Introductor y

Microeconomics
Textbook in Economics for Class XII

2020-21
 ISBN 81-7450-678-0

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 Foreword
THE National Curriculum Framework (NCF), 2005, recommends that
children’s life at school must be linked to their life outside the school.
This principle marks a departure from the legacy of bookish learning
which continues to shape our system and causes a gap between the
school, home and community. The syllabi and textbooks developed
on the basis of NCF signify an attempt to implement this basic idea.
They also attempt to discourage rote learning and the maintenance
of sharp boundaries between different subject areas. We hope these
measures will take us significantly further in the direction of a child-
centred system of education outlined in the National Policy of
Education (1986).
The success of this effort depends on the steps that school
principals and teachers will take to encourage children to reflect on
their own learning and to pursue imaginative activities and
questions. We must recognise that, given space, time and freedom,
children generate new knowledge by engaging with the information
passed on to them by adults. Treating the prescribed textbook as the
sole basis of examination is one of the key reasons why other resources
and sites of learning are ignored. Inculcating creativity and initiative
is possible if we perceive and treat children as participants in
learning, not as receivers of a fixed body of knowledge.
These aims imply considerable change in school routines and
mode of functioning. Flexibility in the daily time-table is as necessary
as rigour in implementing the annual calendar so that the required
number of teaching days are actually devoted to teaching. The
methods used for teaching and evaluation will also determine how
effective this textbook proves for making children’s life at school a
happy experience, rather than a source of stress or boredom. Syllabus
designers have tried to address the problem of curricular burden by
restructuring and reorienting knowledge at different stages with
greater consideration for child psychology and the time available
for teaching. The textbook attempts to enhance this endeavour by
giving higher priority and space to opportunities for contemplation
and wondering, discussion in small groups, and activities requiring
hands-on experience.
The National Council of Educational Research and Training
(NCERT) appreciates the hard work done by the textbook development
committee responsible for this book. We wish to thank the
Chairperson of the advisory group in Social Sciences, at the higher
secondary level, Professor Hari Vasudevan and the Chief Advisor for
this book, Professor Tapas Majumdar, for guiding the work of this

2020-21
committee. Several teachers contributed to the development of this textbook; we are
grateful to their principals for making this possible. We are indebted to the
institutions and organisations which have generously permitted us to draw upon
their resources, materials and personnel. We are especially grateful to the members
of the National Monitoring Committee, appointed by the Department of Secondary
and Higher Education, Ministry of Human Resource Development, under the
Chairpersonship of Professor Mrinal Miri and Professor G.P. Deshpande for their
valuable time and contribution. As an organisation committed to systemic reform
and continuous improvement in the quality of its products, NCERT welcomes
comments and suggestions which will enable us to undertake further revision and
refinements.

Director
New Delhi National Council of Educational
20 November 2006 Research and Training

iv

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CHAIRPERSON, ADVISORY COMMITTEE FOR SOCIAL SCIENCE TEXTBOOKS
AT THE H IGHER SECONDARY LEVEL
Hari Vasudevan, Professor, Department of History, University of
Calcutta, Kolkata

CHIEF ADVISOR
Tapas Majumdar, Professor Emeritus of Economics,
Jawaharlal Nehru University, New Delhi

ADVISOR
Satish Jain, Professor, Centre for Economics Studies and Planning,
School of Social Sciences, Jawaharlal Nehru University, New Delhi

MEMBERS
Harish Dhawan, Lecturer, Ramlal Anand College (Evening) New Delhi
Papiya Ghosh, Research Associate, Delhi School of Economics, New Delhi
Rajendra Prasad Kundu, Lecturer, Economics Department,
Jadavpur University, Kolkata
Sugato Das Gupta, Associate Professor, CESP, Jawaharlal Nehru
University, New Delhi
Tapasik Bannerjee, Research Fellow, Centre for Economics Studies
and Planning, Jawaharlal Nehru University, New Delhi

MEMBER-COORDINATOR
Jaya Singh, Lecturer, Economics, Department of Education in Social
Sciences and Humanities, NCERT, New Delhi

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The National Council of Educational Research and Training (NCERT)
acknowledges the invaluable contribution of academicians and
practising school teachers for bringing out this textbook. We are grateful
to Anjan Mukherjee, Professor, JNU, for going through the manuscript
and suggesting relevant changes. We thank Jhaljit Singh, Reader,
Department of Economics, University of Manipur for his contribution.
We also thank our colleagues Neeraja Rashmi, Reader, Curriculum
Group; M.V. Srinivasan, Ashita Raveendran, Lecturers, Department of
Education in Social Sciences and Humanities (DESSH), for their
feedback and suggestions.
We would like to place on record the precious advise of (Late) Dipak
Banerjee, Professor (Retd.), Presidency College, Kolkata. We could have
benefited much more of his expertise, had his health permitted.
The practising school teachers have helped in many ways. The
Council expresses its gratitude to A.K. Singh, PGT (Economics), Kendriya
Vidyalaya, Varanasi, Uttar Pradesh; Ambika Gulati, Head, Department
of Economics, Sanskriti School; B.C. Thakur, PGT (Economics),
Government Pratibha Vikas Vidyalaya, Surajmal Vihar; Ritu Gupta,
Principal, Sneh International School, Shoban Nair, PGT (Economics),
Mother’s International School, Rashmi Sharma, PGT (Economics),
Kendriya Vidalaya, JNU Campus, New Delhi.
We thank Savita Sinha, Professor and Head, DESSH, for her support.
Special thanks are due to Vandana R. Singh, Consultant Editor,
NCERT for going through the manuscript.
The council also gratefully acknowledges the contributions of Dinesh
Kumar, In-charge, Computer Station; Amar Kumar Prusty and Neena
Chandra, Copy Editors; in shaping this book. The contribution of the
Publication Department in bringing out this book is duly acknowledged.
This textbook has been reviewed with the support of experts like
Meeta Kumar, Associate Professor, Miranda House, University of Delhi;
Shalini Saksena, Associate Professor, DCAC; and Bharat Garg, Assistant
Professor, Shyam Lal College, University of Delhi. Their contributions
are duly acknowledged.
The council is also thankful to Tampakmayum Alan Mustofa, JPF;
Ayaz Ahmad Ansari, Farheen Fatima and Amjad Husain, DTP Operators,
in shaping this textbook.

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 Contents
Foreword iii
1. INTRODUCTION 1
1.1 A Simple Economy 1
1.2 Central Problems of an Economy 2
1.3 Organisation of Economic Activities 4
1.3.1 The Centrally Planned Economy 4
1.3.2 The Market Economy 5
1.4 Positive and Normative Economics 6
1.5 Microeconomics and Macroeconomics 6
1.6 Plan of the Book 6
2. THEORY OF CONSUMER BEHAVIOUR 8
2.1 Utility 8
2.1.1 Cardinal Utility Analysis 9
2.1.2 Ordinal Utility Analysis 11
2.2 The Consumer’s Budget 15
2.2.1 Budget Set and Budget Line 15
2.2.2 Changes in the Budget Set 17
2.3 Optimal Choice of the Consumer 19
2.4 Demand 21
2.4.1 Demand Curve and the Law of Demand 21
2.4.2 Deriving a Demand Curve from Indifference
Curves and Budget Constraints 23
2.4.3 Normal and Inferior Goods 24
2.4.4 Substitutes and Complements 25
2.4.5 Shifts in the Demand Curve 25
2.4.6 Movements along the Demand Curve and Shifts 26
in the Demand Curve
2.5 Market Demand 26
2.6 Elasticity of Demand 27
2.6.1 Elasticity along a Linear Demand Curve 29
2.6.2 Factors Determining Price Elasticity of Demand for a Good 31
2.6.3 Elasticity and Expenditure 31
3. PRODUCTION AND COSTS 36
3.1 Production Function 36
3.2 The Short Run and the Long Run 38
3.3 Total Product, Average Product and Marginal Product 39
3.3.1 Total Product 39
3.3.2 Average Product 39
3.3.3 Marginal Product 39

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 3.4 The Law of Diminishing Marginal Product and the Law of 40
Variable Proportions
3.5 Shapes of Total Product, Marginal Product and Average Product Curves 41
3.6 Returns to Scale 42
3.7 Costs 43
3.7.1 Short Run Costs 43
3.7.2 Long Run Costs 48
4. THE THEORY OF THE FIRM UNDER PERFECT COMPETITION 53
4.1 Perfect Competition: Defining Features 53
4.2 Revenue 54
4.3 Profit Maximisation 56
4.3.1 Condition 1 56
4.3.2 Condition 2 56
4.3.3 Condition 3 57
4.3.4 The Profit Maximisation Problem: Graphical Representation 58
4.4 Supply Curve of a Firm 59
4.4.1 Short Run Supply Curve of a Firm 59
4.4.2 Long Run Supply Curve of a Firm 60
4.4.3 The Shut Down Point 61
4.4.4 The Normal Profit and Break-even Point 61
4.5 Determinants of a Firm’s Supply Curve 62
4.5.1 Technological Progress 62
4.5.2 Input Prices 62
4.6 Market Supply Curve 63
4.7 Price Elasticity of Supply 65
5. MARKET EQUILIBRIUM 71
5.1 Equilibrium, Excess Demand, Excess Supply 71
5.1.1 Market Equilibrium: Fixed Number of Firms 72
5.1.2 Market Equilibrium: Free Entry and Exit 80
5.2 Applications 84
5.2.1 Price Ceiling 84
5.2.2 Price Floor 85
6. NON-COMPETITIVE MARKETS 88
6.1 Simple Monopoly in the Commodity Market 88
6.1.1 Market Demand Curve is the Average Revenue Curve 89
6.1.2 Total, Average and Marginal Revenues 92
6.1.3 Marginal Revenue and Price Elasticity of Demand 93
6.1.4 Short Run Equilibrium of the Monopoly Firm 93
6.2 Other Non-perfectly Competitive Markets 98
6.2.1 Monopolistic Competition 98
6.2.2 How do Firms behave in Oligopoly? 99

Glossary 102

viii

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 Chapter 1
Introduction
1.1 A SIMPLE ECONOMY
Think of any society. People in the society need many goods and
services1 in their everyday life including food, clothing, shelter,
transport facilities like roads and railways, postal services and
various other services like that of teachers and doctors. In fact, the
list of goods and services that any individual2 needs is so large that
no individual in society, to begin with, has all the things she needs.
Every individual has some amount of only a few of the goods and
services that she would like to use. A family farm may own a plot of
land, some grains, farming implements, maybe a pair of bullocks
and also the labour services of the family members. A weaver may
have some yarn, some cotton and other instruments required for
weaving cloth. The teacher in the local school has the skills required
to impart education to the students. Some others in society may
not have any resource3 excepting their own labour services. Each of
these decision making units can produce some goods or services
by using the resources that it has and use part of the produce to
obtain the many other goods and services which it needs. For
example, the family farm can produce corn, use part of the produce
for consumption purposes and procure clothing, housing and
various services in exchange for the rest of the produce. Similarly,
the weaver can get the goods and services that she wants in exchange
for the cloth she produces in her yarn. The teacher can earn some
money by teaching students in the school and use the money for
obtaining the goods and services that she wants. The labourer also
can try to fulfill her needs by using whatever money she can earn by
working for someone else. Each individual can thus use her
resources to fulfill her needs. It goes without saying that no
individual has unlimited resources compared to her needs. The
amount of corn that the family farm can produce is limited by the
amount of resources it has, and hence, the amount of different goods

1
By goods we means physical, tangible objects used to satisfy people’s wants and needs. The
term ‘goods’ should be contrasted with the term ‘services’, which captures the intangible satisfaction
of wants and needs. As compared to food items and clothes, which are examples of goods, we can
think of the tasks that doctors and teachers perform for us as examples of services.
2
By individual, we mean an individual decision making unit. A decision making unit can be a
single person or a group like a household, a firm or any other organisation.
3
By resource, we mean those goods and services which are used to produce other goods and
services, e.g. land, labour, tools and machinery, etc.

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 and services that it can procure in exchange of corn is also limited. As a result, the
family is forced to make a choice between the different goods and services that are
available. It can have more of a good or service only by giving up some amounts of
other goods or services. For example, if the family wants to have a bigger house, it
may have to give up the idea of having a few more acres of arable land. If it wants
more and better education for the children, it may have to give up some of the
luxuries of life. The same is the case with all other individuals in society. Everyone
faces scarcity of resources, and therefore, has to use the limited resources in the
best possible way to fulfill her needs.
In general, every individual in society is engaged in the production of some
goods or services and she wants a combination of many goods and services not
all of which are produced by her. Needless to say that there has to be some
compatibility between what people in society collectively want to have and what
they produce4. For example, the total amount of corn produced by family farm
along with other farming units in a society must match the total amount of corn
that people in the society collectively want to consume. If people in the society
do not want as much corn as the farming units are capable of producing
collectively, a part of the resources of these units could have been used in the
production of some other good or services which is in high demand. On the
other hand, if people in the society want more corn compared to what the farming
units are producing collectively, the resources used in the production of some
other goods and services may be reallocated to the production of corn. Similar is
the case with all other goods or services. Just as the resources of an individual
are scarce, the resources of the society are also scarce in comparison to what the
people in the society might collectively want to have. The scarce resources of the
society have to be allocated properly in the production of different goods and
services in keeping with the likes and dislikes of the people of the society.
Any allocation5 of resources of the society would result in the production of a
particular combination of different goods and services. The goods and services
thus produced will have to be distributed among the individuals of the society.
2 The allocation of the limited resources and the distribution of the final mix of goods
Introductory Microeconomics

and services are two of the basic economic problems faced by the society.
In reality, any economy is much more complex compared to the society
discussed above. In the light of what we have learnt about the society, let us now
discuss the fundamental concerns of the discipline of economics some of which
we shall study throughout this book.

1.2 CENTRAL PROBLEMS OF AN ECONOMY

Production, exchange and consumption of goods and services are among the
basic economic activities of life. In the course of these basic economic activities,
every society has to face scarcity of resources and it is the scarcity of resources
that gives rise to the problem of choice. The scarce resources of an economy
have competing usages. In other words, every society has to decide on how to
use its scarce resources. The problems of an economy are very often summarised
as follows:

4
Here we assume that all the goods and services produced in a society are consumed by the people
in the society and that there is no scope of getting anything from outside the society. In reality, this
is not true. However, the general point that is being made here about the compatibility of production
and consumption of goods and services holds for any country or even for the entire world.
5
By an allocation of the resources, we mean how much of which resource is devoted to the
production of each of the goods and services.

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What is produced and in what quantities?
Every society must decide on how much of each of the many possible goods and
services it will produce. Whether to produce more of food, clothing, housing or
to have more of luxury goods. Whether to have more agricultural goods or to
have industrial products and services. Whether to use more resources in education
and health or to use more resources in building military services. Whether to
have more of basic education or more of higher education. Whether to have
more of consumption goods or to have investment goods (like machine) which
will boost production and consumption tomorrow.
How are these goods produced?
Every society has to decide on how much of which of the resources to use in the
production of each of the different goods and services. Whether to use more
labour or more machines. Which of the available technologies to adopt in the
production of each of the goods?
For whom are these goods produced?
Who gets how much of the goods that are produced in the economy? How should
the produce of the economy be distributed among the individuals in the economy?
Who gets more and who gets less? Whether or not to ensure a minimum amount
of consumption for everyone in the economy. Whether or not elementary education
and basic health services should be available freely for everyone in the economy.
Thus, every economy faces the problem of allocating the scarce resources to
the production of different possible goods and services and of distributing the
produced goods and services among the individuals within the economy. The
allocation of scarce resources and the distribution of the final goods and
services are the central problems of any economy.

Production Possibility Frontier

Just as individuals face scarcity of resources, the resources of an economy
as a whole are always limited in comparison to what the people in the 3
economy collectively want to have. The scarce resources have alternative

Introduction
usages and every society has to decide on how much of each of the resources
to use in the production of different goods and services. In other words,
every society has to determine how to allocate its scarce resources to different
goods and services.
An allocation of the scarce resource of the economy gives rise to a
particular combination of different goods and services. Given the total amount
of resources, it is possible to allocate the resources in many different ways
and, thereby achieving different mixes of all possible goods and services. The
collection of all possible combinations of the goods and services that can be
produced from a given amount of resources and a given stock of technological
knowledge is called the production possibility set of the economy.

EXAMPLE 1
Table1.1: Production Possibilities
Consider an economy which
can produce corn or cotton Possibilities Corn Cotton
by using its resources. A 0 10
Table 1.1 gives some of the
B 1 9
combinations of corn and
C 2 7
cotton that the economy can
produce. When its resources D 3 4
are fully utilised. E 4 0

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 If all the resources are used in the production of corn, the maximum
amount of corn that can be produced is 4 units and if all resources are used
in the production of cotton, at the most, 10 units of cotton can be produced.
The economy can also produce1 unit of corn and 9 units of cotton or 2 units
of corn and 7 units of cotton or 3 units of corn and 4 units of cotton. There
can be many other possibilities. The figure illustrates the production
possibilities of the economy. Any point on or below the curve represents a
combination of corn and cotton that can be produced with the economy’s
resources. The curve gives the maximum amount of corn that can be produced
in the economy for any given amount of cotton and vice-versa. This curve is
called the production possibility
frontier. Cotton
The production possibility
frontier gives the combinations of A
corn and cotton that can be B
produced when the resources of the C
economy are fully utilised. Note
D
that a point lying strictly below the
production possibility frontier
represents a combination of corn E
O Corn
and cotton that will be produced
when all or some of the resources
are either underemployed or are
utilised in a wasteful fashion.
If more of the scarce resources are used in the production of corn,
less resources are available for the production of cotton and vice versa.
Therefore, if we want to have more of one of the goods, we will have less
of the other good. Thus, there is always a cost of having a little more of
one good in terms of the amount of the other good that has to be forgone.
This is known as the opportunity costa of an additional unit of the
4 goods.
Introductory Microeconomics

Every economy has to choose one of the many possibilities that it has.
In other words, one of the central problems of the economy is to choose
from one of the many production possibilities.
a
Note that the concept of opportunity cost is applicable to the individual as well as the
society. The concept is very important and is widely used in economics. Because of its
importance in economics, sometimes, opportunity cost is also called the economic cost.

1.3 ORGANISATION OF ECONOMIC ACTIVITIES

Basic problems can be solved either by the free interaction of the individuals
pursuing their own objectives as is done in the market or in a planned manner
by some central authority like the government.

1.3.1 The Centrally Planned Economy

In a centrally planned economy, the government or the central authority plans
all the important activities in the economy. All important decisions regarding
production, exchange and consumption of goods and services are made by the
government. The central authority may try to achieve a particular allocation of
resources and a consequent distribution of the final combination of goods and
services which is thought to be desirable for society as a whole. For example, if it
is found that a good or service which is very important for the prosperity and

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well-being of the economy as a whole, e.g. education or health service, is not
produced in adequate amount by the individuals on their own, the government
might try to induce the individuals to produce adequate amount of such a good
or service or, alternatively, the government may itself decide to produce the good
or service in question. In a different context, if some people in the economy get
so little a share of the final mix of goods and services produced in the economy
that their survival is at stake, then the central authority may intervene and try
to achieve an equitable distribution of the final mix of goods and services.

1.3.2 The Market Economy

In contrast to a centrally planned economy, in a market economy, all economic
activities are organised through the market. A market, as studied in economics,
is an institution6 which organises the free interaction of individuals pursuing
their respective economic activities. In other words, a market is a set of
arrangements where economic agents can freely exchange their endowments or
products with each other. It is important to note that the term ‘market’ as used
in economics is quite different from the common sense understanding of a
market. In particular, it has nothing as such to do with the marketplace as you
might tend to think of. For buying and selling commodities, individuals may or
may not meet each other in an actual physical location. Interaction between
buyers and sellers can take place in a variety of situations such as a village-
chowk or a super bazaar in a city, or alternatively, buyers and sellers can interact
with each other through telephone or internet and conduct the exchange of
commodities. The arrangements which allow people to buy and sell commodities
freely are the defining features of a market.
For the smooth functioning of any system, it is imperative that there is
coordination in the activities of the different constituent parts of the system.
Otherwise, there can be chaos. You may wonder as to what are the forces which
bring the coordination between the activities of millions of isolated individuals
in a market system.
In a market system, all goods or services come with a price (which is mutually 5

Introduction
agreed upon by the buyers and sellers) at which the exchanges take place. The
price reflects, on an average, the society’s valuation of the good or service in
question. If the buyers demand more of a certain good, the price of that good
will rise. This signals to the producers of that good that the society as a whole
wants more of that good than is currently being produced and the producers of
the good, in their turn, are likely to increase their production. In this way, prices
of goods and services send important information to all the individuals across
the market and help achieve coordination in a market system. Thus, in a market
system, the central problems regarding how much and what to produce are
solved through the coordination of economic activities brought about by the
price signals.
In reality, all economies are mixed economies where some important
decisions are taken by the government and the economic activities are by and
large conducted through the market. The only difference is in terms of the
extent of the role of the government in deciding the course of economic activities.
In the United States of America, the role of the government is minimal. The
closest example of a centrally planned economy is the China for the major part
of the twentieth century. In India, since Independence, the government has
played a major role in planning economic activities. However, the role of the
6
An institution is usually defined as an organisation with some purpose.

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 government in the Indian economy has been reduced considerably in the last
couple of decades.

1.4 POSITIVE AND NORMATIVE ECONOMICS

It was mentioned earlier that in principle there are more than one ways of
solving the central problems of an economy. These different mechanisms in
general are likely to give rise to different solutions to those problems, thereby
resulting in different allocations of the resources and also different distributions
of the final mix of goods and services produced in the economy. Therefore, it is
important to understand which of these alternative mechanisms is more
desirable for the economy as a whole. In economics, we try to analyse the
different mechanisms and figure out the outcomes which are likely to result
under each of these mechanisms. We also try to evaluate the mechanisms by
studying how desirable the outcomes resulting from them are. Often a
distinction is made between positive economic analysis and normative
economic analysis depending on whether we are trying to figure out how a
particular mechanism functions or we are trying to evaluate it. In positive
economic analysis, we study how the different mechanisms function, and in
normative economics, we try to understand whether these mechanisms are
desirable or not. However, this distinction between positive and normative
economic analysis is not a very sharp one. The positive and the normative
issues involved in the study of the central economic problems are very closely
related to each other and a proper understanding of one is not possible in
isolation to the other.

1.5 MICROECONOMICS AND MACROECONOMICS

Traditionally, the subject matter of economics has been studied under two broad
branches: Microeconomics and Macroeconomics. In microeconomics, we study
6 the behaviour of individual economic agents in the markets for different goods
and services and try to figure out how prices and quantities of goods and services
Introductory Microeconomics

are determined through the interaction of individuals in these markets. In

macroeconomics, on the other hand, we try to get an understanding of the
economy as a whole by focusing our attention on aggregate measures such as
total output, employment and aggregate price level. Here, we are interested in
finding out how the levels of these aggregate measures are determined and how
the levels of these aggregate measures change over time. Some of the important
questions that are studied in macroeconomics are as follows: What is the level of
total output in the economy? How is the total output determined? How does the
total output grow over time? Are the resources of the economy (eg labour) fully
employed? What are the reasons behind the unemployment of resources? Why
do prices rise? Thus, instead of studying the different markets as is done in
microeconomics, in macroeconomics, we try to study the behaviour of aggregate
or macro measures of the performance of the economy.

1.6 PLAN OF THE BOOK

This book is meant to introduce you to the basic ideas in microeconomics. In
this book, we will focus on the behaviour of the individual consumers and
producers of a single commodity and try to analyse how the price and the
quantity is determined in the market for a single commodity. In Chapter 2, we

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 shall study the consumer’s behaviour. Chapter 3 deals with basic ideas of
production and cost. In Chapter 4, we study the producer’s behaviour. In Chapter
5, we shall study how price and quantity is determined in a perfectly competitive
market for a commodity. Chapter 6 studies some other forms of market.

Consumption Production Exchange

Key Concepts

Scarcity Production possibilities Opportunity cost

Market Market economy Centrally planned economy
Mixed economy Positive analysis Normative analysis
Microeconomics Macroeconomics

?
Exercises

1. Discuss the central problems of an economy.

2. What do you mean by the production possibilities of an economy?
3. What is a production possibility frontier?
4. Discuss the subject matter of economics.
5. Distinguish between a centrally planned economy and a market economy.
6. What do you understand by positive economic analysis?
7. What do you understand by normative economic analysis?

? 8. Distinguish between microeconomics and macroeconomics.

Introduction

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Chapter 2
Theor
Theoryy of
Consumer Behaviour
In this chapter, we will study the behaviour of an individual
consumer. The consumer has to decide how to spend her income
on different goods1. Economists call this the problem of choice.
Most naturally, any consumer will want to get a combination of
goods that gives her maximum satisfaction. What will be this ‘best’
combination? This depends on the likes of the consumer and what
the consumer can afford to buy. The ‘likes’ of the consumer are
also called ‘preferences’. And what the consumer can afford to buy,
depends on prices of the goods and the income of the consumer.
This chapter presents two different approaches that explain
consumer behaviour (i) Cardinal Utility Analysis and (ii) Ordinal
Utility Analysis.

Preliminary Notations and Assumptions

A consumer, in general, consumes many goods; but for simplicity,
we shall consider the consumer’s choice problem in a situation
where there are only two goods2: bananas and mangoes. Any
combination of the amount of the two goods will be called a
consumption bundle or, in short, a bundle. In general, we shall
use the variable x1 to denote the quantity of bananas and x2 to
denote the quantity of mangoes. x1 and x2 can be positive or zero.
(x1, x2) would mean the bundle consisting of x1 quantity of bananas
and x2 quantity of mangoes. For particular values of x1 and x2, (x1,
x2), would give us a particular bundle. For example, the bundle
(5,10) consists of 5 bananas and 10 mangoes; the bundle (10, 5)
consists of 10 bananas and 5 mangoes.

2.1 UTILITY
A consumer usually decides his demand for a commodity on the
basis of utility (or satisfaction) that he derives from it. What is
utility? Utility of a commodity is its want-satisfying capacity. The
more the need of a commodity or the stronger the desire to have it,
the greater is the utility derived from the commodity.
Utility is subjective. Different individuals can get different levels
of utility from the same commodity. For example, some one who

1
We shall use the term goods to mean goods as well as services.
2
The assumption that there are only two goods simplifies the analysis considerably and allows us
to understand some important concepts by using simple diagrams.

2020-21
likes chocolates will get much higher utility from a chocolate than some one
who is not so fond of chocolates, Also, utility that one individual gets from the
commodity can change with change in place and time. For example, utility from
the use of a room heater will depend upon whether the individual is in Ladakh
or Chennai (place) or whether it is summer or winter (time).

2.1.1 Cardinal Utility Analysis

Cardinal utility analysis assumes that level of utility can be expressed in
numbers. For example, we can measure the utility derived from a shirt and say,
this shirt gives me 50 units of utility. Before discussing further, it will be useful
to have a look at two important measures of utility.
Measures of Utility
Total Utility: Total utility of a fixed quantity of a commodity (TU) is the total
satisfaction derived from consuming the given amount of some commodity x.
More of commodity x provides more satisfaction to the consumer. TU depends
on the quantity of the commodity consumed. Therefore, TUn refers to total utility
derived from consuming n units of a commodity x.
Marginal Utility: Marginal utility (MU) is the change in total utility due to
consumption of one additional unit of a commodity. For example, suppose 4
bananas give us 28 units of total utility and 5 bananas give us 30 units of total
utility. Clearly, consumption of the 5th banana has caused total utility to increase
by 2 units (30 units minus 28 units). Therefore, marginal utility of the 5th banana
is 2 units.
MU5 = TU5 – TU4 = 30 – 28 = 2
In general, MUn = TUn – TUn-1, where subscript n refers to the nth unit of the
commodity
Total utility and marginal utility can also be related in the following way.
TUn = MU1 + MU2 + … + MUn-1 + MUn
This simply means that TU derived from consuming n units of bananas is
the sum total of marginal utility of first banana (MU1), marginal utility of second 9
banana (MU2), and so on, till the marginal utility of the nth unit.

Theory of Consumer
Table No. 2.1 and Figure 2.1 show an imaginary example of the values of

Behaviour
marginal and total utility derived from consumption of various amounts of a
commodity. Usually, it is seen that the marginal utility diminishes with increase
in consumption of the commodity. This happens because having obtained some
amount of the commodity, the desire of the consumer to have still more of it
becomes weaker. The same is also shown in the table and graph.

Table 2.1: Values of marginal and total utility derived from consumption
of various amounts of a commodity

Units Total Utility Marginal Utility

1 12 12
2 18 6
3 22 4
4 24 2
5 24 0
6 22 -2

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 Notice that MU3 is less than
MU2. You may also notice that
total utility increases but at a
diminishing rate: The rate of
change in total utility due to
change in quantity of commodity
consumed is a measure of
marginal utility. This marginal
utility diminishes with increase
in consumption of the
commodity from 12 to 6, 6 to 4 The values of marginal and total utility derived
and so on. This follows from the from consumption of various amounts of a
law of diminishing marginal commodity. The marginal utility diminishes with
utility. Law of Diminishing increase in consumption of the commodity.
Marginal Utility states that
marginal utility from consuming each additional unit of a commodity declines
as its consumption increases, while keeping consumption of other commodities
constant.
MU becomes zero at a level when TU remains constant. In the example, TU
does not change at 5th unit of consumption and therefore MU5= 0. Thereafter,
TU starts falling and MU becomes negative.
Derivation of Demand Curve in the Case of a Single Commodity (Law of
Diminishing Marginal Utility)
Cardinal utility analysis can be used to derive demand curve for a commodity.
What is demand and what is demand curve? The quantity of a commodity that
a consumer is willing to buy and is able to afford, given prices of goods and
income of the consumer, is called demand for that commodity. Demand for a
commodity x, apart from the price of x itself, depends on factors such as prices
of other commodities (see substitutes and complements 2.4.4), income of the
10 consumer and tastes and preferences of the consumers. Demand curve is a
graphic presentation of various quantities of a commodity that a consumer is
Microeconomics
Introductory

willing to buy at different prices of the same commodity, while holding constant
prices of other related commodities
and income of the consumer.
Figure 2.2 presents hypothetical
demand curve of an individual for
commodity x at its different prices.
Quantity is measured along the
horizontal axis and price is measured
along the vertical axis.
The downward sloping demand
curve shows that at lower prices, the
individual is willing to buy more of
commodity x; at higher prices, she is
willing to buy less of commodity x. Demand curve of an individual for
Therefore, there is a negative commodity x
relationship between price of a
commodity and quantity demanded which is referred to as the Law of Demand.
An explaination for a downward sloping demand curve rests on the notion
of diminishing marginal utility. The law of diminishing marginal utility states
that each successive unit of a commodity provides lower marginal utility.

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Therefore the individual will not be willing to pay as much for each additional
unit and this results in a downward sloping demand curve. At a price of Rs. 40
per unit x, individual’s demand for x was 5 units. The 6th unit of commodity x
will be worth less than the 5th unit. The individual will be willing to buy the 6th
unit only when the price drops below Rs. 40 per unit. Hence, the law of
diminishing marginal utility explains why demand curves have a negative slope.

2.1.2 Ordinal Utility Analysis

Cardinal utility analysis is simple to understand, but suffers from a major
drawback in the form of quantification of utility in numbers. In real life, we
never express utility in the form of numbers. At the most, we can rank various
alternative combinations in terms of having more or less utility. In other words,
the consumer does not measure utility in numbers, though she often ranks
various consumption bundles. This forms the starting point of this topic – Ordinal
Utility Analysis.
A consumer’s preferences over the set of available bundles can often be
represented diagrammatically. We
have already seen that the bundles
available to the consumer can be
plotted as points in a two- A

dimensional diagram. The points

representing bundles which give the
consumer equal utility can generally
be joined to obtain a curve like the
one in Figure 2.3. The consumer is
said to be indifferent on the different
bundles because each point of the
bundles give the consumer equal
utility. Such a curve joining all points
representing bundles among which Indifference curve. An indifference curve joins
the consumer is indifferent is called all points representing bundles which are 11

Theory of Consumer
an indifference curve. All the points considered indifferent by the consumer.
such as A, B, C and D lying on an

Behaviour
indifference curve provide the consumer with the same level of satisfaction.
It is clear that when a consumer gets one more banana, he has to forego
some mangoes, so that her total utility level remains the same and she remains
on the same indifference curve. Therefore, indifference curve slopes downward.
The amount of mangoes that the consumer has to forego, in order to get an
additional banana, her total utility level being the same, is called marginal rate
of substitution (MRS). In other words, MRS is simply the rate at which the
consumer will substitute bananas for mangoes, so that her total utility remains
constant. So, MRS =| ∆Y / ∆X | 3.
One can notice that, in the table 2.2, as we increase the quantity of bananas,
the quantity of mangoes sacrificed for each additional banana declines. In other
words, MRS diminishes with increase in the number of bananas. As the number

3
| ∆Y / ∆X |= ∆Y / ∆X if (∆Y / ∆X ) ≥ 0
= −∆Y / ∆X if (∆Y / ∆X ) < 0
MRS =| ∆Y / ∆X | means that MRS equals only the magnitude of the expression ∆Y / ∆X . If
∆Y / ∆X = −3 / 1 it means MRS=3.

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 Table 2.2: Representation of Law of Diminishing Marginal Rate of Substitution

Combination Quantity of bananas (Qx) Quantity of Mangoes (Qy) MRS

A 1 15 -
B 2 12 3:1
C 3 10 2:1
D 4 9 1:1

of bananas with the consumer increases, the MU derived from each additional
banana falls. Similarly, with the fall in quantity of mangoes, the marginal utility
derived from mangoes increases. So, with increase in the number of bananas,
the consumer will feel the inclination to sacrifice small and smaller amounts of
mangoes. This tendency for the MRS to fall with increase in quantity of bananas
is known as Law of Diminishing Marginal Rate of Substitution. This can be
seen from figure 2.3 also. Going from point A to point B, the consumer sacrifices
3 mangoes for 1 banana, going from point B to point C, the consumer sacrifices
2 mangoes for 1 banana, and going from point C to point D, the consumer
sacrifices just 1 mango for 1 banana. Thus, it is clear that the consumer sacrifices
smaller and smaller quantities of mangoes for each additional banana.
Shape of an Indifference Curve
It may be mentioned that the law of Diminishing Marginal Rate of Substitution
causes an indifference curve to be convex to the origin. This is the most common
shape of an indifference curve. But in case of goods being perfect substitutes4,
the marginal rate of substitution does not diminish. It remains the same. Let’s
take an example.
Table 2.3: Representation of Law of Diminishing Marginal Rate of Substitution

12 Combination Quantity of five Quantity of five MRS

Rupees notes (Qx) Rupees coins (Qy)
Microeconomics
Introductory

A 1 8 -
B 2 7 1:1
C 3 6 1:1
D 4 5 1:1

Here, the consumer is indifferent for all these combinations as long as the total
of five rupee coins and five rupee notes remains the same. For the consumer, it
hardly matters whether she gets a five rupee coin or a five rupee note. So,
irrespective of how many five rupee notes she has, the consumer will sacrifice
only one five rupee coin for a five rupee note. So these two commodities are
perfect substitutes for the consumer and indifference curve depicting these will
be a straight line.
In the figure.2.4, it can be seen that consumer sacrifices the same number of
five-rupee coins each time he has an additional five-rupee note.

4
Perfect Substitutes are the goods which can be used in place of each other, and provide exactly
the same level of utility to the consumer.

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 Monotonic Preferences
Consumer’s preferences are
assumed to be such that between
any two bundles (x1, x2) and (y1, y2),
if (x1, x2) has more of at least one of
the goods and no less of the other
good compared to (y1, y2), then the
consumer prefers (x1, x2) to (y1, y2).
Preferences of this kind are called
monotonic preferences. Thus, a
consumer’s preferences are
monotonic if and only if between Indif ference Curve for per fect
any two bundles, the consumer substitutes. Indifference curve depicting two
prefers the bundle which has more commodities which are perfect substitutes is
of at least one of the goods and no a straight line.
less of the other good as compared
to the other bundle.

Indifference Map
The consumer’s preferences over all the
bundles can be represented by a family
of indifference curves as shown in Figure
2.5. This is called an indifference map of
the consumer. All points on an
indifference curve represent bundles
which are considered indifferent by the
consumer. Monotonicity of preferences Indifference Map. A family of
imply that between any two indifference indifference curves. The arrow indicates 13
curves, the bundles on the one which lies that bundles on higher indifference curves

Theory of Consumer
above are preferred to the bundles on the are preferred by the consumer to the
bundles on lower indifference curves.

Behaviour
one which lies below.
Features of Indifference Curve
1. Indifference curve slopes
downwards from left to right:
An indifference curve slopes downwards
from left to right, which means that in
order to have more of bananas, the
consumer has to forego some mangoes.
If the consumer does not forego some
mangoes with an increase in number of
bananas, it will mean consumer having
more of bananas with same number of
mangoes, taking her to a higher
Slope of the Indifference Curve. The
indifference curve. Thus, as long as the indifference curve slopes downward. An
consumer is on the same indifference increase in the amount of bananas along the
curve, an increase in bananas must be indifference curve is associated with a
compensated by a fall in quantity of decrease in the amount of mangoes. If ∆ x1
mangoes. > 0 then ∆ x2 < 0.

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 [Link] indifference curve gives greater level of utility:
As long as marginal utility of a commodity is positive, an individual will always
prefer more of that commodity, as more of the commodity will increase the level
of satisfaction.

Table 2.4: Representation of different level of utilities from different combination

of goods
Combination Quantity of bananas Quantity of Mangoes
A 1 10
B 2 10
C 3 10

Consider the different combination of bananas and mangoes, A, B and C

depicted in table 2.4 and figure 2.7. Combinations A, B and C consist of same
quantity of mangoes but different quantities of bananas. Since combination B
has more bananas than A, B will
provide the individual a higher
level of satisfaction than A.
Therefore, B will lie on a higher
indifference curve than A,
depicting higher satisfaction.
Likewise, C has more bananas
than B (quantity of mangoes is the
same in both B and C). Therefore,
C will provide higher level of
satisfaction than B, and also lie on
a higher indifference curve than B.
A higher indifference curve
14 consisting of combinations with Higher indifference curves give greater level
more of mangoes, or more of of utility.
Microeconomics
Introductory

bananas, or more of both, will

represent combinations that give higher level of satisfaction.

[Link] indifference curves never intersect each other:

Two indifference curves intersecting
each other will lead to conflicting
results. To explain this, let us allow
two indifference curves to intersect
each other as shown in the figure
Mangoes

2.8. As points A and B lie on the

A (7,10)
same indifference curve IC1, utilities
B (9,7)
derived from combination A and IC1
combination B will give the same C (9,5)
Ic2
level of satisfaction. Similarly, as
points A and C lie on the same
Bananas
indifference curve IC 2, utility
8
derived from combination A and
from combination C will give the Two indifference curves never intersect
same level of satisfaction. each other

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 From this, it follows that utility from point B and from point C will also be the
same. But this is clearly an absurd result, as on point B, the consumer gets a
greater number of mangoes with the same quantity of bananas. So consumer is
better off at point B than at point C. Thus, it is clear that intersecting indifference
curves will lead to conflicting results. Thus, two indifference curves cannot
intersect each other.

2.2 THE CONSUMER’S BUDGET

Let us consider a consumer who has only a fixed amount of money (income) to
spend on two goods. The prices of the goods are given in the market. The consumer
cannot buy any and every combination of the two goods that she may want to
consume. The consumption bundles that are available to the consumer depend
on the prices of the two goods and the income of the consumer. Given her fixed
income and the prices of the two goods, the consumer can afford to buy only
those bundles which cost her less than or equal to her income.

2.2.1 Budget Set and Budget Line

Suppose the income of the consumer is M and the prices of bananas and mangoes
are p1 and p2 respectively5. If the consumer wants to buy x1 quantities of bananas,
she will have to spend p1x1 amount of money. Similarly, if the consumer wants
to buy x2 quantities of mangoes, she will have to spend p2x2 amount of money.
Therefore, if the consumer wants to buy the bundle consisting of x1 quantities of
bananas and x2 quantities of mangoes, she will have to spend p1x1 + p2x2 amount
of money. She can buy this bundle only if she has at least p1x1 + p2x2 amount of
money. Given the prices of the goods and the income of a consumer, she can
choose any bundle as long as it costs less than or equal to the income she has.
In other words, the consumer can buy any bundle (x1, x2) such that

p1x1 + p2x2 ≤ M (2.1) 15

Theory of Consumer
The inequality (2.1) is called the consumer’s budget constraint. The set of

Behaviour
bundles available to the consumer is called the budget set. The budget set is
thus the collection of all bundles that the consumer can buy with her income at
the prevailing market prices.

EXAMPLE 2.1
Consider, for example, a consumer who has Rs 20, and suppose, both the goods
are priced at Rs 5 and are available only in integral units. The bundles that this
consumer can afford to buy are: (0, 0), (0, 1), (0, 2), (0, 3), (0, 4), (1, 0), (1, 1),
(1, 2), (1, 3), (2, 0), (2, 1), (2, 2), (3, 0), (3, 1) and (4, 0). Among these bundles,
(0, 4), (1,3), (2, 2), (3, 1) and (4, 0) cost exactly Rs 20 and all the other bundles
cost less than Rs 20. The consumer cannot afford to buy bundles like (3, 3) and
(4, 5) because they cost more than Rs 20 at the prevailing prices.

5
Price of a good is the amount of money that the consumer has to pay per unit of the good she
wants to buy. If rupee is the unit of money and quantity of the good is measured in kilograms, the
price of banana being p1 means the consumer has to pay p1 rupees per kilograms of banana that she
wants to buy.

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 If both the goods are perfectly
divisible6, the consumer’s budget set
would consist of all bundles (x1, x2)
such that x1 and x2 are any numbers
greater than or equal to 0 and p1x1 +
p 2x 2 ≤ M. The budget set can be
represented in a diagram as in Figure
2.9.
All bundles in the positive
quadrant which are on or below the
line are included in the budget set.
The equation of the line is Budget Set. Quantity of bananas is measured
p1x1 + p2x2 = M (2.2) along the horizontal axis and quantity of mangoes
is measured along the vertical axis. Any point in
The line consists of all bundles which the diagram represents a bundle of the two
cost exactly equal to M. This line is goods. The budget set consists of all points on
called the budget line. Points below or below the straight line having the equation
the budget line represent bundles p1x1 + p2x2 = M.
which cost strictly less than M.
The equation (2.2) can also be written as7
p
x 2 = M − 1 x1 (2.3)
p2 p 2
M
The budget line is a straight line with horizontal intercept p and vertical
1
M
intercept p . The horizontal intercept represents the bundle that the consumer
2
can buy if she spends her entire income on bananas. Similarly, the vertical
intercept represents the bundle that the consumer can buy if she spends her
p1
entire income on mangoes. The slope of the budget line is – p .
16 2
Introductory
Microeconomics

Price Ratio and the Slope of the Budget Line

Think of any point on the budget line. Such a point represents a bundle which
costs the consumer her entire budget. Now suppose the consumer wants to
have one more banana. She can do it only if she gives up some amount of the
other good. How many mangoes does she have to give up if she wants to have an
extra quantity of bananas? It would depend on the prices of the two goods. A
quantity of banana costs p1. Therefore, she will have to reduce her expenditure
on mangoes by p1 amount, if she wants one more quantity of banana. With p1,
p1
she could buy p quantities of mangoes. Therefore, if the consumer wants to
2

have an extra quantity of bananas when she is spending all her money, she will
p1
have to give up p quantities of mangoes. In other words, in the given market
2

6
The goods considered in Example 2.1 were not divisible and were available only in integer units.
There are many goods which are divisible in the sense that they are available in non-integer units
also. It is not possible to buy half an orange or one-fourth of a banana, but it is certainly possible to
buy half a kilogram of rice or one-fourth of a litre of milk.
7
In school mathematics, you have learnt the equation of a straight line as y = c + mx where c is the
vertical intercept and m is the slope of the straight line. Note that equation (2.3) has the same form.

