factor Cost (NNPfc) or National IncomeNet factor income from abroad (NFIA) provides the link between NDP and NNP.

Therefore,


28/75

NDPfc + NFIA = NNPfc

or NNPfc - NFIA = NDPfc

Similarly,

NDPmp + NFIA = NNPmp

GDPmp + NFIA = GNPmp

Summing upThe three crucial adjustments required for deriving one aggregate from the other

are:

Gross - depreciation = Net

Market price - I.T. + Subsidies = Factor cost

Domestic + NFIA = National

METHODS OF ESTIMATION OF NATIONAL INCOME (N.I.) ANDOTHER RELATEDAGGREGATESThere are three methods of estimation of national income : production (value

added),6

income-distribution and final expenditure methods. You are familiar with the

various steps required

to be taken in each. Let us see what aggregates are arrived through each

method.(I) Production method (value added method)In this method we first find out Gross Value Added at Market Price (GVAmp) in

each sector

and then take their sum to arrive at GDPmp

Sum total of GVAmp

by all the sectors = GDPmp

Then we make adjustments to arrive at national income or NNPfc

GDPmp - Consumption of fixed capital = NDPmp

NDPmp - I.T. + Subsidies = NDP fc

NDPfc + NFIA = NNPfc

(2) Income distribution methodIn this method we first estimate factor payments by each sector. The sum of such

factor

payments equals Net value Added at Factor Cost (NVAfc) by that sector. Then we

take sum total

of NVAfc by all the sectors to arrive at NDPfc. The components of NDPfc are:1. Compensation of employees

2. Rent and royalty

3. Interest

4. Profits

NDPfc

System of National Accounts 1993, a joint publication of the United Nations and

the World


29/75

Bank,has elaborated the above components and recommended their use by all

the countries in

preparing national income estimates.

Compensation of employees is defined as : the total remuneration in cash

or in kind, payable by

an enterprise to an employee in return for work done by the latter during theaccounting period.

The main components of compensation of employees are :

(1) Wages and salaries

(a) in cash

(b) in kind7

(2) Social security contributions by the employers.

Rent is defined as the amount receivable by a landlord from a tenant for the use

of land.

Royalty is defined as the amount receivable by the landlord for granting theleasing rights of subsoil

assets.

Interest is defined as the amount payable to the owners of financial assets in

the production

unit. The production unit uses these assets for production and in turn makes

interest payment,

imputed or actual.

Profit is a residual factor payment to the owners of a production unit. The

production unit

uses profit for (i) payment of corporation tax, (ii) dividend payments and (iii)

undistributed profits/

retained earnings.

The main source of factor payments are the accounts of production units. Since

accounts

of most production units are not available to the estimators, and also since the

accounting practices

differ, it is not possible for the estimators to clearly identify the components.

Therefore, in cases

where total factors payment is estimable but not its different components, an

additional factor

payment item called mixed income is added. Since this problem arises mainly incase of selfemployed

people like doctors, chartered accountants, consultants, etc, this factor payment

is

popularly called mixed income of the self employed. In case there is such item

then,

NDPfc = Compensation of employees


30/75

+ Rent and royalty

+ Interest

+ Profit

+ Mixed income (if any)

There is another term used in factor payments. It is operating surplus. It is

defined as thesum of rent and royalty, interest and profits. In that case then:

NDPfc = Compensation of employees

+ operating surplus

+ mixed income (if any)

Once we estimate NDPfc, we can find NNPfc, or national income, by adding NFIA.

NDPfc + NFIA = NNPfc.

(3) Final expenditure methodIn this method we take the sum of final expenditures on consumption and

investment.

This sum equals GDPmp. These final expenditures are on the output producedwithin the economic

territory of the country. Its main components are:

Private final Consumption expenditure (PFCE)

+ Government final consumption expenditure (GFCE)

+ Gross domestic Capital formation (GDCF)8

+ Net exports (= Export - imports) (X-M)

= GDPmp

By making the usual adjsutments we can arrive at national income

OFCE

+ GFCE

+ GDCF

+ (X-M)

= GDPmp

- Consumption of fixed capital

= NDPmp

- indired Tax

+ Subsidies

= NDPfc

+ NFIA

= NNPfc (National income)Note that GDCF is composed of the following:

GDCF= Net domestic fixed capital formation

+ Closing stock

- Opening stock

+ Consumption of fixed capital

Also note that. Clossing stock - opening stock equals net change in stocks.