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 Derivation of the Slope of the
Mangoes
Budget Line
The slope of the budget line
measures the amount of change in
mangoes required per unit of
change in bananas along the
budget line. Consider any two
points (x1, x2) and (x1 + ∆x1, x2 + ∆x2)
on the budget line.a Bananas
It must be the case that
p1x1 + p2x2 = M (2.4)
and, p1(x1 + ∆x1) + p2(x2 + ∆x2) = M (2.5)
Subtracting (2.4) from (2.5), we obtain
p1∆x1 + p2∆x2 = 0 (2.6)

By rearranging terms in (2.6), we obtain

∆x 2 p
=− 1 (2.7)
∆x1 p2

a
∆ (delta) is a Greek letter. In mathematics, ∆ is sometimes used to denote ‘a change’.
Thus, ∆x1 stands for a change in x1 and ∆x2 stands for a change in x2.

p1
conditions, the consumer can substitute bananas for mangoes at the rate p .
2

The absolute value8 of the slope of the budget line measures the rate at which
the consumer is able to substitute bananas for mangoes when she spends her 17
entire budget.

Theory of Consumer
2.2.2 Changes in the Budget Set

Behaviour
The set of available bundles depends on the prices of the two goods and the income
of the consumer. When the price of either of the goods or the consumer’s income
changes, the set of available bundles is also likely to change. Suppose the
consumer’s income changes from M to M ′ but the prices of the two goods remain
unchanged. With the new income, the consumer can afford to buy all bundles
(x1, x2) such that p1x1 + p2x2 ≤ M ′. Now the equation of the budget line is
p1x1 + p2x2 = M ′ (2.8)
Equation (2.8) can also be written as
p
x 2 = M' – 1 x 1 (2.9)
p2 p2
Note that the slope of the new budget line is the same as the slope of the
budget line prior to the change in the consumer’s income. However, the vertical
intercept has changed after the change in income. If there is an increase in the

8
The absolute value of a number x is equal to x if x ≥ 0 and is equal to – x if x < 0. The absolute
value of x is usually denoted by |x|.

2020-21
 income, i.e. if M' > M, the vertical as well as horizontal intercepts increase, there
is a parallel outward shift of the budget line. If the income increases, the
consumer can buy more of the goods at the prevailing market prices. Similarly,
if the income goes down, i.e. if M' < M, both intercepts decrease, and hence, there
is a parallel inward shift of the budget line. If income goes down, the availability
of goods goes down. Changes in the set of available bundles resulting from
changes in consumer’s income when the prices of the two goods remain
unchanged are shown in Figure 2.10.

Mangoes Mangoes

M'<M M'>M

Bananas Bananas

10

Changes in the Set of Available Bundles of Goods Resulting from Changes in the
Consumer’s Income. A decrease in income causes a parallel inward shift of the budget
line as in panel (a). An increase in income causes a parallel outward shift of the budget line
as in panel (b).

Now suppose the price of bananas change from p1 to p'1 but the price of
mangoes and the consumer’s income remain unchanged. At the new price of
bananas, the consumer can afford to buy all bundles (x1,x2) such that p'1x1 +
p2x2 ≤ M. The equation of the budget line is
18
p'1x1 + p2x2 = M (2.10)
Introductory
Microeconomics

Equation (2.10) can also be written as

p'
x 2 = M – 1 x1 (2.11)
p 2 p2
Note that the vertical intercept of the new budget line is the same as the
vertical intercept of the budget line prior to the change in the price of bananas.
However, the slope of the budget line and horizontal intercept have changed
after the price change. If the price of bananas increases, ie if p'1> p1, the absolute
value of the slope of the budget line increases, and the budget line becomes
steeper (it pivots inwards around the vertical intercept and horizontal intercept
decreases). If the price of bananas decreases, i.e., p'1< p1, the absolute value of
the slope of the budget line decreases and hence, the budget line becomes
flatter (it pivots outwards around the vertical intercept and horizontal intercept
increases). Figure 2.11 shows change in the budget set when the price of only one
commodity changes while the price of the other commodity as well as income of
the consumer are constant.
A change in price of mangoes, when price of bananas and the consumer’s
income remain unchanged, will bring about similar changes in the budget set of
the consumer.

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 Mangoes Mangoes

Bananas
Bananas

11
Changes in the Set of Available Bundles of Goods Resulting from Changes in the
Price of bananas. An increase in the price of bananas makes the budget line steeper as in
panel (a). A decrease in the price of bananas makes the budget line flatter as in panel (b).

2.3 OPTIMAL CHOICE OF THE CONSUMER

The budget set consists of all bundles that are available to the consumer. The
consumer can choose her consumption bundle from the budget set. But on
what basis does she choose her consumption bundle from the ones that are
available to her? In economics, it is assumed that the consumer chooses her
consumption bundle on the basis of her tatse and preferences over the bundles
in the budget set. It is generally assumed that the consumer has well defined
preferences over the set of all possible bundles. She can compare any two
bundles. In other words, between any two bundles, she either prefers one to the
other or she is indifferent between the two.

Equality of the Marginal Rate of Substitution and the Ratio of 19

the Prices

Theory of Consumer
The optimum bundle of the consumer is located at the point where the

Behaviour
budget line is tangent to one of the indifference curves. If the budget line
is tangent to an indifference curve at a point, the absolute value of the
slope of the indifference curve (MRS) and that of the budget line (price
ratio) are same at that point. Recall from our earlier discussion that the
slope of the indifference curve is the rate at which the consumer is willing
to substitute one good for the other. The slope of the budget line is the
rate at which the consumer is able to substitute one good for the other
in the market. At the optimum, the two rates should be the same. To see
why, consider a point where this is not so. Suppose the MRS at such a
point is 2 and suppose the two goods have the same price. At this point,
the consumer is willing to give up 2 mangoes if she is given an extra
banana. But in the market, she can buy an extra banana if she gives up
just 1 mango. Therefore, if she buys an extra banana, she can have more
of both the goods compared to the bundle represented by the point, and
hence, move to a preferred bundle. Thus, a point at which the MRS is
greater, the price ratio cannot be the optimum. A similar argument holds
for any point at which the MRS is less than the price ratio.

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 In economics, it is generally assumed that the consumer is a rational
individual. A rational individual clearly knows what is good or what is bad for
her, and in any given situation, she always tries to achieve the best for herself.
Thus, not only does a consumer have well-defined preferences over the set of
available bundles, she also acts according to her preferences. From the bundles
which are available to her, a rational consumer always chooses the one which
gives her maximum satisfaction.
In the earlier sections, it was observed that the budget set describes the
bundles that are available to the consumer and her preferences over the available
bundles can usually be represented by an indifference map. Therefore, the
consumer’s problem can also be stated as follows: The rational consumer’s
problem is to move to a point on the highest possible indifference curve given
her budget set.
If such a point exists, where would it be located? The optimum point would
be located on the budget line. A point below the budget line cannot be the
optimum. Compared to a point below the budget line, there is always some
point on the budget line which contains more of at least one of the goods and
no less of the other, and is, therefore, preferred by a consumer whose preferences
are monotonic. Therefore, if the consumer’s preferences are monotonic, for any
point below the budget line, there is some point on the budget line which is
preferred by the consumer. Points above the budget line are not available to
the consumer. Therefore, the optimum (most preferred) bundle of the consumer
would be on the budget line.
Where on the budget line will the optimum bundle be located? The point at
which the budget line just touches (is tangent to), one of the indifference curves
would be the optimum.9 To see why this is so, note that any point on the budget
line other than the point at which it touches the indifference curve lies on a
lower indifference curve and hence is inferior. Therefore, such a point cannot be
the consumer’s optimum. The optimum bundle is located on the budget line at
20 the point where the budget line is tangent to an indifference curve.
Figure 2.12 illustrates the
Introductory
Microeconomics

consumer’s optimum. At ( x1* , x 2* ) , the

budget line is tangent to the black
coloured indifference curve. The first
thing to note is that the indifference
curve just touching the budget line
is the highest possible indifference
curve given the consumer’s budget
set. Bundles on the indifference
curves above this, like the grey one,
are not affordable. Points on the
∗ ∗
indifference curves below this, like the Consumer’s Optimum. The point (x 1, x 2 ), at
blue one, are certainly inferior to the which the budget line is tangent to an
indifference curve represents the consumers
points on the indifference curve, just
touching the budget line. Any other
point on the budget line lies on a lower indifference curve and hence, is inferior
to ( x 1* , x 2* ) . Therefore, ( x 1* , x 2* ) is the consumer’s optimum bundle.
9
To be more precise, if the situation is as depicted in Figure 2.12 then the optimum would be
located at the point where the budget line is tangent to one of the indifference curves. However,
there are other situations in which the optimum is at a point where the consumer spends her entire
income on one of the goods only.

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2.4 DEMAND
In the previous section, we studied the choice problem of the consumer and
derived the consumer’s optimum bundle given the prices of the goods, the
consumer’s income and her preferences. It was observed that the amount of a
good that the consumer chooses optimally, depends on the price of the good
itself, the prices of other goods, the consumer’s income and her tastes and
preferences. The quantity of a commodity that a consumer is willing to buy and
is able to afford, given prices of goods and consumer’s tastes and preferences is
called demand for the commodity. Whenever one or more of these variables
change, the quantity of the good chosen
by the consumer is likely to change as
well. Here we shall change one of these
variables at a time and study how the
amount of the good chosen by the
consumer is related to that variable.

2.4.1 Demand Curve and the Law of

Demand
If the prices of other goods, the
consumer’s income and her tastes and
preferences remain unchanged, the
amount of a good that the consumer Demand Curve. The demand curve is a
relation between the quantity of the good
optimally chooses, becomes entirely chosen by a consumer and the price of the
dependent on its price. The relation good. The independent variable (price) is
between the consumer’s optimal choice measured along the vertical axis and
of the quantity of a good and its price is dependent variable (quantity) is measured
very important and this relation is called along the horizontal axis. The demand curve
the demand function. Thus, the gives the quantity demanded by the
consumer at each price.
consumer’s demand function for a good
21

Theory of Consumer
Functions

Behaviour
Consider any two variables x and y. A function
y = f (x)
is a relation between the two variables x and y such that for each value of x,
there is an unique value of the variable y. In other words, f (x) is a rule
which assigns an unique value y for each value of x. As the value of y
depends on the value of x, y is called the dependent variable and x is called
the independent variable.

EXAMPLE 1
Consider, for example, a situation where x can take the values 0, 1, 2, 3 and
suppose corresponding values of y are 10, 15, 18 and 20, respectively.
Here y and x are related by the function y = f (x) which is defined as follows:
f (0) = 10; f (1) = 15; f (2) = 18 and f (3) = 20.

EXAMPLE 2
Consider another situation where x can take the values 0, 5, 10 and 20.
And suppose corresponding values of y are 100, 90, 70 and 40, respectively.

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 Here, y and x are related by the function y = f (x ) which is defined as follows:
f (0) = 100; f (10) = 90; f (15) = 70 and f (20) = 40.
Very often a functional relation between the two variables can be expressed
in algebraic form like
y = 5 + x and y = 50 – x

A function y = f (x) is an increasing function if the value of y does not

decrease with increase in the value of x. It is a decreasing function if the
value of y does not increase with increase in the value of x. The function in
Example 1 is an increasing function. So is the function y = x + 5. The function
in Example 2 is a decreasing function. The function y = 50 – x is also
decreasing.

Graphical Representation of a Function

A graph of a function y = f (x) is a diagrammatic representation of
the function. Following are the graphs of the functions in the examples
given above.

22
Introductory
Microeconomics

Usually, in a graph, the independent variable is measured along the

horizontal axis and the dependent variable is measured along the vertical
axis. However, in economics, often the opposite is done. The demand curve,
for example, is drawn by taking the independent variable (price) along the
vertical axis and the dependent variable (quantity) along the horizontal axis.
The graph of an increasing function is upward sloping or and the graph of a
decreasing function is downward sloping. As we can see from the diagrams
above, the graph of y = 5 + x is upward sloping and that of y = 50 – x, is
downward sloping.

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gives the amount of the good that the consumer chooses at different levels of its
price when the other things remain unchanged. The consumer’s demand for a
good as a function of its price can be written as
X = f (P) (2.12)
where X denotes the quantity and P denotes the price of the good.
The demand function can also be represented graphically as in Figure 2.13.
The graphical representation of the demand function is called the demand curve.
The relation between the consumer’s demand for a good and the price of the
good is likely to be negative in general. In other words, the amount of a good
that a consumer would optimally choose is likely to increase when the price of
the good falls and it is likely to decrease with a rise in the price of the good.

2.4.2 Deriving a Demand Curve from Indifference Curves and Budget

Constraints
Consider an individual consuming bananas (X1)and mangoes (X2), whose income
is M and market prices of X1 and X2 are P '1 and P '2 respectively. Figure (a) depicts
her consumption equilibrium at point C, where she buys X '1 and X '2 quantities
of bananas and mangoes respectively. In panel (b) of figure 2.14, we plot P '1
against X '1 which is the first point on the demand curve for X1.

23

Theory of Consumer
Deriving a demand curve from indifference curves and budget constraints

Behaviour
Suppose the price of X1 drops to P1 with P '2 and M remaining constant. The
budget set in panel (a), expands and new consumption equilibrium is on a
higher indifference curve at point D, where she buys more of bananas ( X1 > X '1 ).
Thus, demand for bananas increases as its price drops. We plot P1 against X 1
in panel (b) of figure 2.14 to get the second point on the∧demand curve for X1.
Likewise the price of bananas can be dropped ∧ ∧
further to P1 , resulting
∧
in further
increase in consumption of bananas to X 1 . P1 plotted against X 1 gives us the
third point on the demand curve. Therefore, we observe that a drop in price of
bananas results in an increase in quality of bananas purchased by an individual
who maximises his utility. The demand curve for bananas is thus negatively
sloped.
The negative slope of the demand curve can also be explained in terms of the
two effects namely, substitution effect and income effect that come into play
when price of a commodity changes. When bananas become cheaper, the
consumer maximises his utility by substituting bananas for mangoes in order
to derive the same level of satisfaction of a price change, resulting in an increase
in demand for bananas.

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 Moreover, as price of bananas drops, consumer’s purchasing power increases,
which further increases demand for bananas (and mangoes). This is the income
effect of a price change, resulting in further increase in demand for bananas.
Law of Demand: Law of Demand states that other things being equal,
there is a negative relation between demand for a commodity and its price. In
other words, when price of the commodity increases, demand for it falls and
when price of the commodity decreases, demand for it rises, other factors
remaining the same.
Linear Demand
A linear demand curve can be written
as
a
d(p) = a – bp; 0 ≤ p ≤
b
a
= 0; p > (2.13)
b
where a is the vertical intercept, –b is
the slope of the demand curve. At
price 0, the demand is a, and at price
a Linear Demand Curve. The diagram depicts
equal to , the demand is 0. The the linear demand curve given by equation 2.13.
b
slope of the demand curve measures
the rate at which demand changes with respect to its price. For a unit increase
in the price of the good, the demand falls by b units. Figure 2.15 depicts a linear
demand curve.

2.4.3 Normal and Inferior Goods

The demand function is a relation between the consumer’s demand for a
good and its price when other things are given. Instead of studying the relation
24 between the demand for a good and its price, we can also study the relation
between the consumer’s demand for the good and the income of the consumer.
Microeconomics
Introductory

The quantity of a good that the

consumer demands can increase or A rise in the purchasing power
decrease with the rise in income (income) of the consumer can
depending on the nature of the good. sometimes induce the consumer to
For most goods, the quantity that a reduce the consumption of a good.
consumer chooses, increases as the In such a case, the substitution
effect and the income effect will work
consumer’s income increases and
in opposite directions. The demand
decreases as the consumer’s income for such a good can be inversely or
decreases. Such goods are called positively related to its price
normal goods. Thus, a consumer’s depending on the relative strengths
demand for a normal good moves in the of these two opposing effects. If the
same direction as the income of the substitution effect is stronger than
consumer. However, there are some the income effect, the demand for the
goods the demands for which move in good and the price of the good would
the opposite direction of the income of still be inversely related. However,
if the income effect is stronger than
the consumer. Such goods are called
the substitution effect, the demand
inferior goods. As the income of the for the good would be positively
consumer increases, the demand for an related to its price. Such a good is
inferior good falls, and as the income called a Giffen good.
decreases, the demand for an inferior

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good rises. Examples of inferior goods include low quality food items like
coarse cereals.
A good can be a normal good for the consumer at some levels of income and
an inferior good for her at other levels of income. At very low levels of income, a
consumer’s demand for low quality cereals can increase with income. But, beyond
a level, any increase in income of the consumer is likely to reduce her
consumption of such food items as she switches to better quality cereals.

2.4.4 Substitutes and Complements

We can also study the relation between the quantity of a good that a consumer
chooses and the price of a related good. The quantity of a good that the
consumer chooses can increase or decrease with the rise in the price of a
related good depending on whether the two goods are substitutes or
complementary to each other. Goods which are consumed together are called
complementary goods. Examples of goods which are complement to each
other include tea and sugar, shoes and socks, pen and ink, etc. Since tea
and sugar are used together, an increase in the price of sugar is likely to
decrease the demand for tea and a decrease in the price of sugar is likely to
increase the demand for tea. Similar is the case with other complements. In
general, the demand for a good moves in the opposite direction of the price of
its complementary goods.
In contrast to complements, goods like tea and coffee are not consumed
together. In fact, they are substitutes for each other. Since tea is a substitute for
coffee, if the price of coffee increases, the consumers can shift to tea, and hence,
the consumption of tea is likely to go up. On the other hand, if the price of coffee
decreases, the consumption of tea is likely to go down. The demand for a good
usually moves in the direction of the price of its substitutes.

2.4.5 Shifts in the Demand Curve

The demand curve was drawn under the assumption that the consumer’s
income, the prices of other goods and the preferences of the consumer are given. 25

Theory of Consumer
What happens to the demand curve when any of these things changes?
Given the prices of other goods and the preferences of a consumer, if the

Behaviour
income increases, the demand for the good at each price changes, and hence,
there is a shift in the demand curve. For normal goods, the demand curve shifts
rightward and for inferior goods, the demand curve shifts leftward.
Given the consumer’s income and her preferences, if the price of a related
good changes, the demand for a good at each level of its price changes, and
hence, there is a shift in the demand curve. If there is an increase in the price of
a substitute good, the demand curve shifts rightward. On the other hand, if
there is an increase in the price of a complementary good, the demand curve
shifts leftward.
The demand curve can also shift due to a change in the tastes and preferences
of the consumer. If the consumer’s preferences change in favour of a good, the
demand curve for such a good shifts rightward. On the other hand, the demand
curve shifts leftward due to an unfavourable change in the preferences of the
consumer. The demand curve for ice-creams, for example, is likely to shift
rightward in the summer because of preference for ice-creams goes up in
summer. Revelation of the fact that cold-drinks might be injurious to health can
adversely affect preferences for cold-drinks. This is likely to result in a leftward
shift in the demand curve for cold-drinks.

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 Shifts in Demand. The demand curve in panel (a) shifts leftward and that in panel
(b) shifts rightward.

Shifts in the demand curve are depicted in Figure 2.16. It may be mentioned
that shift in demand curve takes place when there is a change in some factor,
other than the price of the commodity.

2.4.6 Movements along the Demand Curve and Shifts in the

Demand Curve
As it has been noted earlier, the amount of a good that the consumer chooses
depends on the price of the good, the prices of other goods, income of the
consumer and her tastes and preferences. The demand function is a relation
between the amount of the good and its price when other things remain
unchanged. The demand curve is a graphical representation of the demand
function. At higher prices, the demand is less, and at lower prices, the demand
is more. Thus, any change in the price leads to movements along the demand
curve. On the other hand, changes in any of the other things lead to a shift in
26 the demand curve. Figure 2.17 illustrates a movement along the demand
curve and a shift in the demand curve.
Introductory
Microeconomics

Movement along a Demand Curve and Shift of a Demand Curve. Panel (a) depicts a
movement along the demand curve and panel (b) depicts a shift of the demand curve.

2.5 MARKET DEMAND

In the last section, we studied the choice problem of the individual consumer
and derived the demand curve of the consumer. However, in the market for a

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good, there are many consumers. It is important to find out the market demand
for the good. The market demand for a good at a particular price is the total
demand of all consumers taken together. The market demand for a good can be
derived from the individual demand curves. Suppose there are only two

Derivation of the Market Demand Curve. The market demand curve can be derived as
a horizontal summation of the individual demand curves.

consumers in the market for a good. Suppose at price p′, the demand of consumer
1 is q′1 and that of consumer 2 is q′2. Then, the market demand of the good at p′
is q′1 + q′2. Similarly, at price p̂ , if the demand of consumer 1 is q̂1 and that of
consumer 2 is q̂ 2 , the market demand of the good at p̂ is qˆ 1 + qˆ 2 . Thus, the
market demand for the good at each price can be derived by adding up the
demands of the two consumers at that price. If there are more than two consumers
in the market for a good, the market demand can be derived similarly.
The market demand curve of a good can also be derived from the individual
demand curves graphically by adding up the individual demand curves
horizontally as shown in Figure 2.18. This method of adding two curves is called
horizontal summation. 27

Theory of Consumer
Adding up Two Linear Demand Curves

Behaviour
Consider, for example, a market where there are two consumers and the demand
curves of the two consumers are given as
d1(p) = 10 – p (2.14)
and d2(p) = 15 – p (2.15)
Furthermore, at any price greater than 10, the consumer 1 demands 0 unit of
the good, and similarly, at any price greater than 15, the consumer 2 demands 0
unit of the good. The market demand can be derived by adding equations (2.14)
and (2.15). At any price less than or equal to 10, the market demand is given by
25 – 2p, for any price greater than 10, and less than or equal to 15, market
demand is 15 – p, and at any price greater than 15, the market demand is 0.

2.6 ELASTICITY OF DEMAND

The demand for a good moves in the opposite direction of its price. But the
impact of the price change is always not the same. Sometimes, the demand for a
good changes considerably even for small price changes. On the other hand,
there are some goods for which the demand is not affected much by price changes.

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 Demands for some goods are very responsive to price changes while demands
for certain others are not so responsive to price changes. Price elasticity of demand
is a measure of the responsiveness of the demand for a good to changes in its
price. Price elasticity of demand for a good is defined as the percentage change
in demand for the good divided by the percentage change in its price. Price-
elasticity of demand for a good
percentage change in demand for the good
eD = percentage change in the price of the good (2.16a)

∆Q
× 100
Q
=
∆P
× 100
P
(2.16b)
 ∆Q   P 
= × 
 Q   ∆P 

Where, ∆P is the change in price of the good and ∆Q is the change in quantity
of the good.

EXAMPLE 2.2
Suppose an individual buy 15 bananas when its price is Rs. 5 per banana. when
the price increases to Rs. 7 per banana, she reduces his demand to 12 bananas.

Price Per banana (Rs.) : P Quantity of bananas demanded : Q

Old Price : P1 = 5 Old quantity : Q1 = 15
New Price : P2 = 7 New quantity: Q2 = 12

In order to find her elasticity demand for bananas, we find the percentage change
in quantity demanded and its price, using the information summarized in table.

28
Note that the price elasticity of demand is a negative number since the demand
Microeconomics
Introductory

for a good is negatively related to the price of a good. However, for simplicity, we
will always refer to the absolute value of the elasticity.
∆Q
Percentage change in quantity demanded = Q × 100
1

 Q 2 − Q1 
=   × 100
 Q1 
12 − 15
= × 100 = − 20
15
∆P
Percentage change in Market price = P × 100
1

 P2 − P1 
=  P  × 100
 1 
7−5
= × 100 = 40
5

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 Therefore, in our example, as price of bananas increases by 40 percent,
20
demand for bananas drops by 20 percent. Price elasticity of demand e D = = 0.5 .
40
Clearly, the demand for bananas is not very responsive to a change in price of
bananas. When the percentage change in quantity demanded is less than the
percentage change in market price, e D is estimated to be less than one and the
demand for the good is said to be inelastic at that price. Demand for essential
goods is often found to be inelastic.
When the percentage change in quantity demanded is more than the
percentage change in market price, the demand is said to be highly responsive
to changes in market price and the estimated e D is more than one. The demand
for the good is said to be elastic at that price. Demand for luxury goods is seen
to be highly responsive to changes in their market prices and e D >1.
When the percentage change in quantity demanded equals the percentage
change in its market price, e D is estimated to be equal to one and the demand
for the good is said to be Unitary-elastic at that price. Note that the demand for
certain goods may be elastic, unitary elastic and inelastic at different prices. In
fact, in the next section, elasticity along a linear demand curve is estimated at
different prices and shown to vary at each point on a downward sloping demand
curve.

2.6.1 Elasticity along a Linear Demand Curve

Let us consider a linear demand curve q = a – bp. Note that at any point on the
∆q
demand curve, the change in demand per unit change in the price ∆p = –b.

∆q
Substituting the value of ∆p in (2.16b),
29
p

Theory of Consumer
we obtain, eD = – b q

Behaviour
puting the value of q,
bp
eD = – (2.17)
a – bp
From (2.17), it is clear that the
elasticity of demand is different at
different points on a linear demand
curve. At p = 0, the elasticity is 0, at q = Elasticity along a Linear Demand
a Curve. Price elasticity of demand is different
0, elasticity is ∞. At p = , the elasticity at different points on the linear demand
2b
curve.
is 1, at any price greater than 0 and less
a a
than , elasticity is less than 1, and at any price greater than , elasticity is
2b 2b
greater than 1. The price elasticities of demand along the linear demand curve
given by equation (2.17) are depicted in Figure 2.19.

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 Geometric Measure of Elasticity along a Linear Demand Curve
The elasticity of a linear demand
curve can easily be measured
geometrically. The elasticity of
demand at any point on a straight
line demand curve is given by the
ratio of the lower segment and the
upper segment of the demand curve
at that point. To see why this is the
case, consider the following figure
which depicts a straight line
demand curve, q = a – bp.
Suppose at price p 0 , the
demand for the good is q 0 . Now
consider a small change in the price. The new price is p1, and at that price,
demand for the good is q1.
∆q = q1q0 = CD and ∆p = p1p0 = CE.

∆q / q 0 ∆q p0 q1q 0 Op 0 CD × Op
0
Therefore, eD = = × = × =
∆p / p 0 ∆p q0 p1 p 0 Oq 0 CE Oq 0

0
CD p0D p0D Oq o
Since ECD and Bp D are similar triangles, = 0 . But 0 = o
CE p B p B p B

op 0 q0 D
eD = = .
P 0B P 0B
q 0D DA
Since, Bp0D and BOA are similar triangles, =
p 0B DB
DA
Thus, eD = .
DB
30 The elasticity of demand at different points on a straight line demand
curve can be derived by this method. Elasticity is 0 at the point where the
Microeconomics
Introductory

demand curve meets the horizontal axis and it is ∝ at the point where the
demand curve meets the vertical axis. At the midpoint of the demand curve,
the elasticity is 1, at any point to the left of the midpoint, it is greater than 1
and at any point to the right, it is less than 1.
Note that along the horizontal axis p = 0, along the vertical axis q = 0 and
a
at the midpoint of the demand curve p = .
2b
Constant Elasticity Demand Curve
The elasticity of demand on different points on a linear demand curve is different
varying from 0 to ∞. But sometimes, the demand curves can be such that the
elasticity of demand remains constant throughout. Consider, for example, a
vertical demand curve as the one depicted in Figure 2.20(a). Whatever be the
price, the demand is given at the level q . A price never leads to a change in the
demand for such a demand curve and |eD| is always 0. Therefore, a vertical
demand curve is perfectly inelastic.
Figure 2.20 (b) depics a horizontal demand curve, where market price
remains constant at P , whatever be the level of demand for the commodity. At
any other price, quantity demanded drops to zero and therefore ed = ∞ . A
horizontal demand curve is perfectly elastic.

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 Constant Elasticity Demand Curves. Elasticity of demand at all points along the vertical
demand curve, as shown in panel (a), is 0. Elasticity of demand at all point along the
horizontal demand curve, as shown in panel (b) is ∞ . Elasticity at all points on the demand
curve in panel (c) is 1.

Figure 2.20(c) depicts a demand curve which has the shape of a rectangular
hyperbola. This demand curve has a property that a percentage change in price
along the demand curve always leads to equal percentage change in quantity.
Therefore, |eD| = 1 at every point on this demand curve. This demand curve is
called the unitary elastic demand curve.

2.6.2 Factors Determining Price Elasticity of Demand for a Good

The price elasticity of demand for a good depends on the nature of the good and
the availability of close substitutes of the good. Consider, for example, necessities
like food. Such goods are essential for life and the demands for such goods do
not change much in response to changes in their prices. Demand for food does
not change much even if food prices go up. On the other hand, demand for
luxuries can be very responsive to price changes. In general, demand for a
necessity is likely to be price inelastic while demand for a luxury good is likely 31
to be price elastic.

Theory of Consumer
Though demand for food is inelastic, the demands for specific food items are

Behaviour
likely to be more elastic. For example, think of a particular variety of pulses. If the
price of this variety of pulses goes up, people can shift to some other variety of
pulses which is a close substitute. The demand for a good is likely to be elastic if
close substitutes are easily available. On the other hand, if close substitutes are
not available easily, the demand for a good is likely to be inelastic.

2.6.3 Elasticity and Expenditure

The expenditure on a good is equal to the demand for the good times its price.
Often it is important to know how the expenditure on a good changes as a result
of a price change. The price of a good and the demand for the good are inversely
related to each other. Whether the expenditure on the good goes up or down as
a result of an increase in its price depends on how responsive the demand for
the good is to the price change.
Consider an increase in the price of a good. If the percentage decline in
quantity is greater than the percentage increase in the price, the expenditure on
the good will go down. For example, see row 2 in table 2.5 which shows that as
price of a commodity increases by 10%, its demand drops by 12%, resulting in
a decline in expenditure on the good. On the other hand, if the percentage decline
in quantity is less than the percentage increase in the price, the expenditure on

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 the good will go up (See row 1 in table 2.5). And if the percentage decline in
quantity is equal to the percentage increase in the price, the expenditure on the
good will remain unchanged (see row 3 in table 2.5).
Now consider a decline in the price of the good. If the percentage increase in
quantity is greater than the percentage decline in the price, the expenditure on
the good will go up(see row 4 in table 2.5). On the other hand, if the percentage
increase in quantity is less than the percentage decline in the price, the expenditure
on the good will go down(see row 5 in table 2.5). And if the percentage increase
in quantity is equal to the percentage decline in the price, the expenditure on
the good will remain unchanged (see row 6 in table 2.5).
The expenditure on the good would change in the opposite direction as the
price change if and only if the percentage change in quantity is greater than the
percentage change in price, ie if the good is price-elastic (see rows 2 and 4 in
table 2.5). The expenditure on the good would change in the same direction as
the price change if and only if the percentage change in quantity is less than the
percentage change in price, i.e., if the good is price inelastic (see rows 1 and 5 in
table 2.5). The expenditure on the good would remain unchanged if and only if
the percentage change in quantity is equal to the percentage change in price,
i.e., if the good is unit-elastic (see rows 3 and 6 in table 2.5).
Table 2.5: For hypothetic cases of price rise and drop, the following table
summarises the relationship between elasticity and change in expenditure
of a commodity
Change Change in % Change % Change Impact on Nature of price
in Price Quantity in price in quantity Expenditure Elasticity of
(P) demand (Q) demand = P×Q demand e d

1 ↑ ↓ +10 -8 ↑ Price Inelastic

2 ↑ ↓ +10 -12 ↓ Price Elastic
3 ↑ ↓ +10 -10 No Change Unit Elastic
32
4 ↓ ↑ -10 +15 ↑ Price Elastic
Microeconomics
Introductory

5 ↓ ↑ -10 +7 ↓ Price Inelastic

6 ↓ ↑ -10 +10 No Change Unit Elastic

Rectangular Hyperbola
An equation of the form
xy = c
where x and y are two variables and c is a
constant, giving us a curve called
rectangular hyperbola. It is a downward
sloping curve in the x-y plane as shown
in the diagram. For any two points p and q
on the curve, the areas of the two
rectangles Oy1px1 and Oy2qx2 are same and
equal to c.
If the equation of a demand curve
takes the form pq = e, where e is a constant, it will be a rectangular
hyperbola, where price (p) times quantity (q) is a constant. With such a
demand curve, no matter at what point the consumer consumes, her
expenditures are always the same and equal to e.

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 Relationship between Elasticity and change in Expenditure on a Good
Suppose at price p, the demand for a good is q, and at price p + ∆p, the
demand for the good is q + ∆q.
At price p, the total expenditure on the good is pq, and at price p + ∆p,
the total expenditure on the good is (p + ∆p)(q + ∆q).
If price changes from p to (p + ∆p), the change in the expenditure on the
good is, (p + ∆p)(q + ∆q) – pq = q∆p + p∆q + ∆p∆q.
For small values of ∆p and ∆q, the value of the term ∆p∆q is negligible,
and in that case, the change in the expenditure on the good is approximately
given by q∆p + p∆q.
∆q
Approximate change in expenditure = ∆E = q∆p + p∆q = ∆p(q + p
∆p )
∆q p
= ∆p[q(1 + ∆p q )] = ∆p[q(1 + eD)].

Note that
if eD < –1, then q (1 + eD ) < 0, and hence, ∆E has the opposite sign as ∆p,
if eD > –1, then q (1 + eD ) > 0, and hence, ∆E has the same sign as ∆p,
if eD = –1, then q (1 + eD ) = 0, and hence, ∆E = 0.
Summary

• The budget set is the collection of all bundles of goods that a consumer can buy
with her income at the prevailing market prices.
• The budget line represents all bundles which cost the consumer her entire income.
The budget line is negatively sloping.
• The budget set changes if either of the two prices or the income changes.
• The consumer has well-defined preferences over the collection of all possible
bundles. She can rank the available bundles according to her preferences 33
over them.

Theory of Consumer
• The consumer’s preferences are assumed to be monotonic.

Behaviour
• An indifference curve is a locus of all points representing bundles among which
the consumer is indifferent.
• Monotonicity of preferences implies that the indifference curve is downward
sloping.
• A consumer’s preferences, in general, can be represented by an indifference map.
• A consumer’s preferences, in general, can also be represented by a utility function.
• A rational consumer always chooses her most preferred bundle from the budget set.
• The consumer’s optimum bundle is located at the point of tangency between the
budget line and an indifference curve.
• The consumer’s demand curve gives the amount of the good that a consumer
chooses at different levels of its price when the price of other goods, the consumer’s
income and her tastes and preferences remain unchanged.
• The demand curve is generally downward sloping.
• The demand for a normal good increases (decreases) with increase (decrease) in
the consumer’s income.
• The demand for an inferior good decreases (increases) as the income of the
consumer increases (decreases).
• The market demand curve represents the demand of all consumers in the market

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 taken together at different levels of the price of the good.
• The price elasticity of demand for a good is defined as the percentage change in
demand for the good divided by the percentage change in its price.
• The elasticity of demand is a pure number.
• Elasticity of demand for a good and total expenditure on the good are closely
related.

Budget set Budget line

Key Concepts

Preference Indifference
Indifference curve Marginal Rate of substitution
Monotonic preferences Diminishing rate of substitution
Indifference map,Utility function Consumer’s optimum
Demand Law of demand
Demand curve Substitution effect
Income effect Normal good
Inferior good Substitute
Complement Price elasticity of demand
Exercises

1. What do you mean by the budget set of a consumer?

2. What is budget line?
3. Explain why the budget line is downward sloping.
4. A consumer wants to consume two goods. The prices of the two goods are Rs 4
and Rs 5 respectively. The consumer’s income is Rs 20.
(i) Write down the equation of the budget line.
(ii) How much of good 1 can the consumer consume if she spends her entire
income on that good?
(iii) How much of good 2 can she consume if she spends her entire income on
that good?
34 (iv) What is the slope of the budget line?
Introductory
Microeconomics

Questions 5, 6 and 7 are related to question 4.

5. How does the budget line change if the consumer’s income increases to Rs 40
but the prices remain unchanged?
6. How does the budget line change if the price of good 2 decreases by a rupee
but the price of good 1 and the consumer’s income remain unchanged?
7. What happens to the budget set if both the prices as well as the income double?
8. Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2
if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8
respectively. How much is the consumer’s income?
9. Suppose a consumer wants to consume two goods which are available only in
integer units. The two goods are equally priced at Rs 10 and the consumer’s
income is Rs 40.
(i) Write down all the bundles that are available to the consumer.
(ii) Among the bundles that are available to the consumer, identify those which
cost her exactly Rs 40.
10. What do you mean by ‘monotonic preferences’?
11. If a consumer has monotonic preferences, can she be indifferent between the
bundles (10, 8) and (8, 6)?
12. Suppose a consumer’s preferences are monotonic. What can you say about
her preference ranking over the bundles (10, 10), (10, 9) and (9, 9)?

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13. Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the
preferences of your friend monotonic?
14. Suppose there are two consumers in the market for a good and their demand
functions are as follows:
d1(p) = 20 – p for any price less than or equal to 20, and d1(p) = 0 at any price
greater than 20.
d2(p) = 30 – 2p for any price less than or equal to 15 and d1(p) = 0 at any price
greater than 15.
Find out the market demand function.
15. Suppose there are 20 consumers for a good and they have identical demand
functions:
10
d(p) = 10 – 3p for any price less than or equal to
3 and d1(p) = 0 at any price
10
greater than .
3
What is the market demand function?
16. Consider a market where there are just two p d1 d2
consumers and suppose their demands for the
good are given as follows: 1 9 24
Calculate the market demand for the good. 2 8 20
3 7 18
4 6 16
5 5 14
6 4 12

17. What do you mean by a normal good?

18. What do you mean by an ‘inferior good’? Give some examples.
19. What do you mean by substitutes? Give examples of two goods which are
substitutes of each other.
20. What do you mean by complements? Give examples of two goods which are 35

Theory of Consumer
complements of each other.
21. Explain price elasticity of demand.

Behaviour
22. Consider the demand for a good. At price Rs 4, the demand for the good is 25
units. Suppose price of the good increases to Rs 5, and as a result, the demand
for the good falls to 20 units. Calculate the price elasticity .
5
23. Consider the demand curve D (p) = 10 – 3p. What is the elasticity at price ?
3
24. Suppose the price elasticity of demand for a good is – 0.2. If there is a 5 %
increase in the price of the good, by what percentage will the demand for the
good go down?
25. Suppose the price elasticity of demand for a good is – 0.2. How will the
expenditure on the good be affected if there is a 10 % increase in the price of
the good?
27. Suppose there was a 4 % decrease in the price of a good, and as a result, the
expenditure on the good increased by 2 %. What can you say about the elasticity
of demand?

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Chapter 3
Production and Costs
In the previous chapter, we have discussed the behaviour of the
consumers. In this chapter as well as in the next, we shall examine
the behaviour of a producer. Production is the process by which
inputs are transformed into ‘output’. Production is carried out by
producers or firms. A firm acquires different inputs like labour,
machines, land, raw materials etc. It uses these inputs to produce
output. This output can be consumed by consumers, or used by
other firms for further production. For example, a tailor uses a
sewing machine, cloth, thread and his own labour to ‘produce’
shirts. A farmer uses his land, labour, a tractor, seed, fertilizer,
water etc to produce wheat. A car manufacturer uses land for a
factory, machinery, labour, and various other inputs (steel,
aluminium, rubber etc) to produce cars. A rickshaw puller uses a
rickshaw and his own labour to ‘produce’ rickshaw rides. A
domestic helper uses her labour to produce ‘cleaning services’.
We make certain simplifying assumptions to start with. Production
is instantaneous: in our very simple model of production no
time elapses between the combination of the inputs and
the production of the output. We also tend to use the
terms production and supply synonymously and often
interchangeably.
In order to acquire inputs a firm has to pay for them.
This is called the cost of production. Once output
has been produced, the firm sell it in the market and
earns revenue. The difference between the revenue
and cost is called the firm’s profit. We assume that
the objective of a firm is to earn the maximum profit
that it can.
In this chapter, we discuss the relationship between
inputs and output. Then we look at the cost structure of
the firm. We do this to be able to identifiy the output at which
A Firm Effort firms profits are maximum.

3.1 PRODUCTION FUNCTION

The production function of a firm is a relationship between inputs
used and output produced by the firm. For various quantities of
inputs used, it gives the maximum quantity of output that can be
produced.

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 Consider the farmer we mentioned above. For simplicity, we assume that the
farmer uses only two inputs to produce wheat: land and labour. A production
function tells us the maximum amount of wheat he can produce for a given
amount of land that he uses, and a given number of hours of labour that he
performs. Suppose that he uses 2 hours of labour/ day and 1 hectare of land to
produce a maximum of 2 tonnes of wheat. Then, a function that describes this
relation is called a production function.
One possible example of the form this could take is:
q = K × L,
Where, q is the amount of wheat produced, K is the area of land in hectares,
L is the number of hours of work done in a day.
Describing a production function in this manner tells us the exact relation
between inputs and output. If either K or L increase, q will also increase. For
any L and any K, there will be only one q. Since by definition we are taking the
maximum output for any level of inputs, a production function deals only with
the efficient use of inputs. Efficiency implies that it is not possible to get any
more output from the same level of inputs.
A production function is defined for a given technology. It is the technological
knowledge that determines the maximum levels of output that can be produced
using different combinations of inputs. If the technology improves, the maximum
levels of output obtainable for different input combinations increase. We then
have a new production function.
The inputs that a firm uses in the production process are called factors of
production. In order to produce output, a firm may require any number of
different inputs. However, for the time being, here we consider a firm that produces
output using only two factors of production – labour and capital. Our production
function, therefore, tells us the maximum quantity of output (q) that can be
produced by using different combinations of these two factors of productions-
Labour (L) and Capital (K).
We may write the production function as
37
q = f(L,K) (3.1)

Production and Costs

where, L is labour and K is capital and q is the maximum output that can be
produced.
Table 3.1: Production Function
Factor Capital
0 1 2 3 4 5 6
0 0 0 0 0 0 0 0
1 0 1 3 7 10 12 13
2 0 3 10 18 24 29 33
Labour 3 0 7 18 30 40 46 50
4 0 10 24 40 50 56 57
5 0 12 29 46 56 58 59
6 0 13 33 50 57 59 60

A numerical example of production function is given in Table 3.1. The left

column shows the amount of labour and the top row shows the amount of
capital. As we move to the right along any row, capital increases and as we move
down along any column, labour increases. For different values of the two factors,

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 Isoquant
In Chapter 2, we have learnt about indifference curves. Here, we introduce a
similar concept known as isoquant. It is just an alternative way of
representing the production function. Consider a production function with
two inputs labour and capital. An
isoquant is the set of all possible
combinations of the two inputs
that yield the same maximum
possible level of output. Each
isoquant represents a particular
level of output and is labelled with
that amount of output.
Let us return to table 3.1
notice that the output of 10 units
can be produced in 3 ways (4L,
1K), (2L, 2K), (1L, 4K). All these
combination of L, K lie on the
same isoquant, which represents the level of output 10. Can you identify
the sets of inputs that will lie on the isoquant q = 50?
The diagram here generalizes this concept. We place L on the X axis and
K on the Y axis. We have three isoquants for the three output levels, namely
q = q1, q = q2 and q = q3. Two input combinations (L1, K2) and (L2, K1) give us
the same level of output q1. If we fix capital at K1 and increase labour to L3,
output increases and we reach a higher isoquant, q = q2. When marginal
products are positive, with greater amount of one input, the same level of
output can be produced only using lesser amount of the other. Therefore,
isoquants are negatively sloped.

38 the table shows the corresponding output levels. For example, with 1 unit of
Introductory
Microeconomics

labour and 1 unit of capital, the firm can produce at most 1 unit of output; with
2 units of labour and 2 units of capital, it can produce at most 10 units of
output; with 3 units of labour and 2 units of capital, it can produce at most 18
units of output and so on.
In our example, both the inputs are necessary for the production. If any of
the inputs becomes zero, there will be no production. With both inputs positive,
output will be positive. As we increase the amount of any input, output increases.

3.2 THE SHORT RUN AND THE LONG RUN

Before we begin with any further analysis, it is important to discuss two concepts–
the short run and the long run.
In the short run, at least one of the factor – labour or capital – cannot be
varied, and therefore, remains fixed. In order to vary the output level, the firm
can vary only the other factor. The factor that remains fixed is called the fixed
factor whereas the other factor which the firm can vary is called the variable
factor.
Consider the example represented through Table 3.1. Suppose, in the short
run, capital remains fixed at 4 units. Then the corresponding column shows the
different levels of output that the firm may produce using different quantities of
labour in the short run.

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 In the long run, all factors of production can be varied. A firm in order to
produce different levels of output in the long run may vary both the inputs
simultaneously. So, in the long run, there is no fixed factor.
For any particular production process, long run generally refers to a longer
time period than the short run. For different production processes, the long run
periods may be different. It is not advisable to define short run and long run in
terms of say, days, months or years. We define a period as long run or short run
simply by looking at whether all the inputs can be varied or not.

3.3 TOTAL PRODUCT, AVERAGE PRODUCT AND MARGINAL PRODUCT

3.3.1 Total Product
Suppose we vary a single input and keep all other inputs constant. Then
for different levels of that input, we get different levels of output. This
relationship between the variable input and output, keeping all other inputs
constant, is often referred to as Total Product (TP) of the variable input.
Let us again look at Table 3.1. Suppose capital is fixed at 4 units. Now in
the Table 3.1, we look at the column where capital takes the value 4. As we
move down along the column, we get the output values for different values of
labour. This is the total product of labour schedule with K2 = 4. This is also
sometimes called total return to or total physical product of the variable
input. This is shown again in the second column of table in 3.2
Once we have defined total product, it will be useful to define the concepts of
average product (AP) and marginal product (MP). They are useful in order to
describe the contribution of the variable input to the production process.

3.3.2 Average Product

Average product is defined as the output per unit of variable input. We calculate
it as
TPL
APL = (3.2) 39
L

Production and Costs

The last column of table 3.2 gives us a numerical example of average product
of labour (with capital fixed at 4) for the production function described in
table 3.1. Values in this column are obtained by dividing TP (column 2) by
L (Column 1).

3.3.3 Marginal Product

Marginal product of an input is defined as the change in output per unit of
change in the input when all other inputs are held constant. When capital is held
constant, the marginal product of labour is
Change in output
MPL =
Change in input
∆ TPL
= (3.3)
∆L
where ∆ represents the change of the variable.
The third column of table 3.2 gives us a numerical example of Marginal
Product of labour (with capital fixed at 4) for the production function described
in table 3.1. Values in this column are obtained by dividing change in TP by

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 change in L. For example, when L changes from 1 to 2, TP changes from 10 to
24.
MPL= (TP at L units) – (TP at L – 1 unit) (3.4)

Here, Change in TP = 24 -10 = 14

Change in L = 1
Marginal product of the 2nd unit of labour = 14/1 = 14
Since inputs cannot take negative values, marginal product is undefined at
zero level of input employment. For any level of an input, the sum of marginal
products of every preceeding unit of that input gives the total product. So total
product is the sum of marginal products.
Table 3.2: Total Product, Marginal product and Average product

Labour TP MPL APL

0 0 - -
1 10 10 10
2 24 14 12
3 40 16 13.33
4 50 10 12.5
5 56 6 11.2
6 57 1 9.5

Average product of an input at any level of employment is the average of all

marginal products up to that level. Average and marginal products are often
referred to as average and marginal returns, respectively, to the variable input.

3.4 THE LAW OF DIMINISHING MARGINAL PRODUCT AND

40 THE LAW OF VARIABLE PROPORTIONS
Introductory
Microeconomics

If we plot the data in table 3.2 on graph paper, placing labour on the X-axis and
output on the Y-axis, we get the curves shown in the diagram below. Let us
examine what is happening to TP. Notice that TP increases as labour input
increases. But the rate at which it increases is not constant. An increase in labour
from 1 to 2 increases TP by 10 units. An increase in labour from 2 to 3 increases
TP by 12. The rate at which TP increases, as explained above, is shown by the
MP. Notice that the MP first increases (upto 3 units of labour) and then begins to

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fall. This tendency of the MP to first increase and then fall is called the law of
variable proportions or the law of diminishing marginal product. Law of
variable proportions say that the marginal product of a factor input initially
rises with its employment level. But after reaching a certain level of employment,
it starts falling.
Why does this happen? In order to understand this, we first define the concept
of factor proportions. Factor proportions represent the ratio in which the two
inputs are combined to produce output.
As we hold one factor fixed and keep increasing the other, the factor
proportions change. Initially, as we increase the amount of the variable input,
the factor proportions become more and more suitable for the production and
marginal product increases. But after a certain level of employment, the
production process becomes too crowded with the variable input.
Suppose table 3.2 describes the output of a farmer who has 4 hectares of
land, and can choose how much labour he wants to use. If he uses only 1 worker,
he has too much land for the worker to cultivate alone. As he increases the
number of workers, the amount of labour per unit land increases, and each
worker adds proportionally more and more to the total output. Marginal product
increases in this phase. When the fourth worker is hired, the land begins to get
‘crowded’. Each worker now has insufficient land to work efficiently. So the output
added by each additional worker is now proportionally less. The marginal product
begins to fall.
We can use these observations to describe the general shapes of the TP, MP
and AP curves as below.

3.5 SHAPES OF TOTAL PRODUCT, MARGINAL PRODUCT

AND AVERAGE PRODUCT CURVES

An increase in the amount of one of the inputs keeping all other inputs constant
results in an increase in output. Table 3.2 shows how the total product changes
as the amount of labour increases. The total product curve in the input-output 41

Production and Costs

plane is a positively sloped curve. Figure 3.1 shows the shape of the total product
curve for a typical firm.
We measure units of labour
along the horizontal axis and Output
output along the vertical axis.
TPL
With L units of labour, the firm q 1
can at most produce q 1 units of
output.
According to the law of
variable proportions, the
marginal product of an input
initially rises and then after a
certain level of employment, it
starts falling. The MP curve O L
therefore, looks like an inverse Labour
‘U’-shaped curve as in figure 3.2. Fig. 3.1
Let us now see what the AP Total Product. This is a total product curve for
curve looks like. For the first unit labour. When all other inputs are held constant, it
of the variable input, one can shows the different output levels obtainable from
easily check that the MP and the different units of labour.

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 AP are same. Now as we increase
the amount of input, the MP rises. Output
AP being the average of marginal
P
products, also rises, but rises less
than MP. Then, after a point, the MP
starts falling. However, as long as
the value of MP remains higher APL
than the value of the AP, the AP
continues to rise. Once MP has
MP L
fallen sufficiently, its value becomes
less than the AP and the AP also
starts falling. So AP curve is also O L Labour
inverse ‘U’-shaped. Fig. 3.2
As long as the AP increases, it
Average and Marginal Product. These are
must be the case that MP is greater average and marginal product curves of labour.
than AP. Otherwise, AP cannot rise.
Similarly, when AP falls, MP has to be less than AP. It, follows that MP curve
cuts AP curve from above at its maximum.
Figure 3.2 shows the shapes of AP and MP curves for a typical firm.
The AP of factor 1 is maximum at L. To the left of L, AP is rising and MP is
greater than AP. To the right of L, AP is falling and MP is less than AP.

3.6 RETURNS TO SCALE

The law of variable proportions arises because factor proportions change as
long as one factor is held constant and the other is increased. What if both factors
can change? Remember that this can happen only in the long run. One special
case in the long run occurs when both factors are increased by the same
proportion, or factors are scaled up.
When a proportional increase in all inputs results in an increase in output
42
by the same proportion, the production function is said to display Constant
Microeconomics
Introductory

returns to scale (CRS).

When a proportional increase in all inputs results in an increase in output
by a larger proportion, the production function is said to display Increasing
Returns to Scale (IRS)
Decreasing Returns to Scale (DRS) holds when a proportional increase in
all inputs results in an increase in output by a smaller proportion.
For example, suppose in a production process, all inputs get doubled.
As a result, if the output gets doubled, the production function exhibits CRS.
If output is less than doubled, then DRS holds, and if it is more than doubled,
then IRS holds.

Returns to Scale
Consider a production function
q = f (x1, x2)
where the firm produces q amount of output using x1 amount of factor 1
and x2 amount of factor 2. Now suppose the firm decides to increase the
employment level of both the factors t (t > 1) times. Mathematically, we

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 can say that the production function exhibits constant returns to scale if
we have,
f (tx1, tx2) = t.f (x1, x2)
ie the new output level f (tx1, tx2) is exactly t times the previous output level
f (x1, x2).
Similarly, the production function exhibits increasing returns to scale if,
f (tx1, tx2) > t.f (x1, x2).

It exhibits decreasing returns to scale if,

f (tx1, tx2) < t.f (x1, x2).

3.7 COSTS
In order to produce output, the firm needs to employ inputs. But a given level
of output, typically, can be produced in many ways. There can be more than
one input combinations with which a firm can produce a desired level of output.
In Table 3.1, we can see that 50 units of output can be produced by three
different input combinations (L = 6, K = 3), (L = 4, K = 4) and (L = 3, K = 6). The
question is which input combination will the firm choose? With the input prices
given, it will choose that combination of inputs which is least expensive. So,
for every level of output, the firm chooses the least cost input combination.
Thus the cost function describes the least cost of producing each level of output
given prices of factors of production and technology.

Cobb-Douglas Production Function

Consider a production function
43
q = x 1α x 2β

Production and Costs

where α and β are constants. The firm produces q amount of output
using x1 amount of factor 1 and x2 amount of factor 2. This is called a
Cobb-Douglas production function. Suppose with x1 = x1 and x2 = x 2 , we
have q0 units of output, i.e.
q0 = x 1 α x 2 β
If we increase both the inputs t (t > 1) times, we get the new output
q1 = (t x1 )α (t x 2 )β
= t α + β x1 α x 2 β
When α + β = 1, we have q1 = tq0. That is, the output increases t times. So the
production function exhibits CRS. Similarly, when α + β > 1, the production
function exhibits IRS. When α + β < 1 the production function exhibits DRS.

3.7.1 Short Run Costs

We have previously discussed the short run and the long run. In the short
run, some of the factors of production cannot be varied, and therefore,
remain fixed. The cost that a firm incurs to employ these fixed inputs is
called the total fixed cost (TFC). Whatever amount of output the firm

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 produces, this cost remains fixed for the firm. To produce any required
level of output, the firm, in the short run, can adjust only variable inputs.
Accordingly, the cost that a firm incurs to employ these variable inputs is
called the total variable cost (TVC). Adding the fixed and the variable costs,
we get the total cost (TC) of a firm
TC = TVC + TFC (3.6)
In order to increase the production of output, the firm must employ more of
the variable inputs. As a result, total variable cost and total cost will increase.
Therefore, as output increases, total variable cost and total cost increase.
In Table 3.3, we have an example of cost function of a typical firm. The first
column shows different levels of output. For all levels of output, the total fixed
cost is Rs 20. Total variable cost increases as output increases. With output
zero, TVC is zero. For 1 unit of output, TVC is Rs 10; for 2 units of output, TVC
is Rs 18 and so on. In the fourth column, we obtain the total cost (TC) as the
sum of the corresponding values in second column (TFC) and third column
(TVC). At zero level of output, TC is just the fixed cost, and hence, equal to Rs
20. For 1 unit of output, total cost is Rs 30; for 2 units of output, the TC is Rs 38
and so on.
The short run average cost (SAC) incurred by the firm is defined as the
total cost per unit of output. We calculate it as
TC
SAC = q (3.7)

In Table 3.3, we get the SAC-column by dividing the values of the fourth
column by the corresponding values of the first column. At zero output, SAC is
undefined. For the first unit, SAC is Rs 30; for 2 units of output, SAC is Rs 19
and so on.
Similarly, the average variable cost (AVC) is defined as the total variable
cost per unit of output. We calculate it as
44 TVC
AVC = q (3.8)
Introductory
Microeconomics

Also, average fixed cost (AFC) is

TFC
AFC = q (3.9)

Clearly,
SAC = AVC + AFC (3.10)
In Table 3.3, we get the AFC-column by dividing the values of the second
column by the corresponding values of the first column. Similarly, we get the
AVC-column by dividing the values of the third column by the corresponding
values of the first column. At zero level of output, both AFC and AVC are
undefined. For the first unit of output, AFC is Rs 20 and AVC is Rs 10. Adding
them, we get the SAC equal to Rs 30.
The short run marginal cost (SMC) is defined as the change in total cost
per unit of change in output
change in total cos t ∆TC
SMC = change in output = ∆q (3.11)
where ∆ represents the change in the value of the variable.

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 The last column in table 3.3 gives a numerical example for the calculation of
SMC. Values in this column are obtained by dividing the change in TC by the
change in output, at each level of output.
Thus at q=5,
Change in TC = (TC at q=5) - (TC at q=4) (3.12)
= (53) – (49)
=4
Change in q = 1
SMC = 4/1 = 4
Table 3.3: Various Concepts of Costs

Output TFC TVC TC AFC AVC SAC SMC

(units) (q) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs) (Rs)
0 20 0 20 – – – –
1 20 10 30 20 10 30 10
2 20 18 38 10 9 19 8
3 20 24 44 6.67 8 14.67 6
4 20 29 49 5 7.25 12.25 5
5 20 33 53 4 6.6 10.6 4
6 20 39 59 3.33 6.5 9.83 6
7 20 47 67 2.86 6.7 9.57 8
8 20 60 80 2.5 7.5 10 13
9 20 75 95 2.22 8.33 10.55 15
10 20 95 115 2 9.5 11.5 20

Just like the case of marginal product, marginal cost also is undefined at
zero level of output. It is important to note here that in the short run, fixed cost
cannot be changed. When we change the level of output, whatever change occurs
to total cost is entirely due to the change in total variable cost. So in the short 45

Production and Costs

run, marginal cost is the increase in TVC due to increase in production of one
extra unit of output. For any level of output, the sum of marginal costs up to
that level gives us the total variable cost at that level. One may wish to check this
from the example represented
through Table 3.3. Average variable Costs
cost at some level of output is TC
therefore, the average of all marginal
TVC
costs up to that level. In Table 3.3,
we see that when the output is zero, c
3
SMC is undefined. For the first unit
c
of output, SMC is Rs 10; for the 2

second unit, the SMC is Rs 8 and so

on.
c1 TFC
Shapes of the Short Run Cost
Curves O q1 Otput
Now let us see what these short run Fig. 3.3
cost curves look like. You could plot
the data from in table 3.3 by placing Costs. These are total fixed cost (TFC), total
variable cost (TVC) and total cost (TC) curves
output on the x-axis and costs on for a firm. Total cost is the vertical sum of total
the y-axis. fixed cost and total variable cost.

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 Previously, we have discussed
that in order to increase the Cost
production of output the firm needs
to employ more of the variable
inputs. This results in an increase
in total variable cost, and hence, an
increase in total cost. Therefore, as
output increases, total variable cost F C
and total cost increase. Total fixed
cost, however, is independent of the
amount of output produced and AFC
remains constant for all levels of O q
production.
1
Output
Figure 3.3 illustrates the shapes Fig. 3.4
of total fixed cost, total variable cost
Average Fixed Cost. The average fixed cost
and total cost curves for a typical curve is a rectangular hyperbola. The area
firm. We place output on the x-axis of the rectangle OFCq1 gives us the total
and costs on the y-axis. TFC is a fixed cost.
constant which takes the value c1
and does not change with the change in output. It is, therefore, a horizontal
straight line cutting the cost axis at the point c1. At q1, TVC is c2 and TC is c3.
AFC is the ratio of TFC to q. TFC is a constant. Therefore, as q increases, AFC
decreases. When output is very close to zero, AFC is arbitrarily large, and as
output moves towards infinity, AFC moves towards zero. AFC curve is, in fact, a
rectangular hyperbola. If we multiply any value q of output with its
corresponding AFC, we always get a constant, namely TFC.
Figure 3.4 shows the shape of average fixed cost curve for a typical firm.
We measure output along the horizontal axis and AFC along the vertical axis.
At q1 level of output, we get the corresponding average fixed cost at F. The TFC
can be calculated as
46 TFC = AFC × quantity
= OF × Oq1
Introductory
Microeconomics

= the area of the rectangle OFCq1

Cost
We can also calculate AFC
from TFC curve. In Figure 3.5, the
horizontal straight line cutting
the vertical axis at F is the TFC
curve. At q0 level of output, total
fixed cost is equal to OF. At q0, the F A TFC
corresponding point on the TFC
curve is A. Let the angle ∠AOq0
be θ. The AFC at q0 is
O q0 Output
TFC
AFC = quantity
Fig. 3.5
Aq0 The Total Fixed Cost Curve. The slope of
= Oq = tanθ the angle ∠AOq 0 gives us the average fixed
0
cost at q 0.

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 Let us now look at the SMC
curve. Marginal cost is the additional Cost
cost that a firm incurs to produce AVC
one extra unit of output. According
to the law of variable proportions,
initially, the marginal product of a
factor increases as employment B
V
increases, and then after a certain
point, it decreases. This means
initially to produce every extra unit
of output, the requirement of the
factor becomes less and less, and O q0
Output
then after a certain point, it becomes Fig. 3.6
greater and greater. As a result, with
The Average Variable Cost Curve. The area
the factor price given, initially the
of the rectangle OVBq0 gives us the total
SMC falls, and then after a certain variable cost at q0.
point, it rises. SMC curve is,
therefore, ‘U’-shaped.
At zero level of output, SMC is undefined. The TVC at a particular level of
output is given by the area under the SMC curve up to that level.
Now, what does the AVC curve look like? For the first unit of output, it is
easy to check that SMC and AVC are the same. So both SMC and AVC curves
start from the same point. Then, as output increases, SMC falls. AVC being the
average of marginal costs, also falls, but falls less than SMC. Then, after a point,
SMC starts rising. AVC, however, continues to fall as long as the value of SMC
remains less than the prevailing value of AVC. Once the SMC has risen sufficiently,
its value becomes greater than the value of AVC. The AVC then starts rising. The
AVC curve is therefore ‘U’-shaped.
As long as AVC is falling, SMC must be less than the AVC. As AVC rises,
SMC must be greater than the AVC. So the SMC curve cuts the AVC curve from
below at the minimum point of AVC. 47

Production and Costs

Cost
TVC
In Figure 3.7, we measure
output along the horizontal
axis and TVC along the vertical
axis. At q0 level of output, OV is
the total variable cost. Let the
angle ∠E0q0 be equal to θ. Then, E
V
at q0, the AVC can be calculated
as
TVC O
AV C = output q0 Output

Eq0 Fig. 3.7

= Oq = tan θ
0 The Total Variable Cost Curve. The slope
of the angle ∠EOqo gives us the average
variable cost at qo.

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 In Figure 3.6 we measure output along the horizontal axis and AVC along
the vertical axis. At q0 level of output, AVC is equal to OV . The total variable cost
at q0 is
TVC = AVC × quantity
= OV × Oq0
= the area of the
rectangle OV Bq0.
Let us now look at SAC. SAC is the sum of AVC and AFC. Initially, both AVC
and AFC decrease as output increases. Therefore, SAC initially falls. After a certain
level of output production, AVC starts rising, but AFC continuous to fall. Initially
the fall in AFC is greater than the rise in AVC and SAC is still falling. But, after a
certain level of production, rise in AVC becomes larger than the fall in AFC. From
this point onwards, SAC is rising. SAC curve is therefore ‘U’-shaped.
It lies above the AVC curve with the vertical difference being equal to the
value of AFC. The minimum point of SAC curve lies to the right of the minimum
point of AVC curve.
Similar to the case of AVC and SMC, as long as SAC is falling, SMC is less
than the SAC. When SAC is rising, SMC is greater than the SAC. SMC curve cuts
the SAC curve from below at the minimum point of SAC.
Figure 3.8 shows the shapes of
short run marginal cost, average
variable cost and short run average Cost
SMC
cost curves for a typical firm. AVC
reaches its minimum at q1 units of
output. To the left of q1, AVC is falling SAC
and SMC is less than AVC. To the S AVC
right of q1, AVC is rising and SMC is
greater than AVC. SMC curve cuts P
the AVC curve at ‘P ’ which is the
48
minimum point of AVC curve. The
Introductory
Microeconomics

minimum point of SAC curve is ‘S ’

which corresponds to the output q2. O q
1 q
2
Output
It is the intersection point between Fig. 3.8
SMC and SAC curves. To the left of
q2, SAC is falling and SMC is less Short Run Costs. Short run marginal cost,
than SAC. To the right of q2, SAC is average variable cost and average cost curves.
rising and SMC is greater than SAC.

3.7.2 Long Run Costs

In the long run, all inputs are variable. There are no fixed costs. The total cost
and the total variable cost therefore, coincide in the long run. Long run average
cost (LRAC) is defined as cost per unit of output, i.e.
TC
LRAC = q (3.13)
Long run marginal cost (LRMC) is the change in total cost per unit of change
in output. When output changes in discrete units, then, if we increase production
from q1–1 to q1 units of output, the marginal cost of producing q1th unit will be
measured as
LRMC = (TC at q1 units) – (TC at q1 – 1 units) (3.14)

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 Just like the short run, in the long run, the sum of all marginal costs up to
some output level gives us the total cost at that level.
Shapes of the Long Run Cost Curves
We have previously discussed the returns to scales. Now let us see their
implications for the shape of LRAC.
IRS implies that if we increase all the inputs by a certain proportion, output
increases by more than that proportion. In other words, to increase output by a
certain proportion, inputs need to be increased by less than that proportion.
With the input prices given, cost also increases by a lesser proportion. For example,
suppose we want to double the output. To do that, inputs need to be increased,
but less than double. The cost that the firm incurs to hire those inputs therefore
also need to be increased by less than double. What is happening to the average
cost here? It must be the case that as long as IRS operates, average cost falls as
the firm increases output.
DRS implies that if we want to increase the output by a certain proportion,
inputs need to be increased by more than that proportion. As a result, cost also
increases by more than that proportion. So, as long as DRS operates, the average
cost must be rising as the firm increases output.
CRS implies a proportional increase in inputs resulting in a proportional
increase in output. So the average cost remains constant as long as CRS operates.
It is argued that in a typical firm IRS is observed at the initial level of
production. This is then followed by the CRS and then by the DRS. Accordingly,
the LRAC curve is a ‘U’-shaped curve. Its downward sloping part corresponds
to IRS and upward rising part corresponds to DRS. At the minimum point of the
LRAC curve, CRS is observed.
Let us check how the LRMC curve looks like. For the first unit of output,
both LRMC and LRAC are the same. Then, as output increases, LRAC initially
falls, and then, after a certain point, it rises. As long as average cost is falling,
marginal cost must be less than
the average cost. When the LRMC 49
Cost
average cost is rising, marginal

Production and Costs

cost must be greater than the
average cost. LRMC curve is LRAC
therefore a ‘U’-shaped curve. It
cuts the LRAC curve from below
at the minimum point of the M
LRAC. Figure 3.9 shows the
shapes of the long run marginal
cost and the long run average cost
curves for a typical firm.
LRAC reaches its minimum O 1q
Output
at q1. To the left of q 1, LRAC is Fig. 3.9
falling and LRMC is less than the
Long Run Costs. Long run marginal cost and
LRAC curve. To the right of q1, average cost curves.
LRAC is rising and LRMC is
higher than LRAC.

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 Summary
• For different combinations of inputs, the production function shows the maximum
quantity of output that can be produced.
• In the short run, some inputs cannot be varied. In the long run, all inputs can be
varied.
• Total product is the relationship between a variable input and output when all
other inputs are held constant.
• For any level of employment of an input, the sum of marginal products of every
unit of that input up to that level gives the total product of that input at that
employment level.
• Both the marginal product and the average product curves are inverse ‘U’-shaped.
The marginal product curve cuts the average product curve from above at the
maximum point of average product curve.
• In order to produce output, the firm chooses least cost input combinations.
• Total cost is the sum of total variable cost and the total fixed cost.
• Average cost is the sum of average variable cost and average fixed cost.
• Average fixed cost curve is downward sloping.
• Short run marginal cost, average variable cost and short run average cost curves
are ‘U’-shaped.
• SMC curve cuts the AVC curve from below at the minimum point of AVC.
• SMC curve cuts the SAC curve from below at the minimum point of SAC.
• In the short run, for any level of output, sum of marginal costs up to that level
gives us the total variable cost. The area under the SMC curve up to any level of
output gives us the total variable cost up to that level.
• Both LRAC and LRMC curves are ‘U’ shaped.
• LRMC curve cuts the LRAC curve from below at the minimum point of LRAC.
Key Concepts

Production function Short run

50 Long run Total product
Introductory
Microeconomics

Marginal product Average product

Law of diminishing marginal product Law of variable proportions
Returns to scale
Cost function Marginal cost, Average cost

1. Explain the concept of a production function.

Exercises

2. What is the total product of an input?

3. What is the average product of an input?
4. What is the marginal product of an input?
5. Explain the relationship between the marginal products and the total product
of an input.
6. Explain the concepts of the short run and the long run.
7. What is the law of diminishing marginal product?
8. What is the law of variable proportions?
9. When does a production function satisfy constant returns to scale?
10. When does a production function satisfy increasing returns to scale?

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11. When does a production function satisfy decreasing returns to scale?
12. Briefly explain the concept of the cost function.
13. What are the total fixed cost, total variable cost and total cost of a firm? How are
they related?
14. What are the average fixed cost, average variable cost and average cost of a
firm? How are they related?
15. Can there be some fixed cost in the long run? If not, why?
16. What does the average fixed cost curve look like? Why does it look so?
17. What do the short run marginal cost, average variable cost and short run
average cost curves look like?
18. Why does the SMC curve cut the AVC curve at the minimum point of the AVC
curve?
19. At which point does the SMC curve cut the SAC curve? Give reason in support
of your answer.
20. Why is the short run marginal cost curve ‘U’-shaped?
21. What do the long run marginal cost and the average cost curves look like?
22. The following table gives the total product schedule of L TPL
labour. Find the corresponding average product and
marginal product schedules of labour. 0 0
1 15
2 35
3 50
4 40
5 48

23. The following table gives the average product schedule

L APL
of labour. Find the total product and marginal product
schedules. It is given that the total product is zero at 1 2
zero level of labour employment. 2 3
3 4
51
4 4.25

Production and Costs

5 4
6 3.5

24. The following table gives the marginal product schedule L MPL
of labour. It is also given that total product of labour is
zero at zero level of employment. Calculate the total and 1 3
average product schedules of labour. 2 5
3 7
4 5
5 3
6 1

25. The following table shows the total cost schedule of a firm.
Q TC
What is the total fixed cost schedule of this firm? Calculate
the TVC, AFC, AVC, SAC and SMC schedules of the firm. 0 10
1 30
2 45
3 55
4 70
5 90
6 120

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 26. The following table gives the total cost schedule of
Q TC
a firm. It is also given that the average fixed cost at
4 units of output is Rs 5. Find the TVC, TFC, AVC, 1 50
AFC, SAC and SMC schedules of the firm for the 2 65
corresponding values of output. 3 75
4 95
5 130
6 185

27. A firm’s SMC schedule is shown in the following

Q TC
table. The total fixed cost of the firm is Rs 100. Find
the TVC, TC, AVC and SAC schedules of the firm. 0 -
1 500
2 300
3 200
4 300
5 500
6 800
28. Let the production function of a firm be
1 1
Q = 5 L2 K 2
Find out the maximum possible output that the firm can produce with 100
units of L and 100 units of K.
29. Let the production function of a firm be
Q = 2L2K2
Find out the maximum possible output that the firm can produce with 5 units
of L and 2 units of K. What is the maximum possible output that the firm can
produce with zero unit of L and 10 units of K?
30. Find out the maximum possible output for a firm with zero unit of L and 10
52 units of K when its production function is
Q = 5L + 2K
Introductory
Microeconomics

2020-21
 Chapter 4
The Theor
Theoryy of the Firm
Firm
under Per
Per fect Competition
erfect

In the previous chapter, we studied concepts related to a firm’s

production function and cost curves. The focus of this chapter is
different. Here we ask : how does a firm decide how much to
produce? Our answer to this question is by no means simple or
uncontroversial. We base our answer on a critical, if somewhat
unreasonable, assumption about firm behaviour – a firm, we
maintain, is a ruthless profit maximiser. So, the amount that a
firm produces and sells in the market is that which maximises its
profit. Here, we also assume that the firm sells whatever it produces
so that ‘output’ and quantity sold are often used interchangebly.
The structure of this chapter is as follows. We first set up and
examine in detail the profit maximisation problem of a firm. Then,0
we derive a firm’s supply curve. The supply curve shows the levels
of output that a firm chooses to produce at different market prices.
Finally, we study how to aggregate the supply curves of individual
firms and obtain the market supply curve.

4.1 PERFECT COMPETITION: DEFINING FEATURES

In order to analyse a firm’s profit maximisation problem, we must
first specify the market environment in which the firm functions.
In this chapter, we study a market environment called perfect
competition. A perfectly competitive market has the following
defining features:
1. The market consists of a large number of buyers and sellers
2. Each firm produces and sells a homogenous product. i.e., the
product of one firm cannot be differentiated from the product
of any other firm.
3. Entry into the market as well as exit from the market are free
for firms.
4. Information is perfect.
The existence of a large number of buyers and sellers means
that each individual buyer and seller is very small compared to
the size of the market. This means that no individual buyer or
seller can influence the market by their size. Homogenous products
further mean that the product of each firm is identical. So a buyer
can choose to buy from any firm in the market, and she gets the
same product. Free entry and exit mean that it is easy for firms to
enter the market, as well as to leave it. This condition is essential

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 for the large numbers of firms to exist. If entry was difficult, or restricted, then
the number of firms in the market could be small. Perfect information implies
that all buyers and all sellers are completely informed about the price, quality
and other relevant details about the product, as well as the market.
These features result in the single most distinguishing characteristic of perfect
competition: price taking behaviour. From the viewpoint of a firm, what does
price-taking entail? A price-taking firm believes that if it sets a price above the
market price, it will be unable to sell any quantity of the good that it produces.
On the other hand, should the set price be less than or equal to the market price,
the firm can sell as many units of the good as it wants to sell. From the viewpoint
of a buyer, what does price-taking entail? A buyer would obviously like to buy
the good at the lowest possible price. However, a price-taking buyer believes that
if she asks for a price below the market price, no firm will be willing to sell to her.
On the other hand, should the price asked be greater than or equal to the market
price, the buyer can obtain as many units of the good as she desires to buy.
Price-taking is often thought to be a reasonable assumption when the market
has many firms and buyers have perfect information about the price prevailing
in the market. Why? Let us start with a situation where each firm in the market
charges the same (market) price. Suppose, now, that a certain firm raises its
price above the market price. Observe that since all firms produce the same good
and all buyers are aware of the market price, the firm in question loses all its
buyers. Furthermore, as these buyers switch their purchases to other firms, no
“adjustment” problems arise; their demand is readily accommodated when there
are so many other firms in the market. Recall, now, that an individual firm’s
inability to sell any amount of the good at a price exceeding the market price is
precisely what the price-taking assumption stipulates.

4.2 REVENUE
We have indicated that in a perfectly competitive market, a firm believes that it
54 can sell as many units of the good as it wants by setting a price less than or equal
to the market price. But, if this is the case, surely there is no reason to set a price
Microeconomics
Introductory

lower than the market price. In other words, should the firm desire to sell some
amount of the good, the price that it sets is exactly equal to the market price.
A firm earns revenue by selling the good that it produces in the market. Let
the market price of a unit of the good be p. Let q be the quantity of the good
produced, and therefore sold, by the firm at price p. Then, total revenue (TR) of
the firm is defined as the market price of the good (p) multiplied by the firm’s
output (q). Hence,
TR = p × q
To make matters concrete, consider the following numerical example. Let the
market for candles be perfectly competitive and let the market price of a box of
candles be Rs 10. For a candle manufacturer, Table 4.1: Total Revenue
Table 4.1 shows how total revenue is related to
output. Notice that when no box is sold, Boxes sold TR (in Rs)
TR is equal to zero; if one box of candles is sold, 0 0
TR is equal to 1×Rs 10= Rs 10; if two boxes of 1 10
candles are produced, TR is equal to 2 × Rs 10 2 20
= Rs 20; and so on. 3 30
We can depict how the total revenue changes 4 40
as the quantity sold changes through a Total 5 50
Revenue Curve. A total revenue curve plots

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the quantity sold or output on the
Revenue
X-axis and the Revenue earned on
the Y-axis. Figure 4.1 shows the
total revenue curve of a firm. Three TR
observations are relevant here.
First, when the output is zero, the
total revenue of the firm is also
zero. Therefore, the TR curve A
passes through point O. Second,
the total revenue increases as the
output goes up. Moreover, the
equation ‘TR = p × q’ is that of a O q1 Output
straight line because p is constant. Fig. 4.1
This means that the TR curve is
an upward rising straight line. Total Revenue curve. The total revenue curve of
a firm shows the relationship between the total
Third, consider the slope of this revenue that the firm earns and the output level of
straight line. When the output is the firm. The slope of the curve, Aq1/Oq1, is the
one unit (horizontal distance Oq1 market price.
in Figure 4.1), the total revenue
(vertical height Aq1 in Figure 4.1)
is p × 1 = p. Therefore, the slope of
Price
the straight line is Aq1/Oq1 = p.
The average revenue ( AR ) of
a firm is defined as total revenue
per unit of output. Recall that if a
firm’s output is q and the market p
Price Line
price is p, then TR equals p × q.
Hence
TR p ×q
AR = q = q =p
55
In other words, for a price-taking

under Perfect Competition

The Theory of the Firm
O Output
firm, average revenue equals the
market price. Fig. 4.2
Now consider Figure 4.2. Price Line. The price line shows the relationship
Here, we plot the average revenue between the market price and a firm’s output level.
or market price (y-axis) for The vertical height of the price line is equal to the
different values of a firm’s output market price, p.
(x-axis). Since the market price is
fixed at p, we obtain a horizontal straight line that cuts the y-axis at a height
equal to p. This horizontal straight line is called the price line. It is also the
firm’s AR curve under perfect competition The price line also depicts the demand
curve facing a firm. Observe that the demand curve is perfectly elastic. This means
that a firm can sell as many units of the good as it wants to sell at price p.
The marginal revenue (MR) of a firm is defined as the increase in total
revenue for a unit increase in the firm’s output. Consider table 4.1 again. Total
revenue from the sale of 2 boxes of candles is Rs.20. Total revenue from the sale
of 3 boxes of candles is Rs.30.
Change in total revenue 30 - 20
Marginal Revenue (MR) = = = 10
Changein quantity 3- 2

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 Is it a coincidence that this is the same as the price? Actually it is not. Consider
the situation when the firm’s output changes from q1 to q2. Given the market
price p,
MR = (pq2 –pq1)/ (q2 –q1)
= [p (q2 –q1)]/ (q2 –q1)
=p
Thus, for the perfectly competitive firm, MR=AR=p
In other words, for a price-taking firm, marginal revenue equals the market
price.
Setting the algebra aside, the intuition for this result is quite simple. When a
firm increases its output by one unit, this extra unit is sold at the market price.
Hence, the firm’s increase in total revenue from the one-unit output expansion –
that is, MR – is precisely the market price.

4.3 PROFIT MAXIMISATION

A firm produces and sells a certain amount of a good. The firm’s profit, denoted
by π 1, is defined to be the difference between its total revenue (TR) and its total
cost of production (TC ). In other words
π = TR – TC
Clearly, the gap between TR and TC is the firm’s earnings net of costs.
A firm wishes to maximise its profit. The firm would like to identify the quantity
q0 at which its profits are maximum. By definition, then, at any quantity other
than q0, the firm’s profits are less than at q0. The critical question is: how do we
identify q0?
For profits to be maximum, three conditions must hold at q0:
1. The price, p, must equal MC
2. Marginal cost must be non-decreasing at q0
3. For the firm to continue to produce, in the short run, price must be greater
than the average variable cost (p > AVC); in the long run, price must be greater
56 than the average cost (p > AC).
Microeconomics
Introductory

4.3.1 Condition 1
Profits are the difference between total revenue and total cost. Both total revenue
and total cost increase as output increases. Notice that as long as the change in
total revenue is greater than the change in total cost, profits will continue to
increase. Recall that change in total revenue per unit increase in output is the
marginal revenue; and the change in total cost per unit increase in output is the
marginal cost. Therefore, we can conclude that as long as marginal revenue is
greater than marginal cost, profits are increasing. By the same logic, as long as
marginal revenue is less than marginal cost, profits will fall. It follows that for
profits to be maximum, marginal revenue should equal marginal cost.
In other words, profits are maximum at the level of output (which we have
called q0) for which MR = MC
For the perfectly competitive firm, we have established that the MR = P. So the
firm’s profit maximizing output becomes the level of output at which P=MC.

4.3.2 Condition 2
Consider the second condition that must hold when the profit-maximising output
level is positive. Why is it the case that the marginal cost curve cannot slope
1
It is a convention in economics to denote profit with the Greek letter π.

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downwards at the profit-
maximising output level? To
answer this question, refer once
again to Figure 4.3. Note that at
output levels q 1 and q 4, the
market price is equal to the
marginal cost. However, at the
output level q1, the marginal
cost curve is downward sloping.
We claim that q1 cannot be a
profit-maximising output level.
Why?
Observe that for all output
levels slightly to the left of q 1,
the market price is lower than Conditions 1 and 2 for profit maximisation.
the marginal cost. But, the The figure is used to demonstrate that when the
market price is p, the output level of a profit-
argument outlined in section
maximising firm cannot be q1 (marginal cost curve,
4.3.1 immediately implies that MC, is downward sloping), q2 and q3 (market price
the firm’s profit at an output exceeds marginal cost), or q5 and q6 (marginal cost
level slightly smaller than q 1 exceeds market price).
exceeds that corresponding to
the output level q 1. This being the case, q 1 cannot be a profit-maximising
output level.

4.3.3 Condition 3
Consider the third condition that Price,
SMC
costs
must hold when the profit-
maximising output level is
positive. Notice that the third SAC
condition has two parts: one part AVC
applies in the short run while the 57

under Perfect Competition

The Theory of the Firm
other applies in the long run. B
E
Case 1: Price must be greater p
than or equal to AVC in the A
short run
O q1 Output
We will show that the
statement of Case 1 (see above) is Fig. 4.4
true by arguing that a profit-
Price-AVC Relationship with Profit
maximising firm, in the short run, Maximisation (Short Run). The figure is used to
will not produce at an output level demonstrate that a profit-maximising firm produces
wherein the market price is lower zero output in the short run when the market price,
than the AVC. p, is less than the minimum of its average variable
cost (AVC). If the firm’s output level is q1, the firm’s
total variable cost exceeds its revenue by an amount
Let us turn to Figure 4.4.
equal to the area of rectangle pEBA.
Observe that at the output level q1,
the market price p is lower than
the AVC. We claim that q 1 cannot be a profit-maximising output level. Why?
Notice that the firm’s total revenue at q1 is as follows
TR = Price ×Quantity
= Vertical height Op × width Oq1
= The area of rectangle OpAq1

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 Similarly, the firm’s total variable cost at q1 is as follows
TVC = Average variable cost × Quantity
= Vertical height OE × Width Oq1
= The area of rectangle OEBq1
Now recall that the firm’s profit at q1 is TR – (TVC + TFC); that is, [the area of
rectangle OpAq1] – [the area of rectangle OEBq1] – TFC. What happens if the firm
produces zero output? Since output is zero, TR and TVC are zero as well. Hence,
the firm’s profit at zero output is equal to – TFC. But, the area of rectangle OpAq1
is strictly less than the area of rectangle OEBq1. Hence, the firm’s profit at q1 is
[(area EBAp)-TFC], which is strictly less than what it obtains by not producing at
all. So, the firm will choose not to
produce at all, and exit from the Price, LRMC
market. costs

Case 2: Price must be greater

than or equal to AC in the LRAC
long run
We will show that the statement of E B
Case 2 (see above) is true by
arguing that a profit-maximising p
firm, in the long run, will not A
produce at an output level
wherein the market price is lower O q1 Output
than the AC. Fig. 4.5
Let us turn to Figure 4.5.
Observe that at the output level q1, Price-AC Relationship with Profit
Maximisation (Long Run). The figure is used to
the market price p is lower than demonstrate that a profit-maximising firm
the (long run) AC. We claim that produces zero output in the long run when the
q1 cannot be a profit-maximising market price, p, is less than the minimum of its
output level. Why? long run average cost (LRAC). If the firm’s output
58 Notice that the firm’s total level is q1, the firm’s total cost exceeds its revenue
revenue, TR, at q1 is the area of the by an amount equal to the area of rectangle pEBA.
Microeconomics
Introductory

rectangle OpAq1 (the product of

price and quantity) while the firm’s
total cost, TC , is the area of the
rectangle OEBq1 (the product of
average cost and quantity). Since
the area of rectangle OEBq1 is
larger than the area of rectangle
OpAq1, the firm incurs a loss at the
output level q1. But, in the long
run set-up, a firm that shuts down
production has a profit of zero.
Again, the firm chooses to exit in
this case.

4.3.4 The Profit Maximisation

Problem: Graphical
Representation Geometric Representation of Profit
Maximisation (Short Run). Given market
Using the material in sections 3.1, price p, the output level of a profit-maximising
3.2 and 3.3, let us graphically firm is q0. At q0, the firm’s profit is equal to the
represent a firm’s profit area of rectangle EpAB.

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maximisation problem in the short run. Consider Figure 4.6. Notice that the
market price is p. Equating the market price with the (short run) marginal
cost, we obtain the output level q0. At q0, observe that SMC slopes upwards
and p exceeds AVC. Since the three conditions discussed in sections 3.1-3.3
are satisfied at q0, we maintain that the profit-maximising output level of the
firm is q0.
What happens at q0? The total revenue of the firm at q0 is the area of
rectangle OpAq0 (the product of price and quantity) while the total cost at q0 is
the area of rectangle OEBq0 (the product of short run average cost and quantity).
So, at q0, the firm earns a profit equal to the area of the rectangle EpAB.

4.4 SUPPLY CURVE OF A FIRM

A firm’s ‘supply’ is the quantity that it chooses to sell at a given price, given
technology, and given the prices of factors of production. A table describing the
quantities sold by a firm at various prices, technology and prices of factors
remaining unchanged, is called a supply schedule. We may also represent the
information as a graph, called a supply curve. The supply curve of a firm shows
the levels of output (plotted on the x-axis) that the firm chooses to produce
corresponding to different values of the market price (plotted on the y-axis),
again keeping technology and prices of factors of production unchanged. We
distinguish between the short run supply curve and the long run supply
curve.