31/75

PRECAUTIONS IN MARKINGESTIMATES OF NATIONAL INCOMEThere are a large number of conceptual and statistical problem that orise in

estimating

national income of a country. To minimize error, it is necessary that certain

precautions are takenin advance. Some of the methodwise precautions are:

(1) Value added (Production) method(i) Avoid double countingValue added equals value of output less intermediate cost. There is a possibility

that

instead of counting value added one may count value of output. You can verify

by taking some

imaginary numerical example that counting only values of output will lead to

counting the same

output more thanonce. This will lead to overestimation of national income. There

are two alternative

ways of avoiding double counting: (a) count only valueadded and (b) count only

the value of final

products.9

(ii) Do not include sale of second hand goods.Sale of the used goods is not a production activity. The good should not treated

as fresh

production, and therefore doesnt should not treated as fresh production, and

therefore doesnt

qualify for inclusion in national income however, any brokerage or commissionpaid to facilitate

the sale is a fresh production activity. It should be included in production but to

the extent of

brokerage or commission only.

(iii) Self-consumed output must be included.Output produced but retained for self-consumption, rather than selling in market,

is output

and must be included in estimates. Services of owner-occupied buildings, farmer

consuming its

own produce, etc are some examples.(2) Income distribution method(i) Avoid transfersNational income includes only factor payments, i.e. payment for the services

rendered to

the production units by the owners of factors. Any payment for which no service

is rendered is


32/75


33/75

For example, a house owner using the house for seef. Although explicitly he does

not

incur any expenditure, implicitly he is making payment of rent to himself. Since

the house is

producing a service, the imputed value of this service must be include in national

income.(iv) Avoid transfer expendituresA transfer payment is a apayment against which no services are rendered.

Therfore no

production takes place. Since no production takes place it has no place in

national income.

Charities, donations, gifts, scholarships, etc are some examples.DISPOSABLE INCOMEIntroductionDisposable income refers to the income actually available for use as consumption

expenditure and saving. It includes both factor contrast national income includesonly factor

incomes. Broadly, therefore, if we are given national income we can find

disposable income by

making adjustments of non factor incomes.National Disposable IncomeGiven GNPmp, we can derive Gross National Disposable income (GNDI) and Net

National

Disposable income (NNDI).

GNPmp

+ Net current transfers from abroad

= GNDI- Consumption of fixed capital

= NNDI

aLTERNATIVELY,

NNDI = NNPmp

+ Net current transfers from abroad

Disposable income aggregate of the private sectorGNDI and NNDI are the disposable income aggregates of the nation. Let us now

derive

the disposable income of the private sector of the nation. As a first step, given

national income,11

we deduct-national income accring to the government. Then as a second step we

make

adjustments of non-factor incomes in various stages to ultimately arrive at

personal disposable

income. These steps are summed up in the following table.

NDPfc


34/75

Less : Income from property and entrepreneurship accruing to the government

administrative departments

Less : Saving of non-departmental enterprises= NDPfc accruing to the private sectorAdd : Net factor income from abroad

Add : National debt interestAdd : Current transfers from the government administrative departments.

Add : Net current transfers from the rest of the world.= Private IncomeLess : Saving of private corporate sector

(net of retained earnings of foreign companies)

Less : Corporation tax

= Personal IncomeLess : Direct taxes paid by households

Less : Miscellaneous receipts of government administrative departments

= Personal disposable incomeof the above national debt interest is the interest paid by government on loans

taken to

meet its administrative expenditure, a consumption expenditure, a consumption

expenditure.

Since interest on loans taken to meet consumption expenditure is not a factor

income it was not

included in NDPfc. But since it is a disposable income it is added to NDP fc to arrive

at disposable

income of which private income is a part.