4.4.1 Short Run Supply Curve of a Firm

Let us turn to Figure 4.7 and derive a firm’s short run supply curve. We shall
split this derivation into two parts. We first determine a firm’s profit-maximising
output level when the market price is greater than or equal to the minimum
AVC. This done, we determine the firm’s profit-maximising output level when
the market price is less than the minimum AVC.
59
Case 1: Price is greater than

under Perfect Competition

The Theory of the Firm
or equal to the minimum AVC
Price,
SMC
Suppose the market price is p1, costs
which exceeds the minimum AVC.
We start out by equating p1 with
SAC
SMC on the rising part of the SMC
curve; this leads to the output level AVC
q1. Note also that the AVC at q1 p1
does not exceed the market price,
p 1. Thus, all three conditions
highlighted in section 3 are p2
satisfied at q1. Hence, when the
market price is p 1, the firm’s O q1 Output
output level in the short run is Fig. 4.7
equal to q1.
Market Price Values. The figure shows the
Case 2: Price is less than the output levels chosen by a profit-maximising firm
minimum AVC in the short run for two values of the market price:
Suppose the market price is p2, p1 and p2. When the market price is p1, the output
level of the firm is q1; when the market price is
which is less than the minimum
p 2, the firm produces zero output.
AVC. We have argued (see

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 condition 3 in section 3) that if a Price,
profit-maximising firm produces Supply
costs
Curve
a positive output in the short run, (SMC)
then the market price, p2, must be
SAC
greater than or equal to the AVC
at that output level. But notice AVC
from Figure 4.7 that for all positive
output levels, AVC strictly exceeds
p2. In other words, it cannot be the
case that the firm supplies a
positive output. So, if the market
O Output
price is p2, the firm produces zero
output. Fig. 4.8
Combining cases 1 and 2, we
The Short Run Supply Curve of a Firm. The
reach an important conclusion. A short run supply curve of a firm, which is based
firm’s short run supply curve is on its short run marginal cost curve (SMC) and
the rising part of the SMC curve average variable cost curve (AVC), is represented
from and above the minimum AVC by the bold line.
together with zero output for all prices strictly less than the minimum AVC. In
figure 4.8, the bold line represents the short run supply curve of the firm.

4.4.2 Long Run Supply Curve of a Firm

Let us turn to Figure 4.9 and
Price, LRMC
derive the firm’s long run supply
costs
curve. As in the short run case,
we split the derivation into two
LRAC
parts. We first determine the firm’s
p1
profit-maximising output level
when the market price is greater
60 than or equal to the minimum
(long run) AC. This done, we
Introductory
Microeconomics

determine the firm’s profit- p2

maximising output level when the
market price is less than the O q1 Output
minimum (long run) AC. Fig. 4.9
Case 1: Price greater than or Profit maximisation in the Long Run for
equal to the minimum LRAC Different Market Price Values. The figure
shows the output levels chosen by a profit-
Suppose the market price is p1,
maximising firm in the long run for two values
which exceeds the minimum of the market price: p1 and p2. When the market
LRAC. Upon equating p 1 with price is p1, the output level of the firm is q1;
LRMC on the rising part of the when the market price is p2, the firm produces
LRMC curve, we obtain output zero output.
level q 1. Note also that the LRAC
at q 1 does not exceed the market price, p 1. Thus, all three conditions
highlighted in section 3 are satisfied at q 1. Hence, when the market price is
p 1, the firm’s supplies in the long run become an output equal to q 1.
Case 2: Price less than the minimum LRAC
Suppose the market price is p2, which is less than the minimum LRAC. We have

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argued (see condition 3 in section Supply Curve(LRMC)
Price,
3) that if a profit-maximising firm costs
produces a positive output in the
long run, the market price, p2, LRAC
must be greater than or equal to
the LRAC at that output level. But
notice from Figure 4.9 that for all
positive output levels, LRAC
strictly exceeds p2. In other words,
it cannot be the case that the firm
supplies a positive output. So,
when the market price is p2, the O Output
firm produces zero output. Fig. 4.10
Combining cases 1 and 2, we
The Long Run Supply Curve of a Firm. The
reach an important conclusion. A long run supply curve of a firm, which is based on
firm’s long run supply curve is the its long run marginal cost curve (LRMC) and long
rising part of the LRMC curve from run average cost curve (LRAC), is represented by
and above the minimum LRAC the bold line.
together with zero output for all
prices less than the minimum LRAC. In Figure 4.10, the bold line represents the
long run supply curve of the firm.

4.4.3 The Shut Down Point

Previously, while deriving the supply curve, we have discussed that in the short
run the firm continues to produce as long as the price remains greater than or
equal to the minimum of AVC. Therefore, along the supply curve as we move
down, the last price-output combination at which the firm produces positive
output is the point of minimum AVC where the SMC curve cuts the AVC curve.
Below this, there will be no production. This point is called the short run shut
down point of the firm. In the long run, however, the shut down point is the 61
minimum of LRAC curve.

under Perfect Competition

The Theory of the Firm
4.4.4 The Normal Profit and Break-even Point
The minimum level of profit that is needed to keep a firm in the existing business
is defined as normal profit. A firm that does not make normal profits is not
going to continue in business. Normal profits are therefore a part of the firm’s
total costs. It may be useful to think of them as an opportunity cost for
entrepreneurship. Profit that a firm earns over and above the normal profit is
called the super-normal profit. In the long run, a firm does not produce if it
earns anything less than the normal profit. In the short run, however, it may
produce even if the profit is less than this level. The point on the supply curve at
which a firm earns only normal profit is called the break-even point of the firm.
The point of minimum average cost at which the supply curve cuts the LRAC
curve (in short run, SAC curve) is therefore the break-even point of a firm.

Opportunity cost
In economics, one often encounters the concept of opportunity cost.
Opportunity cost of some activity is the gain foregone from the second best
activity. Suppose you have Rs 1,000 which you decide to invest in your family
business. What is the opportunity cost of your action? If you do not invest

2020-21
 this money, you can either keep it in the house-safe which will give you zero
return or you can deposit it in either bank-1 or bank-2 in which case you get
an interest at the rate of 10 per cent or 5 per cent respectively. So the maximum
benefit that you may get from other alternative activities is the interest from
the bank-1. But this opportunity will no longer be there once you invest the
money in your family business. The opportunity cost of investing the money
in your family business is therefore the amount of forgone interest from the
bank-1.

4.5 DETERMINANTS OF A FIRM’S SUPPLY CURVE

In the previous section, we have seen that a firm’s supply curve is a part of its
marginal cost curve. Thus, any factor that affects a firm’s marginal cost curve is
of course a determinant of its supply curve. In this section, we discuss two
such factors.

4.5.1 Technological Progress

Suppose a firm uses two factors of production – say, capital and labour – to
produce a certain good. Subsequent to an organisational innovation by the firm,
the same levels of capital and labour now produce more units of output. Put
differently, to produce a given level of output, the organisational innovation allows
the firm to use fewer units of inputs. It is expected that this will lower the firm’s
marginal cost at any level of output; that is, there is a rightward (or downward)
shift of the MC curve. As the firm’s supply curve is essentially a segment of the
MC curve, technological progress shifts the supply curve of the firm to the right.
At any given market price, the firm now supplies more units of output.

4.5.2 Input Prices

A change in input prices also affects a firm’s supply curve. If the price of an
62 input (say, the wage rate of labour) increases, the cost of production rises. The
consequent increase in the firm’s average cost at any level of output is usually
Introductory
Microeconomics

accompanied by an increase in the firm’s marginal cost at any level of output;

that is, there is a leftward (or upward) shift of the MC curve. This means that the
firm’s supply curve shifts to the left: at any given market price, the firm now
supplies fewer units of output.

Impact of a unit tax on supply

A unit tax is a tax that the government imposes per unit sale of output. For
example, suppose that the unit tax imposed by the government is Rs 2.
Then, if the firm produces and sells 10 units of the good, the total tax that
the firm must pay to the government is 10 × Rs 2 = Rs 20.
How does the long run supply curve of a firm change when a unit tax is
imposed? Let us turn to figure 4.11. Before the unit tax is imposed, LRMC0
and LRAC0 are, respectively, the long run marginal cost curve and the long
run average cost curve of the firm. Now, suppose the government puts in
place a unit tax of Rs t. Since the firm must pay an extra Rs t for each unit
of the good produced, the firm’s long run average cost and long run marginal
cost at any level of output increases by Rs t. In Figure 4.11, LRMC1 and
LRAC1 are, respectively, the long run marginal cost curve and the long run
average cost curve of the firm upon imposition of the unit tax.

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 Recall that the long run supply curve of a firm is the rising part of the
LRMC curve from and above the minimum LRAC together with zero output
for all prices less than the minimum LRAC. Using this observation in Figure
4.12, it is immediate that S0 and S1 are, respectively, the long run supply
curve of the firm before and after the imposition of the unit tax. Notice that
the unit tax shifts the firm’s long run supply curve to the left: at any given
market price, the firm now supplies fewer units of output.

LRMC1 Price S1 S0
Costs
LRAC1

LRMC0

LRAC0
0
p +t
p0 + t
t
p0
0
p

O O q0 Output
q0 Output
Fig. 4.11 Fig. 4.12

Cost Curves and the Unit Tax. LRAC0 Supply Curves and Unit Tax. S0 is the
and LRMC0 are, respectively, the long run supply curve of a firm before a unit tax
average cost curve and the long run is imposed. After a unit tax of Rs t is
marginal cost curve of a firm before a unit imposed, S1 represents the supply curve
tax is imposed. LRAC1 and LRMC1 are, of the firm.
respectively, the long run average cost
curve and the long run marginal cost curve
of a firm after a unit tax of Rs t is imposed.

4.6 MARKET SUPPLY CURVE

63
The market supply curve shows the output levels (plotted on the x-axis) that

under Perfect Competition

The Theory of the Firm
firms in the market produce in aggregate corresponding to different values of
the market price (plotted on the y-axis).
How is the market supply curve derived? Consider a market with n firms:
firm 1, firm 2, firm 3, and so on. Suppose the market price is fixed at p. Then,
the output produced by the n firms in aggregate is [supply of firm 1 at price p]
+ [supply of firm 2 at price p] + ... + [supply of firm n at price p]. In other words,
the market supply at price p is the summation of the supplies of individual
firms at that price.
Let us now construct the market supply curve geometrically with just two
firms in the market: firm 1 and firm 2. The two firms have different cost structures.
Firm 1 will not produce anything if the market price is less than p1 while firm 2
will not produce anything if the market price is less than p 2 . Assume also that
p 2 is greater than p1 .
In panel (a) of Figure 4.13 we have the supply curve of firm 1, denoted by
S1; in panel (b), we have the supply curve of firm 2, denoted by S2. Panel (c) of
Figure 4.13 shows the market supply curve, denoted by Sm. When the market
price is strictly below p1 , both firms choose not to produce any amount of the
good; hence, market supply will also be zero for all such prices. For a market

2020-21
 price greater than or equal to p1 but strictly less than p 2 , only firm 1 will produce
a positive amount of the good. Therefore, in this range, the market supply curve
coincides with the supply curve of firm 1. For a market price greater than or
equal to p 2 , both firms will have positive output levels. For example, consider a
situation wherein the market price assumes the value p3 (observe that p3
exceeds p 2 ). Given p3, firm 1 supplies q3 units of output while firm 2 supplies q4
units of output. So, the market supply at price p3 is q5, where q5 = q3 + q4. Notice
how the market supply curve, Sm, in panel (c) is being constructed: we obtain Sm
by taking a horizontal summation of the supply curves of the two firms in the
market, S1 and S2.
Price
S1 S2

Sm

p3

p2

p1

O q3 O q4 O q5 Output
(a) (b) (c)
Fig. 4.13

The Market Supply Curve Panel. (a) shows the supply curve of firm 1. Panel (b) shows the
supply curve of firm 2. Panel (c) shows the market supply curve, which is obtained by taking
a horizontal summation of the supply curves of the two firms.

It should be noted that the market supply curve has been derived for a fixed
64 number of firms in the market. As the number of firms changes, the market
supply curve shifts as well. Specifically, if the number of firms in the market
Introductory
Microeconomics

increases (decreases), the market supply curve shifts to the right (left).
We now supplement the graphical analysis given above with a related
numerical example. Consider a market with two firms: firm 1 and firm 2. Let the
supply curve of firm 1 be as follows

0 : p < 10
S1(p) =  p – 10 : p ≥ 10

Notice that S1(p) indicates that (1) firm 1 produces an output of 0 if the market
price, p, is strictly less than 10, and (2) firm 1 produces an output of (p – 10) if
the market price, p, is greater than or equal to 10. Let the supply curve of firm 2
be as follows
0 : p < 15
S2(p) =  p – 15 : p ≥ 15

The interpretation of S2(p) is identical to that of S1(p), and is, hence, omitted.
Now, the market supply curve, Sm(p), simply sums up the supply curves of the
two firms; in other words
Sm(p) = S1(p) + S2(p)

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 But, this means that Sm(p) is as follows

0 : p < 10

Sm(p) =  p – 10 : p ≥ 10 and p < 15
( p – 10) + ( p – 15) = 2 p – 25 : p ≥ 15


4.7 PRICE ELASTICITY OF SUPPLY

The price elasticity of supply of a good measures the responsiveness of quantity
supplied to changes in the price of the good. More specifically, the price elasticity
of supply, denoted by eS, is defined as follows
Percentage change in quantity supplied
Price elasticity of supply, eS =
Percentage change in price

∆Q
× 100
Q ∆Q P
= = ×
∆P Q ∆P
× 100
P

Where ∆Q is the change in quantity of the good supplied to the market as market
price changes by ∆P .
To make matters concrete, consider the following numerical example. Suppose
the market for cricket balls is perfectly competitive. When the price of a cricket ball
is Rs10, let us assume that 200 cricket balls are produced in aggregate by the firms
in the market. When the price of a cricket ball rises to Rs 30, let us assume that 1,000
cricket balls are produced in aggregate by the firms in the market.
The percentage change in quantity supplied and market price can be estimated
using the information summarised in the table below:
65
Price of Cricket balls (P) Quantity of Cricket balls

under Perfect Competition

The Theory of the Firm
produced and sold (Q)
Old price : P1 = 10 Old quantity : Q1 = 200
New price : P2 = 30 New quantity: Q2 = 1000

∆Q
Percentage change in quantity supplied= Q × 100
1

Q 2 − Q1
= × 100
Q1
1000 − 200
= × 100
200
= 400
∆P
Percentage change in market price = P × 100
1

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 P2 − P1
= × 100
P1
30 − 10
= × 100
10
= 200
400
Therefore, price elasticity of supply, eS = =2
200
When the supply curve is vertical, supply is completely insensitive to price
and the elasticity of supply is zero. In other cases, when supply curve is
positively sloped, with a rise in price, supply rises and hence, the elasticity of
supply is positive. Like the price elasticity of demand, the price elasticity of
supply is also independent of units.

The Geometric Method

Consider the Figure 4.14. Panel (a) shows a straight line supply curve. S is a
point on the supply curve. It cuts the price-axis at its positive range and as we
extend the straight line, it cuts the quantity-axis at M which is at its negative
range. The price elasticity of this supply curve at the point S is given by the
ratio, Mq0/Oq0. For any point S on such a supply curve, we see that Mq0 > Oq0.
The elasticity at any point on such a supply curve, therefore, will be greater
than 1.
In panel (c) we consider a straight line supply curve and S is a point on it.
It cuts the quantity-axis at M which is at its positive range. Again the price
elasticity of this supply curve at the point S is given by the ratio, Mq0/Oq0.
Now, Mq0 < Oq0 and hence, eS < 1. S can be any point on the supply curve,
and therefore at all points on such a supply curve eS < 1.
Now we come to panel (b). Here the supply curve goes through the origin.
66 One can imagine that the point M has coincided with the origin here, i.e., Mq0
has become equal to Oq0. The price elasticity of this supply curve at the
Introductory
Microeconomics

point S is given by the ratio, Oq0/Oq0 which is equal to 1. At any point on a

straight line, supply curve going through the origin price elasticity will be
one.
Price Price Price

S S S
p0 p0 p0

O M q0
M O q0 Output O q0 Output Output

(a) (b) (c)

Fig. 4.14

Price Elasticity Associated with Straight Line Supply Curves. In panel (a), price elasticity
(eS ) at S is greater than 1. In panel (b), price elasticity (eS) at S is equal to 1. In panel (c), price
elasticity (eS) at S is less than 1.

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 • In a perfectly competitive market, firms are price-takers.
Summary

• The total revenue of a firm is the market price of the good multiplied by the firm’s
output of the good.
• For a price-taking firm, average revenue is equal to market price.
• For a price-taking firm, marginal revenue is equal to market price.
• The demand curve that a firm faces in a perfectly competitive market is perfectly
elastic; it is a horizontal straight line at the market price.
• The profit of a firm is the difference between total revenue earned and total cost
incurred.
• If there is a positive level of output at which a firm’s profit is maximised in the
short run, three conditions must hold at that output level
(i) p = SMC
(ii) SMC is non-decreasing
(iii) p ≥ AV C.
• If there is a positive level of output at which a firm’s profit is maximised in the
long run, three conditions must hold at that output level
(i) p = LRMC
(ii) LRMC is non-decreasing
(iii) p ≥ LRAC.
• The short run supply curve of a firm is the rising part of the SMC curve from and
above minimum AVC together with 0 output for all prices less than the minimum
AVC.
• The long run supply curve of a firm is the rising part of the LRMC curve from and
above minimum LRAC together with 0 output for all prices less than the minimum
LRAC.
• Technological progress is expected to shift the supply curve of a firm to the right.
• An increase (decrease) in input prices is expected to shift the supply curve of a
firm to the left (right).
• The imposition of a unit tax shifts the supply curve of a firm to the left.
67
• The market supply curve is obtained by the horizontal summation of the supply

under Perfect Competition

The Theory of the Firm
curves of individual firms.
• The price elasticity of supply of a good is the percentage change in quantity
supplied due to one per cent change in the market price of the good.
Key Concepts

Perfect competition Revenue, Profit

Profit maximisation Firms supply curve
Market supply curve Price elasticity of supply
Exercises

1. What are the characteristics of a perfectly competitive market?

? 2. How are the total revenue of a firm, market price, and the quantity sold by the
firm related to each other?
3. What is the ‘price line’?
4. Why is the total revenue curve of a price-taking firm an upward-sloping straight
? line? Why does the curve pass through the origin?

2020-21
 5. What is the relation between market price and average revenue of a price-
taking firm?
6. What is the relation between market price and marginal revenue of a price-
taking firm?
7. What conditions must hold if a profit-maximising firm produces positive output
in a competitive market?
8. Can there be a positive level of output that a profit-maximising firm produces
in a competitive market at which market price is not equal to marginal cost?
Give an explanation.
9. Will a profit-maximising firm in a competitive market ever produce a positive
level of output in the range where the marginal cost is falling? Give an
explanation.
10. Will a profit-maximising firm in a competitive market produce a positive level of
output in the short run if the market price is less than the minimum of AVC?
Give an explanation.
11. Will a profit-maximising firm in a competitive market produce a positive level of
output in the long run if the market price is less than the minimum of AC?
Give an explanation.
12. What is the supply curve of a firm in the short run?
13. What is the supply curve of a firm in the long run?
14. How does technological progress affect the supply curve of a firm?
15. How does the imposition of a unit tax affect the supply curve of a firm?
16. How does an increase in the price of an input affect the supply curve of a firm?
17. How does an increase in the number of firms in a market affect the market
supply curve?
18. What does the price elasticity of supply mean? How do we measure it?
19. Compute the total revenue, marginal
revenue and average revenue schedules Quantity Sold TR MR AR
in the following table. Market price of each 0
68 unit of the good is Rs 10.
1
Introductory
Microeconomics

2
3
4
5
6

20. The following table shows the

Quantity Sold TR (Rs) TC (Rs) Profit
total revenue and total cost
schedules of a competitive 0 0 5
firm. Calculate the profit at 1 5 7
each output level. Determine 2 10 10
also the market price of the
3 15 12
good.
4 20 15
5 25 23
6 30 33
7 35 40

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21. The following table shows the total cost schedule
Output TC (Rs)
of a competitive firm. It is given that the price
of the good is Rs 10. Calculate the profit at each 0 5
output level. Find the profit maximising level of 1 15
output. 2 22
3 27
4 31
5 38
6 49
7 63
8 81
9 101
10 123
22. Consider a market with two
firms. The following table Price (Rs) SS1 (units) SS2 (units)
shows the supply schedules 0 0 0
of the two firms: the SS 1 1 0 0
column gives the supply
2 0 0
schedule of firm 1 and the
SS2 column gives the supply 3 1 1
schedule of firm 2. Compute 4 2 2
the market supply schedule. 5 3 3
6 4 4

23. Consider a market with two

firms. In the following table, Price (Rs) SS1 (kg) SS2 (kg)
columns labelled as SS 1 0 0 0
and SS 2 give the supply 1 0 0
schedules of firm 1 and firm
2 0 0
2 respectively. Compute the
market supply schedule. 3 1 0 69
4 2 0.5

under Perfect Competition

The Theory of the Firm
5 3 1
6 4 1.5
7 5 2
8 6 2.5

24. There are three identical firms in a market. The

following table shows the supply schedule of firm Price (Rs) SS1 (units)
1. Compute the market supply schedule. 0 0
1 0
2 2
3 4
4 6
5 8
6 10
7 12
8 14

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 25. A firm earns a revenue of Rs 50 when the market price of a good is Rs 10. The
? market price increases to Rs 15 and the firm now earns a revenue of Rs 150.
What is the price elasticity of the firm’s supply curve?
26. The market price of a good changes from Rs 5 to Rs 20. As a result, the quantity
supplied by a firm increases by 15 units. The price elasticity of the firm’s supply
curve is 0.5. Find the initial and final output levels of the firm.
27. At the market price of Rs 10, a firm supplies 4 units of output. The market price

? increases to Rs 30. The price elasticity of the firm’s supply is 1.25. What quantity
will the firm supply at the new price?

70
Introductory
Microeconomics

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 Chapter 5

Price
Market
Market Equilibrium SS

pf

p*

This chapter will be built on the foundation laid down in Chapters p1

DD
2 and 4 where we studied the consumer and firm behaviour when
they are price takers. In Chapter 2, we have seen that an O q'1 q'1 q* q2 q1
individual’s demand curve for a commodity tells us what quantity Quantity
a consumer is willing to buy at different prices when he takes price
as given. The market demand curve in turn tells us how much of
the commodity all the consumers taken together are willing to
purchase at different prices when everyone takes price as given.
In Chapter 4, we have seen that an individual firm’s supply curve
tells us the quantity of the commodity that a profit-maximising
firm would wish to sell at different prices when it takes price as
given and the market supply curve tells us how much of the
commodity all the firms taken together would wish to supply at
different prices when each firm takes price as given.
In this chapter, we combine both consumers’ and firms’
behaviour to study market equilibrium through demand-supply
analysis and determine at what price equilibrium will be attained.
We also examine the effects of demand and supply shifts on
equilibrium. At the end of the chapter, we will look at some of the
applications of demand-supply analysis.

5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY

A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
An equilibrium is defined as a situation where the plans of all
consumers and firms in the market match and the market clears.
In equilibrium, the aggregate quantity that all firms wish to sell
equals the quantity that all the consumers in the market wish to
buy; in other words, market supply equals market demand. The
price at which equilibrium is reached is called equilibrium price
and the quantity bought and sold at this price is called equilibrium
quantity. Therefore, (p*, q*) is an equilibrium if
qD(p∗) = qS(p∗)

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 where p∗ denotes the equilibrium price and qD(p∗) and qS(p∗) denote the market
demand and market supply of the commodity respectively at price p∗.
If at a price, market supply is greater than market demand, we say that
there is an excess supply in the market at that price and if market demand
exceeds market supply at a price, it is said that excess demand exists in the
market at that price. Therefore, equilibrium in a perfectly competitive market
can be defined alternatively as zero excess demand-zero excess supply situation.
Whenever market supply is not equal to market demand, and hence the market
is not in equilibrium, there will be a tendency for the price to change. In the next
two sections, we will try to understand what drives this change.

Out-of-equilibrium Behaviour
From the time of Adam Smith (1723-1790), it has been maintained that in
a perfectly competitive market an ‘Invisible Hand’ is at play which changes
price whenever there is imbalance in the market. Our intuition also tells us
that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’
and lower the prices in case of ‘excess supply’. Throughout our analysis we
shall maintain that the ‘Invisible Hand’ plays this very important role.
Moreover, we shall take it that the ‘Invisible Hand’ by following this process
is able to reach the equilibrium. This assumption will be taken to hold in all
that we discuss in the text.

5.1.1 Market Equilibrium: Fixed Number of Firms

Recall that in Chapter 2 we have derived the market demand curve for price-
taking consumers, and for price-taking firms the market supply curve was
derived in Chapter 4 under the assumption of a fixed number of firms. In this
section with the help of these two curves we will look at how supply and demand
forces work together to determine where the market will be in equilibrium when
the number of firms is fixed. We will also study how the equilibrium price and
72 quantity change due to shifts in demand and supply curves.
Figure 5.1 illustrates equilibrium
Introductory Microeconomics

for a perfectly competitive market Price

with a fixed number of firms. Here
SS denotes the market supply
curve and DD denotes the market SS
demand curve for a commodity.
The market supply curve SS p 2

shows how much of the

p*
commodity, firms would wish to
supply at different prices, and the
p
demand curve DD tells us how 1
DD
much of the commodity, the
consumers would be willing to O q' 1 q' 2 q* q 2 q Quantity
1

purchase at different prices. Fig. 5.1

Graphically, an equilibrium is a
point where the market supply Market Equilibrium with Fixed Number of
curve intersects the market Firms. Equilibrium occurs at the intersection of the
market demand curve DD and market supply curve
demand curve because this is SS. The equilibrium quantity is q* and the equilibrium
where the market demand equals price is p*. At a price greater than p*, there will be
market supply. At any other point, excess supply, and at a price below p*, there will be
either there is excess supply or excess demand.

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there is excess demand. To see what happens when market demand does not
equal market supply, let us look in figure 5.1 again.
In Figure 5.1, if the prevailing price is p1, the market demand is q1 whereas
the market supply is q'1 . Therefore, there is excess demand in the market equal
to q'1 q1. Some consumers who are either unable to obtain the commodity at all
or obtain it in insufficient quantity will be willing to pay more than p1. The market
price would tend to increase. All other things remaining the same as price rises,
quantity demanded falls and quantity supplied increases. The market moves
towards the point where the quantity that the firms want to sell is equal to the
quantity that the consumers want to buy. This happens when price is p* , the
supply decisions of the firms only match with the demand decisions of the
consumers.
Similarly, if the prevailing price is p2, the market supply (q2) will exceed the
market demand ( q 2' ) at that price giving rise to excess supply equal to q 2' q2.
Some firms will not be then able to sell quantity they want to sell; so, they will
lower their price. All other things remaining the same as price falls, quantity
demanded rises, quantity supplied falls, and at p*, the firms are able to sell
their desired output since market demand equals market supply at that price.
Therefore, p* is the equilibrium price and the corresponding quantity q* is the
equilibrium quantity.
To understand the equilibrium price and quantity determination more
clearly, let us explain it through an example.

EXAMPLE 5.1
Let us consider the example of a market consisting of identical1 farms producing
same quality of wheat. Suppose the market demand curve and the market supply
curve for wheat are given by:
qD = 200 – p for 0 ≤ p ≤ 200
=0 for p > 200 73
qS = 120 + p for p ≥ 10

Market Equilibrium
=0 for 0 ≤ p < 10
where qD and qS denote the demand for and supply of wheat (in kg) respectively
and p denotes the price of wheat per kg in rupees.
Since at equilibrium price market clears, we find the equilibrium price
(denoted by p*) by equating market demand and supply and solve for p*.
qD(p*) = qS(p*)
200 – p* = 120 + p*
Rearranging terms,
2p* = 80
p* = 40
Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium
quantity (denoted by q* ) is obtained by substituting the equilibrium price into
either the demand or the supply curve’s equation since in equilibrium quantity
demanded and supplied are equal.

1
Here, by identical we mean that all farms have same cost structure.

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 qD = q* = 200 – 40 = 160
Alternatively,
qS = q* = 120 + 40 = 160
Thus, the equilibrium quantity is 160 kg.
At a price less than p*, say p1 = 25
qD = 200 – 25 = 175
qS = 120 + 25 = 145
Therefore, at p1 = 25, qD > qS which implies that there is excess demand at
this price.
Algebraically, excess demand (ED) can be expressed as
ED(p) = qD – qS
= 200 – p – (120 + p)
= 80 – 2p
Notice from the above expression that for any price less than p*(= 40), excess
demand will be positive.
Similarly, at a price greater than p*, say p2 = 45
qD = 200 – 45 = 155
qS = 120 + 45 = 165
Therefore, there is excess supply at this price since qS > qD. Algebraically,
excess supply (ES) can be expressed as
ES(p) = qS – qD
= 120 + p – (200 – p)
= 2p – 80
Notice from the above expression that for any price greater than p*(= 40),
74 excess supply will be positive.
Therefore, at any price greater than p*, there will be excess supply, and at
Introductory Microeconomics

any price lower than p*,there will be excess demand.

Wage Determination in Labour Market

Here we will briefly discuss the theory of wage determination under a
perfectly competitive market structure using the demand-supply analysis.
The basic difference between a labour market and a market for goods is
with respect to the source of supply and demand. In the labour market,
households are the suppliers of labour and the demand for labour comes
from firms whereas in the market for goods, it is the opposite. Here, it is
important to point out that by labour, we mean the hours of work provided
by labourers and not the number of labourers. The wage rate is determined
at the intersection of the demand and supply curves of labour where the
demand for and supply of labour balance. We shall now see what the demand
and supply curves of labour look like.
To examine the demand for labour by a single firm, we assume that the
labour is the only variable factor of production and the labour market is
perfectly competitive, which in turn, implies that each firm takes wage rate
as given. Also, the firm we are concerned with, is perfectly competitive in

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nature and carries out production with the goal of profit maximisation. We
also assume that given the technology of the firm, the law of diminishing
marginal product holds.
The firm being a profit maximiser will always employ labour upto
the point where the extra cost she incurs for employing the last unit of
labour is equal to the additional benefit she earns from that unit. The
extra cost of hiring one more unit of labour is the wage rate (w). The
extra output produced by one more unit of labour is its marginal product
(MPL) and by selling each extra unit of output, the additional earning of
the firm is the marginal revenue (MR) she gets from that unit. Therefore,
for each extra unit of labour, she gets an additional benefit equal to
marginal revenue times marginal product which is called Marginal
Revenue Product of Labour (MRPL ). Thus, while hiring labour, the firm
employs labour up to the point where
w = MRPL
and MRPL = MR × MPL
Since we are dealing with a perfectly competitive firm, marginal
revenue is equal to the price of the commoditya and hence marginal
revenue product of labour in this case is equal to the value of marginal
product of labour (VMPL).
As long as the VMPL is greater than the wage rate, the firm will earn
more profit by hiring one more unit of labour, and if at any level of labour
employment VMPL is less than the wage rate, the firm can increase her
profit by reducing a unit of labour employed.
Given the assumption of the law of diminishing marginal product,
the fact that the firm always produces at w = VMPL implies that the
demand curve for labour is downward sloping. To explain why it is so,
let us assume at some wage rate w1, demand for labour is l1. Now, suppose
the wage rate increases to w2. To maintain the wage-VMPL equality, VMPL
should also increase. The price of the commodity remaining 75
constant b, this is possible

Market Equilibrium
only if MPL increases which in Wage
turn implies that less labour
should be employed owing to S L

the diminishing marginal

p r o d u c t i v i t y o f l a b o u r.
Hence, at higher wage, less
w*
labour is demanded thereby
leading to a downward
sloping demand, curve. To
arrive at the market demand D L

curve from individual firms’

demand curve, we simply
O l*
add up the demand for Labour(in hrs)
labour by individual firms at
different wages and since Wage is determined at the point where the labour
e a c h f i r m d e m a n d s l e s s demand and supply curves intersect.
labour as wage increases, the
market demand curve is also downward sloping.
a
Recall from Chapter 4 that for a perfectly competitive firm, marginal revenue equals price.
b
Since the firm under consideration is perfectly competitive, it believes it cannot influence
the price of the commodity.

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 Having explored the demand side, we now turn to the supply side.
As already mentioned, it is the households which determine how much
labour to supply at a given wage rate. Their supply decision is essentially
a choice between income and leisure. On the one hand, individuals enjoy
leisure and find work irksome and on the other, they value income for
which they must work.
So there is a trade-off between enjoying leisure and spending more
hours for work. To derive the labour supply curve for a single individual,
let us assume at some wage rate w1, the individual supplies l1 units of
labour. Now suppose the wage rises to w2. This increase in wage rate will
have two effects: First, due to the increase in wage rate, the opportunity
cost of leisure increases which makes leisure costlier. Therefore, the
individual will want to enjoy less leisure. As a result, they will work for
longer hours. Second, because of the increase in wage rate to w2, the
purchasing power of the individual increases. So, she would want to
spend more on leisure activities. The final effect of the increase in wage
rate will depend on which of the two effects predominates. At low wage
rates, the first effect dominates the second and so the individual will be
willing to supply more labour with an increase in wage rate. But at high
wage rates, the second effect dominates the first and the individual will
be willing to supply less labour for every increase in wage rate. Thus, we
get a backward bending individual labour supply curve which shows
that up to a certain wage rate for every increase in wage rate, there is an
increased supply of labour. Beyond this wage rate for every increase in
wage rate, labour supply will decrease. Nevertheless, the market supply
curve of labour, which we obtain by aggregating individuals’ supply at
different wages, will be upward sloping because though at higher wages
some individuals may be willing to work less, many more individuals
will be attracted to supply more labour.
With an upward sloping supply curve and downward sloping demand
curve, the equilibrium wage rate is determined at the point where these two
76 curves intersect; in other words, where the labour that the households wish
to supply is equal to the labour that the firms wish to hire. This is shown in
Introductory Microeconomics

the diagram.

Shifts in Demand and Supply

In the above section, we studied market equilibrium under the assumption
that tastes and preferences of the consumers, prices of the related
commodities, incomes of the consumers, technology, size of the market, prices
of the inputs used in production, etc remain constant. However, with changes
in one or more of these factors either the supply or the demand curve or both
may shift, thereby affecting the equilibrium price and quantity. Here, we first
develop the general theory which outlines the impact of these shifts on
equilibrium and then discuss the impact of changes in some of the above
mentioned factors on equilibrium.
Demand Shift
Consider Figure 5.2 in which we depict the impact of demand shift when the
number of firms is fixed. Here, the initial equilibrium point is E where the market
demand curve DD0 and the market supply curve SS0 intersect so that q0 and p0
are the equilibrium quantity and price respectively.

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 Price Price
SS0
SS0

G E
p2 p0
F
p0 p1
E

DD2 DD0

DD0 DD1
O q0 q2 q¢¢0 Quantity O q 1
0 q1 q0 Quantity
Fig. 5.2 (a) (b)

Shifts in Demand. Initially, the market equilibrium is at E. Due to the shift in demand to the
right, the new equilibrium is at G as shown in panel (a) and due to the leftward shift, the new
equilibrium is at F, as shown in panel (b). With rightward shift the equilibrium quantity and price
increase whereas with leftward shift, equilibrium quantity and price decrease.

Now suppose the market demand curve shifts rightward to DD2 with supply
curve remaining unchanged at SS0, as shown in panel (a). This shift indicates
that at any price the quantity demanded is more than before. Therefore, at price
p0 now there is excess demand in the market equal to q0q''0 . In response to this
excess demand some individuals will be willing to pay higher price and the price
would tend to rise. The new equilibrium is attained at G where the equilibrium
quantity q2 is greater than q0 and the equilibrium price p2 is greater than p0.
Similarly if the demand curve shifts leftward to DD1, as shown in panel (b), at
any price the quantity demanded will be less than what it was before the shift.
Therefore, at the initial equilibrium price p0 now there will be excess supply in
the market equal to q'0 q0 in response to which some firms will reduce the price
of their commodity so that they can sell their desired quantity. The new 77
equilibrium is attained at the point F at which the demand curve DD1 and the

Market Equilibrium
supply curve SS0 intersect and the resulting equilibrium price p1 is less than p0
and quantity q1 is less than q0. Notice that the direction of change in equilibrium
price and quantity is same whenever there is a shift in demand curve.
Having developed the general theory, we now consider some examples to
understand how demand curve and the equilibrium quantity and price are
affected in response to a change in some of the aforementioned factors which
are also enlisted in Chapter 2. More specifically, we would analyse the impact
of increase in consumers’ income and an increase in the number of consumers
on equilibrium.
Suppose due to a hike in the salaries of the consumers, their incomes increase.
How would it affect equilibrium? With an increase in income, consumers are able
to spend more money on some goods. But recall from Chapter 2 that the consumers
will spend less on an inferior good with increase in income whereas for a normal
good, with prices of all commodities and tastes and preferences of the consumers
held constant, we would expect the demand for the good to increase at each price
as a result of which the market demand curve will shift rightward. Here we consider
the example of a normal good like clothes, the demand for which increases
with increase in income of consumers, thereby causing a rightward shift in the
demand curve. However, this income increase does not have any impact on

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 the supply curve, which shifts only due to some changes in the factors relating to
technology or cost of production of the firms. Thus, the supply curve remains
unchanged. In the Figure 5.2 (a), this is shown by a shift in the demand curve
from DD0 to DD2 but the supply curve remains unchanged at SS0. From the figure,
it is clear that at the new equilibrium, the price of clothes is higher and the quantity
demanded and sold is also higher.
Now let us turn to another example. Suppose due to some reason, there is
increase in the number of consumers in the market for clothes. As the number
of consumers increases, other factors remaining unchanged, at each price, more
clothes will be demanded. Thus, the demand curve will shift rightwards. But
this increase in the number of consumers does not have any impact on the
supply curve since the supply curve may shift only due to changes in the
parameters relating to firms’ behaviour or with an increase in the number of
firms, as stated in Chapter 4. This case again can be illustrated through Figure
5.2(a) in which the demand curve DD0 shifts rightward to DD2, the supply curve
remaining unchanged at SS0. The figure clearly shows that compared to the old
equilibrium point E, at point G which is the new equilibrium point, there is an
increase in both price and quantity demanded and supplied.
Supply Shift
In Figure 5.3, we show the impact of a shift in supply curve on the equilibrium
price and quantity. Suppose, initially, the market is in equilibrium at point E
where the market demand curve DD0 intersects the market supply curve SS0
such that the equilibrium price is p0 and the equilibrium quantity is q0.

78
Introductory Microeconomics

Shifts in Supply. Initially, the market equilibrium is at E. Due to the shift in supply curve to the
left, the new equilibrium point is G as shown in panel (a) and due to the rightward shift the new
equilibrium point is F, as shown in panel (b). With rightward shift, the equilibrium quantity
increases and price decreases whereas with leftward shift,equilibrium quantity decreases and
price increases.

Now, suppose due to some reason, the market supply curve shifts leftward to
SS2 with the demand curve remaining unchanged, as shown in panel (a). Because
of the shift, at the prevailing price, p0, there will be excess demand equal to q0'' qo in
the market. Some consumers who are unable to obtain the good will be willing to
pay higher prices and the market price tends to increase. The new equilibrium is
attained at point G where the supply curve SS2 intersects the demand curve DD0
such that q2 quantity will be bought and sold at price p2. Similarly, when supply
curve shifts rightward, as shown in panel (b), at p0 there will be supply excess of

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goods equal to q0 q 0' . In response to this excess supply, some firms will reduce
their price and the new equilibrium will be attained at F where the supply curve
SS1 intersects the demand curve DD0 such that the new market price is p1 at
which q1 quantity is bought and sold. Notice the directions of change in price and
quantity are opposite whenever there is a shift in supply curve.
Now with this understanding, we can analyse the behaviour of equilibrium
price and quantity when various aspects of the market change. Here, we will
consider the effect of an increase in input price and an increase in number of
firms on equilibrium.
Let us consider a situation where all other things remaining constant, there
is an increase in the price of an input used in the production of a commodity.
This will increase the marginal cost of production of the firms using this input.
Therefore, at each price, the market supply will be less than before. Hence, the
supply curve shifts leftward. In the Figure 5.3(a), this is shown by a shift in the
supply curve from SS0 to SS2. But this increase in input price has no impact on
the demand of the consumers since it does not depend on the input prices
directly. Therefore, the demand curve remains unchanged. In Figure 5.3(a), this
is shown by the demand curve remaining unchanged at DD0. As a result,
compared to the old equilibrium, now the market price rises and quantity
produced decreases.
Let us discuss the impact of an increase in the number of firms. Since at
each price now more firms will supply the commodity, the supply curve shifts to
the right but it does not have any effect on the demand curve. This example can
be illustrated by Figure 5.3(b) where the supply curve shifts from SS0 to SS1
whereas the demand curve remains unchanged at DD0. From the figure, we can
say that there will be a decrease in price of the commodity and increase in the
quantity produced compared to the initial situation.
Simultaneous Shifts of Demand and Supply
What happens when both demand and supply curves shift simultaneously?
The simultaneous shifts can happen in four possible ways: 79
(i) Both supply and demand curves shift rightwards.

Market Equilibrium
(ii) Both supply and demand curves shift leftwards.
(iii) Supply curve shifts leftward and demand curve shifts rightward.
(iv) Supply curve shifts rightward and demand curve shifts leftward.
The impact on equilibrium price and quantity in all the four cases are
given in Table 5.1. Each row of the table describes the direction in which the
equilibrium price and quantity will change for each possible combination of
the simultaneous shifts in demand and supply curves. For instance, from the
second row of the table, we see that due to a rightward shift in both demand
and supply curves, the equilibrium quantity increases invariably but the
equilibrium price may either increase, decrease or remain unchanged. The
actual direction in which the price will change will depend on the
magnitude of the shifts. Check this yourself by varying the magnitude
of shifts for this particular case.
In the first two cases which are shown in the first two rows of the table, the
impact on equilibrium quantity is unambiguous but the equilibrium price may
change, if at all, in either direction depending on the magnitudes of shifts. In the
next two cases, shown in the last two rows of the table, the effect on price is
unambiguous whereas effect on quantity depends on the magnitude of shifts in
the two curves.

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 Table 5.1: Impact of Simultaneous Shifts on Equilibrium

Shift in Demand Shift in Supply Quantity Price

Leftward Leftward Decreases May increase,
decrease or
remain unchanged
Rightward Rightward Increases May increase,
decrease or
remain unchanged
Leftward Rightward May increase, Decreases
decrease or
remain unchanged
Rightward Leftward May increase, Increases
decrease or
remain unchanged

Here we give diagrammatic representations for case (ii) and case (iii) in Figure
5.4 and leave the rest as exercises for the readers.

80
Introductory Microeconomics

Simultaneous Shifts in Demand and Supply. Initially, the equilibrium is at E where

the demand curve DD0 and supply curve SS0 intersect. In panel (a), both the supply and
the demand curves shift rightward leaving price unchanged but a higher equilibrium quantity.
In panel (b), the supply curve shifts rightward and demand curve shifts leftward leaving
quantity unchanged but a lower equilibrium price.

In the Figure 5.4(a), it can be seen that due to rightward shifts in both demand
and supply curves, the equilibrium quantity increases whereas the equilibrium
price remains unchanged, and in Figure 5.4(b), equilibrium quantity remains
the same whereas price decreases due to a leftward shift in demand curve and a
rightward shift in supply curve.

5.1.2 Market Equilibrium: Free Entry and Exit

In the last section, the market equilibrium was studied under the assumption
that there is a fixed number of firms. In this section, we will study market
equilibrium when firms can enter and exit the market freely. Here, for simplicity,
we assume that all the firms in the market are identical.
What is the implication of the entry and exit assumption? This assumption
implies that in equilibrium no firm earns supernormal profit or incurs loss by
remaining in production; in other words, the equilibrium price will be equal to
the minimum average cost of the firms.

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 To see why it is so, suppose, at the
prevailing market price, each firm is
earning supernormal profit. The
possibility of earning supernormal profit
will attract some new firms. As new
firms enter the market supply curve
shifts rightward. However, demand remains
unchanged. This causes market price to fall. As
prices fall, supernormal profits are eventually
wiped out. At this point, with all firms in the
market earning normal profit, no more firms will
have incentive to enter. Similarly, if the firms are
earning less than normal profit at the prevailing
price, some firms will exit which will lead to an
increase in price, and with sufficient number of
firms, the profits of each firm will increase to
the level of normal profit. At this point, no more
firm will want to leave since they will be earning
normal profit here. Thus, with free entry and
Free for all
exit, each firm will always earn normal profit at
the prevailing market price.
Recall from the previous chapter that the firms will earn supernormal profit
so long as the price is greater than the minimum average cost and at prices less
than minimum average cost, they will earn less than normal profit. Therefore, at
prices greater than the minimum average cost, new firms will enter, and at prices
below minimum average cost, existing firms will start exiting. At the price level
equal to the minimum average cost of the firms, each firm will earn normal profit
so that no new firm will be attracted to enter the market. Also the existing firms
will not leave the market since they are not incurring any loss by producing at
this point. So, this price will prevail in the market.
Therefore, free entry and exit of the firms imply that the market price will 81

Market Equilibrium
always be equal to the minimum average cost, that is
p = min AC
From the above, it follows
that the equilibrium price will be
equal to the minimum average
cost of the firms. In equilibrium,
the quantity supplied will be
determined by the market
demand at that price so that they
are equal. Graphically, this is
shown in Figure 5.5 where the
market will be in equilibrium at
point E at which the demand
curve DD intersects the p0 = min
AC line such that the market
Price Determination with Free Entry and
price is p0 and the total quantity Exit. With free entry and exit in a perfectly
demanded and supplied is competitive market, the equilibrium price is always
equal to q0. equal to min AC and the equilibrium quantity is
At p 0 = min AC each firm determined at the intersection of the market
supplies same amount of output, demand curve DD with the price line p = min AC.

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 say q0f . Therefore, the equilibrium number of firms in the market is equal to the
number of firms required to supply q0 output at p0, each in turn supplying q 0f
amount at that price. If we denote the equilibrium number of firms by n 0, then
q0
n0 = q
0f

To understand the equilibrium price and quantity determination more

clearly, let us look at the following example.

EXAMPLE 5.2
Consider the example of a market for wheat such that the demand curve for
wheat is given as follows
qD = 200 – p for 0 ≤ p ≤ 200
=0 for p > 200
Assume that the market consists of identical firms. The supply curve of a
single firm is given by
s
q f = 10 + p for p ≥ 20
=0 for 0 ≤ p < 20
The free entry and exit of firms would mean that the firms will never produce
below minimum average cost because otherwise they will incur loss from
production in which case they will exit the market.
As we know, with free entry and exit, the market will be in equilibrium at a
price which equals the minimum average cost of the firms. Therefore, the
equilibrium price is
p0 = 20
At this price, market will supply that quantity which is equal to the market
demand. Therefore, from the demand curve, we get the equilibrium quantity:
82
q0 = 200 – 20 = 180
Introductory Microeconomics

Also at p0 = 20, each firm supplies

q 0f = 10 + 20 = 30
Therefore, the equilibrium number of firms is
q0 180
n 0 = q0 = =6
f 30
Thus, with free entry and exit, the equilibrium price, quantity and number of
firms are Rs 20, 180 kg and 6 respectively.

Shifts in Demand
Let us examine the impact of shift in demand on equilibrium price and quantity
when the firms can freely enter and exit the market. From the previous section,
we know that free entry and exit of the firms would imply that under all
circumstances equilibrium price will be equal to the minimum average cost of
the existing firms. Under this condition, even if the market demand curve shifts
in either direction, at the new equilibrium, the market will supply the desired
quantity at the same price.
In Figure 5.6, DD0 is the market demand curve which tells us how much
quantity will be demanded by the consumers at different prices and p 0 denotes

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the price which is equal to the minimum average cost of the firms. The initial
equilibrium is at point E where the demand curve DD0 cuts the p0 = minAC line
and the total quantity demanded and supplied is q0. The equilibrium number of
firms is n0 in this situation.
Now suppose the demand curve shifts to the right for some reason. At p0
there will be excess demand for the commodity. Some dissatisfied consumers
will be willing to pay higher price for the commodity, so the price tends to
rise. This gives rise to a possibility of earning supernormal profit which will
attract new firms to the market. The entry of these new firms will eventually
wipe out the supernormal profit and the price will again reach p0. Now higher
quantity will be supplied at the same price. From the panel (a), we can see
that the new demand curve DD1 intersects the p0 = minAC line at point F such
that the new equilibrium will be (p0, q 1) where q1 is greater than q 0. The new
equilibrium number of firms n1 is greater than n0 because of the entry of new
firms. Similarly, for a leftward shift of the demand curve to DD2, there will be

Shifts in Demand. Initially, the demand curve was DD0, the equilibrium quantity and price 83
were q0 and p0 respectively. With rightward shift of the demand curve to DD1, as shown in

Market Equilibrium
panel (a), the equilibrium quantity increases and with leftward shift of the demand curve to
DD2, as shown in panel (b), the equilibrium quantity decreases. In both the cases, the equilibrium
price remains unchanged at p0.

excess supply at the price p0. In response to this excess supply, some firms,
which will be unable to sell their desired quantity at p0, will wish to lower
their price. The price tends to decrease which will lead to the exit of some of
the existing firms and the price will again reach p 0. Therefore, in the new
equilibrium, less quantity will be supplied which will be equal to the reduced
demand at that price. This is shown in panel (b) where due to the shift of
demand curve from DD0 to DD2, quantity demanded and supplied will
decrease to q 2 whereas the price will remain unchanged at p 0. Here, the
equilibrium number of firms, n2 is less than n0 due to the exit of some existing
firms. Thus, due to a shift in demand rightwards (leftwards), the equilibrium
quantity and number of firms will increase (decrease) whereas the
equilibrium price will remain unchanged.
Here, we should note that with free entry and exit, shift in demand has a
larger effect on quantity than it does with the fixed number of firms. But
unlike with fixed number of firms, here, we do not have any effect on
equilibrium price at all.

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 5.2 APPLICATIONS
In this section, we try to understand how the supply-demand analysis can be
applied. In particular, we look at two examples of government intervention in
the form of price control. Often, it becomes necessary for the government to
regulate the prices of certain goods and services when their prices are either too
high or too low in comparison to the
desired levels. We will analyse these
issues within the framework of perfect
competition to look at what impact
these regulations have on the market for
these goods.

5.2.1 Price Ceiling

It is not very uncommon to come across
instances where government fixes a
maximum allowable price for certain
goods. The government-imposed upper
limit on the price of a good or service is
called price ceiling. Price ceiling is
generally imposed on necessary items
like wheat, rice, kerosene, sugar and it
is fixed below the market-determined
price since at the market-determined
Price Catcher price some section of the population
will not be able to afford these goods.
Let us examine the effects of price ceiling on market equilibrium through the
example of market for wheat.
Figure 5.7 shows the market
supply curve SS and the market
84 demand curve DD for wheat.
The equilibrium price and
Introductory Microeconomics

quantity of wheat are p* and

q* respectively. When the
government imposes price ceiling
at pc which is lower than the
equilibrium price level, there will
be an excess demand for wheat in
the market at that price. The
consumers demand qc kilograms
of wheat whereas the firms
Effect of Price Ceiling in Wheat Market. The
supply q c' kilograms. equilibrium price and quantity are p* and q*
Hence, though the intention of respectively. Imposition of price ceiling at pc gives
rise to excess demand in the wheat market.
the government was to help the
consumers, it could end up creating shortage of wheat. How is the quantity of
wheat (q'c) then distributed among the consumers? One way of doing this is to
distribute it to everyone, through a system of rationing. Ration coupons are
issued to the consumers so that no individual can buy more than a certain amount
of wheat and this stipulated amount of wheat is sold through ration shops which
are also called fair price shops.

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 In general, price ceiling accompanied by rationing of the goods may have the
following adverse consequences on the consumers: (a) Each consumer has to
stand in long queues to buy the good from ration shops. (b) Since all consumers
will not be satisfied by the quantity of the goods that they get from the fair price
shop, some of them will be willing to pay higher price for it. This may result in
the creation of black market.

5.2.2 Price Floor

For certain goods and services, fall Price
in price below a particular level is
not desirable and hence the
government sets floors or SS
minimum prices for these goods
and services. The government- p f

imposed lower limit on the price

p*
that may be charged for a
particular good or service is called
price floor. Most well-known DD
examples of imposition of price
floor are agricultural price O q f q* fq' Quantity
support programmes and the Fig. 5.8
minimum wage legislation.
Through an agricultural price Effect of Price Floor on the Market for Goods.
support programme, the The market equilibrium is at (p*, q*). Imposition of
price floor at pf gives rise to an excess supply.
government imposes a lower limit
on the purchase price for some of
the agricultural goods and the floor is normally set at a level higher than the
market-determined price for these goods. Similarly, through the minimum wage
legislation, the government ensures that the wage rate of the labourers does not
fall below a particular level and here again the minimum wage rate is set above
the equilibrium wage rate. 85

Market Equilibrium
Figure 5.8 shows the market supply and the market demand curve for a
commodity on which price floor is imposed. The market equilibrium here would
occur at price p* and quantity q*. But when the government imposes a floor higher
than the equilibrium price at pf , the market demand is qf whereas the firms want
to supply q f′ , thereby leading to an excess supply in the market equal to qf q f′ .
In the case of agricultural support, to prevent price from falling because of
excess supply, government needs to buy the surplus at the predetermined price.

• In a perfectly competitive market, equilibrium occurs where market demand

Summary

equals market supply.

• The equilibrium price and quantity are determined at the intersection of the
market demand and market supply curves when there is fixed number of firms.
• Each firm employs labour upto the point where the marginal revenue product
of labour equals the wage rate.
• With supply curve remaining unchanged when demand curve shifts
rightward (leftward), the equilibrium quantity increases (decreases) and
equilibrium price increases (decreases) with fixed number of firms.

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 • With demand curve remaining unchanged when supply curve shifts
rightward (leftward), the equilibrium quantity increases (decreases) and
equilibrium price decreases (increases) with fixed number of firms.
• When both demand and supply curves shift in the same direction, the effect
on equilibrium quantity can be unambiguously determined whereas the
effect on equilibrium price depends on the magnitude of the shifts.
• When demand and supply curves shift in opposite directions, the effect on
equilibrium price can be unambiguously determined whereas the effect on
equilibrium quantity depends on the magnitude of the shifts.
• In a perfectly competitive market with identical firms if the firms can enter
and exit the market freely, the equilibrium price is always equal to minimum
average cost of the firms.
• With free entry and exit, the shift in demand has no impact on equilibrium
price but changes the equilibrium quantity and number of firms in the same
direction as the change in demand.
• In comparison to a market with fixed number of firms, the impact of a shift
in demand curve on equilibrium quantity is more pronounced in a market
with free entry and exit.
• Imposition of price ceiling below the equilibrium price leads to an excess demand.
• Imposition of price floor above the equilibrium price leads to an excess supply.

Equilibrium
Key Concepts

Excess demand
Excess supply
Marginal revenue product of labour
Value of marginal product of labour
Price ceiling, Price floor

86
Exercises

1. Explain market equilibrium.

Introductory Microeconomics

2. When do we say there is excess demand for a commodity in the market?

3. When do we say there is excess supply for a commodity in the market?
4. What will happen if the price prevailing in the market is
(i) above the equilibrium price?
(ii) below the equilibrium price?
5. Explain how price is determined in a perfectly competitive market with fixed
number of firms.
6. Suppose the price at which equilibrium is attained in exercise 5 is above the
minimum average cost of the firms constituting the market. Now if we allow for
free entry and exit of firms, how will the market price adjust to it?
7. At what level of price do the firms in a perfectly competitive market supply
when free entry and exit is allowed in the market? How is equilibrium quantity
determined in such a market?
8. How is the equilibrium number of firms determined in a market where entry
and exit is permitted?
9. How are equilibrium price and quantity affected when income of the consumers
(a) increase? (b) decrease?
10. Using supply and demand curves, show how an increase in the price of shoes
affects the price of a pair of socks and the number of pairs of socks bought and sold.

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11. How will a change in price of coffee affect the equilibrium price of tea? Explain
the effect on equilibrium quantity also through a diagram.
12. How do the equilibrium price and quantity of a commodity change when price
of input used in its production changes?
13. If the price of a substitute(Y) of good X increases, what impact does it have on
the equilibrium price and quantity of good X?
14. Compare the effect of shift in demand curve on the equilibrium when the number
of firms in the market is fixed with the situation when entry-exit is permitted.
15. Explain through a diagram the effect of a rightward shift of both the demand
and supply curves on equilibrium price and quantity.
16. How are the equilibrium price and quantity affected when
(a) both demand and supply curves shift in the same direction?
(b) demand and supply curves shift in opposite directions?
17. In what respect do the supply and demand curves in the labour market differ
from those in the goods market?
18. How is the optimal amount of labour determined in a perfectly competitive market?
19. How is the wage rate determined in a perfectly competitive labour market?
20. Can you think of any commodity on which price ceiling is imposed in India?
What may be the consequence of price-ceiling?
21. A shift in demand curve has a larger effect on price and smaller effect on
quantity when the number of firms is fixed compared to the situation when
free entry and exit is permitted. Explain.
22. Suppose the demand and supply curve of commodity X in a perfectly competitive
market are given by:
qD = 700 – p
qS = 500 + 3p for p ≥ 15
= 0 for 0 ≤ p < 15
Assume that the market consists of identical firms. Identify the reason behind
the market supply of commodity X being zero at any price less than Rs 15.
What will be the equilibrium price for this commodity? At equilibrium, what
quantity of X will be produced?
23. Considering the same demand curve as in exercise 22, now let us allow for free 87
entry and exit of the firms producing commodity X. Also assume the market

Market Equilibrium
consists of identical firms producing commodity X. Let the supply curve of a
single firm be explained as
qSf = 8 + 3p for p ≥ 20
=0 for 0 ≤ p < 20
(a) What is the significance of p = 20?
(b) At what price will the market for X be in equilibrium? State the reason for
your answer.
(c) Calculate the equilibrium quantity and number of firms.
24. Suppose the demand and supply curves of salt are given by:
qD = 1,000 – p qS = 700 + 2p
(a) Find the equilibrium price and quantity.
(b) Now suppose that the price of an input used to produce salt has increased
so that the new supply curve is
qS = 400 + 2p
How does the equilibrium price and quantity change? Does the change
conform to your expectation?
(c) Suppose the government has imposed a tax of Rs 3 per unit of sale of salt.
How does it affect the equilibrium price and quantity?
25. Suppose the market determined rent for apartments is too high for common people
to afford. If the government comes forward to help those seeking apartments on rent
by imposing control on rent, what impact will it have on the market for apartments?

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Chapter 6
Non-competitive Mark ets
Markets
We recall that perfect competition is a market structure where
both consumers and firms are price takers. The behaviour of
the firm in such circumstances was described in the Chapter 4.
We discussed that the perfect competition market structure is
approximated by a market satisfying the following conditions:
(i) there exist a very large number of firms and consumers of the
commodity, such that the output sold by each firm is negligibly
small as compared to the total output of all the firms combined,
and similarly, the amount purchased by each consumer is
extremely small in comparison to the quantity purchased by
all consumers together;
(ii) firms are free to start producing the commodity or to stop
production; i.e., entry and exit is free
(iii) the output produced by each firm in the industry is
indistinguishable from the others and the output of any other
industry cannot substitute this output; and
(iv) consumers and firms have perfect knowledge of the output,
inputs and their prices.
In this chapter, we shall discuss situations where one or more
of these conditions are not satisfied. If assumption (ii) is dropped,
and it becomes difficult for firms to enter a market, then a market
may not have many firms. In the extreme case a market may have
only one firm. Such a market, where there is one firm and many
buyers is called a monopoly. A market that has a small number
of large firms is called an oligopoly. Notice that dropping
assumption (ii) leads to dropping assumption (i) as well. Similarly,
dropping the assumption that goods produced by a firm are
indistinguishable from those of other firms (assumption iii) implies
that goods produced by firms are close substitutes, but not perfect
substitutes for each other. Such markets, where assumptions (i)
and (ii) may hold, but (iii) does not hold are called markets with
monopolistic competition. This chapter examines the market
structures of monopoly, monopolistic competition and oligopoly.

6.1 SIMPLE MONOPOLY IN THE COMMODITY MARKET

A market structure in which there is a single seller is called
monopoly. The conditions hidden in this single line definition,
however, need to be explicitly stated. A monopoly market structure
requires that there is a single producer of a particular commodity;
no other commodity works as a substitute for this commodity; and

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for this situation to persist over time, sufficient restrictions are
required to be in place to prevent any other firm from entering
the market and to start selling the commodity.
In order to examine the difference in the equilibrium
resulting from a monopoly in the commodity market
as compared to other market structures, we
also need to assume that all other
markets remain perfectly competitive.
In particular, we need (i) All the
consumers are price takers; and (ii)
that the markets of the inputs used
in the production of this commodity
‘I’ ‘M’ Perfect Competition
are perfectly competitive both from
the supply and demand side.
If all the above conditions are satisfied, then we define the situation as one of
monopoly in a single commodity market.

Competitive Behaviour versus Competitive Structure

A perfectly competitive market has been defined as one where an individual
firm is unable to influence the price at which the product is sold in the
market. Since price remains the same for any level of output of the individual
firm, such a firm is able to sell any quantity that it wishes to sell at the given
market price. It, therefore, does not need to compete with other firms to
obtain a market for its produce.
This is clearly opposite of the meaning of what is commonly understood
by competition or competitive behaviour. We see that Coke and Pepsi
compete with each other in a variety of ways to achieve a higher level of sales
or a greater share of the market. Conversely, we do not find individual farmers
competing among themselves to sell a larger amount of crop. This is because
both Coke and Pepsi possess the power to influence the market price of soft 89
drinks, while the individual farmer does not.

Non-competitive Markets
Thus, competitive behaviour and competitive market structure are, in
general, inversely related; the more competitive the market structure, less
competitive is the behaviour of the firms. On the other hand, the less
competitive the market structure, the more competitive is the behaviour of
firms towards each other. In a monopoly there is no other firm to compete
with.

6.1.1 Market Demand Curve is the Average Revenue Curve

The market demand curve in Figure 6.1 shows the quantities that consumers
as a whole are willing to purchase at different prices. If the market price is at p0,
consumers are willing to purchase the quantity q 0. On the other hand, if the
market price is at the lower level p1, consumers are willing to buy a higher quantity
q1. That is, price in the market affects the quantity demanded by the consumers.
This is also expressed by saying that the quantity purchased by the consumers
is a decreasing function of the price. For the monopoly firm, the above argument
expresses itself from the reverse direction. The monopoly firm’s decision to sell a
larger quantity is possible only at a lower price. Conversely, if the monopoly
firm brings a smaller quantity of the commodity into the market for sale it will
be able to sell at a higher price. Thus, for the monopoly firm, the price depends
on the quantity of the commodity sold. The same is also expressed by stating

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 that price is a decreasing function
Price
of the quantity sold. Thus, for the
monopoly firm, the market
demand curve expresses the price D
that consumers are willing to pay
for different quantities supplied. 0p
This idea is reflected in the
statement that the monopoly firm
faces the market demand curve, p
1
which is downward sloping.
D
The above idea can be viewed
from another angle. Since the firm O
q
0 q 1 Output
is assumed to have perfect Fig. 6.1
knowledge of the market demand
curve, the monopoly firm can Market Demand Curve. Shows the quantities that
decide the price at which it wishes consumers as a whole are willing to purchase at
different prices.
to sell its commodity, and
therefore, determines the quantity to be sold. For instance, examining Figure
6.1 again, since the monopoly firm is aware of the shape of the curve DD, if it
wishes to sell the commodity at the price p0, it can do so by producing and
selling quantity q0, since at the price p0, consumers are willing to purchase the
quantity q0. On the other hand, if it wants to sell q1, it will only be able to do so
at the price p1.
The contrast with the firm in a perfectly competitive market structure should
be clear. In that case, the firm could bring into the market as much quantity of
the commodity as it wished and could sell it at the same price. Since this does
not happen for a monopoly firm, the amount received by the firm through the
sale of the commodity has to be examined again.
We do this exercise through a schedule, a graph, and using a simple equation
of a straight line demand curve. As an example, let the demand function be
90 given by the equation
Introductory
Microeconomics

q = 20 – 2p,
where q is the quantity sold and p is the Table 6.1: Prices and Revenue
price in rupees. q p TR AR MR
The equation can be written in terms of p
0 10 0 – –
as
1 9.5 9.5 9.5 9.5
p = 10 – 0.5q
2 9 18 9 8.5
Substituting different values of q from 0
3 8.5 25.5 8.5 7.5
to 13 gives us the prices from 10 to 3.5. These
4 8 32 8 6.5
are shown in the q and p columns of Table
6.1. 5 7.5 37.5 7.5 5.5
These numbers are depicted in a graph in 6 7 42 7 4.5
Figure 6.2 with prices on the vertical axis and 7 6.5 45.5 6.5 3.5
quantities on the horizontal axis. The prices 8 6 48 6 2.5
that are available for different quantities of the 9 5.5 49.5 5.5 1.5
commodity are shown by the solid straight
10 5 50 5 0.5
line D.
The total revenue (TR) received by the firm 11 4.5 49.5 4.5 -0.5
from the sale of the commodity equals the 12 4 48 4 -1.5
product of the price and the quantity sold. In 13 3.5 45.5 3.5 -2.5

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the case of the monopoly firm, the
total revenue is not a straight line. TR,
Its shape depends on the shape AR,
MR
of the demand curve.
Mathematically, TR is represented
as a function of the quantity sold.
TR
Hence, in our example
TR = p × q
= (10 – 0.5q) × q
= 10q – 0.5q2 D = AR
O 10 Output
This is not the equation of a MR
straight line. It is a quadratic Fig. 6.2
equation in which the squared Total, Average and Marginal Revenue Curves:
term has a negative cofficient. The total revenue, average revenue and the marginal
Such an equation represents an revenue curves are depicted here.
inverted vertical parabola.
In Table 6.1, the TR column represents the product of the p and q columns.
It can be noticed that as the quantity increases, TR increases to Rs 50 when
output becomes 10 units, and after this level of output, total revenue starts
declining. The same is visible in Figure 6.2.
The revenue received by the firm per unit of commodity sold is called the
Average Revenue (AR). Mathematically, AR = TR/q. In Table 6.1, the AR column
provides values obtained by dividing TR values by q values. It can be seen that
the AR values turn out to be the same as the values in the p column. This is only
to be expected
TR
AR = q

Since TR = p × q, substituting this into the AR equation

91
(p × q)

Non-competitive Markets
AR = q =p

As seen earlier, the p values

represent the market demand
curve as shown in Figure 6.2.
The AR curve will therefore lie
exactly on the market demand
curve. This is expressed by the
statement that the market
demand curve is the average
revenue curve for the monopoly
firm.
Graphically, the value of AR
can be found from the TR curve
for any level of quantity sold
Relation between Average Revenue and
through a simple construction
Total Revenue Curves. The average revenue
given in Figure 6.3. When quantity at any level of output is given by the slope of the
is 6 units, draw a vertical line line joining the origin and the point on the total
passing through the value 6 on revenue curve corresponding to the output level
the horizontal axis. This line will under consideration.

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 cut the TR curve at the point marked ‘a’ at a height equal to 42. Draw a straight
line joining the origin O and point ‘a’. The slope of this ray from the origin to a
point on the TR provides the value of AR. The slope of this ray is equal to 7.
Therefore, AR has the value 7. The same can be verified from Table 6.1.

6.1.2 Total, Average and Marginal Revenues

A more careful glance at Table 6.1 reveals that TR does not increase by the
same amount for every unit increase in quantity. Sale of the first unit leads to
a change in TR from Rs 0 when quantity is of 0 unit to Rs 9.50 when quantity
is 1 unit, i.e., a rise of Rs 9.50. As the quantity increases further, the rise in TR
is smaller. For example, for the 5th unit of the commodity, the rise in TR is
Rs 5.50 (Rs 37.50 for 5 units minus Rs 32 for 4 units). As mentioned earlier,
after 10 units of output, TR starts declining. This implies that bringing more
than 10 units for sale leads to a level of TR less than Rs 50. Thus, the rise in TR
due to the 12th unit is: 48 – 49.50 = –1.5, ie a fall of Rs 1.50.
This change in TR due to the sale of an additional unit is termed Marginal
Revenue (MR). In Table 6.1, this is depicted in the last column. Observe that the
MR at any quantity is the difference between the TR at that quantity and the TR
at the previous quantity. For
example, when q = 3, MR = (25.5
– 18) = 7.5 TR,
MR c
In the last paragraph, it was
shown that TR increases more L 2 d
b
slowly as quantity sold increases TR
and falls after quantity reaches
L
10 units. The same can be 1

a
viewed through the MR values
which fall as q increases. After
the quantity reaches 10 units,
MR has negative values. In O 10 Output
92 MR
Figure 6.2, MR is depicted by
Introductory
Microeconomics

the dotted line. Fig. 6.4

Graphically, the values of
the MR curve are given by the Relation between Marginal Revenue and Total
Revenue Curves. The marginal revenue at any level
slope of the TR curve. The slope
of output is given by the slope of the total revenue
of any smooth curve is defined curve at that level of output.
as the slope of the tangent to the
curve at that point. This is depicted in Figure 6.4. At point ‘a’ on the TR curve,
the value of MR is given by the slope of the line L1, and at point ‘b’ by the line
L2. It can be seen that both lines have positive slope, but the line L2 is flatter
than line L1, ie its slope is lesser. When 10 units of the commodity are sold, the
tangent to the TR is horizontal, ie its slope is zero.1 The value of the MR for the
same quantity is zero. At point ‘d’ on the TR curve, where the tangent is
negatively sloped, the MR takes a negative value.
We can now conclude that when total revenue is rising, marginal revenue
is positive, and when total revenue shows a fall, marginal revenue is negative.
Another relation can be seen between the AR and the MR curves. Figure

1
Question: Why is the MR not equal to zero at q=10 in table 6.1? This is because we are
measuring MR ‘discretely’, i.e, by jumping from 9 units to 10 units. If you recalculate the TR for
values of q closer to 10 e.g., 9.5, 9.75 or 9.9, the TR will get closer to 50, Eg: at q=9.9, TR will be
49.995.

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 AR,
MR
AR,
MR

AR
AR
O O
Output Output
MR MR
(a) (b)
Fig. 6.5
Relation between Average Revenue and Marginal Revenue curves. If the AR curve is
steeper, then the MR curve is far below the AR curve.
6.2 shows that the MR curve lies below the AR curve. The same can be seen in
Table 6.1 where the values of MR at any level of output are lower than the
corresponding values of AR. We can conclude that if the AR curve (ie the demand
curve) is falling steeply, the MR curve is far below the AR curve. On the other
hand, if the AR curve is less steep, the vertical distance between the AR and
MR curves is smaller. Figure 6.5(a) shows a flatter AR curve while Figure 6.5(b)
shows a steeper AR curve. For the same units of the commodity, the difference
between AR and MR in panel (a) is smaller than the difference in panel (b).

6.1.3 Marginal Revenue and Price Elasticity of Demand

The MR values also have a relation with the price elasticity of demand. The detailed
relation is not derived here. It is sufficient to notice only one aspect– price
elasticity of demand is more than 1 when the MR has a positive value, and becomes
less than the unity when MR has a negative value. This can be seen in Table 6.2,
which uses the same data presented in Table 6.1. As the quantity of the commodity 93
increases, MR value becomes smaller and

Non-competitive Markets
the value of the price elasticity of demand Table 6.2: MR and Price Elasticity
also becomes smaller. Recall that the
q p MR Elasticity
demand curve is called elastic at a point
where price elasticity is greater than unity, 0 10 - -
inelastic at a point where the 1 9.5 9.5 19
price elasticity is less than unity and unitary 2 9 8.5 9
elastic when price elasticity is equal to 1. 3 8.5 7.5 5.67
Table 6.2 shows that when quantity is less
4 8 6.5 4
than 10 units, MR is positive and the
demand curve is elastic and when quantity 5 7.5 5.5 3
is of more than 10 units, the demand curve 6 7 4.5 2.33
is inelastic. At the quantity level of 10 units, 7 6.5 3.5 1.86
the demand curve is unitary elastic. 8 6 2.5 1.5
6.1.4 Short Run Equilibrium of the 9 5.5 1.5 1.22
Monopoly Firm 10 5 0.5 1
As in the case of perfect competition, we 11 4.5 -0.5 0.82
continue to regard the monopoly firm as 12 4 -1.5 0.67
one which maximises profit. In this section, 13 3.5 -2.5 0.54
we analyse this profit maximising

2020-21
 behaviour to determine the quantity produced by a monopoly firm and price at
which it is sold. We shall assume that a firm does not maintain stocks of the
quantity produced and that the entire quantity produced is put up for sale.
The Simple Case of Zero Cost
Suppose there exists a village TR,
AR,
situated sufficiently far away from
MR,
other villages. In this village, there Price
a
is exactly one well from which
water is available. All residents are
TR
completely dependent for their
water requirements on this well.
The well is owned by one person
who is able to prevent others from
drawing water from it except 5 AR = D

through purchase of water. The O 10 Output

MR
person who purchases the water
Fig. 6.6
has to draw the water out of the
well. The well owner is thus a Short Run Equilibrium of the Monopolist with
monopolist firm which bears zero Zero Costs. The monopolist’s profit is maximised
cost in producing the good. at that level of output for which the total revenue is
We shall analyse this simple case the maximum.
of a monopolist bearing zero costs to determine the amount of water sold and
the price at which it is sold.
Figure 6.6 depicts the same TR, AR and MR curves, as in Figure 6.2. The
profit received by the firm equals the revenue received by the firm minus the
cost incurred, that is, Profit = TR – TC. Since in this case TC is zero, profit is
maximum when TR is maximum. This, as we have seen earlier, occurs when
output is of 10 units. This is also the level when MR equals zero. The amount of
profit is given by the length of the vertical line segment from ‘a’ to the horizontal
94 axis.
The price at which this output will be sold is the price that the consumers
Introductory
Microeconomics

as a whole are willing to pay. This is given by the market demand curve D. At
output level of 10 units, the price is Rs 5. Since the market demand curve is
the AR curve for the monopolist firm, Rs 5 is the average revenue received by
the firm. The total revenue is given by the product of AR and the quantity sold,
ie Rs 5 × 10 units = Rs 50. This is depicted by the area of the shaded rectangle.
Comparison with Perfect Competition
We compare the above outcome with what it would be under perfectly competitive
market structure. Let us assume that there is an infinite number of such wells.
Suppose a well-owner decides to charge Rs.5/bucket of water. Who will buy
from him? Remember that there are many, many well-owners. Any other well-
owner can attract all the buyers willing to buy for Rs. 5/bucket, by offering to
sell to them at a lower price, say, Rs. 4/bucket.. Some other well-owner can offer
to sell at a still lower price, and the story will repeat itself. In fact, competition
among well-owners will drive the price down to zero. At this price 20 buckets of
water will be sold.
Through this comparison, we can see that a perfectly competitive equilibrium
results in a larger quantity being sold at a lower price. We can now proceed to
the general case involving positive costs of production.

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Introducing Positive Costs
Analysing using Total curves
In Chapter 3, we have discussed the concept of cost and the shape of the
total cost curve having been depicted as shown by TC in Figure 6.7. The TR
curve is also drawn in the same diagram. The profit received by the firm
equals the total revenue minus

Revenue,
the total cost. In the figure, we
can see that if quantity q1 is a TC

Profit
Cost,
produced, the total revenue is
A
TR1 and total cost is TC1. The TR 1 TR
difference, TR1 – TC1, is the profit
received. The same is depicted B
TC
by the length of the line segment 1

AB, i.e., the vertical distance

between the TR and TC curves
at q1 level of output. It should O q q q q Output
be clear that this vertical 2 1 0 3

distance changes for diferent Profit

levels of output. When output Fig. 6.7
level is less than q2, the TC curve
lies above the TR curve, i.e., TC Equilibrium of the Monopolist in terms of the
Total Curves. The monopolist’s profit is maximised
is greater than TR, and therefore at the level of output for which the vertical distance
profit is negative and the firm between the TR and TC is a maximum and TR is
makes losses. above the TC.
The same situation exists for
output levels greater than q3. Hence, the firm can make positive profits only
at output levels between q2 and q3, where TR curve lies above the TC curve.
The monopoly firm will choose that level of output which maximises its profit.
This would be the level of output for which the vertical distance between the 95
TR and TC is maximum and TR is above the TC, i.e., TR – TC is maximum.

Non-competitive Markets
This occurs at the level of output q0.
If the difference TR – TC is calculated and drawn as a graph, it will look
as in the curve marked ‘Profit’ in Figure 6.7. It should be noticed that the
Profit curve has its maximum value at the level of output q0.
The price at which this output is sold is the price consumers are willing to
pay for this q0 quantity of the commodity. So the monopoly firm will charge
the price corresponding to the quantity level q0 on the demand curve.

Using Average and Marginal curves

The analysis shown above can also be conducted using Average and
Marginal Revenue and Average and Marginal Cost. Though a bit more
complex, this method is able to exhibit the process in greater light.
In Figure 6.8, the Average Cost (AC), Average Variable Cost (AVC) and
Marginal Cost (MC) curves are drawn along with the Demand (Average
Revenue) Curve and Marginal Revenue crve.
It may be seen that at quantity level below q0, the level of MR is higher than
the level of MC. This means that the increase in total revenue from selling an
extra unit of the commodity is greater than the increase in total cost for
producing the additional unit. This implies that an additional unit of output

2020-21
 would create additional profits since Change in profit = Change in TR – Change
in TC. Therefore, if the firm is
producing a level of output
Price
less than q0, it would desire to
MC
increase its output since that
would add to its profits. As
long as the MR curve lies AC
above the MC curve, the
reasoning provided above b a
p f
would apply and thus the firm c
C

d
would increase its output. e D = AR
This process comes to a halt
when the firm reaches an
output level of q0 since at this O
q q
0 C Output
level MR equals MC and Fig. 6.8 MR
increasing output provides no
increase in profits. Equilibrium of the Monopolist in terms of the
On the other hand, if the Average and the Marginal Curve. The monopolist’s
profit is maximised at that level of output for which
firm was producing a level of the MR = MC and the MC is rising.
output which is greater than
q0, MC is greater than MR. This means that the lowering of total cost by
reducing one unit of output is greater than the loss in total revenue due to
this reduction. It is therefore advisable for the firm to reduce output. This
argument would hold good as long as the MC curve lies above the MR
curve, and the firm would keep reducing its output. Once output level
reaches q0, the values of MC and MR become equal and the firm stops
reducing its output.
At qo the firm will make maximum profits. It has no incentive to change
from qo. This level is called the equilibrium level of output. Since this
96 equilibrium level of output corresponds to the point where the MR equals
MC, this equality is called the equilibrium condition for the output produced
Introductory
Microeconomics

by a monopoly firm.
At this equilibrium level of output q0, the average cost is given by the
point ‘d’ where the vertical line from q0 cuts the AC curve. The average cost
is thus given by the height dq0. Since total cost equals the product of AC
and the quantity produced being q0, the same is given by the area of the
rectangle Oq0dc.
As shown earlier, once the quantity of output produced is determined,
the price at which it is sold is given by the amount that the consumers are
willing to pay, as expressed through the market demand curve. Thus, the
price is given by the point ‘a’ where the vertical line through q0 meets the
market demand curve D. This provides price given by the height aq0. Since
the price received by the firm is the revenue per unit of output, it is the
Average Revenue for the firm. The total revenue being the product of AR
and the level of output q0, can be shown as the area of the rectangle Oq0ab.
It can be seen from the diagram that the area of the rectangle Oq0ab is
larger than the area of the rectangle Oq0dc, i.e., TR is greater than TC. The
difference is the area of the rectangle cdab. Thus, Profit = TR – TC which
can be represented by this area cdab.

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Comparison with Perfect Competition again
We compare the monopoly firm’s equilibrium quantity and price with that of
the perfectly competitive firm. Recall that the perfectly competitive firm was a
price taker. Given the market price, the firm in a perfectly competitive market
structure believed that it could not alter the price by producing more of the
output or less of it.
Suppose that the firm, whose equilibrium we were considering above, believed
that it was a perfectly competitive firm. Then, given its level of output at q0, price
of the commodity at aq0 = Ob, it would expect the price to remain fixed at Ob,
and therefore, every additional unit of output could be sold at that price. Since
the cost of producing an additional unit, given by the MC, stands at eq0 which is
less than aq0, the firm would expect a gain in profit by increasing the output.
This would continue as long as the price remained higher than the MC. At the
point ‘f ’ in Figure 6.8, where the MC curve cuts the demand curve, price received
by the firm becomes equal to the MC. Hence, it would no longer be considered
beneficial by this perfectly competitive firm to increase output. It is for this reason
that Price = Marginal Cost that is considered the equilibrium condition for the
perfectly competitive firm.
The diagram shows that at this level of output, the quantity produced qc is
greater than q0. Also, the price paid by the consumers is lower at pc. From this we
conclude that the perfectly competitive market provides a production and sale of
a larger quantity of the commodity compared to a monopoly firm. Further the
price of the commodity under perfect competition is lower compared to monopoly.
The profit earned by the perfectly competitive firm is also smaller.
In the Long Run
We saw in Chapter 5 that with free entry and exit, perfectly competitive firms
obtain zero profits. That was due to the fact that if profits earned by firms were
positive, more firms would enter the market and the increase in output would
bring the price down, thereby decreasing the earnings of the existing firms.
Similarly, if firms were facing losses, some firms would close down and the 97

Non-competitive Markets
reduction in output would raise prices and increase the earnings of the remaining
firms. The same is not the case with monopoly firms. Since other firms are
prevented from entering the market, the profits earned by monopoly firms do
not go away in the long run.
Some Critical Views
We have seen how a monopoly will typically charge higher prices than a
competitive firm. In this sense, monopolies are often considered exploitative.
However, varying views have been expressed by economists concerning the
question of monopoly. First, it can be argued that monopoly of the kind described
above cannot exist in the real world. This is because all commodities are, in a
sense, substitutes for each other. This in turn is because of the fact that all the
firms producing commodities, in the final analysis, compete to obtain the income
in the hands of consumers.
Another argument is that even a firm in a pure monopoly situation is never
without competition. This is because the economy is never stationary. New
commodities using new technologies are always coming up, which are close
substitutes for the commodity produced by the monopoly firm. Hence, the
monopoly firm always has competition in the long run. Even in the short run,
the threat of competition is always present and the monopoly firm is unable to
behave in the manner we have described above.

2020-21
 Still another view argues that the existence of monopolies may be beneficial
to society. Since monopoly firms earn large profits, they possess sufficient funds
to take up research and development work, something which the small perfectly
competitive firm is unable to do. By doing such research, monopoly firms are
able to produce better quality goods, or goods at lower cost, or both. While it is
true that monopolies make supernormal profits, they may benefit consumers
by lowering costs.

6.2 OTHER NON-PERFECTLY COMPETITIVE MARKETS

6.2.1 Monopolistic Competition
We now consider a market structure where the number of firms is large, there is
free entry and exit of firms, but the goods produced by them are not
homogeneous. Such a market structure is called monopolistic competition.
This kind of a structure is more commonly visible. There is a very large
number of biscuit producing firms, for example. But many of the biscuits being
produced are associated with some brand name and are distinguishable from
one another by these brand names and packaging and are slightly different in
taste. The consumer develops a taste for a particular brand of biscuit over time,
or becomes loyal to a particular brand for some reason, and is, therefore, not
immediately willing to substitute it for another biscuit. However, if the price
difference becomes large, the consumer would be willing to choose a biscuit of
another brand. A consumers’ preference for a brand will often vary in depth, so
the change in price required for the consumer to change her brand may vary.
Therefore, if price of a particular brand is lowered, some consumers will shift to
consuming that brand. Lowering of the price further will lead to more consumers
shifting to the brand with the lower price.
Hence, the demand curve faced by the firm is not horizontal (perfectly elastic)
as is the case with perfect competition. The demand curve faced by the firm is
also not the market demand curve, as in the case with monopoly. In the case of
98 monopolistic competition, the firm expects increases in demand if it lowers the
Microeconomics
Introductory

price. Recall that the demand curve of a firm is also its AR curve. This firm,
therefore has downward sloping AR curve. The marginal revenue is less than the
average revenue, and also downward sloping. The firm increases its output
whenever the marginal revenue is greater than the marginal cost. What does this
firm’s equilibrium look like? The monopolistic competitive firm is also a profit
maximizer. So it will increase production as long as the addition to its total revenue
is greater than the addition to its total costs. In other words, this firm (like the
perfectly competitive firm as well as the monopoly) will choose to produce the
quantity that equates its marginal revenue to its marginal cost. How does this
quantity compare with that of the perfectly competitive firm? Recall that the MR
for a perfectly competitive firm is equal to its AR. So the perfectly competitive
firm, in an identical situation, would equate its AR to MC. So a firm under
monopolistic competition will produce less than the perfectly competitive firm.
Given lower output, the price of the commodity becomes higher than the price
under perfect competition.
The situation described above is one that exists in the short run. But the
market structure of monopolistic competition allows for new firms to enter the
market. If the firms in the industry are receiving supernormal profit in the short
run, this will attract new firms. As new firms enter, some customers shift from
existing firms to these new firms. So existing firms find that their demand curve

2020-21
 has shifted leftward, and the price that they receive falls. This causes profits to
fall. The process continues till super-normal profits are wiped out, and firms are
making only normal profits. Conversely, if firms in the industry are facing losses
in the short run, some firms would stop producing (exit from the market). The
demand curve for existing firms would shift rightward. This would lead to a
higher price, and profit. Entry or exit would halt once supernormal profits become
zero and this would serve as the long run equilibrium.