Miscellaneous receipts of government administrative departments are small

compulsorypayments by the people to the government in the form of fees, fines, etc and

treated like a tax,

and therefore deducted.12

UNIT 7 - Determination of Income and EmploymentInvoluntary unemployment : Involuntary unemployment occurs when

those who are able and

willing to work at the going wage rate do not get work.

Aggregate demand : Aggregated demand means the total demand for final goods

in an economy.It also means the aggregate expenditure on final goods in an economy.

The components of aggregate demand are :

1. Demand for goods and services for private consumption also called private

final

consumption expenditure.

2. Demand for private investment


35/75

3. Demand for goods and services by the government

4. Net exports.

Since the determination of income and employment is to be studied in the context

of two

sector model, the third and fourth components of aggregate demand are not

discussed indetails. The two sectors taken are households and firms.

1. Demand for goods and services for private consumption is made by household

sector. It

is also called private final consumption expenditure and will be refered to as

consumption

expenditure. It must be kept in mind that the consumption expenditure we are

discussing

is ex-ante i.e. planned consumption expenditure.

This demand is influenced by many variables such as price of the goods or

services,income, wealth, expected income, tastes and preferences of individuals and so

on. Keynes

formulated his fundamental Psychological Law of Consumption to lay down a

behavioural rule to

the process of consumption activity.

Keynes stated that men are disposed, as a rule and on the average, to increase

their

consumption as their income increases, but not by as much as the increase in

their income. This

relationship between consumption and income is called the consumption

function.

The consumption function may be represented by the following equation.

C =

C + bY

C > 0, 0 < b < I.

Where,13

C = Consumption

C = Autonomous Consumption

b = Marginal Propensity to Consume

Y = Level of income

The intercept

C represents autonomous consumption, that is, the amount of consumption


36/75

expenditure when income is zero.

C is assumed to be positive, that is there is consumption even

in the absence of any income. Hence, it is not possible to think of a situation

where there is no

comsumption at all.The slope of the consumption function is b. It measures the rate of change in

consumption

per unit change in income and is also known as the Marginal Propensity to

Consume (MPC). For

example, if b is 0.6, then a rupee change in income causes a 0.60 rupee change

in consumption.

If b is 0.45, then a rupee change in income will cause a 0.45 rupee change in

consumption.

By assumption, the MPC is positive, and its value ranges between 0 and 1. This

meansthat consumption increases with income, but a rupee increase in income causes

less than a

rupee increase (of b) in consumption. For example, if b is 0.90, a rupee increase

in income

causes a 0.90, a rupee increase in consumption.

The consumption function may be plotted on a graph with the help of a numerical

example.

Figure 1 shows the graph of the hypothetical consumption function.

Consider a consumption function given by

C = 100 + 0.8 Y

Since this is an equation of a straight line, the consumption function will have a

constant

slope.

Table 1 shows the level of consumption for various levels of income.

Column (1) shows the consumption expenditure at various levels of income. The

values in

column (1) are obtained from the consumption function. Column (5) in table 1

shows how MPC is

calculated. As income increases from Rs. 600 to Rs. 700 (an increase of 100

rupees), the

consumption increases from Rs. 580 to Rs. 660 (an increase of 80rupees). TheMPC is therefore

80/100 = 0.8. The MPC at all levels of income is the same because of the

particular consumption

function we have used in our example. (Constant slope and therefore constant

MPC is a feature


37/75

of all straight line consumption functions). The information given in the Table 1

can be plotted in

a graph, as shown in Fig. 1.14

Table 1 : Consumption, Income and Marginal Propensity to

ConsumeConsumption Change in Income Change in Marginal Prpensity

C Consumption Y Y to consume (MPC)

C = (2)/(4) = C/ Y

(1) (2) (3) (4) (5)

100 - 0 - -

180 80 100 100 (80/100) = 0.8

260 80 200 100 (80/100) = 0.8

340 80 300 100 (80/100) = 0.8

420 80 400 100 (80/100) = 0.8

500 80 500 100 (80/100) = 0.8580 80 600 100 (80/100) = 0.8

660 80 700 100 (80/100) = 0.8

740 80 800 100 (80/100) = 0.8

820 80 900 100 (80/100) = 0.8

900 80 1000 100 (80/100) = 0.8

Fig. 1 shows, the graph of the consumption function C = 100 + 0.8Y.