6.2.2 How do Firms behave in Oligopoly?

If the market of a particular commodity consists of more than one seller but
the number of sellers is few, the market structure is termed oligopoly. The
special case of oligopoly where there are exactly two sellers is termed duopoly.
In analysing this market structure, we assume that the product sold by the
two firms is homogeneous and there is no substitute for the product, produced
by any other firm.
Given that there are a few firms, each firm is relatively large when compared
to the size of the market. As a result each firm is in a position to affect the total
supply in the market, and thus influence the market price. For example, if the
two firms in a duopoly are equal in size, and one of them decides to double its
output, the total supply in the market will increase substantially, causing the
price to fall. This fall in price affects the profits of all firms in the industry. Other
firms will respond to such a move in order to protect their own profits, by taking
fresh decisions regarding how much to produce. Therefore the level of output in
the industry, the level of prices, as well as the profits, are outcomes of how firms
are interacting with each other.
At one extreme, firms could decide to ‘collude’ with each other to maximize
collective profits. In this case, the firms form a ‘cartel’ that acts as a monopoly.
The quantity supplied collectively by the industry and the price charged are the
same as a single monopolist would have done.
At the other extreme, firms could decide to compete with each other. For
example, a firm may lower its price a little below the other firms, in order to 99

Non-competitive Markets
attract away their customers. Obviously, the other firms would retaliate by doing
the same. So the market price keeps falling as long as firms keep undercutting
each others’ prices. If the process continues to its logical conclusion, the price
will have fallen till the marginal cost. (No firm will supply at a lower price than the
marginal cost). Recall that this is the same as the perfectly competitive price.
In practice, cooperation of the kind that is needed to ensure a monopoly
outcome is often difficult to achieve in the real world. On the other hand, firms
are likely to realize that competing fiercely by continuously under-cutting prices
is harmful to their own profits. So, the oligopolistic equilibrium is likely to lie
somewhere between the two extremes of monopoly and perfect competition.

• The market structure called monopoly exists where there is exactly one seller
Summary

in any market.
• A commodity market has a monopoly structure, if there is one seller of the
commodity, the commodity has no substitute, and entry into the industry
by another firm is prevented.
• The market price of the commodity depends on the amount supplied by the
monopoly firm. The market demand curve is the average revenue curve for
the monopoly firm.

2020-21
 • The shape of the total revenue curve depends on the shape of the average
revenue curve. In the case of a negatively sloping straight line demand curve,
the total revenue curve is an inverted vertical parabola.
• Average revenue for any quantity level can be measured by the slope of the
line from the origin to the relevant point on the total revenue curve.
• Marginal revenue for any quantity level can be measured by the slope of the
tangent at the relevant point on the total revenue curve.
• The average revenue is a declining curve if and only if the value of the marginal
revenue is lesser than the average revenue.
• The steeper is the negatively sloped demand curve, the further below is the
marginal revenue curve.
• The demand curve is elastic when marginal revenue has a positive value, and
inelastic when the marginal revenue has a negative value.
• If the monopoly firm has zero costs or only has fixed cost, the quantity supplied
in equilibrium is given by the point where marginal revenue is zero. In
contrast, perfect competition would supply an equilibrium quantity given by
the point where average revenue is zero.
• Equilibrium of a monopoly firm is defined as the point where MR = MC
and MC is rising. This point provides the equilibrium quantity produced.
The equilibrium price is provided by the demand curve given the
equilibrium quantity.
• Positive short run profit to a monopoly firm continue in the long run.
• Monopolistic competition in a commodity market arises due to the commodity
being non-homogenous.
• In monopolistic competition, the short run equilibrium results in quantity
produced being lesser and prices being higher compared to perfect
competition. This situation persists in the long run, but long run profits
are zero.
100
• Oligopoly in a commodity market occurs when there are a small number of
Introductory
Microeconomics

firms producing a homogenous commodity.

Monopoly
Key Concepts

Monopolistic Competition
Oligopoly.

1. What would be the shape of the demand curve so that the total revenue curve is
Exercises

(a) a positively sloped straight line passing through the origin?

(b) a horizontal line?
2. From the schedule provided below calculate the total revenue, demand curve
and the price elasticity of demand:
Quantity 1 2 3 4 5 6 7 8 9
Marginal Revenue 10 6 2 2 2 0 0 0 -5
3. What is the value of the MR when the demand curve is elastic?

2020-21
 4. A monopoly firm has a total fixed cost of Rs 100 and has the following
demand schedule:
Quantity 1 2 3 4 5 6 7 8 9 10
Price 100 90 80 70 60 50 40 30 20 10
Find the short run equilibrium quantity, price and total profit. What would be
the equilibrium in the long run? In case the total cost was Rs 1000, describe the
equilibrium in the short run and in the long run.
5. If the monopolist firm of Exercise 3, was a public sector firm. The government
set a rule for its manager to accept the goverment fixed price as given (i.e. to be
a price taker and therefore behave as a firm in a perfectly competitive market),
and the government decide to set the price so that demand and supply in the
market are equal. What would be the equilibrium price, quantity and profit in
this case?
6. Comment on the shape of the MR curve in case the TR curve is a (i) positively
sloped straight line, (ii) horizontal straight line.
7. The market demand curve for a commodity and the total cost for a monopoly
firm producing the commodity is given by the schedules below. Use the
information to calculate the following:

Quantity 0 1 2 3 4 5 6 7 8
Price 52 44 37 31 26 22 19 16 13

Quantity 0 1 2 3 4 5 6 7 8
Total Cost 10 60 90 100 102 105 109 115 125

(a) The MR and MC schedules

(b) The quantites for which the MR and MC are equal
(c) The equilibrium quantity of output and the equilibrium price of the
commodity
(d) The total revenue, total cost and total profit in equilibrium.
8. Will the monopolist firm continue to produce in the short run if a loss is incurred 101
at the best short run level of output?

Non-competitive Markets
9. Explain why the demand curve facing a firm under monopolistic competition is
negatively sloped.
10. What is the reason for the long run equilibrium of a firm in monopolistic
competition to be associated with zero profit?
11. List the three different ways in which oligopoly firms may behave.
12. If duopoly behaviour is one that is described by Cournot, the market demand
curve is given by the equation q = 200 – 4p, and both the firms have zero costs,
find the quantity supplied by each firm in equilibrium and the equilibrium
market price.
13. What is meant by prices being rigid? How can oligopoly behaviour lead to such
an outcome?

2020-21
 Introductor y
Macroeconomics
Textbook in Economics for Class XII

2020-21
 ISBN 81-7450-715-9
First Edition
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2020-21
 Foreword
The National Curriculum Framework (NFC) 2005, recommends that
children’s life at school must be linked to their life outside the school.
This principle marks a departure from the legacy of bookish learning
which continues to shape our system and causes a gap between
the school, home and community. The syllabi and textbooks
developed on the basis of NCF signify an attempt to implement this
basic idea. They also attempt to discourage rote learning and the
maintenance of sharp boundaries between different subject areas.
We hope these measures will take us significantly further in the
direction of a child-centred system of education outlined in the
National Policy on Education (1986).
The success of this effort depends on the steps that school
principals and teachers will take to encourage children to reflect on
their own learning and to pursue imaginative activities and
questions. We must recognise that, given space, time and freedom,
children generate new knowledge by engaging with the information
passed on to them by adults. Treating the prescribed textbook as
the sole basis of examination is one of the key reasons why other
resources and sites of learning are ignored. Inculcating creativity
and initiative is possible if we perceive and treat children as
participants in learning, not as receivers of a fixed body of knowledge.
These aims imply considerable change in school routines and
mode of functioning. Flexibility in the daily time-tables is as
necessary as rigour in implementing the annual calendar so that
the required number of teaching days are actually devoted to
teaching. The methods used for teaching and evaluation will also
determine how effective this textbook proves for making children’s
life at school a happy experience, rather than a source of stress or
problem. Syllabus designers have tried to address the problem of
curricular burden by restructuring and reorienting knowledge at
different stages with greater consideration for child psychology and
the time available for teaching. The textbook attempts to enhance
this endeavour by giving higher priority and space to opportunities
for contemplation and wondering, discussion in small groups, and
activities requiring hands-on experience.
The National Council of Educational Research and Training
(NCERT) appreciates the hardwork done by the textbook development
committee responsible for this textbook. We wish to thank the
Chairperson of the advisory group in Social Sciences, Professor Hari
Vasudevan, and the Chief Advisor for this textbook, Professor Tapas
Majumdar, for guiding the work of this committee. Several teachers

2020-21
contributed to the development of this textbook; we are grateful to their principals
for making this possible. We are indebted to the institutions and organisations
which have generously permitted us to draw upon their resources, material and
personnel. We are especially grateful to the members of the National Monitoring
Committee, appointed by the Department of Secondary and Higher Education,
Ministry of Human Resource Development under the Chairpersonship of Professor
Mrinal Miri and Professor G.P. Deshpande, for their valuable time and contribution.
As an organisation committed to systemic reform and continuous improvement in
the quality of its products, NCERT welcomes comments and suggestions which will
enable us to undertake further revision and refinement.

Director
New Delhi National Council of Educational
16 February 2007 Research and Training

iv

2020-21
 Textbook Development Committee
CHAIRPERSON, ADVISORY COMMITTEE FOR SOCIAL SCIENCE TEXTBOOKS AT THE HIGHER
SECONDARY LEVEL
Hari Vasudevan, Professor, Department of History, University of Calcutta,
Kolkata

CHIEF ADVISOR
Tapas Majumdar, Professor Emeritus of Economics,
Jawaharlal Nehru University, New Delhi.

ADVISOR
Satish Jain, Professor, Centre for Economics Studies and Planning,
School of Social Sciences, Jawaharlal Nehru University, New Delhi

MEMBERS
Debarshi Das, Lecturer, Department of Economics, Punjab University,
Chandigarh
Saumyajit Bhattacharya, Senior Lecturer, Department of Economics,
Kirorimal College, University of Delhi, New Delhi
Sanmitra Ghosh, Lecturer, Department of Economics, Jadavpur
University, Kolkata
Malbika Pal, Senior Lecturer, Department of Economics, Miranda House,
University of Delhi, New Delhi

MEMBER-COORDINATOR
Jaya Singh, Lecturer, Economics, Department of Education in Social
Sciences, NCERT, New Delhi

2020-21
The National Council of Educational Research and Training
acknowledges the invaluable contribution of academicians and
practising school teachers for bringing out this textbook. We are
grateful to Subrato Guha, Assistant Professor, Jawaharlal Nehru
University, for going through our manuscript and suggesting relevant
changes. We thank Sunil Ashra, Associate Professor, Management
Development Institute, Gurgaon, for his contribution. We also thank
our colleagues Neeraja Rashmi, Reader, Curriculum Group; M.V.
Srinivasan, Ashita Raveendran, Pratima Kumari, Lecturers,
Department of Education in Social Sciences and Humanities, (DESSH),
for their feedback and suggestions.
We would like to place on record the precious advise of (Late)
Dipak Banerjee, Professor (Retd.), Presidency College, Kolkata.
We could have benefited much more of his expertise had his health
permitted.
The practising school teachers have helped in many ways. The
council expresses its gratitude to S.K. Mishra, PGT (Economics),
Kendriya Vidyalaya, Uttarkashi, Uttarakhand; Ambika Gulati, Head,
Department of Economics, Sanskriti School; B.C. Thakur, PGT
(Economics), Government Pratibha Vikas Vidyalaya, Surajmal Vihar;
Ritu Gupta, Principal, Sneh International School, Rashmi Sharma,
PGT (Economics), Kendriya Vidyalaya, JNU Campus, New Delhi.
We also thank Savita Sinha, Professor and Head, DESSH for her support.
Special thanks are due to Vandana [Link], Consultant Editor, for going
through the manuscript.
The council gratefully acknowledges the contributions of Dinesh Kumar,
In-charge, Computer Station; Amar Kumar Prusty, Copy Editor, in shaping
this book. The contribution of the Publication Department in bringing
out his book is duly acknowledged.
This textbook has been reviewed with the support of Archana
Aggarwal, Assistant Professor, Hindu College; Malabika Pal,
Associate Professor, Miranda House; Lokendra Kumawat, Assistant
Professor, Ramjas College; T. M. Thomas, Associate Professor,
Deshbandhu College, Delhi School of Arts and Commerce and Rashmi
Sharma, Assistant Professor, (DCAC). Their contributions are duly
acknowledged.
The council is also thankful to Tampakmayum Alan Mustofa, JPF;
Farheen Fatima, and Amjad Husain, DTP Operators, in shaping this
textbook.

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 Contents
F OREWORD
? iii

1. INTRODUCTION 1
1.1 Emergence of Macroeconomics 5
1.2 Context of the Present Book of Macroeconomics 6

2. NATIONAL INCOME ACCOUNTING 9

2.1 Some Basic Concepts of Macroeconomics 9
2.2 Circular Flow of Income and Methods of
Calculating National Income 14
2.2.1 The Product or Value Added Method 17
2.2.2 Expenditure Method 21
2.2.3 Income Method 22
2.2.4 Factor Cost, Basic Prices and Market Prices 24
2.3 Some Macroeconomic Identities 25
2.4 Nominal and Real GDP 29
2.5 GDP and Welfare 30

3. MONEY AND BANKING 36

3.1 Functions of Money 36
3.2 Demand for Money and Supply of Money 37
3.2.1 Demand for Money 37
3.2.2 Supply of Money 38
3.3 Money Creation by Banking System 39
3.3.1 Balance Sheet of a Fictional Bank 40
3.3.2 Limits to Credit Creation and Money Multiplier 40
3.4 Policy Tools to Control Money Supply 42
4. DETERMINATION OF INCOME AND EMPLOYMENT 53
4.1 Aggregate Demand and its Components 53
4.1.1 Consumption 54
4.1.2 Investment 56
4.2 Determination of Income in Two-sector Model 56
4.3 Determination of Equilibrium Income in the Short Run 57
4.3.1 Macroeconomic equilibrium with price level fixed 57
4.3.2 Effect of an autonomous change in aggregate
demand on income and output 60

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 4.3.3 The Multiplier Mechanism 61
4.4 Some More Concepts 64

5. GOVERNMENT BUDGET AND THE ECONOMY 66

5.1 Government Budget – Meaning and its Components 66
5.1.1 Objectives of Government Budget 67
5.1.2 Classification of Receipts 68
5.1.3 Classification of Expenditure 69
5.2 Balanced, Surplus and Deficit Budget 70
5.2.1 Measures of Government Deficit 71

6. OPEN ECONOMY MACROECONOMICS 85

6.1 The Balance of Payments 86
6.1.1 Current Account 86
6.1.2 Capital Account 88
6.1.3 Balance of Payments Surplus and Deficit 88
6.2 The Foreign Exchange Market 91
6.2.1 Foreign Exchange Rate 91
6.2.2 Determination of the Exchange Rate 92
6.2.3 Merits and Demerits of Flexible and Fixed
Exchange Rate Systems 95
6.2.4 Managed Floating 95
GLOSSARY 105

viii

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 Chapter 1
Introduction
You must have already been introduced to a study of basic
microeconomics. This chapter begins by giving you a
simplified account of how macroeconomics differs from the
microeconomics that you have known.
Those of you who will choose later to specialise in
economics, for your higher studies, will know about the
more complex analyses that are used by economists to
study macroeconomics today. But the basic questions of
the study of macroeconomics would remain the same and
you will find that these are actually the broad economic
questions that concern all citizens – Will the prices as a
whole rise or come down? Is the employment condition of
the country as a whole, or of some sectors of the economy,
getting better or is it worsening? What would be reasonable
indicators to show that the economy is better or worse?
What steps, if any, can the State take, or the people ask
for, in order to improve the state of the economy? These
are the kind of questions that make us think about the
health of the country’s economy as a whole. These
questions are dealt within macroeconomics at different
levels of complexity.
In this book you will be introduced to some of the basic
principles of macroeconomic analysis. The principles will
be stated, as far as possible, in simple language.
Sometimes elementary algebra will be used in the
treatment for introducing the reader to some rigour.
If we observe the economy of a country as a whole it will
appear that the output levels of all the goods and services
in the economy have a tendency to move together. For
example, if output of food grain is experiencing a growth, it
is generally accompanied by a rise in the output level of
industrial goods. Within the category of industrial goods
also output of different kinds of goods tend to rise or fall
simultaneously. Similarly, prices of different goods and
services generally have a tendency to rise or fall
simultaneously. We can also observe that the employment
level in different production units also goes up or down
together.
If aggregate output level, price level, or employment
level, in the different production units of an economy,

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 bear close relationship to each other then the task of analysing the
entire economy becomes relatively easy. Instead of dealing with the
above mentioned variables at individual (disaggregated) levels, we
can think of a single good as the representative of all the goods and
services produced within the economy. This representative good will
have a level of production which will correspond to the average
production level of all the goods and services. Similarly, the price or
employment level of this representative good will reflect the general
price and employment level of the economy.
In macroeconomics we usually simplify the analysis of how the
country’s total production and the level of employment are related to
attributes (called ‘variables’) like prices, rate of interest, wage rates,
profits and so on, by focusing on a single imaginary commodity and
what happens to it. We are able to afford this simplification and thus
usefully abstain from studying what happens to the many real
commodities that actually are bought and sold in the market because
we generally see that what happens to the prices, interests, wages and
profits etc. for one commodity more or less also happens for the others.
Particularly, when these attributes start changing fast, like when prices
are going up (in what is called an inflation), or employment and
production levels are going down (heading for a depression), the general
directions of the movements of these variables for all the individual
commodities are usually of the same kind as are seen for the aggregates
for the economy as a whole.
We will see below why, sometimes, we also depart from this useful
simplification when we realise that the country’s economy as a whole
may best be seen as composed of distinct sectors. For certain purposes
the interdependence of (or even rivalry between) two sectors of the
economy (agriculture and industry, for example) or the relationships
between sectors (like the household sector, the business sector and
2 government in a democratic set-up) help us understand some things
happening to the country’s economy much better, than by only looking
Introductory Macroeconomics

at the economy as a whole.

While moving away from different goods and focusing on a
representative good may be convenient, in the process, we may be
overlooking some vital distinctive characteristics of individual goods.
For example, production conditions of agricultural and industrial
commodities are of a different nature. Or, if we treat a single category
of labour as a representative of all kinds of labours, we may be unable
to distinguish the labour of the manager of a firm from the labour of the
accountant of the firm. So, in many cases, instead of a single
representative category of good (or labour, or production technology),
we may take a handful of different kinds of goods. For example, three
general kinds of commodities may be taken as a representative of all
commodities being produced within the economy: agricultural goods,
industrial goods and services. These goods may have different production
technology and different prices. Macroeconomics also tries to analyse
how the individual output levels, prices, and employment levels of these
different goods gets determined.
From this discussion here, and your earlier reading of
microeconomics, you may have already begun to understand in what

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way macroeconomics differs from microeconomics. To recapitulate briefly,
in microeconomics, you came across individual ‘economic agents’ (see
box) and the nature of the motivations that drive them. They were
‘micro’ (meaning ‘small’) agents – consumers choosing their respective
optimum combinations of goods to buy, given their tastes and incomes;
and producers trying to make maximum profit out of producing their
goods keeping their costs as low as possible and selling at a price as
high as they could get in the markets. In other words, microeconomics
was a study of individual markets of demand and supply and the ‘players’,
or the decision-makers, were also individuals (buyers or sellers, even
companies) who were seen as trying to maximise their profits (as
producers or sellers) and their personal satisfaction or welfare levels
(as consumers). Even a large company was ‘micro’ in the sense that it
had to act in the interest of its own shareholders which was not
necessarily the interest of the country as a whole. For microeconomics
the ‘macro’ (meaning ‘large’) phenomena affecting the economy as a
whole, like inflation or unemployment, were either not mentioned or
were taken as given. These were not variables that individual buyers or
sellers could change. The nearest that microeconomics got to
macroeconomics was when it looked at General Equilibrium, meaning
the equilibrium of supply and demand in each market in the economy.

Economic Agents
By economic units or economic agents, we mean those individuals
or institutions which take economic decisions. They can be
consumers who decide what and how much to consume. They may
be producers of goods and services who decide what and how much
to produce. They may be entities like the government, corporation,
banks which also take different economic decisions like how much
to spend, what interest rate to charge on the credits, how much to 3
tax, etc.

Introduction
Macroeconomics tries to address situations facing the economy as a
whole. Adam Smith, the founding father of modern economics, had
suggested that if the buyers and sellers in each market take their
decisions following only their own self-interest, economists will not need
to think of the wealth and welfare of the country as a whole separately.
But economists gradually discovered that they had to look further.
Economists found that first, in some cases, the markets did not or
could not exist. Secondly, in some other cases, the markets existed
but failed to produce equilibrium of demand and supply. Thirdly, and
most importantly, in a large number of situations society (or the State,
or the people as a whole) had decided to pursue certain important
social goals unselfishly (in areas like employment, administration,
defence, education and health) for which some of the aggregate effects
of the microeconomic decisions made by the individual economic agents
needed to be modified. For these purposes macroeconomists had to
study the effects in the markets of taxation and other budgetary
policies, and policies for bringing about changes in money supply, the
rate of interest, wages, employment, and output. Macroeconomics has,

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 Adam Smith

Adam Smith is regarded as the founding

father of modern economics (it was known
as political economy at that time). He was
a Scotsman and a professor at the
University of Glasgow. Philosopher by
training, his well known work An Enquiry
into the Nature and Cause of the Wealth
of Nations (1776) is regarded as the first
major comprehensive book on the subject.
The passage from the book. ‘It is not from
the benevolence of the butcher, the brewer,
of the baker, that we expect our dinner,
but from their regard to their own interest.
We address ourselves, not to their
humanity but to their self-love, and never talk to them of our own
necessities but of their advantage’ is often cited as an advocacy for
free market economy. The Physiocrats of France were prominent
thinkers of political economy before Smith.

therefore, deep roots in microeconomics because it has to study the

aggregate effects of the forces of demand and supply in the markets.
However, in addition, it has to deal with policies aimed at also
modifying these forces, if necessary, to follow choices made by society
outside the markets. In a developing country like India such choices
have to be made to remove or reduce unemployment, to improve
4 access to education and primary health care for all, to provide for
good administration, to provide sufficiently for the defence of the
Introductory Macroeconomics

country and so on. Macroeconomics shows two simple characteristics

that are evident in dealing with the situations we have just listed.
These are briefly mentioned below.
First, who are the macroeconomic decision makers (or ‘players’)?
Macroeconomic policies are pursued by the State itself or statutory
bodies like the Reserve Bank of India (RBI), Securities and Exchange
Board of India (SEBI) and similar institutions. Typically, each such
body will have one or more public goals to pursue as defined by law
or the Constitution of India itself. These goals are not those of
individual economic agents maximising their private profit or welfare.
Thus the macroeconomic agents are basically different from the
individual decision-makers.
Secondly, what do the macroeconomic decision-makers try to do?
Obviously they often have to go beyond economic objectives and try
to direct the deployment of economic resources for such public needs
as we have listed above. Such activities are not aimed at serving
individual self-interests. They are pursued for the welfare of the
country and its people as a whole.

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1.1 EMERGENCE OF MACROECONOMICS
Macroeconomics, as a separate branch of economics, emerged after the
British economist John Maynard Keynes published his celebrated book
The General Theory of Employment, Interest and Money in 1936. The
dominant thinking in economics before Keynes was that all the labourers
who are ready to work will find employment and all the factories will be
working at their full capacity. This school of thought is known as the
classical tradition.

John Maynard Keynes

John Maynard Keynes, British
economist, was born in 1883.
He was educated in King’s
College, Cambridge, United
Kingdom and later appointed
its Dean. Apart from being a
sharp intellectual he actively
involved in international
diplomacy during the years
following the First World War.
He prophesied the break down
of the peace agreement of the
War in the book The Economic
Consequences of the Peace
(1919). His book General
Theory of Employment,
Interest and Money (1936) is
regarded as one of the most 5
influential economics books of the twentieth century. He was

Introduction
also a shrewd foreign currency speculator.

However, the Great Depression of 1929 and the subsequent years

saw the output and employment levels in the countries of Europe
and North America fall by huge amounts. It affected other countries
of the world as well. Demand for goods in the market was low, many
factories were lying idle, workers were thrown out of jobs. In USA,
from 1929 to 1933, unemployment rate rose from 3 per cent to
25 per cent (unemployment rate may be defined as the number of
people who are not working and are looking for jobs divided by the
total number of people who are working or looking for jobs). Over the
same period aggregate output in USA fell by about 33 per cent. These
events made economists think about the functioning of the economy
in a new way. The fact that the economy may have long lasting
unemployment had to be theorised about and explained. Keynes’ book
was an attempt in this direction. Unlike his predecessors, his approach
was to examine the working of the economy in its entirety and examine
the interdependence of the different sectors. The subject of
macroeconomics was born.

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 1.2 CONTEXT OF THE PRESENT BOOK OF MACROECONOMICS
We must remember that the subject under study has a particular
historical context. We shall examine the working of the economy of a
capitalist country in this book. In a capitalist country production
activities are mainly carried out by capitalist enterprises. A typical
capitalist enterprise has one or several entrepreneurs (people who
6 exercise control over major decisions and bear a large part of the risk
associated with the firm/enterprise). They may themselves supply the
Introductory Macroeconomics

capital needed to run the enterprise, or they may borrow the capital. To
carry out production they also need natural resources – a part consumed
in the process of production (e.g. raw materials) and a part fixed (e.g.
plots of land). And they need the most important element of human
labour to carry out production. This we shall refer to as labour. After
producing output with the help of these three factors of production,
namely capital, land and labour, the entrepreneur sells the product in
the market. The money that is earned is called revenue. Part of the
revenue is paid out as rent for the service rendered by land, part of it is
paid to capital as interest and part of it goes to labour as wages. The
rest of the revenue is the earning of the entrepreneurs and it is called
profit. Profits are often used by the producers in the next period to buy
new machinery or to build new factories, so that production can be
expanded. These expenses which raise productive capacity are examples
of investment expenditure.
In short, a capitalist economy can be defined as an economy in
which most of the economic activities have the following characteristics
(a) there is private ownership of means of production (b) production
takes place for selling the output in the market (c) there is sale and
purchase of labour services at a price which is called the wage rate (the

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labour which is sold and purchased against wages is referred to as
wage labour).
If we apply the above mentioned four criteria to the countries of
the world we would find that capitalist countries have come into
being only during the last three to four hundred years. Moreover,
strictly speaking, even at present, a handful of countries in North
America, Europe and Asia will qualify as capitalist countries. In many
underdeveloped countries production (in agriculture especially) is
carried out by peasant families. Wage labour is seldom used and
most of the labour is performed by the family members themselves.
Production is not solely for the market; a great part of it is consumed
by the family. Neither do many peasant farms experience significant
rise in capital stock over time. In many tribal societies the ownership
of land does not exist; the land may belong to the whole tribe. In
such societies the analysis that we shall present in this book will
not be applicable. It is, however, true that many developing countries
have a significant presence of production units which are organised
according to capitalist principles. The production units will be called
firms in this book. In a firm the entrepreneur (or entrepreneurs) is
at the helm of affairs. She hires wage labour from the market, she
employs the services of capital and land as well. After hiring these
inputs she undertakes the task of production. Her motive for
producing goods and services (referred to as output) is to sell them
in the market and earn profits. In the process she undertakes risks
and uncertainties. For example, she may not get a high enough price
for the goods she is producing; this may lead to fall in the profits
that she earns. It is to be noted that in a capitalist country the
factors of production earn their incomes through the process of
production and sale of the resultant output in the market.
In both the developed and developing countries, apart from the
7
private capitalist sector, there is the institution of State. The role of
the state includes framing laws, enforcing them and delivering justice.

Introduction
The state, in many instances, undertakes production – apart from
imposing taxes and spending money on building public infrastructure,
running schools, colleges, providing health services etc. These
economic functions of the state have to be taken into account when
we want to describe the economy of the country. For convenience we
shall use the term “Government” to denote state.
Apart from the firms and the government, there is another major
sector in an economy which is called the household sector. By a
household we mean a single individual who takes decisions relating
to her own consumption, or a group of individuals for whom decisions
relating to consumption are jointly determined. Households also save
and pay taxes. How do they get the money for these activities? We
must remember that the households consist of people. These people
work in firms as workers and earn wages. They are the ones who
work in the government departments and earn salaries, or they are
the owners of firms and earn profits. Indeed the market in which the
firms sell their products could not have been functioning without the
demand coming from the households. Moreover, they can also earn
rent by leasing land or earn interest by lending capital.

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 So far we have described the major players in the domestic economy.
But all the countries of the world are also engaged in external trade.
The external sector is the fourth important sector in our study. Trade
with the external sector can be of two kinds
1. The domestic country may sell goods to the rest of the world. These
are called exports.
2. The economy may also buy goods from the rest of the world. These
are called imports. Besides exports and imports, the rest of the
world affects the domestic economy in other ways as well.
3. Capital from foreign countries may flow into the domestic country,
or the domestic country may be exporting capital to foreign countries.
Summary

Macroeconomics deals with the aggregate economic variables of an

economy. It also takes into account various interlinkages which may
exist between the different sectors of an economy. This is what
distinguishes it from microeconomics; which mostly examines the
functioning of the particular sectors of the economy, assuming that
the rest of the economy remains the same. Macroeconomics emerged
as a separate subject in the 1930s due to Keynes. The Great Depression,
which dealt a blow to the economies of developed countries, had provided
Keynes with the inspiration for his writings. In this book we shall
mostly deal with the working of a capitalist economy. Hence it may not
be entirely able to capture the functioning of a developing country.
Macroeconomics sees an economy as a combination of four sectors,
namely households, firms, government and external sector.
Key Concepts

Rate of interest Wage rate

Profits Economic agents or units
Great Depression Unemployment rate
Four factors of production Means of production
8
Inputs Land
Introductory Macroeconomics

Labour Capital
Entrepreneurship Investment expenditure
Wage labour Capitalist country or capitalist
economy
Firms Capitalist firms
Output Households
Government External sector
Exports Imports

? 1. What is the difference between microeconomics and macroeconomics?

Exercises

2. What are the important features of a capitalist economy?

3. Describe the four major sectors in an economy according to the

? macroeconomic point of view.

4. Describe the Great Depression of 1929.

Suggested Readings
1. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production,
pages 1 – 27, Macmillan India Limited, New Delhi.
2. Mankiw, N. G., 2000. Macroeconomics, pages 2 – 14, Macmillan Worth
Publishers, New York.

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 National Income Accounting
In this chapter we will introduce the fundamental functioning of a
simple economy. In section 2.1 we describe some primary ideas
we shall work with. In section 2.2 we describe how we can view
the aggregate income of the entire economy going through the
sectors of the economy in a circular way. The same section also
deals with the three ways to calculate the national income; namely
product method, expenditure method and income method. The
last section 2.3 describes the various sub-categories of national
income. It also defines different price indices like GDP deflator,
Consumer Price Index, Wholesale Price Indices and discusses the
problems associated with taking GDP of a country as an indicator
of the aggregate welfare of the people of the country.

2.1 SOME BASIC CONCEPTS OF MACROECONOMICS

One of the pioneers of the subject we call in economics today,
Adam Smith, named his most influential work – An Enquiry into
the Nature and Cause of the Wealth of Nations. What generates
the economic wealth of a nation? What makes countries rich or
poor? These are some of the central questions of economics. It is
not that countries which are endowed with a bounty of natural
wealth – minerals or forests or the most fertile lands – are naturally
the richest countries. In fact the resource rich Africa and Latin
America have some of the poorest countries in the world, whereas
many prosperous countries have scarcely any natural wealth.
There was a time when possession of natural resources was the
most important consideration but even then the resource had to
be transformed through a production process.
The economic wealth, or well-being, of a country thus does
not necessarily depend on the mere possession of resources; the
point is how these resources are used in generating a flow of
production and how, as a consequence, income and wealth are
generated from that process.
Let us now dwell upon this flow of production. How does this
flow of production arise? People combine their energies with
natural and manmade environment within a certain social and
technological structure to generate a flow of production.
In our modern economic setting this flow of production arises
out of production of commodities – goods and services by millions
of enterprises large and small. These enterprises range from giant

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 corporations employing a large number of people to single entrepreneur
enterprises. But what happens to these commodities after being produced? Each
producer of commodities intends to sell her output. So from the smallest items
like pins or buttons to the largest ones like aeroplanes, automobiles, giant
machinery or any saleable service like that of the doctor, the lawyer or the financial
consultant–the goods and services produced are to be sold to the consumers.
The consumer may, in turn, be an individual or an enterprise and the good or
service purchased by that entity might be for final use or for use in further
production. When it is used in further production it often loses its characteristic
as that specific good and is transformed through a productive process into
another good. Thus a farmer producing cotton sells it to a spinning mill where
the raw cotton undergoes transformation to yarn; the yarn is, in turn, sold to a
textile mill where, through the productive process, it is transformed into cloth;
the cloth is, in turn, transformed through another productive process into an
article of clothing which is then ready to be sold finally to the consumers for
final use. Such an item that is meant for final use and will not pass through any
more stages of production or transformations is called a final good.
Why do we call this a final good? Because once it has been sold it passes out
of the active economic flow. It will not undergo any further transformation at the
hands of any producer. It may, however, undergo transformation by the action
of the ultimate purchaser. In fact many such final goods are transformed during
their consumption. Thus the tea leaves purchased by the consumer are not
consumed in that form – they are used to make drinkable tea, which is consumed.
Similarly most of the items that enter our kitchen are transformed through the
process of cooking. But cooking at home is not an economic activity, even though
the product involved undergoes transformation. Home cooked food is not sold
to the market. However, if the same cooking or tea brewing was done in a
restaurant where the cooked product would be sold to customers, then the
same items, such as tea leaves, would cease to be final goods and would be
10 counted as inputs to which economic value addition can take place. Thus it is
not in the nature of the good but in the economic nature of its use that a good
Introductory Macroeconomics

becomes a final good.

Of the final goods, we can distinguish between consumption goods and
capital goods. Goods like food and clothing, and services like recreation that
are consumed when purchased by their ultimate consumers are called
consumption goods or consumer goods. (This also includes services which are
consumed but for convenience we may refer to them as consumer goods.)
Then there are other goods that are of durable character which are used in
the production process. These are tools, implements and machines. While they
make production of other commodities feasible, they themselves don’t get
transformed in the production process. They are also final goods yet they are
not final goods to be ultimately consumed. Unlike the final goods that we have
considered above, they are the crucial backbone of any production process, in
aiding and enabling the production to take place. These goods form a part of
capital, one of the crucial factors of production in which a productive enterprise
has invested, and they continue to enable the production process to go on for
continuous cycles of production. These are capital goods and they gradually
undergo wear and tear, and thus are repaired or gradually replaced over time.
The stock of capital that an economy possesses is thus preserved, maintained
and renewed partially or wholly over time and this is of some importance in the
discussion that will follow.

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 We may note here that some commodities like television sets, automobiles
or home computers, although they are for ultimate consumption, have one
characteristic in common with capital goods – they are also durable. That is,
they are not extinguished by immediate or even short period consumption;
they have a relatively long life as compared to articles such as food or even
clothing. They also undergo wear and tear with gradual use and often need
repairs and replacements of parts, i.e., like machines they also need to be
preserved, maintained and renewed. That is why we call these goods
consumer durables.
Thus if we consider all the final goods and services produced in an economy
in a given period of time they are either in the form of consumption goods (both
durable and non-durable) or capital goods. As final goods they do not undergo
any further transformation in the economic process.
Of the total production taking place in the economy a large number of
products don’t end up in final consumption and are not capital goods either.
Such goods may be used by other producers as material inputs. Examples are
steel sheets used for making automobiles and copper used for making utensils.
These are intermediate goods, mostly used as raw material or inputs for
production of other commodities. These are not final goods.
Now, to have a comprehensive idea of the total flow of production in the
economy, we need to have a quantitative measure of the aggregate level of final
goods produced in the economy. However, in order to get a quantitative
assessment – a measure of the total final goods and services produced in the
economy – it is obvious that we need a common measuring rod. We cannot
add metres of cloth produced to tonnes of rice or number of automobiles or
machines. Our common measuring rod is money. Since each of these
commodities is produced for sale, the sum total of the monetary value of
these diverse commodities gives us a measure of final output. But why are
we to measure final goods only? Surely intermediate goods are crucial inputs
to any production process and a significant part of our manpower and capital
11
stock are engaged in production of these goods. However, since we are dealing
with value of output, we should realise that the value of the final goods already

National Income Accounting

includes the value of the intermediate goods that have entered into their
production as inputs. Counting them separately will lead to the error of double
counting. Whereas considering intermediate goods may give a fuller description
of total economic activity, counting them will highly exaggerate the final value
of our economic activity.
At this stage it is important to introduce the concepts of stocks and flows.
Often we hear statements like the average salary of someone is Rs 10,000 or the
output of the steel industry is so many tonnes or so many rupees in value. But
these are incomplete statements because it is not clear whether the income which
is being referred to is yearly or monthly or daily income and surely that makes
a huge difference. Sometimes, when the context is familiar, we assume that the
time period is known and therefore do not mention it. But inherent in all such
statements is a definite period of time. Otherwise such statements are
meaningless. Thus income, or output, or profits are concepts that make sense
only when a time period is specified. These are called flows because they occur
in a period of time. Therefore we need to delineate a time period to get a
quantitative measure of these. Since a lot of accounting is done annually in an
economy, many of these are expressed annually like annual profits or production.
Flows are defined over a period of time.

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 In contrast, capital goods or consumer durables once produced do not wear
out or get consumed in a delineated time period. In fact capital goods continue
to serve us through different cycles of production. The buildings or machines in
a factory are there irrespective of the specific time period. There can be addition
to, or deduction from, these if a new machine is added or a machine falls in
disuse and is not replaced. These are called stocks. Stocks are defined at a
particular point of time. However we can measure a change in stock over a
specific period of time like how many machines were added this year. Such
changes in stocks are thus flows, which can be measured over specific time
periods. A particular machine can be part of the capital stock for many years
(unless it wears out); but that machine can be part of the flow of new machines
added to the capital stock only for a single year when it was initially installed.
To further understand the difference between stock variables and flow
variables, let us take the following example. Suppose a tank is being filled with
water coming from a tap. The amount of water which is flowing into the tank
from the tap per minute is a flow. But how much water there is in the tank at a
particular point of time is a stock concept.
To come back to our discussion on the measure of final output, that part
of our final output that comprises of capital goods constitutes gross
investment of an economy1. These may be machines, tools and implements;
buildings, office spaces, storehouses or infrastructure like roads, bridges,
airports or jetties. But all the capital goods produced in a year do not
constitute an addition to the capital stock already existing. A significant part
of current output of capital goods goes in maintaining or replacing part of
the existing stock of capital goods. This is because the already existing capital
stock suffers wear and tear and needs maintenance and replacement. A part
of the capital goods produced this year goes for replacement of existing capital
goods and is not an addition to the stock of capital goods already existing
and its value needs to be subtracted from gross investment for arriving at the
measure for net investment. This deletion, which is made from the value of
12 gross investment in order to accommodate regular wear and tear of capital,
is called depreciation.
Introductory Macroeconomics

So new addition to capital stock in an economy is measured by net investment

or new capital formation, which is expressed as
Net Investment = Gross investment – Depreciation
Let us examine this concept called depreciation a little more in detail. Let us
consider a new machine that a firm invests in. This machine may be in service for
the next twenty years after which it falls into disrepair and needs to be replaced.
We can now imagine as if the machine is being gradually used up in each year’s
production process and each year one twentieth of its original value is getting
depreciated. So, instead of considering a bulk investment for replacement after
twenty years, we consider an annual depreciation cost every year. This is the
usual sense in which the term depreciation is used and inherent in its conception
is the expected life of a particular capital good, like twenty years in our example of
the machine. Depreciation is thus an annual allowance for wear and tear of a

1
This is how economists define investment. This must not be confused with the commonplace
notion of investment which implies using money to buy physical or financial assets. Thus use of the
term investment to denote purchase of shares or property or even having an insurance policy has
nothing to do with how economists define investment. Investment for us is always capital formation,
a gross or net addition to capital stock.

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capital good.2 In other words it is the cost of the good divided by number of years
of its useful life.3
Notice here that depreciation is an accounting concept. No real expenditure
may have actually been incurred each year yet depreciation is annually
accounted for. In an economy with thousands of enterprises with widely varying
periods of life of their equipment, in any particular year, some enterprises are
actually making the bulk replacement spending. Thus, we can realistically
assume that there will be a steady flow of actual replacement spending which
will more or less match the amount of annual depreciation being accounted
for in that economy.
Now if we go back to our discussion of total final output produced in an
economy, we see that there is output of consumer goods and services and
output of capital goods. The consumer goods sustain the consumption of
the entire population of the economy. Purchase of consumer goods depends
on the capacity of the people to spend on these goods which, in turn, depends
on their income. The other part of the final goods, the capital goods, are
purchased by business enterprises. They are used either for maintenance of
the capital stock because there are wear and tear of it, or they are used for
addition to their capital stock. In a specific time period, say in a year, thetotal
production of final goods can thus be either in the form of consumption or
investment. This implies that there is a trade-off. If an economy, produces
more of consumer goods, it is producing less of capital goods and vice-
versa.
It is generally observed that more sophisticated and heavy capital goods
raise the ability of a labourer to produce goods. The traditional weaver would
take months to weave a sari but with modern machinery thousands of pieces of
clothing are produced in a day. Decades were taken to construct the great
historical monuments like the Pyramids or the Taj Mahal but with modern
construction machinery one can build a skyscraper in a few years. More
production of newer varities of capital goods therefore would help in the greater
13
production of consumer goods.
But aren’t we contradicting ourselves? Earlier we have seen how, of the total

National Income Accounting

output of final goods of an economy, if a larger share goes for production of
capital goods, a smaller share is available for production of consumer goods.
And now we are saving more capital goods would mean more consumer goods.
There is no contradiction here however. What is important here is the element of
time. At a particular period, given a level of total output of the economy, it is
true if more capital goods are produced less of consumer goods would be
produced. But production of more capital goods would mean that in future the
labourers would have more capital equipments to work with. We have seen that
this leads to a higher capacity of the economy to produce with the same number
of labourers. Thus total input itself would be higher compared to the case when
less capital goods were produced. If total output is higher the amount of
consumer goods that can be produced would surely be higher.

2
Depreciation does not take into account unexpected or sudden destruction or disuse of
capital as can happen with accidents, natural calamities or other such extraneous circumstances.
3
We are making a rather simple assumption here that there is a constant rate of depreciation
based on the original value of the asset. There can be other methods to calculate depreciation in
actual practice.

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 Thus the economic cycle not only rolls on, higher production of capital goods
enables the economy to expand. It is possible to find another view of the circular
flow in the discussion we have made so far.
Since we are dealing with all goods and services that are produced for the
market, the crucial factor enabling such sale is demand for such products backed
by purchasing power. One must have the necessary ability to purchase
commodities. Otherwise one’s need for commodities does not get recognised by
the market.
We have already discussed above that one’s ability to buy commodities comes
from the income one earns as labourer (earning wages), or as entrepreneur
(earning profits), or as landlord (earning rents), or as owner of capital (earning
interests). In short, the incomes that people earn as owners of factors of production
are used by them to meet their demand for goods and services.
So we can see a circular flow here which is facilitated through the market.
Simply put, the firms’ demand for factors of production to run the production
process creates payments to the public. In turn, the public’s demand for goods
and services creates payments to the firms and enables the sale of the products
they produce.
So the social act of consumption and production are intricately linked and,
in fact, there is a circular causation here. The process of production in an economy
generates factor payments for those involved in production and generates goods
and services as the outcome of the production process. The incomes so generated
create the capacity to purchase the final consumption goods and thus enable
their sale by the business enterprises, the basic object of their production. The
capital goods which are also generated in the production process also enable
their producers to earn income – wages, profits etc. in a similar manner. The
capital goods add to, or maintain, the capital stock of an economy and thus
make production of other commodities possible.

2.2 CIRCULAR FLOW OF INCOME AND METHODS

14
OF CALCULATING NATIONAL INCOME
Introductory Macroeconomics

The description of the economy in the previous section enables us to have a

rough idea of how a simple economy – without a government, external trade or
any savings – may function. The households receive their payments from the
firms for productive activities they perform for the latter. As we have mentioned
before, there may fundamentally be four kinds of contributions that can be
made during the production of goods and services (a) contribution made by
human labour, remuneration for which is called wage (b) contribution made by
capital, remuneration for which is called interest (c) contribution made by
entrepreneurship, remuneration of which is profit (d) contribution made by fixed
natural resources (called ‘land’), remuneration for which is called rent.
In this simplified economy, there is only one way in which the households
may dispose off their earnings – by spending their entire income on the goods
and services produced by the domestic firms. The other channels of disposing
their income are closed: we have assumed that the households do not save, they
do not pay taxes to the government – since there is no government, and neither
do they buy imported goods since there is no external trade in this simple
economy. In other words, factors of production use their remunerations to buy
the goods and services which they assisted in producing. The aggregate
consumption by the households of the economy is equal to the aggregate
expenditure on goods and services produced by the firms in the economy. The

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entire income of the economy,
therefore, comes back to the
producers in the form of sales
revenue. There is no leakage
from the system – there is no
difference between the amount
that the firms had distributed in
the form of factor payments
(which is the sum total of
remunerations earned by the
four factors of production) and
the aggregate consumption
expenditure that they receive as
sales revenue.
In the next period the firms
will once again produce goods Fig. 2.1: Circular Flow of Income in a Simple Economy
and services and pay
remunerations to the factors of production. These remunerations will once
again be used to buy the goods and services. Hence year after year we can
imagine the aggregate income of the economy going through the two sectors,
firms and households, in a circular way. This is represented in Fig. 2.1. When
the income is being spent on the goods and services produced by the firms, it
takes the form of aggregate expenditure received by the firms. Since the value
of expenditure must be equal to the value of goods and services, we can
equivalently measure the aggregate income by “calculating the aggregate value
of goods and services produced by the firms”. When the aggregate revenue
received by the firms is paid out to the factors of production it takes the form
of aggregate income.
In Fig. 2.1, the uppermost arrow, going from the households to the firms,
represents the spending the households undertake to buy goods and services 15
produced by the firms. The second arrow going from the firms to the households

National Income Accounting

is the counterpart of the arrow above. It stands for the goods and services which
are flowing from the firms to the households. In other words, this flow is what
the households are getting from the firms, for which they are making the
expenditures. In short, the two arrows on the top represent the goods and services
market – the arrow above represents the flow of payments for the goods and
services, the arrow below represents the flow of goods and services. The two
arrows at the bottom of the diagram similarly represent the factors of production
market. The lower most arrow going from the households to the firms symbolises
the services that the households are rendering to the firms. Using these services
the firms are manufacturing the output. The arrow above this, going from the
firms to the households, represents the payments made by the firms to the
households for the services provided by the latter.
Since the same amount of money, representing the aggregate value of goods
and services, is moving in a circular way, if we want to estimate the aggregate
value of goods and services produced during a year we can measure the annual
value of the flows at any of the dotted lines indicated in the diagram. We can
measure the uppermost flow (at point A) by measuring the aggregate value of
spending that the firms receive for the final goods and services which they produce.
This method will be called the expenditure method. If we measure the flow at
B by measuring the aggregate value of final goods and services produced by all

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 the firms, it will be called product method. At C, measuring the sum total of all
factor payments will be called income method.
Observe that the aggregate spending of the economy must be equal to the
aggregate income earned by the factors of production (the flows are equal at A
and C). Now let us suppose that at a particular period of time the households
decide to spend more on the goods and services produced by the firms. For the
time being let us ignore the question where they would find the money to finance
that extra spending since they are already spending all of their income (they
may have borrowed the money to finance the additional spending). Now if they
spend more on the goods and services, the firms will produce more goods and
services to meet this extra demand. Since they will produce more, the firms
must also pay the factors of production extra remunerations. How much extra
amount of money will the firms pay? The additional factor payments must be
equal to the value of the additional goods and services that are being produced.
Thus the households will eventually get the extra earnings required to support
the initial additional spending that they had undertaken. In other words, the
households can decide to spend more – spend beyond their means. And in the
end their income will rise exactly by the amount which is necessary to carry out
the extra spending. Putting it differently, an economy may decide to spend more
than the present level of income. But by doing so, its income will eventually rise
to a level consistent with the higher spending level. This may seem a little
paradoxical at first. But since income is moving in a circular fashion, it is not
difficult to figure out that a rise in the flow at one point must eventually lead to
a rise in the flow at all levels. This is one more example of how the functioning of
a single economic agent (say, a household) may differ from the functioning of
the economy as a whole. In the former the spending gets restricted by the
individual income of a household. It can never happen that a single worker
decides to spend more and this leads to an equivalent rise in her income. We
shall spend more time on how higher aggregate spending leads to change in
aggregate income in a later chapter.
16 The above mentioned sketchy illustration of an economy is admittedly a
simplified one. Such a story which describes the functioning of an imaginary
Introductory Macroeconomics

economy is called a macroeconomic model. It is clear that a model does

not describe an actual economy in detail. For example, our model assumes
that households do not save, there is no government, no trade with other
countries. However models do not want to capture an economy in its every
minute detail – their purpose is to highlight some essential features of the
functioning of an economic system. But one has to be cautious not to simplify
the matters in such a way that misrepresents the essential nature of the
economy. The subject of economics is full of models, many of which will be
presented in this book. One task of an economist is to figure out which model
is applicable to which real life situation.
If we change our simple model described above and introduce savings,
will it change the principal conclusion that the aggregate estimate of the
income of the economy will remain the same whether we decide to calculate it
at A, B or C? It turns out that this conclusion does not change in a
fundamental way. No matter how complicated an economic system may be,
the annual production of goods and services estimated through each of the
three methods is the same.
We have seen that the aggregate value of goods and services produced in an
economy can be calculated by three methods. We now discuss the detailed steps
of these calculations.

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2.2.1 The Product or Value Added Method
In product method we calculate the aggregate annual value of goods and services
produced (if a year is the unit of time). How to go about doing this? Do we add
up the value of all goods and services produced by all the firms in an economy?
The following example will help us to understand.
Let us suppose that there are only two kinds of producers in the economy.
They are the wheat producers (or the farmers) and the bread makers (the bakers).
The wheat producers grow wheat and they do not need any input other than
human labour. They sell a part of the wheat to the bakers. The bakers do not
need any other raw materials besides wheat to produce bread. Let us suppose
that in a year the total value of wheat that the farmers have produced is Rs 100.
Out of this they have sold Rs 50 worth of wheat to the bakers. The bakers have
used this amount of wheat completely during the year and have produced
Rs 200 worth of bread. What is the value of total production in the economy? If
we follow the simple way of aggregating the values of production of the sectors,
we would add Rs 200 (value of production of the bakers) to Rs 100 (value of
production of farmers). The result will be Rs 300.
A little reflection will tell us that the value of aggregate production is not Rs
300. The farmers had produced Rs 100 worth of wheat for which it did not need
assistance of any inputs. Therefore the entire Rs 100 is rightfully the contribution
of the farmers. But the same is not true for the bakers. The bakers had to buy Rs
50 worth of wheat to produce their bread. The Rs 200 worth of bread that they
have produced is not entirely their own contribution. To calculate the net
contribution of the bakers, we need to subtract the value of the wheat that they
have bought from the farmers. If we do not do this we shall commit the mistake
of ‘double counting’. This is because Rs 50 worth of wheat will be counted twice.
First it will be counted as part of the output produced by the farmers. Second
time, it will be counted as the imputed value of wheat in the bread produced by
the bakers.
Therefore, the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150. 17
Hence, aggregate value of goods produced by this simple economy is Rs 100 (net

National Income Accounting

contribution by the farmers) + Rs 150 (net contribution by the bakers) = Rs 250.
The term that is used to denote the net contribution made by a firm is
called its value added. We have seen that the raw materials that a firm buys
from another firm which are completely used up in the process of production
are called ‘intermediate goods’. Therefore the value added of a firm is, value of
production of the
fir m – value of Table 2.1: Production, Intermediate Goods and Value Added
intermediate goods
used by the firm. The Farmer Baker
value added of a firm Total production 100 200
is distributed among Intermediate goods used 0 50
its four factors of Value added 100 200 – 50 =150
production, namely,
labour, capital,
entrepreneurship and land. Therefore wages, interest, profits and rents paid
out by the firm must add up to the value added of the firm. Value added is a
flow variable.
We c a n r e p r e s e n t t h e e x a m p l e g i v e n a b o v e i n t e r m s o f
Table 2.1.

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 Here all the variables are expressed in terms of money. We can think of the
market prices of the goods being used to evaluate the different variables listed
here. And we can introduce more players in the chain of production in the
example and make it more realistic and complicated. For example, the farmer
may be using fertilisers or pesticides to produce wheat. The value of these inputs
will have to be deducted from the value of output of wheat. Or the bakers may
be selling the bread to a restaurant whose value added will have to be calculated
by subtracting the value of intermediate goods (bread in this case).
We have already introduced the concept of depreciation, which is also known
as consumption of fixed capital. Since the capital which is used to carry out
production undergoes wear and tear, the producer has to undertake replacement
investments to keep the value of capital constant. The replacement investment
is same as depreciation of capital. If we include depreciation in value added
then the measure of value added that we obtain is called Gross Value Added. If
we deduct the value of depreciation from gross value added we obtain Net Value
Added. Unlike gross value added, net value added does not include wear and
tear that capital has undergone. For example, let us say a firm produces Rs 100
worth of goods per year, Rs 20 is the value of intermediate goods used by it
during the year and Rs 10 is the value of capital consumption. The gross value
added of the firm will be, Rs 100 – Rs 20 = Rs 80 per year. The net value added
will be, Rs 100 – Rs 20 – Rs 10 = Rs 70 per year.
It is to be noted that while calculating the value added we are taking the
value of production of firm. But a firm may be unable to sell all of its produce. In
such a case it will have some unsold stock at the end of the year. Conversely, it
may so happen that a firm had some initial unsold stock to begin with. During
the year that follows it has produced very little. But it has met the demand in the
market by selling from the stock it had at the beginning of the year. How shall we
treat these stocks which a firm may intentionally or unintentionally carry with
itself? Also, let us remember that a firm buys raw materials from other firms. The
part of raw material which gets used up is categorised as an intermediate good.
18 What happens to the part which does not get used up?
In economics, the stock of unsold finished goods, or semi-finished goods,
Introductory Macroeconomics

or raw materials which a firm carries from one year to the next is called
inventory. Inventory is a stock variable. It may have a value at the beginning
of the year; it may have a higher value at the end of the year. In such a case
inventories have increased (or accumulated). If the value of inventories is less
at the end of the year compared to the beginning of the year, inventories have
decreased (decumulated). We can therefore infer that the change of inventories
of a firm during a year ≡ production of the firm during the year – sale of the
firm during the year.
The sign ‘≡’ stands for identity. Unlike equality (‘=’), an identity always holds
irrespective of what variables we have on the left hand and right hand sides of it.
For example, we can write 2 + 2 ≡ 4, because this is always true. But we must
write 2 × x = 4. This is because two times x equals to 4 for a particular value of
x, (namely when x = 2) and not always. We cannot write 2 × x ≡ 4.
Observe that since production of the firm ≡ value added + intermediate
goods used by the firm, we get, change of inventories of a firm during a year
≡ value added + intermediate goods used by the firm – sale of the firm during
a year.
For example, let us suppose that a firm had an unsold stock worth of Rs
100 at the beginning of a year. During the year it had produced Rs 1,000

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worth of goods and managed to sell Rs 800 worth of goods. Therefore, the
Rs 200 is the difference between production and sales. This Rs 200 worth of
goods is the change in inventories. This will add to the Rs 100 worth of
inventories the firm started with. Hence the inventories at the end of the year
is, Rs 100 + Rs 200 = Rs 300. Notice that change in inventories takes place
over a period of time. Therefore it is a flow variable.
Inventories are treated as capital. Addition to the stock of capital of a firm
is known as investment. Therefore, change in the inventory of a firm is treated
as investment. There can be three major categories of investment. First is the
rise in the value of inventories of a firm over a year which is treated as
investment expenditure undertaken by the firm. The second category of
investment is the fixed business investment, which is defined as the addition
to the machinery, factory buildings and equipment employed by the firms.
The last category of investment is the residential investment, which refers to
the addition of housing facilities.
Change in inventories may be planned or unplanned. In case of an unexpected
fall in sales, the firm will have unsold stock of goods which it had not anticipated.
Hence there will be unplanned accumulation of inventories. In the opposite
case where there is unexpected rise in the sales there will be unplanned
decumulation of inventories.
This can be illustrated with the help of the following example. Suppose a
firm produces shirts. It starts the year with an inventory of 100 shirts. During
the coming year it expects to sell 1,000 shirts. Hence, it produces 1,000
shirts, expecting to keep an inventory of 100 at the end of the year. However,
during the year, the sales of shirts turn out to be unexpectedly low. The firm
is able to sell only 600 shirts. This means that the firm is left with 400 unsold
shirts. The firm ends the year with 400 + 100 = 500 shirts. The unexpected
rise of inventories by 400 will be an example of unplanned accumulation of
inventories. If, on the other hand, the sales had been more than 1,000 we 19
would have unplanned decumulation of inventories. For example, if the sales

National Income Accounting

had been 1,050, then not only the production of 1,000 shirts will be sold,
the firm will have to sell 50 shirts out of the inventory. This 50 unexpected
reduction in inventories is an example of unexpected decumulation of
inventories.
What can be the examples of planned accumulation or decumulation of
inventories? Suppose the firm wants to raise the inventories from 100 shirts
to 200 shirts during the year. Expecting sales of 1,000 shirts during the year
(as before), the firm produces 1000 + 100 = 1,100 shirts. If the sales are actually
1,000 shirts, then the firm indeed ends up with a rise of inventories. The new
stock of inventories is 200 shirts, which was indeed planned by the firm. This
rise is an example of planned accumulation of inventories. On the other hand
if the firm had wanted to reduce the inventories from 100 to 25 (say), then it
would produce 1000 – 75 = 925 shirts. This is because it plans to sell 75
shirts out of the inventory of 100 shirts it started with (so that the inventory at
the end of the year becomes 100 – 75 = 25 shirts, which the firm wants). If the
sales indeed turn out to be 1000 as expected by the firm, the firm will be left
with the planned, reduced inventory of 25 shirts.
We shall have more to say on the distinction between unplanned and
planned change in inventories in the chapters which follow.

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 Taking cognizance of change of inventories we may write
Gross value added of firm, i (GV Ai) ≡ Gross value of the output produced by
the firm i (Qi) – Value of intermediate goods used by the firm (Zi)
GV Ai ≡ Value of sales by the firm (Vi ) + Value of change in inventories (Ai ) –
Value of intermediate goods used by the firm (Zi) (2.1)
Equation (2.1) has been derived by using: Change in inventories of a firm
during a year ≡ Production of the firm during the year – Sale of the firm
during the year.
It is worth noting that the sales by the firm includes sales not only to
domestic buyers but also to buyers abroad (the latter is termed as exports). It
is also to be noted that all the above mentioned variables are flow variables.
Generally these are measured on an annual basis. Hence they measure value
of the flows per year.
Net value added of the firm i ≡ GVAi – Depreciation of the firm i (Di)
If we sum the gross value added of all the firms of the economy in a year, we
get a measure of the value of aggregate amount of goods and services produced
by the economy in a year (just as we had done in the wheat-bread example).
Such an estimate is called Gross Domestic Product (GDP). Thus GDP ≡ Sum
total of gross value added of all the firms in the economy.
If there are N firms in the economy, each assigned with a serial number
from 1 to N, then GDP ≡ Sum total of the gross value added of all the firms in
the economy
≡ GVA1 + GVA2 + ..... + GVAN
Therefore
N
GDP ≡ ∑ i =1
GVAi (2.2)

20
The symbol is a notation – it is used to denote summation. Suppose, there
Introductory Macroeconomics

are 3 students, having pocket money of Rs. 200, 250 and 350 respectively.
We can say, if ith student has pocket money X i , then,
X 1 = 200, X 2 = 250, X 3 = 300 . The total pocket money will be given by
X1 + X 2 + X 3 . The summation notation given above is useful in writing it in
a shorter form: X 1 + X 2 + X 3 can be written as , which means that
there are three values of X corresponding to the three individuals 1 to 3,
and we are referring to the sum of the values of X for individuals 1 to 3.
This notation is particularly useful in macroeconomics since we deal with
aggregates. For instance, suppose there are 1000 consumers in the economy,
having consumption c1 , c2 ,...., c1000 . If we want to compute the aggregate
consumption for this economy, we have to add up all these values, which
means aggregate consumption for this economy will be given by
C = c1 + c2 + ... + c1000 . The summation notation, however, allows us to write
it in a much shorter form. Since we are summing up the values of
consumption for individual 1 to individual 1000, where the value of

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 consumption for the individual i is ci, aggregate consumption will be

In general, if we are taking sum of a quantity xi over individuals 1 to n ,

it will be denoted by .

2.2.2 Expenditure Method

An alternative way to calculate the GDP is by looking at the demand side of the
products. This method is referred to as the expenditure method. In the farmer-
baker example that we have described before, the aggregate value of the output
in the economy by expenditure method will be calculated in the following way.
In this method we add the final expenditures that each firm makes. Final
expenditure is that part of expenditure which is undertaken not for intermediate
purposes. The Rs 50 worth of wheat which the bakers buy from the farmers
counts as intermediate goods, hence it does not fall under the category of final
expenditure. Therefore the aggregate value of output of the economy is Rs 200
(final expenditure received by the baker) + Rs 50 (final expenditure received by
the farmer) = Rs 250 per year.
Firm i can make the final expenditure on the following accounts (a) the final
consumption expenditure on the goods and services produced by the firm. We
shall denote this by Ci. We may note that mostly it is the households which
undertake consumption expenditure. There may be exceptions when the firms
buy consumables to treat their guests or for their employees (b) the final
investment expenditure, Ii , incurred by other firms on the capital goods produced
by firm i. Observe that unlike the expenditure on intermediate goods which is
not included in the calculation of GDP, expenditure on investments is included. 21
The reason is that investment goods remain with the firm, whereas intermediate

National Income Accounting

goods are consumed in the process of production (c) the expenditure that the
government makes on the final goods and services produced by firm i. We shall
denote this by Gi . We may point out that the final expenditure incurred by the
government includes both the consumption and investment expenditure (d) the
export revenues that firm i earns by selling its goods and services abroad. This
will be denoted by Xi .
Thus the sum total of the revenues that the firm i earns is given by
RVi ≡ Sum total of final consumption, investment, government and exports
expenditures received by the firm i
≡ Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get
N
∑ i =1
RVi ≡ Sum total of final consumption, investment, government and
exports expenditures received by all the firms in the economy
N N N N
≡ ∑ i =1
Ci + ∑ I +
i =1 i ∑ i =1
Gi + ∑ i =1
Xi (2.3)

Let C be the aggregate final consumption expenditure of the entire

economy. Notice that a part of C is spent on imports of consumption goods C

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 N
= ∑ i =1 Ci + Cm. Let Cm denote expenditure on the imports of consumption goods.
Therefore C – Cm denotes that part of aggregate final consumption expenditure
that is spent on the domestic firms. Similarly, let I – I m stand for that part of
aggregate final investment expenditure that is spent on domestic firms, where
I is the value of the aggregate final investment expenditure of the economy and
out of this I m is spent on foreign investment goods. Similarly
G – Gm stands for that part of aggregate final government expenditure that is
spent on the domestic firms, where G is the aggregate expenditure of the
government of the economy and Gm is the part of G which is spent on imports.
N
Therefore, ∑ i =1
Ci ≡ Sum total of final consumption expenditures
N
received by all the firms in the economy ≡ C – Cm; ∑ i =1 I i ≡ Sum total of final
investment expenditures received by all the firms in the economy ≡ I – Im;
N
∑ Gi ≡ Sum total of final government expenditures received by all the firms
i =1
in the economy ≡ G – Gm. Substituting these in equation (2.3) we get
N N
∑ i =1
RVi ≡ C – Cm + I – Im + G – Gm + ∑ i =1
Xi
N
≡C+I+G + ∑ i =1
X i – (Cm + Im + Gm)

≡C+I+G+X– M
N
Here X ≡ ∑ i = 1 X i denotes aggregate expenditure by the foreigners on the
exports of the economy. M ≡ Cm + Im + Gm is the aggregate imports expenditure
incurred by the economy.
We know, GDP ≡ Sum total of all the final expenditure received by the firms
in the economy.
In other words
N
GDP ≡ ∑ i =1
RVi ≡ C + Ι + G + X – M (2.4)
22 Equation (2.4) expresses GDP according to the expenditure method. It may
be noted that out of the five variables on the right hand side, investment
Introductory Macroeconomics

expenditure, I, is the most unstable.

2.2.3 Income Method

As we mentioned in the beginning, the sum of final expenditures in the economy
must be equal to the incomes received by all the factors of production taken
together (final expenditure is the spending on final goods, it does not include
spending on intermediate goods). This follows from the simple idea that the
revenues earned by all the firms put together must be distributed among the
factors of production as salaries, wages, profits, interest earnings and rents. Let
there be M number of households in the economy. Let Wi be the wages and
salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri
be the gross profits, interest payments and rents received by the i-th household
in a particular year. Therefore, GDP is given by

M M M M
GDP ≡ ∑ i =1
Wi + ∑ i =1
Pi + ∑ i =1
In i + ∑ i =1
Ri ≡ W + P + In + R (2.5)

M M M M
Here, ∑ i =1
Wi ≡ W, ∑ i =1
Pi ≡ P, ∑ i =1
In i ≡ In, ∑ i =1
Ri ≡ R.

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 Taking equations (2.2), (2.4) and (2.5) together we get
N
GDP ≡ ∑ i =1
GV Ai ≡ C + I + G + X – M ≡ W + P + In + R (2.6)
It is to be noted that in identity (2.6), I stands for sum total of both planned
and unplanned investments undertaken by the firms.
Since, the identities (2.2), (2.4) and (2.6) are different expressions of the same
variable, namely GDP, we may represent the equivalence by Fig. 2.2.
Now, let us look at
X–M P N
a numerical example åi =1GVA i
to see how all the three G In
methods of estimating I R
GDP give us the same C W
answer. GDP
Example: There are
two firms, A and B.
Suppose A uses no
raw material and Expenditure Income Product
produces cotton worth Method Method Method
Rs. 50. A sells its cotton Fig. 2.2: Diagramtic Representation of GDP by the Three Methods
to firm B, who uses it
to produce cloth. B sells the cloth produced to consumers for Rs. 200.
1. GDP in the phase of production or the value added method:
Recall that value added (VA) = Sales – Intermediate Goods
Thus,
VAA = 50 - 0 = 50
VAB = 200 - 50 = 150
Thus,
GDP = VAA + VAB = 200.

Table 2.2: Distributions of GDPs for firms A and B 23

National Income Accounting

Firm A Firm B

Sales 50 200
Intermediate
0 50
consumption

Value added 50 150

2. GDP in the phase of disposition or the expenditure method:

Recall that GDP = Sum of final expenditure or expenditures on goods
and services for end use. In the above case, final expenditure is
expenditure by consumers on cloth. Therefore, GDP = 200.
3. GDP in the phase of distribution or Income method
Let us look at the firms A and B again.
Now, of this 50 received by A, the firm gives Rs. 20 to the workers as wages,
and keeps the remaining 30 as its profits. Similarly, B gives 60 as wages and
keeps 90 as profits.

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 Table 2.3: Distributions of factor incomes of firms A and B

Firm A Firm B
Wages 20 60

Profits 30 90

Recall that GDP by income method = sum total of factor incomes, which is
equal to total wages received (workers of A and B) and total profits earned (by A
and B), which is equal4 to 80 + 120 = 200.

2.2.4 Factor Cost, Basic Prices and Market Prices

In India, the most highlighted measure of national income has been the GDP at
factor cost. The Central Statistics Office (CSO) of the Government of India has
been reporting the GDP at factor cost and at market prices. In its revision in
January 2015 the CSO replaced GDP at factor cost with the GVA at basic prices,
and the GDP at market prices, which is now called only GDP, is now the most
highlighted measure.
The idea of GVA has already been discussed: it is the value of total output
produced in the economy less the value of intermediate consumption (the output
which is used in production of output further, and not used in final consumption).
Here we discuss the concept of basic prices. The distinction between factor cost,
basic prices and market prices is based on the distinction between net production
taxes (production taxes less production subsidies) and net product taxes (product
taxes less product subsidies). Production taxes and subsidies are paid or received
in relation to production and are independent of the volume of production such
as land revenues, stamp and registration fee. Product taxes and subsidies, on
the other hand, are paid or received per unit or product, e.g., excise tax, service
tax, export and import duties etc. Factor cost includes only the payment to factors
24 of production, it does not include any tax. In order to arrive at the market prices,
we have to add to the factor cost the total indirect taxes less total subsidies. The
Introductory Macroeconomics

basic prices lie in between: they include the production taxes (less production
subsidies) but not product taxes (less product subsidies). Therefore in order to
arrive at market prices we have to add product taxes (less product subsidies) to
the basic prices.
As stated above, now the CSO releases GVA at basic prices. Thus, it includes
the net production taxes but not net product taxes. In order to arrive at the GDP
(at market prices) we need to add net product taxes to GVA at basic prices.
Thus,

GVA at factor costs + Net production taxes = GVA at

basic prices
GVA at basic prices + Net product taxes = GVA at
market prices
Table 2.5 at the end of the chapter gives the figures for GDP (at market prices)
and GVA at basic prices, while Table 2.6 gives the composition of GDP from
expenditure side.
4
In this example, we have left out factor payments in the form of rent and interest. But this
will not make any difference to the basic result, because after paying wages the remainder of value
added by a firm will be distributed between rent, interest and profits (together called operating
surplus).

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2.3 SOME MACROECONOMIC IDENTITIES
Gross Domestic Product measures the aggregate production of final goods and
services taking place within the domestic economy during a year. But the whole
of it may not accrue to the citizens of the country. For example, a citizen of India
working in Saudi Arabia may be earning her wage and it will be included in the
Saudi Arabian GDP. But legally speaking, she is an Indian. Is there a way to take
into account the earnings made by Indians abroad or by the factors of production
owned by Indians? When we try to do this, in order to maintain symmetry, we
must deduct the earnings of the foreigners who are working within our domestic
economy, or the payments to the factors of production owned by the foreigners.
For example, the profits earned by the Korean-owned Hyundai car factory will
have to be subtracted
from the GDP of India.
The macroeconomic
variable which takes
into account such
additions and
subtractions is
known as Gross
National Product
The foreigners have a share in your domestic economy.
(GNP). It is, therefore,
Discuss this in the classroom.
defined as follows
GNP ≡ GDP + Factor income earned by the domestic factors of production
employed in the rest of the world – Factor income earned by the factors of
production of the rest of the world employed in the domestic economy
Hence, GNP ≡ GDP + Net factor income from abroad
(Net factor income from abroad = Factor income earned by the domestic factors
of production employed in the rest of the world – Factor income earned by the
factors of production of the rest of the world employed in the domestic economy).
We have already noted that a part of the capital gets consumed during the 25
year due to wear and tear. This wear and tear is called depreciation. Naturally,

National Income Accounting

depreciation does not become part of anybody’s income. If we deduct
depreciation from GNP the measure of aggregate income that we obtain is called
Net National Product (NNP). Thus
NNP ≡ GNP – Depreciation
It is to be noted that all these variables are evaluated at market prices.
Through the expression given above, we get the value of NNP evaluated at
market prices. But market price includes indirect taxes. When indirect taxes
are imposed on goods and services, their prices go up. Indirect taxes accrue to
the government. We have to deduct them from NNP evaluated at market prices
in order to calculate that part of NNP which actually accrues to the factors of
production. Similarly, there may be subsidies granted by the government on
the prices of some commodities (in India petrol is heavily taxed by the
government, whereas cooking gas is subsidised). So we need to add subsidies
to the NNP evaluated at market prices. The measure that we obtain by doing
so is called Net National Product at factor cost or National Income.
Thus, NNP at factor cost ≡ National Income (NI ) ≡ NNP at market prices –
(Indirect taxes – Subsidies) ≡ NNP at market prices – Net indirect taxes (Net
indirect taxes ≡ Indirect taxes – Subsidies)

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 We can further subdivide the National Income into smaller categories. Let us try
to find the expression for the part of NI which is received by households. We shall
call this Personal Income (PI). First, let us note that out of NI, which is earned by
the firms and government enterprises, a part of profit is not distributed among the
factors of production. This is called Undistributed Profits (UP). We have to deduct
UP from NI to arrive at PI, since UP does not accrue to the households. Similarly,
Corporate Tax, which is imposed on the earnings made by the firms, will also have
to be deducted from the NI, since it does not accrue to the households. On the other
hand, the households do receive interest payments from private firms or the
government on past loans advanced by them. And households may have to pay
interests to the firms and the government as well, in case they had borrowed money
from either. So, we have to deduct the net interests paid by the households to the
firms and government. The households receive transfer payments from government
and firms (pensions, scholarship, prizes, for example) which have to be added to
calculate the Personal Income of the households.
Thus, Personal Income (PI) ≡ NI – Undistributed profits – Net interest
payments made by households – Corporate tax + Transfer payments to
the households from the government and firms.
However, even PI is not the income over which the households have complete
say. They have to pay taxes from PI. If we deduct the Personal Tax Payments
(income tax, for example) and Non-tax Payments (such as fines) from PI, we
obtain what is known as the Personal Disposable Income. Thus
Personal Disposable Income (PDI ) ≡ PI – Personal tax payments – Non-tax
payments.
Personal Disposable Income is the part of the aggregate income which
belongs to the households. They may decide to consume a part of it, and
save the rest. In Fig. 2.3 we present a diagrammatic representation of the
relations between these major macroeconomic variables.

NFIA D
26
GDP GNP NNP ID - Sub
Introductory Macroeconomics

(at
Market NI UP + NIH
Price) (NNP at + CT –
FC) TrH
PI PTP +
NP
PDI

Fig. 2.3: Diagrammatic representation of the subcategories of aggregate income. NFIA: Net
Factor Income from Abroad, D: Depreciation, ID: Indirect Taxes, Sub: Subsidies, UP: Undistributed
Profits, NIH: Net Interest Payments by Households, CT: Corporate Taxes, TrH: Transfers recived
by Households, PTP: Personal Tax Payments, NP: Non-Tax Payments.

National Disposable Income and Private Income

Apart from these categories of aggregate macroeconomic variables, in India, a
few other aggregate income categories are also used in National Income
accounting
• National Disposable Income = Net National Product at market prices
+ Other current transfers from the rest of the world
The idea behind National Disposable Income is that it gives an idea of

2020-21
 what is the maximum amount of goods and services the domestic economy
has at its disposal. Current transfers from the rest of the world include
items such as gifts, aids, etc.
• Private Income = Factor income from net domestic product accruing to
the private sector + National debt interest + Net factor income from abroad
+ Current transfers from government + Other net transfers from the rest of
the world.

Table 2.4: Basic National Income Aggregates5

1. Gross Domestic • GDP is the market value of all final goods
Product at Market and services produced within a domestic
Prices (GDPMP) territory of a country measured in a year.
• All production done by the national
residents or the non-residents in a
country gets included, regardless of
whether that production is owned by a
local company or a foreign entity.
• Everything is valued at market prices.
GDPMP = C + I + G + X − M
2. GDP at Factor Cost • GDP at factor cost is gross domestic
(GDPFC) product at market prices, less net
product taxes.
• Market prices are the prices as paid by
the consumers Market prices also include
product taxes and subsides. The term
factor cost refers to the prices of products
as received by the producers. Thus, factor
cost is equal to market prices, minus net
indirect taxes. GDP at factor cost 27
measures money value of output produced

National Income Accounting

by the firms within the domestic
boundaries of a country in a year.
GDPFC = GDPMP − NIT
3. Net Domestic • This measure allows policy-makers to
Product at Market estimate how much the country has to
Prices (NDPMP) spend just to maintain their current GDP.
If the country is not able to replace the
capital stock lost through depreciation,
then GDP will fall.
NDPMP = GDPMP − Dep.

4. NDP at Factor Cost • NDP at factor cost is the income earned

by the factors in the form of wages, profits,
(NDPFC)
rent, interest, etc., within the domestic
territory of a country.
NDPFC = NDPMP - Net Product Taxes - Net ProductionTaxes

5
Following the System of National Accounts 2008 (SNA2008) given by the United Nations in
partnership with some other agencies, countries are now switching to new aggregates. India shifted
to these aggregates a few years back.

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 5. Gross National • GNPMP is the value of all the final goods
and services that are produced by the
Product at Market
normal residents of India and is
Prices (GNPMP) measured at the market prices, in a year.
• GNP refers to all the economic output
produced by a nation’s normal residents,
whether they are located within the
national boundary or abroad.
• Everything is valued at the market prices.
GNPMP = GDPMP + NFIA

6. GNP at Factor Cost • GNP at factor cost measures value of

(GNPFC) output received by the factors of
production belonging to a country in a
year.
GNPFC =GNPMP - Net Product Taxes - Net ProductionTaxes

7. Net National • This is a measure of how much a country

can consume in a given period of time.
Product at Market
NNP measures output regardless of where
Prices (NNPMP) that production has taken place (in
domestic territory or abroad).
NNPMP = GNPMP − Depreciation
NNPMP = NDPMP + NFIA

8. NNP at Factor Cost • NNP at factor cost is the sum of income

28 (NNPFC) earned by all factors in the production in
the form of wages, profits, rent and
Introductory Macroeconomics

interest, etc., belonging to a country

Or during a year.
• It is the National Product and is not bound
National Income by production in the national boundaries.
It is the net domestic factor income added
(NI)
with the net factor income from abroad.
NI = NNPMP − Net Product Taxes - Net ProductionTaxes
= NDPFC + NFIA = NNPFC

9. GVA at Market Prices • GDP at market prices

10. GVA at basic prices • GVAMP - Net Product Taxes

11. GVA at factor cost • GVA at basic prices - Net Production Taxes

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2.4 NOMINAL AND REAL GDP
One implicit assumption in all this discussion is that the prices of goods and
services do not change during the period of our study. If prices change, then
there may be difficulties in comparing GDPs. If we measure the GDP of a country
in two consecutive years and see that the figure for GDP of the latter year is
twice that of the previous year, we may conclude that the volume of production
of the country has doubled. But it is possible that only prices of all goods and
services have doubled between the two years whereas the production has
remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic
variables) of different countries or to compare the GDP figures of the same country
at different points of time, we cannot rely on GDPs evaluated at current market
prices. For comparison we take the help of real GDP. Real GDP is calculated in
a way such that the goods and services are evaluated at some constant set of
prices (or constant prices). Since these prices remain fixed, if the Real GDP
changes we can be sure that it is the volume of production which is undergoing
changes. Nominal GDP, on the other hand, is simply the value of GDP at the
current prevailing prices. For example, suppose a country only produces bread.
In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread.
GDP at current price was Rs 1,000. In 2001 the same country produced 110
units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs
1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000
(2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100.
Notice that the ratio of nominal GDP to real GDP gives us an idea of how the
prices have moved from the base year (the year whose prices are being used to
calculate the real GDP) to the current year. In the calculation of real and nominal
GDP of the current year, the volume of production is fixed. Therefore, if these
measures differ it is only due to change in the price level between the base year
and the current year. The ratio of nominal to real GDP is a well known index of
prices. This is called GDP Deflator. Thus if GDP stands for nominal GDP and 29
GDP

National Income Accounting

gdp stands for real GDP then, GDP deflator = gdp .
Sometimes the deflator is also denoted in percentage terms. In such a case
GDP
deflator = gdp × 100 per cent. In the previous example, the GDP deflator is
1,650
= 1.50 (in percentage terms this is 150 per cent). This implies that the
1,100
price of bread produced in 2001 was 1.5 times the price in 2000. Which is true
because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP
deflator, we can have GNP deflator as well.
There is another way to measure change of prices in an economy which is
known as the Consumer Price Index (CPI). This is the index of prices of a
given basket of commodities which are bought by the representative consumer.
CPI is generally expressed in percentage terms. We have two years under
consideration – one is the base year, the other is the current year. We calculate
the cost of purchase of a given basket of commodities in the base year. We also
calculate the cost of purchase of the same basket in the current year. Then we
express the latter as a percentage of the former. This gives us the Consumer
Price Index of the current year vis-´a-vis the base year. For example let us take
an economy which produces two goods, rice and cloth. A representative
consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the

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 year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100.
So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in
2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation
of the two items is, Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs
15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes
the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated
in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950. The
1,950
CPI therefore will be
1,400 × 100 = 139.29 (approximately).
It is worth noting that many commodities have two sets of prices. One is
the retail price which the consumer actually pays. The other is the wholesale
price, the price at which goods are traded in bulk. These two may differ in
value because of the margin kept by traders. Goods which are traded in
bulk (such as raw materials or semi-finished goods) are not purchased by
ordinary consumers. Like CPI, the index for wholesale prices is called
Wholesale Price Index (WPI). In countries like USA it is referred to as
Producer Price Index (PPI). Notice CPI (and analogously WPI) may differ
from GDP deflator because
1. The goods purchased by consumers do not represent all the goods which
are produced in a country. GDP deflator takes into account all such goods
and services.
2. CPI includes prices of goods consumed by the representative consumer, hence
it includes prices of imported goods. GDP deflator does not include prices of
imported goods.
3. The weights are constant in CPI – but they differ according to production
level of each good in GDP deflator.

2.5 GDP AND WELFARE

30
Can the GDP of a country be taken as an index of the welfare of the people of
Introductory Macroeconomics

that country? If a person has more income he or she can buy more goods and
services and his or her material well-being improves. So it may seem reasonable
to treat his or her income level as his or her level of well-being. GDP is the sum
total of value of goods and services created within the geographical boundary of
a country in a particular year. It gets distributed among the people as incomes
(except for retained earnings). So we may be tempted to treat higher level of GDP
of a country as an index of greater well-being of the people of that country (to
account for price changes, we may take the value of real GDP instead of nominal
GDP). But there are at least three reasons why this may not be correct.
1. Distribution of GDP – how uniform is it: If the GDP of the country is rising,
the welfare may not rise as a consequence. This is because the rise in GDP may
be concentrated in the hands of very few individuals or firms. For the rest, the
income may in fact have fallen. In such a case the welfare of the entire country
cannot be said to have increased. For example, suppose in year 2000, an
imaginary country had 100 individuals each earning Rs 10. Therefore the GDP
of the country was Rs 1,000 (by income method). In 2001, let us suppose the
same country had 90 individuals earning Rs 9 each, and the rest 10 individual
earning Rs 20 each. Suppose there had been no change in the prices of goods
and services between these two periods. The GDP of the country in the year 2001
was 90 × (Rs 9) + 10 × (Rs 20) = Rs 810 + Rs 200 = Rs 1,010. Observe that

2020-21
 compared to 2000, the GDP of the country in 2001 was higher by Rs10. But
this has happened when 90 per cent of people of the country have seen a drop in
their real income by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent
have benefited by a rise in their income by 100 per cent (from Rs 10 to Rs 20). 90
per cent of the people are worse off though the GDP of the country has gone up.
If we relate welfare improvement in the country to the percentage of people who
are better off, then surely GDP is not a good index.
2. Non-monetary exchanges: Many activities in an economy are not evaluated
in monetary terms. For example, the domestic services women perform at
home are not paid for. The
exchanges which take place in the
informal sector without the help
of money are called barter
exchanges. In barter exchanges,
goods (or services) are directly
exchanged against each other.
But since money is not being used
here, these exchanges are not
registered as part of economic
activity. In developing countries,
where many remote regions are
underdeveloped, these kinds of
exchanges do take place, but they
are generally not counted in the
GDPs of these countries. This is
a case of underestimation of GDP.
Hence, GDP calculated in the
standard manner may not give us How uniform is the distribution of GDP? It still
a clear indication of the seems that a majority of the people are poor and
productive activity and well-being a few benefited.
31
of a country.
3. Externalities: Externalities refer to the benefits (or harms) a firm or an

National Income Accounting

individual causes to another for which they are not paid (or penalised).
Externalities do not have any market in which they can be bought and
sold. For example, let us suppose there is an oil refinery which refines
crude petroleum and sells it in the market. The output of the refinery is
the amount of oil it refines. We can estimate the value added of the refinery
by deducting the value of intermediate goods used by the refinery (crude
oil in this case) from the value of its output. The value added of the refinery
will be counted as part of the GDP of the economy. But in carrying out
the production the refinery may also be polluting the nearby river. This
may cause harm to the people who use the water of the river. Hence their
well being will fall. Pollution may also kill fish or other organisms of the
river on which fish survive. As a result, the fishermen of the river may be
losing their livelihood. Such harmful effects that the refinery is inflicting
on others, for which it will not bear any cost, are called externalities. In
this case, the GDP is not taking into account such negative externalities.
Therefore, if we take GDP as a measure of welfare of the economy we shall
be overestimating the actual welfare. This was an example of negative
externality. There can be cases of positive externalities as well. In
such cases, GDP will underestimate the actual welfare of
the economy.

2020-21
 At a very fundamental level, the macroeconomy (it refers to the economy that we

Summary
study in macroeconomics) can be seen as working in a circular way. The firms
employ inputs supplied by households and produce goods and services to be sold to
households. Households get the remuneration from the firms for the services
rendered by them and buy goods and services produced by the firms. So we can
calculate the aggregate value of goods and services produced in the economy by
any of the three methods (a) measuring the aggregate value of factor payments
(income method) (b) measuring the aggregate value of goods and services produced
by the firms (product method) (c) measuring the aggregate value of spending received
by the firms (expenditure method). In the product method, to avoid double counting,
we need to deduct the value of intermediate goods and take into account only the
aggregate value of final goods and services. We derive the formulae for calculating
the aggregate income of an economy by each of these methods. We also take note
that goods can also be bought for making investments and these add to the productive
capacity of the investing firms. There may be different categories of aggregate income
depending on whom these are accruing to. We have pointed out the difference between
GDP, GNP, NNP at market price, NNP at factor cost, PI and PDI. Since prices of goods
and services may vary, we have discussed how to calculate the three important
price indices (GDP deflator, CPI, WPI). Finally we have noted that it may be incorrect
to treat GDP as an index of the welfare of the country.
Key Concepts

Final goods Consumption goods

Consumer durables Capital goods
Intermediate goods Stocks
Flows Gross investment
Net investment Depreciation
Wage Interest
32 Profit Rent
Circular flow of income Product method of calculating
Introductory Macroeconomics

National Income
Expenditure method of calculating Income method of calculating
National Income National Income
Macroeconomic model Input
Value added Inventories
Planned change in inventories Unplanned change in inventories
Gross Domestic Product (GDP) Net Domestic Product (NDP)
Gross National Product (GNP) Net National Product (NNP)
(at market price)
NNP (at factor cost) or Undistributed profits
National Income (NI)
Net interest payments made Corporate tax
by households
Transfer payments to the Personal Income (PI)
households from the government
and firms
Personal tax payments Non-tax payments
Personal Disposable Income (PDI) National Disposable Income

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 Private Income Nominal GDP
Real GDP Base year
GDP Deflator Consumer Price Index (CPI)
Wholesale Price Index (WPI) Externalities

1. What are the four factors of production and what are the remunerations to
? each of these called?
2. Why should the aggregate final expenditure of an economy be equal to the
Exercises

aggregate factor payments? Explain.