To understand the figure, it is helpful to look at the 45o line drawn from the origin.

Since the

vertical and horizontal axes have the same scale, the 45o line has the property

that at any point

on it, the distance up from the horizontal axis (which is consumption expenditure)exactly equals

the distance across from the vertical axis (which is income).

Thus, at any point on the 45o line, consumption expenditure exactly equals

income. The

45o line therefore immediately tells us whether consumption spending (as per the

consumption

function) is equal to, greater than, or less than the level of income.

The consumption function crosses the 45o line at point B. This point is known as

the

breakeven point. Here households are just breaking even, because theconsumption is exactly

equal to the income. In our example, the income and consumption at the

breakeven point is Rs.

500.

At any point other than B on the consumption function, consumption is not equal

to income.


38/75

At points to the left of B, the consumption function lies above the 45o line.

Therefore consumption

expenditure is greater than income. For example, at an income level of Rs. 200,

the consumption15

is Rs. 260. The household must find funds to meet this consumption expenditure.The shortage

in income will make them to sell the assets acquired in the past, or to resort to

borrowing so that

Rs. 60 could be raised for consumption. This act on the part of the household to

liquidate their

own assets or to go in for a loan is referred to as the process of dissaving.

Dissaving is in order

to help the households to finance the consumption over and above the level of

income.

Fig. 1 : The Consumption Function C = 100 + 0.8 YAt any point to the right of B, the consumption function lies below the 45oline;therefore

consumption expenditure is less than the level of income. The part of income,

which is not

consumed, is saved. This must be so, because income is either consumed or

save, there is no

other use to which it can be put. Savings can be measured in the graph as the

vertical distance

between the consumption function and the 45o line. For example, at an income

level of Rs. 900.

consumption is Rs. 820. Therefore, the amount of savings is the diference

between the two, that

is, Rs. 80.

To sum up: when the consumption functiuon lies above the 45o line, consumption

is greater

than income at each level of income. This means that there is dissaving, Where

the two lines

intersect, the level of consumption is exactly equal to the level of income, When

the consumption

function lies below the 45o line, the level of consumption is less than the level of

income. Thismeans that there is positive saving. The amount of dissaving or saving is always

measured by

the vertical distance between the consumption function and the 45o line.16

Consumption and Savings


39/75

We shall now look into the relationship between consumption and saving. We

may obtain

the savings function from this relationship.

The equation below says that income that is not spent on consumption is saved,

that is

S = Y - CThis equation tells us that by definition, saving is equal to income minus

consumption.

The consumption function, along with the above equation, implies a savings

function. The

savings function relates the level of saving to the level of income. Substituting the

consumption

function into the above equation we can get the saving function.

S = Y - C

= Y - (

C + bY) (Since C =

C + bY)

= Y -

C - bY

S = -

C + (1 - b)Y

This is the savings function. The intercept term

C is the amount of savings done when

there is zero level of income. It is already shown that

C is positive. Therefore

C savings is negative.

Thus, there is negative savings

C at zero level of income. Since negative savings is nothing but

dissaving, this means that at zero level of income, there is a dissaving of amount

C. Note that the

amount of autonomous consumption is exactly equal to the amount of dissaving

at zero level of

income. This is because of the fact that Y = C + S (whether S is positive or

negative).


40/75

The slope of the savings function is (1 - b). The slope of the savings function

gives the

increase in savings per unit increase in income. This is known as the Marginal

Propensity to

Save (MPS) Since b is less than one it follows that (1 - b) and therefore MPS is

positive. Therefore,savings is an increasing function of income.Suppose the MPC, that is, b is 0.8,

then the MPS, tha

is (1 - b) is 0.2. This means that for every one rupee increase in income, savings

increase by 0.2

rupee.

Note that MPS = 1 - b = 1 - MPC. This means that the part of the increase in

income, which

is not consumed, is saved, This is because income is either consumed or saved.

Therefore, it is

always the case that MPC + MPS = 1.Using the numerical example of the consumption function we had earlier given,

we can

derive the corresponding savings function.

S =

C + (1 - b) Y

= - 100 + (1 - 0.8)Y

S = -100 + 0.2Y17

Table 2 : Consumption - Saving Relationship

Y Change C Change MPC Saving Change MPS C+S MPC+

in Y in C C/ Y S in S S/ Y MPS

Y C S

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

0 - 100 - - -100 - - 0 -

100 100 180 80 0.8 -80 20 0.2 100 1

200 100 260 80 0.8 -60 20 0.2 200 1

300 100 340 80 0.8 -40 20 0.2 300 1

400 100 420 80 0.8 -20 20 0.2 400 1

500 100 500 80 0.8 0 20 0.2 500 1

600 100 580 80 0.8 20 20 0.2 600 1700 100 660 80 0.8 40 20 0.2 700 1

800 100 740 80 0.8 60 20 0.2 800 1

900 100 820 80 0.8 80 20 0.2 900 1

1000 100 900 80 0.8 100 20 0.2 100 1

Table 2 shows the levels of consumption and savings for various levels of

income.


41/75

Note that (a) consumption plus saving everywhere equals income, and (b) MPC +

MPS = 1.

Columns (1) to (5) are repeated from Table 1. Column (6) shows the level of

savings at different

levels of income. The values in this column are obtained from the savings

function. Column (8) intable 2 shows how MPS is calculated. As income increases from Rs. 600 to Rs.

700 (an increase

of Rs. 100), the savings rises from Rs. 20 to Rs. 40 (an increase of Rs. 20). The

MPS is therefore

(20/100) = 0.2.

The MPS is the same at all levels of income because of the particular savings

function

(a linear curve with constant slope) we used in our example (constant slope and

therefore constant

MPS is a feature of all straight line savings functions).Column (9) of the table shows the sum of consumption expenditure and savings

at

every level of income. Note that column (9) is identical to column (1). This is

because income is

either consumed or saved, there is no other use to which it can be put. Thus, the

sum of

consumption expenditure and saving must be identically equal to income.

Column (10) of the table shows the sum of the MPC and MPS. Note that the sum

of

MPC and MPS is equal to one. This means that the part of the increase in

income, which is not

consumed, is saved. This is because income is either consumed or saved.

The information given in table 2, can be plotted in a graph, as shown in Fig. 218

The information given in table 2 can be plotted in a graph, as shown in Fig 2.

Fig 2 : The consumption Function and its associated Savings Function

Part A of Fig 2 shows the consumption function, Part B shows the savings

function.

This is the counterpart of the consumption shown in part A. In part A, the amount

of saving at any

level of income is the vertical distance between the consumption function and the45o line. The

saving function shown in part B can therefore be directly derived from part A.

When income is 500, we see in part A that consumption is 500 and saving equals

0.

This is depicted in part B by the intersection of the savings function with the

horizontal axis at


42/75

point B, which corresponds to an income level of 500. When income is 200,

consumption is 260

and saving is -60 (dissaving is 60); the savings function lies 60 below the

horizontal axis at an

income level of 200.

When income is 900, consumption is 820 and saving is 80; the saving functionlies 80

above the horizontal axis at an income level of 900.

In general, to the left of points B in part A, the consumption function lies above

the 45o

line (consumption is more than income). Hence to the left of point B in part B,

savings is negative

and the savings function lies below the horizontal axis.19

To the right of point B in part A, the consumption function lies below the 45o line

(consumption is less than income). Hence to the right of point B in part B,savings is positive and

the savings function lies above the horizontal axis.

Average Propensities to Consume and SaveFrom the consumption function, we can find out the value of the consumption

income ratio

C/Y, at every level of income. At any particular level of income. the ratio of

consumption to income

is called the Average Propensity to Consume (APC). The APC gives the average

consumption -

income relationship at different levels of income.

Similarly, from the savings function, we can find out the average savings - income

ratio. At

any particular level of income, the Average Propensity to Save (APS) is the ratio

of savings to

income.

We have

APC = C/Y and APS = S/Y

Now, the sum of the APC and APS is always equal to one. This is because

income is either

consumed or saved. The proof of this statement is as follows; From the

relationship betweenincome, consumption and saving,

We have

Y = C + S

Dividing both sides of the equation by Y we have

Y/Y = C/Y + S/Y

Thus, I = APC + APS


43/75

Using the earlier examples of consumption function and savings function we can

calculate

the values of APC and APS for every level of income. This is done in Table 3.Table 3 Average Propensities to Consume and SaveY C APC S APS APC+APS

(2)/(1) (4)/(1)(1) (2) (3) (4) (5) (6)

0 100 - -100 - -

100 180 1.8 -80 -0.8 1

200 260 1.3 -60 -0.3 1

300 340 1.13 -40 -0.13 1

400 420 1.05 -20 -0.05 1

500 500 1 0 0 1

600 580 0.97 20 0.03 1

700 660 0.94 40 0.06 1

800 740 0.92 60 0.08 1900 820 0.91 80 0.09 1

1000 900 0.90 100 0.10 1

Note : Figures in table are rounded upto two decimal points20

Column (3) shows how APC is calculated. At a particular income level, the APC

is the corresponding

level of consumption divided by that level of income. Similarly: APS is calculated

in column (5). At

a particular income level, the APS is the corresponding level of saving divided by

that level of

income. Column (6) shows the sum of APC and APS. As expected, at every level

of income, the

sum of APC and APS is equal to one. This is because income is either

consumed or saved.

Therefore the proportion of income that is not consumed must be saved.

As we can see from the above table. APC is continuously declining as income

increases;

and APS is continuously increasing as income increases. This means that as

income increases,

the proportion of income saved increases and the proportion of income

consumed decreases.2. Demand for Private InvestmentDemand for private investment refers to the planned or ex-ante investment

expenditure

by the firms. It includes addition to the stock of physical capital and change in

inventory. For


44/75

simplicity sake it is assumed in our study that the investment expenditure is

autonomous. This

means investment decisions are not influenced by any of its determinants,

including output.

Aggregate Supply : It is total quantity of goods and services produced in the

economic teritory ofa country. It refers to the planned aggregate output in the economy. It is assumed

that in the short

run the prices of goods do not change and the elasticity of supply is infinite. At

the given price

level, output can be increased till all resources are fully employed. So how much

will be the

aggregate output will primarily depend upon how much is the aggregate demand

in the economy.

The level of output income and employment in an economy move together in the

samedirection till full employment is reached. Increase in output means, increase in

level of employment

and increase in level of income. Decrease in output means less employment and

lower level of

income.Determination of Equilibrium Level of Output, Income &EmploymentWe shall confine our analysis of the determination of the equilibrium level of

output to an

economy with only two sectors, households and firms. Hence, the only

components of aggregate

demand will be consumption demand and investment demand.

Consumption plus Investment ApproachWe may show output determination using the consumption plus investment (C+I)

approach.

This is illustrated in Fig. 3, which shows total spending or aggregate demand

plotted against

output or income. The line CC is the consumption function, showing the desired

(planned level)

of consumption corresponding to each level of income. We now add desired

(planned) investment(which is at fixed level I) to the consumption function. This gives the level of total

desired spending

or aggregate demand, represented by the C+Io curve. At every point, the (C+Io)

curve lies above

the CC curve by an amount equal to Io.


45/75

The 45o line will enable us to identify the equilibrium. At any point on the 45 o line,

the

aggregate demand(measured vertically) equals the total level of output

(measured

horizontally).

The economy is in equilibrium when aggregate demand, represented by the C+Iocurve is

equal to the total output.21

Fig. 3 : Output Determination by Consumption plus Investment approach

The aggregate demand or (C + Io) curve shows the desired level of expenditure

by consumers

and firms corresponding to each level of output. The economy is in equilibrium at

the point where

the C + Io curve interseets the 45o line - point E in Fig. 3. At point E, the economy

is in equilibriumbecause the level of desired spending on consumption and investment exactly

equals the level

of total output. The level of output corresponding to point E, is the level of output

OM. Thus, OM

is the equilibrium level of out

Documents

Supplementary Material in Economics