3. Distinguish between stock and flow. Between net investment and capital which
is a stock and which is a flow? Compare net investment and capital with flow of
water into a tank.
4. What is the difference between planned and unplanned inventory
accumulation? Write down the relation between change in inventories and value
added of a firm.
5. Write down the three identities of calculating the GDP of a country by the
three methods. Also briefly explain why each of these should give us the same
value of GDP.
6. Define budget deficit and trade deficit. The excess of private investment over saving
of a country in a particular year was Rs 2,000 crores. The amount of budget deficit
was ( – ) Rs 1,500 crores. What was the volume of trade deficit of that country?
7. Suppose the GDP at market price of a country in a particular year was Rs 1,100 crores.
Net Factor Income from Abroad was Rs 100 crores. The value of Indirect taxes –
Subsidies was Rs 150 crores and National Income was Rs 850 crores. Calculate
the aggregate value of depreciation.
8. Net National Product at Factor Cost of a particular country in a year is
Rs 1,900 crores. There are no interest payments made by the households to the
firms/government, or by the firms/government to the households. The Personal 33
Disposable Income of the households is Rs 1,200 crores. The personal income

National Income Accounting

taxes paid by them is Rs 600 crores and the value of retained earnings of the
firms and government is valued at Rs 200 crores. What is the value of transfer
payments made by the government and firms to the households?
9. From the following data, calculate Personal Income and Personal Disposable
Income.
Rs (crore)
(a) Net Domestic Product at factor cost 8,000
(b) Net Factor Income from abroad 200
(c) Undisbursed Profit 1,000
(d) Corporate Tax 500
(e) Interest Received by Households 1,500
(f) Interest Paid by Households 1,200
(g) Transfer Income 300
(h) Personal Tax 500
10. In a single day Raju, the barber, collects Rs 500 from haircuts; over this day,
his equipment depreciates in value by Rs 50. Of the remaining Rs 450, Raju

?
pays sales tax worth Rs 30, takes home Rs 200 and retains Rs 220 for
improvement and buying of new equipment. He further pays Rs 20 as income
tax from his income. Based on this information, complete Raju’s contribution
to the following measures of income (a) Gross Domestic Product (b) NNP

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 ?
at market price (c) NNP at factor cost (d) Personal income (e) Personal
disposable income.
11. The value of the nominal GNP of an economy was Rs 2,500 crores in a particular
year. The value of GNP of that country during the same year, evaluated at the
prices of same base year, was Rs 3,000 crores. Calculate the value of the GNP
deflator of the year in percentage terms. Has the price level risen between the
base year and the year under consideration?
12. Write down some of the limitations of using GDP as an index of welfare of a
country.

Suggested Readings
1. Bhaduri, A., 1990. Macroeconomics: The Dynamics of Commodity Production, pages
1 – 27, Macmillan India Limited, New Delhi.
2. Branson, W. H., 1992. Macroeconomic Theory and Policy, (third edition), pages
15 – 34, Harper Collins Publishers India Pvt Ltd., New Delhi.
3. Dornbusch, R and S. Fischer. 1988. Macroeconomics, (fourth edition) pages 29–
62, McGraw Hill, Paris.
4. Mankiw, N. G., 2000. Macroeconomics, (fourth edition) pages 15–76, Macmillan
Worth Publishers, New York.
Appendix 2.1

Table 2.5: GVA and GDP for India at constant (2011-12) prices6

34 PE (Provisional Estimates)
[Link]. Item 2017–18
Introductory Macroeconomics

(Rs. Lakh Crore)

1. GVA at basic prices 119.76

2. Net production taxes 10.35

3. GDP (1+2) 130.11

6
These are provisional estimates released by the CSO in 2018.

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Appendix 2.2

Table 2.6: Composition of GDP: expenditure side (2011-12 prices)

(First Advance
[Link]. Item Estimates)
2017–18
(Rs. Lakh
Crore)

1. Private Final Consumption Expenditure (PFCE) 72.382

2. Government Final Consumption Expenditure 14.544

(GFCE)

3. Gross Fixed Capital Formation (GFCF) 37.55

4. Change in Stocks 3.01

5. Valuables 2.54

Investment (3+4+5) 43.20

6. Exports of Goods and Services 25.98

7. Imports of Goods and Services 28.26

Net Exports (6-7) 2.28

8. Discrepancies 2

9. GDP (1+2+3+4+5+6-7+8) 129.85

Source: CSO in January 5, 2018 35

National Income Accounting

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 Money and Banking

Money is the commonly accepted medium of exchange. In an

economy which consists of only one individual there cannot be
any exchange of commodities and hence there is no role for money.
Even if there is more than one individual but these individuals do
not take part in market transactions, example: family living on an
isolated island, money has no function for them. However, as soon
as there is more than one economic agent who engage themselves
in transactions through the market, money becomes an important
instrument for facilitating these exchanges. Economic exchanges
without the mediation of money are referred to as barter
exchanges. However, they presume the rather improbable double
coincidence of wants. Consider, for example, an individual who
has a surplus of rice which she wishes to exchange for clothing. If
she is not lucky enough she may not be able to find another person
who has the diametrically opposite demand for rice with a surplus
of clothing to offer in exchange. The search costs may become
prohibitive as the number of individuals increases. Thus, to
smoothen the transaction, an intermediate good is necessary which
36 is acceptable to both parties. Such a good is called money. The
individuals can then sell their produces for money and use this
Introductory Macroeconomics

money to purchase the commodities they need. Though facilitation

of exchanges is considered to be the principal role of money, it
serves other purposes as well. Following are the main functions of
money in a modern economy.

3.1 FUNCTIONS OF MONEY

As explained above, the first and foremost role of money is that it
acts as a medium of exchange. Barter exchanges become extremely
difficult in a large economy because of the high costs people would
have to incur looking for suitable persons to exchange their
surpluses.
Money also acts as a convenient unit of account. The value of
all goods and services can be expressed in monetary units. When
we say that the value of a certain wristwatch is Rs 500 we mean
that the wristwatch can be exchanged for 500 units of money,
where a unit of money is rupee in this case. If the price of a pencil
is Rs 2 and that of a pen is Rs 10 we can calculate the relative
price of a pen with respect to a pencil, viz. a pen is worth 10 ÷ 2 =
5 pencils. The same notion can be used to calculate the value of

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money itself with respect to other commodities. In the above example, a rupee is
worth 1 ÷ 2 = 0.5 pencil or 1 ÷ 10 = 0.1 pen. Thus if prices of all commodities
increase in terms of money i.e., there is a general increase in the price level, the
value of money in terms of any commodity must have decreased – in the sense
that a unit of money can now purchase less of any commodity. We call it a
deterioration in the purchasing power of money.
A barter system has other deficiencies. It is difficult to carry forward one’s
wealth under the barter system. Suppose you have an endowment of rice which
you do not wish to consume today entirely. You may regard this stock of surplus
rice as an asset which you may wish to consume, or even sell off, for acquiring
other commodities at some future date. But rice is a perishable item and cannot
be stored beyond a certain period. Also, holding the stock of rice requires a lot of
space. You may have to spend considerable time and resources looking for people
with a demand for rice when you wish to exchange your stock for buying other
commodities. This problem can be solved if you sell your rice for money. Money
is not perishable and its storage costs are also considerably lower. It is also
acceptable to anyone at any point of time. Thus money can act as a store of
value for individuals. Wealth can be stored in the form of money for future use.
However, to perform this function well, the value of money must be sufficiently
stable. A rising price level may erode the purchasing power of money. It may be
noted that any asset other than money can also act as a store of value, e.g. gold,
landed property, houses or even bonds (to be introduced shortly). However,
they may not be easily convertible to other commodities and do not have universal
acceptability.
Some countries have made an attempt to move towards an economy which
use less of cash and more of digital transactions. A cashless society describes an
economic state whereby financial transactions are not connected with money in
the form of physical bank notes or coins but rather through the transfer of digital
information (usually an electronic representation of money) between the
transacting parties. In India government has been consistently investing in various
reforms for greater financial inclusion. During the last few years’ initiatives such 37
as Jan Dhan accounts, Aadhar enabled payment systems, e –Wallets, National

Money and Banking

financial Switch (NFS) and others have strengthened the government resolve to
go cashless. Today, financial inclusion is seen as a realistic dream because of
mobile and smart phone penetration across the country.

3.2 DEMAND FOR MONEY AND SUPPLY OF MONEY

3.2.1. Demand for Money

The demand for money tells us what makes people desire a certain
amount of money. Since money is required to conduct transactions, the
value of transactions will determine the money people will want to keep:
the larger is the quantum of transactions to be made, the larger is the
quantity of money demanded. Since the quantum of transactions to be made
depends on income, it should be clear that a rise in income will lead to rise in
demand for money. Also, when people keep their savings in the form of money
rather than putting it in a bank which gives them interest, how much money
people keep also depends on rate of interest. Specifically, when interest rates go
up, people become less interested in holding money since holding money amounts
to holding less of interest-earning deposits, and thus less interest received.
Therefore, at higher interest rates, money demanded comes down.

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 3.2.2. Supply of Money
In a modern economy, money comprises cash and bank deposits.
Depending on what types of bank deposits are being included, there are
many measures of money1. These are created by a system comprising two types
of institutions: central bank of the economy and the commercial banking system.
Central bank
Central Bank is a very important institution in a modern economy.
Almost every country has one central bank. India got its central bank in
1935. Its name is the ‘Reserve Bank of India’. Central bank has several
important functions. It issues the currency of the country. It controls
money supply of the country through various methods, like bank rate, open
market operations and variations in reserve ratios. It acts as a banker to the
government. It is the custodian of the foreign exchange reserves of the economy.
It also acts as a bank to the banking system, which is discussed in detail later.
From the point of view of money supply, we need to focus on its function of
issuing currency. This currency issued by the central bank can be held by the
public or by the commercial banks, and is called the ‘high-powered money’ or
‘reserve money’ or ‘monetary base’ as it acts as a basis for credit creation.
Commercial Banks
Commercial banks are the other type of institutions which are a part of
the money-creating system of the economy. In the following section we look at
the commercial banking system in detail. They accept deposits from the public
and lend out part of these funds to those who want to borrow. The interest rate
paid by the banks to depositors is lower than the rate charged from the borrowers.
This difference between these two types of interest rates, called the ‘spread’ is the
profit appropriated by the bank.
The process of deposit and loan (credit) creation by banks is explained below.
In order to understand this process, let us discuss a story.
38 Once there was a goldsmith named Lala in a village. In this village,
people used gold and other precious metals in order to buy goods and
Introductory Macroeconomics

services. In other words, these metals were acting as money. People in

the village started keeping their gold with Lala for safe-keeping. In return
for keeping their gold, Lala issued paper receipts to people of the village
and charged a small fee from them. Slowly, over time, the paper receipts
issued by Lala began to circulate as money. This means that instead of
giving gold for purchasing wheat, someone would pay for wheat or shoes
or any other good by giving the paper receipts issued by Lala. Thus, the
paper receipts started acting as money since everyone in the village
accepted these as a medium of exchange.
Now, let us suppose that Lala had 100 Kgs of gold, deposited by
different people and he had issued receipts corresponding to 100 kgs of
gold. At this time Ramu comes to Lala and asks for a loan of 25 kgs of gold. Can
Lala give the loan? The 100 kgs of gold with him already has claimants. However,
Lala could decide that everyone with gold deposits will not come to withdraw
their deposits at the same time and so he may as well give the loan to Ramu and
charge him for it. If Lala gives the loan of 25 kgs of gold, Ramu could also pay Ali
with these 25 kgs of gold and Ali could keep the 25 kgs of gold with Lala in
return for a paper receipt. In effect, the paper receipts, acting as money, would

1
See the box on the measures of money supply at the end of the chapter.

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have risen to 125 kgs now. It seems that Lala has created money out of thin air!
The modern banking system works precisely the way Lala behaves in this example.
Commercial banks mediate between individuals or firms with excess funds
and lend to those who need funds. People with excess funds can keep their funds
in the form of deposits in banks and those who need funds, borrow funds in
form of home loans, crop loans, etc. People prefer to keep money in banks because
banks offer to pay some interest on any deposits made. Also, it may be safer to
keep excess funds in a bank, rather than at home, just as people in the example
above preferred to keep their gold with Lala instead of keeping at home. In the
modern context, given cheques and debit cards, having a demand deposit makes
transactions more convenient and safer, even when they do not earn any interest.
(Imagine having to pay a large amount in cash – for purchasing a house.)
What does the bank do with the funds that have been deposited with it?
Assuming that not everyone who has deposited funds with it will ask for their
funds back at the same time, the bank can loan these funds to someone who
needs the funds at interest (of course, the bank has to be sure it will get the
funds back at the required time). So the bank will typically retain a portion of the
funds to repay depositors whenever they demand their funds back, and loan the
rest. Since banks earn interest from loans they make, any bank would like to
lend the maximum possible. However, being able to repay depositors on demand
is crucial to the bank’s survival. Depositors would keep their funds in a bank
only if they are fully confident of getting them back on demand. A bank must,
therefore, balance its lending activities so as to ensure that sufficient funds are
available to repay any depositor on demand.

3.3 MONEY CREATION BY BANKING SYSTEM

Banks can create money in a manner similar to that as given in Lala’s story.
Banks can lend simply because they do not expect all the depositors to withdraw
what they have deposited at the same time. When the banks lend to any person,
a new deposit is opened in that person’s name. Thus money supply increases to 39
old deposits plus new deposit (plus currency.)

Money and Banking

Let us take an example. Assume that there is only one bank in the country.
Let us construct a fictional balance sheet for this bank. Balance sheet is a record
of assets and liabilities of any firm. Conventionally, the assets of the firm are
recorded on the left hand side and liabilities on the right hand side. Accounting
rules say that both sides of the balance sheet must be equal or total assets must
be equal to the total liabilities. Assets are things a firm owns or what a firm can
claim from others. In case of a bank, apart from buildings, furniture, etc., its
assets are loans given to public. When the bank gives out loan of Rs 100 to a
person, this is the bank’s claim on that person for Rs 100. Another asset that a
bank has is reserves. Reserves are deposits which commercial banks keep with
the Central bank, Reserve Bank of India (RBI) and its cash. These reserves are
kept partly as cash and partly in the form of financial instruments (bonds and
treasury bills) issued by the RBI. Reserves are similar to deposits we keep with
banks. We keep deposits and these deposits are our assets, they can be withdrawn
by us. Similarly, commercial banks like State Bank of India (SBI) keep their
deposits with RBI and these are called Reserves.
Assets = Reserves + Loans
Liabilities for any firm are its debts or what it owes to others. For a bank, the
main liability is the deposits which people keep with it.
Liabilities = Deposits

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 The accounting rule states that both sides of the account must balance. Hence
if assets are greater than liabilities, they are recorded on the right hand side as
Net Worth.
Net Worth = Assets – Liabilities

3.3.1 Balance Sheet of a Fictional Bank

Let our fictional bank start with deposits (liabilities) equal to Rs 100. This could
be because Ms Fernandes has deposited Rs 100 in the bank. Let this bank
deposit the same amount with RBI as reserves. Table 3.1 represents its balance
sheet.

3.1 Balance Sheet of a Bank

Assets Liabilities

Reserves Rs 100 Deposits Rs 100

Net Worth Rs 0

Total Rs 100 Total Rs 100

If we assume that there is no currency in circulation, then the total

money supply in the economy will be equal to Rs 100.
M 1= Currency + Deposits = 0 +100 =100

3.3.2 Limits to Credit Creation and Money Multiplier

Suppose Mr. Mathew comes to this bank for a loan of Rs 500. Can our bank
give this loan? If it gives the loan and Mr Mathew deposits the loan amount
in the bank itself, the total bank deposits and therefore, the total money
40
supply will rise. It seems as though the banks can go on creating as much
money as they want.
Introductory Macroeconomics

But is there a limit to money or credit creation by banks? Yes, and this is
determined by the Central bank (RBI). The RBI decides a certain percentage of
deposits which every bank must keep as reserves. This is done to ensure that no
bank is ‘over lending’. This is a legal requirement and is binding on the banks.
This is called the ‘Required Reserve Ratio’ or the ‘Reserve Ratio’ or ‘Cash Reserve
Ratio’ (CRR).
Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must
keep as cash reserves with the bank.
Apart from the CRR, banks are also required to keep some reserves
in liquid form in the short term. This ratio is called Statutory Liquidity
Ratio or SLR.
In our fictional example, suppose CRR = 20 per cent, then with deposits of Rs
100, our bank will need to keep Rs 20 (20 per cent of 100) as cash reserves. Only
the remaining amount of deposits, i.e., Rs 80 (100 – 20 = 80) can be used to give
loans. The statutory requirement of the reserve ratio acts as a limit to the amount
of credit that banks can create.
We can understand this by going back to our fictional example of an economy
with one bank. Let us assume that our bank starts with a deposit of Rs 100
made by Leela. The reserve ratio is 20 per cent. Thus our bank has Rs 80 (100 – 20)

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to lend and the bank lends out Rs 80 to Jaspal Kaur, which shows up in the
bank’s deposits in the next round as liabilities, making a total of Rs 180 as
deposits. Now our bank is required to keep 20 per cent of 180 i.e. Rs 36 as cash
reserves. Recall that our bank had started with Rs 100 as cash. Since it is
required to keep only Rs 36 as reserves, it can lend Rs 64 again (100 – 36 = 64).
The bank lends out Rs 64 to Junaid. This in turn shows up in the bank as
deposits. The process keeps repeating itself till all the required reserves become
Rs 100. The required reserves will be Rs 100 only when the total deposits become
Rs 500. This is because for deposits of Rs 500, cash reserves would have to be
Rs 100 (20 per cent of 500 = 100). The process is illustrated in Table 3.2.

Table 3.2: Money Multiplier Process

Column 1 Column 2 Column 3 Column 4

Round Deposit in Required Loan made
Bank Reserve by Bank

1 100.00 20.00 80.00

2 180.00 36.00 64.00

. . . .

. . . .

. . . .

. . . .

... . . .
41

Money and Banking

Last 500.00 100.00 400.00

The first column lists each round. The second column depicts the total
deposits with the bank at the beginning of each round. Twenty per cent of these
deposits need to be deposited with the RBI as required reserves (column 3). What
the bank lends in each round gets added to the deposits with the bank in the
next round. Column 4 indicates the Loans made by the banks.
Table 3.3: Balance Sheet of the Bank

Assets Liabilities

Reserves Rs 100 Deposits Rs 500

(100+400)

Loans Rs 400

Total Rs 500 Total Rs 500

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 Since the bank is only expected to keep 20 per cent of its deposits as reserves,
thus, reserves of Rs 100 (20per cent of 500 = 100) can support the deposits of Rs
500. In other words, our bank can give a loan of Rs 400. Table 3.3 demonstrates
its balance sheet.
M1 = Currency + Deposits = 0 + 500 = 500
Thus, money supply increases from Rs 100 to Rs 500.
Given a CRR of 20 per cent, the bank cannot give a loan beyond Rs 400.
Hence, requirement of reserves acts as a limit to money creation.

In our example, money multiplier . Thus, reserves of Rs 100

create deposits of Rs (5 X 100)=Rs 500.

3.4 POLICY TOOLS TO CONTROL MONEY SUPPLY

Reserve Bank is the only institution which can issue currency. When commercial
banks need more funds in order to be able to create more credit, they may go to
market for such funds or go to the Central Bank. Central bank provides them
funds through various instruments. This role of RBI, that of being ready to lend
to banks at all times is another important function of the central bank, and due
to this central bank is said to be the lender of last resort.
The RBI controls the money supply in the economy in various ways. The
tools used by the Central bank to control money supply can be quantitative
or qualitative. Quantitative tools, control the extent of money supply by
changing the CRR, or bank rate or open market operations. Qualitative tools
include persuasion by the Central bank in order to make commercial banks
discourage or encourage lending which is done through moral suasion, margin
requirement, etc.
42 It should be evident by now that if the Central bank changes the reserve
ratio, this would lead to changes in lending by the banks which, in turn, would
Introductory Macroeconomics

impact the deposits and hence, the money supply. In the previously discussed
example, what would the money multiplier be if the RBI increases the reserve
ratio to 25 per cent? Notice that in the previous case, Rs 100 in reserves could
support deposits of Rs 400. But the banking system would now be able to loan
Rs 300 only. It would have to call back some loans to meet the increased reserve
requirements. Hence, money supply would fall.
Another important tool by which the RBI also influences money supply is
Open Market Operations. Open Market Operations refers to buying and selling
of bonds issued by the Government in the open market. This purchase and sale
is entrusted to the Central bank on behalf of the Government. When RBI buys a
Government bond in the open market, it pays for it by giving a cheque. This
cheque increases the total amount of reserves in the economy and thus increases
the money supply. Selling of a bond by RBI (to private individuals or institutions)
leads to reduction in quantity of reserves and hence the money supply.
There are two types of open market operations: outright and repo. Outright
open market operations are permanent in nature: when the central bank buys
these securities (thus injecting money into the system), it is without any promise
to sell them later. Similarly, when the central bank sells these securities (thus
withdrawing money from the system), it is without any promise to buy them

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later. As a result, the injection/absorption of the money is of permanent nature.
However, there is another type of operation in which when the central bank buys
the security, this agreement of purchase also has specification about date and
price of resale of this security. This type of agreement is called a repurchase
agreement or repo. The interest rate at which the money is lent in this way is
called the repo rate. Similarly, instead of outright sale of securities the central
bank may sell the securities through an agreement which has a specification
about the date and price at which it will be repurchased. This type of agreement
is called a reverse repurchase agreement or reverse repo. The rate at which
the money is withdrawn in this manner is called the reverse repo rate. The Reserve
Bank of India conducts repo and reverse repo operations at various maturities:
overnight, 7-day, 14- day, etc. This type of operations have now become the
main tool of monetary policy of the Reserve Bank of India.
The RBI can influence money supply by changing the rate at which it gives
loans to the commercial banks. This rate is called the Bank Rate in India. By
increasing the bank rate, loans taken by commercial banks become more
expensive; this reduces the reserves held by the commercial bank and hence
decreases money supply. A fall in the bank rate can increase the money supply.

Box 3.1: Demand and Supply for Money : A Detailed Discussion

Money is the most liquid of all assets in the sense that it is universally
acceptable and hence can be exchanged for other commodities very easily.
On the other hand, it has an opportunity cost. If, instead of holding on to
a certain cash balance, you put the money in a fixed deposits in some
bank you can earn interest on that money. While deciding on how much
money to hold at a certain point of time one has to consider the trade off
between the advantage of liquidity and the disadvantage of the foregone
interest. Demand for money balance is thus often referred to as liquidity 43
preference. People desire to hold money balance broadly from two motives.

Money and Banking

The Transaction Motive
The principal motive for holding money is to carry out transactions. If
you receive your income weekly and pay your bills on the first day of
every week, you need not hold any cash balance throughout the rest of
the week; you may as well ask your employer to deduct your expenses
directly from your weekly salary and deposit the balance in your bank
account. But our expenditure patterns do not normally match our
receipts. People earn incomes at discrete points in time and spend it
continuously throughout the interval. Suppose you earn Rs 100 on the
first day of every month and run down this balance evenly over the rest
of the month. Thus your cash balance at the beginning and end of the
month are Rs 100 and 0, respectively. Your average cash holding can
then be calculated as (Rs 100 + Rs 0) ÷ 2 = Rs 50, with which you are
making transactions worth Rs 100 per month. Hence your average
transaction demand for money is equal to half your monthly income, or,
in other words, half the value of your monthly transactions.
Consider, next, a two-person economy consisting of two entities – a
firm (owned by one person) and a worker. The firm pays the worker a
salary of Rs 100 at the beginning of every month. The worker, in turn,

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 spends this income over the month on the output produced by the firm –
the only good available in this economy! Thus, at the beginning of each
month the worker has a money balance of Rs 100 and the firm a balance of
Rs 0. On the last day of the month the picture is reversed – the firm has
gathered a balance of Rs 100 through its sales to the worker. The average
money holding of the firm as well as the worker is equal to Rs 50 each. Thus
the total transaction demand for money in this economy is equal to Rs 100.
The total volume of monthly transactions in this economy is Rs 200 – the
firm has sold its output worth Rs 100 to the worker and the latter has sold
her services worth Rs 100 to the firm. The transaction demand for money of
the economy is again a fraction of the total volume of transactions in the
economy over the unit period of time.
In general, therefore, the transaction demand for money in an economy,
d
M T , can be written in the following form

MdT = k.T (3.1)

where, T is the total value of (nominal) transactions in the economy
over unit period and k is a positive fraction.
The two-person economy described above can be looked at from another
angle. You may perhaps find it surprising that the economy uses money
balance worth only Rs 100 for making transactions worth Rs 200 per month.
The answer to this riddle is simple – each rupee is changing hands twice a
month. On the first day, it is being transferred from the employer’s pocket
to that of the worker and sometime during the month, it is passing from the
worker’s hand to the employer’s. The number of times a unit of money
changes hands during the unit period is called the velocity of circulation
of money. In the above example, it is 2, inverse of half – the ratio of money
balance and the value of transactions. Thus, in general, we may rewrite
equation (3.1) in the following form
1
44 .MdT = T, or, [Link] = T (3.2)
k
where, v = 1/k is the velocity of circulation. Note that the term on the right
Introductory Macroeconomics

hand side of the above equation, T, is a flow variable whereas money demand,
MdT , is a stock concept – it refers to the stock of money people are willing to
hold at a particular point of time. The velocity of money, v, however, has a
time dimension. It refers to the number of times every unit of stock changes
hand during a unit period of time, say, a month or a year. Thus, the left
hand side, [Link], measures the total value of monetary transactions that
has been made with this stock in the unit period of time. This is a flow
variable and is, therefore, equal to the right hand side.
We are ultimately interested in learning the relationship between the
aggregate transaction demand for money of an economy and the (nominal)
GDP in a given year. The total value of annual transactions in an economy
includes transactions in all intermediate goods and services and is clearly
much greater than the nominal GDP. However, normally, there exists a
stable, positive relationship between value of transactions and the nominal
GDP. An increase in nominal GDP implies an increase in the total value of
transactions and hence a greater transaction demand for money from
equation (3.1). Thus, in general, equation (3.1) can be modified in the
following way
MdT = kPY (3.3)

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 where Y is the real GDP and P is the general price level or the GDP
deflator. The above equation tells us that transaction demand for money is
positively related to the real income of an economy and also to its average
price level.
The Speculative Motive
An individual may hold her wealth in the form of landed property, bullion,
bonds, money etc. For simplicity, let us club all forms of assets other than
money together into a single category called ‘bonds’. Typically, bonds are
papers bearing the promise of a future stream of monetary returns over a
certain period of time. These papers are issued by governments or firms for
borrowing money from the public and they are tradable in the market. Consider
the following two-period bond. A firm wishes to raise a loan of Rs 100 from the
public. It issues a bond that assures Rs 10 at the end of the first year and Rs
10 plus the principal of Rs 100 at the end of the second year. Such a bond is
said to have a face value of Rs 100, a maturity period of two years and a
coupon rate of 10 per cent. Assume that the rate of interest prevailing in
your savings bank account is equal to 5 per cent. Naturally you would like to
compare the earning from this bond with the interest earning of your savings
bank account. The exact question that you would ask is as follows: How
much money, if kept in my savings bank account, will generate Rs 10 at the
end of one year? Let this amount be X. Therefore
5
X (1 + ) = 10
100
In other words,

X= 10
(1 + 5 )
100
This amount, Rs X, is called the present value of Rs 10 discounted at
the market rate of interest. Similarly, let Y be the amount of money which
if kept in the savings bank account will generate Rs 110 at the end of two 45
years. Thus, the present value of the stream of returns from the bond should

Money and Banking

be equal to
10 (10 + 100)
PV = X + Y = +
(1 + 5 ) (1 + 5 )2
100 100
Calculation reveals that it is Rs 109.29 (approx.). It means that if you
put Rs 109.29 in your savings bank account it will fetch the same return as
the bond. But the seller of the bond is offering the same at a face value of
only Rs 100. Clearly the bond is more attractive than the savings bank
account and people will rush to get hold of the bond. Competitive bidding
will raise the price of the bond above its face value, till price of the bond is
equal to its PV. If price rises above the PV the bond becomes less attractive
compared to the savings bank account and people would like to get rid of it.
The bond will be in excess supply and there will be downward pressure on
the bond-price which will bring it back to the PV. It is clear that under
competitive assets market condition the price of a bond must always be
equal to its present value in equilibrium.
Now consider an increase in the market rate of interest from 5 per cent
to 6 per cent. The present value, and hence the price of the same bond, will
become

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 10 (10 + 100)
+ = 107.33 (approx.)
(1 + 6 ) (1 + 6 )2
100 100
It follows that the price of a bond is inversely related to the market
rate of interest.
Different people have different expectations regarding the future
movements in the market rate of interest based on their private information
regarding the economy. If you think that the market rate of interest should
eventually settle down to 8 per cent per annum, then you may consider the
current rate of 5 per cent too low to be sustainable over time. You expect
interest rate to rise and consequently bond prices to fall. If you are a bond
holder a decrease in bond price means a loss to you – similar to a loss you
would suffer if the value of a property held by you suddenly depreciates in
the market. Such a loss occurring from a falling bond price is called a
capital loss to the bond holder. Under such circumstances, you will try to
sell your bond and hold money instead. Thus speculations regarding future
movements in interest rate and bond prices give rise to the speculative
demand for money.
When the interest rate is very high everyone expects it to fall in future
and hence anticipates capital gains from bond-holding. Hence people convert
their money into bonds. Thus, speculative demand for money is low. When
interest rate comes down, more and more people expect it to rise in the
future and anticipate capital loss. Thus they convert their bonds into money
giving rise to a high speculative demand for money. Hence speculative
demand for money is inversely related to the rate of interest. Assuming a
simple form, the speculative demand for money can be written as
rmax – r
MdS = r – r (3.4)
min
46
where r is the market rate of interest and rmax and rmin are the upper and
Introductory Macroeconomics

lower limits of r, both

positive constants. It is
evident from the above r
equation that as r decreases
from rmax to rmin, the value of
MdS increases from 0 to ∞ . rmax
As mentioned earlier,
interest rate can be thought
rmax – r
of as an opportunity cost or MSd = r – r
min
‘price’ of holding money
balance. If supply of money rmin ¥
in the economy increases
O
and people purchase bonds MSd
with this extra money,
Fig. 3.1
demand for bonds will go
up, bond prices will rise and The Speculative Demand for Money
rate of interest will decline.
In other words, with an increased supply of money in the economy the price
you have to pay for holding money balance, viz. the rate of interest, should

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come down. However, if the market rate of interest is already low enough
so that everybody expects it to rise in future, causing capital losses, nobody
will wish to hold bonds. Everyone in the economy will hold their wealth in
money balance and if additional money is injected within the economy it
will be used up to satiate people’s craving for money balances without
increasing the demand for bonds and without further lowering the rate of
interest below the floor rmin. Such a situation is called a liquidity trap. The
speculative money demand function is infinitely elastic here.
In Fig. 3.1 the speculative demand for money is plotted on the
horizontal axis and the rate of interest on the vertical axis. When r = rmax,
speculative demand for money is zero. The rate of interest is so high that
everyone expects it to fall in future and hence is sure about a future
capital gain. Thus everyone has converted the speculative money balance
into bonds. When r = rmin, the economy is in the liquidity trap. Everyone is
sure of a future rise in interest rate and a fall in bond prices. Everyone
puts whatever wealth they acquire in the form of money and the
speculative demand for money is infinite.
Total demand for money in an economy is, therefore, composed of
transaction demand and speculative demand. The former is directly
proportional to real GDP and price level, whereas the latter is inversely
related to the market rate of interest. The aggregate money demand in
an economy can be summarised by the following equation

d d
Md = M T + M S
rmax r
or, Md = kPY + (3.5)
r rmin

THE SUPPLY OF MONEY : VARIOUS MEASURES

47
In a modern economy money consists mainly of currency notes and coins

Money and Banking

issued by the monetary authority of the country. In India currency notes
are issued by the Reserve Bank of India (RBI), which is the monetary
authority in India. However, coins are issued by the Government of India.
Apart from currency notes and coins, the balance in savings, or current
account deposits, held by the public in commercial banks is also considered
money since cheques drawn on these accounts are used to settle
transactions. Such deposits are called demand deposits as they are payable
by the bank on demand from the account-holder. Other deposits, e.g. fixed
deposits, have a fixed period to maturity and are referred to as time
deposits.
Though a hundred-rupee note can be used to obtain commodities worth
Rs 100 from a shop, the value of the paper itself is negligible – certainly
less than Rs 100. Similarly, the value of the metal in a five-rupee coin is
probably not worth Rs 5. Why then do people accept such notes and coins
in exchange of goods which are apparently more valuable than these? The
value of the currency notes and coins is derived from the guarantee
provided by the issuing authority of these items. Every currency note bears
on its face a promise from the Governor of RBI that if someone produces
the note to RBI, or any other commercial bank, RBI will be responsible for

2020-21
 giving the person purchasing power equal to the value printed on the note.
The same is also true of coins. Currency notes and coins are therefore
called fiat money. They do not have intrinsic value like a gold or silver
coin. They are also called legal tenders as they cannot be refused by any
citizen of the country for settlement of any kind of transaction. Cheques
drawn on savings or current accounts, however, can be refused by anyone
as a mode of payment. Hence, demand deposits are not legal tenders.

Legal Definitions: Narrow and Broad Money

Money supply, like money demand, is a stock variable. The total stock of
money in circulation among the public at a particular point of time is called
money supply. RBI publishes figures for four alternative measures of money
supply, viz. M1, M2, M3 and M4. They are defined as follows
M1 = CU + DD
M2 = M1 + Savings deposits with Post Office savings banks
M3 = M1 + Net time deposits of commercial banks
M4 = M3 + Total deposits with Post Office savings organisations (excluding
National Savings Certificates)
where, CU is currency (notes plus coins) held by the public and DD is
net demand deposits held by commercial banks. The word ‘net’ implies
that only deposits of the public held by the banks are to be included in
money supply. The interbank deposits, which a commercial bank holds in
other commercial banks, are not to be regarded as part of money supply.
M1 and M2 are known as narrow money. M3 and M4 are known as
broad money. These measures are in decreasing order of liquidity. M1 is
most liquid and easiest for transactions whereas M4 is least liquid of all.
M3 is the most commonly used measure of money supply. It is also known
as aggregate monetary resources2.
48
Introductory Macroeconomics

2
See Appendix 3.2 for an estimate of the variations in M1 and M3 over time.

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 Box No. 3.2: Demonetisation
Demonetisation was a new initiative taken by the Government of India in
November 2016 to tackle the problem of corruption, black money, terrorism
and circulation of fake currency in the economy. Old currency notes of
Rs 500, and Rs 1000 were no longer legal tender. New currency notes in the
denomination of Rs 500 and Rs 2000 were launched. The public were advised
to deposit old currency notes in their bank account till 31 December 2016
without any declaration and upto 31March 2017 with the RBI with
declaration
Further to avoid a complete breakdown and cash crunch, notes
government had allowed exchange of Rs 4000 old currency the by new
currency per person and per day. Further till 12 December 2016, old currency
notes were acceptable as legal tender at petrol pumps, government hospitals
and for payment of government dues, like taxes, power bills, etc.
This move received both appreciation and criticism. There were long
queues outside banks and ATM booths. The shortage of currency in
circulation had an adverse impact on the economic activities. However, things
improved with time and normalcy returned.
This move has had positive impact also. It improved tax compliance as a
large number of people were bought in the tax ambit. The savings of an
individual were channelised into the formal financial system. As a result,
banks have more resources at their disposal which can be used to provide
more loans at lower interest rates. It is a demonstration of State’s decision
to put a curb on black money, showing that tax evasion will no longer be
tolerated. Tax evasion will result in financial penalty and social
condemnation. Tax compliance will improve and corruption will decrease.
Demonetisation could also help tax administration in another way, by shifting
transactions out of the cash economy into the formal payment system.
Households and firms have begun to shift from cash to electronic payment
technologies.
49

Money and Banking

Summary

Exchange of commodities without the mediation of money is called Barter Exchange.

It suffers from lack of double coincidence of wants. Money facilitates exchanges by
acting as a commonly acceptable medium of exchange. In a modern economy, people
hold money broadly for two motives – transaction motive and speculative motive.
Supply of money, on the other hand, consists of currency notes and coins, demand
and time deposits held by commercial banks, etc. It is classified as narrow and
broad money according to the decreasing order of liquidity. In India, the supply of
money is regulated by the Reserve Bank of India (RBI) which acts as the monetary
authority of the country. Various actions of the public, the commercial banks of the
country and RBI are responsible for changes in the supply of money in the economy.
RBI regulates money supply by controlling the stock of high powered money, the
bank rate and reserve requirements of the commercial banks. It also sterilises the
money supply in the economy against external shocks.

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 Barter exchange Double coincidence of wants

Key Concepts
Money Medium of exchange
Unit of account Store of value
Bonds Rate of interest
Liquidity trap Fiat money
Legal tender Narrow money
Broad money Currency deposit ratio
Reserve deposit ratio High powered money
Money multiplier Lender of last resort
Open market operation Bank Rate
Cash Reserve Ratio (CRR) Repo Rate
Reverse Repo Rate

? 1. What is a barter system? What are its drawbacks?

Exercises

2. What are the main functions of money? How does money overcome the
shortcomings of a barter system?
3. What is transaction demand for money? How is it related to the value of
transactions over a specified period of time?
4. What are the alternative definitions of money supply in India?
5. What is a ‘legal tender’? What is ‘fiat money’?
6. What is High Powered Money?
7. Explain the functions of a commercial bank.
8. What is money multiplier? What determines the value of this multiplier?
50 9. What are the instruments of monetary policy of RBI?
Introductory Macroeconomics

10. Do you consider a commercial bank ‘creator of money’ in the economy?

11. What role of RBI is known as ‘lender of last resort’?

Suggested Readings
1. Dornbusch, R. and S. Fischer. 1990. Macroeconomics, (fifth edition) pages 345 –
427, McGraw Hill, Paris.
2. Sikdar, S., 2006. Principles of Macroeconomics, pages 77 – 89, Oxford
University Press, New Delhi.

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Appendix 3.1

The Sum of an Infinite Geometric Series

We want to find out the sum of an infinite geometric series of the following
form
S = a + a.r + a.r2 + a.r3 + ...... + [Link] + ..... +·∞
where a and r are real numbers and 0 < r < 1. To compute the sum, multiply
the above equation by r to obtain
r.S = a.r + a.r2 + a.r3 + ...... + a.r n + 1
·+ ..... +· ∞
Subtract the second equation from the first to get
S – r.S = a
or, (1 – r)S = a
which yields
a
S =
1–r
In the example used for the derivation of the money multiplier, a = 1 and r =
0.4. Hence the value of the infinite series is
1 5
1 – 0.4 = 3
Appendix 3.2

Money Supply in India

Table 3.4: Changes in M1 and M3 Over Time (in Billion)

Year M1 M3
(Narrow Money) (Broad Money)
1999-00 3417.96 11241.74
2000-01 3794.33 13132.04
2001-02 4228.24 14983.36
2002-03 4735.58 17179.36
2003-04 5786.94 20056.54 51
2004-05 6497.66 22456.53

Money and Banking

2005-06 8263.89 27194.93
2006-07 9679.25 33100.38
2007-08 11558.10 40178.55
2008-09 12596.71 47947.75
2009-10 14892.68 56026.98
2010-11 16383.45 65041.16
2011-12 17373.94 73848.31
2012-13 18975.26 83898.19
2013-14 20597.62 95173.86
2014-15 22924.04 105501.68
2015-16 26025.38 116176.15
2016-17 26819.57 127919.40
2017-18 32673.31 139625.87

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India, 2017-18

The difference in values between the two columns is attributable to the time deposits
held by commercial banks.

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 Changes in the Composition of the Sources of Monetary Base Over Time

Appendix 3.3
Components of Money Stock

Table 3.5: Sources of Change in Monetary Base (in Billion)

Year Currency Cash with Currency Other Banker’s

in Banks with the Deposit Deposit
Circulation Public with the RBI with the
RBI
1981-82 154.11 9.37 144.74 1.68 54.19

1991-92 637.38 26.40 610.98 8.85 348.82

2001-02 2509.74 101.79 2407.94 28.31 841.47

2004-05 3686.61 123.47 3563.14 64.54 1139.96

2005-06 4295.78 174.54 4121.24 68.43 1355.11

2006-07 5040.99 212.44 4828.54 74.67 1972.95

2007-08 5908.01 223.90 5684.10 90.27 3284.47

2008-09 6911.53 257.03 6654.50 55.33 2912.75

2009-10 7995.49 320.56 7674.92 38.06 3522.99

2010-11 9496.59 378.23 9118.36 36.53 4235.09

2011-12 10672.30 435.60 10236.70 28.22 3562.91

2012-13 11909.75 499.14 11410.61 32.40 3206.71

2013-14 13010.75 552.55 12458.19 19.65 4297.03

52
2014-15 14483.12 621.31 13861.82 145.90 4655.61
Introductory Macroeconomics

2015-16 16634.63 662.09 15972.54 154.51 5018.26

2016-17 13352.66 711.42 1241.24 210.91 5441.27

2017-18 18293.48 696.35 17597.12 239.07 5655.25

Source: Handbook of Statistics on Indian Economy, Reserve Bank of India, 2017-18

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 Chapter 4
Chapter 4
Determination of Income and
Employment
We have so far talked about the national income, price level,
rate of interest etc. in an ad hoc manner – without
investigating the forces that govern their values. The basic
objective of macroeconomics is to develop theoretical tools,
called models, capable of describing the processes which
determine the values of these variables. Specifically, the
models attempt to provide theoretical explanation to
questions such as what causes periods of slow growth or
recessions in the economy, or increment in the price level,
or a rise in unemployment. It is difficult to account for all
the variables at the same time. Thus, when we concentrate
on the determination of a particular variable, we must hold
the values of all other variables constant. This is a stylisation
typical of almost any theoretical exercise and is called the
assumption of ceteris paribus, which literally means ‘other
things remaining equal’. You can think of the procedure as
follows – in order to solve for the values of two variables x
and y from two equations, we solve for one variable, say x,
in terms of y from one equation first, and then substitute
this value into the other equation to obtain the complete
solution. We apply the same method in the analysis of the
macroeconomic system.
In this chapter we deal with the determination of National
Income under the assumption of fixed price of final goods
and constant rate of interest in the economy. The
theoretical model used in this chapter is based on the theory
given by John Maynard Keynes.

4.1 AGGREGATE DEMAND AND ITS COMPONENTS

In the chapter on National Income Accounting, we have

come across terms like consumption, investment, or the
total output of final goods and services in an economy (GDP).
These terms have dual connotations. In Chapter 2 they
were used in the accounting sense – denoting actual values
of these items as measured by the activities within the
economy in a certain year. We call these actual or
accounting values ex post measures of these items.
These terms, however, can be used with a different
connotation. Consumption may denote not what people
have actually consumed in a given year, but what they

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 had planned to consume during the same period. Similarly, investment
can mean the amount a producer plans to add to her inventory. It may
be different from what she ends up doing. Suppose the producer plans
to add Rs 100 worth goods to her stock by the end of the year. Her
planned investment is, therefore, Rs 100 in that year. However, due to
an unforeseen upsurge of demand for her goods in the market the
volume of her sales exceeds what she had planned to sell and, to meet
this extra demand, she has to sell goods worth Rs 30 from her stock.
Therefore, at the end of the year, her inventory goes up by Rs (100 –
30) = Rs 70 only. Her planned investment is Rs 100 whereas her
actual, or ex post, investment is Rs 70 only. We call the planned
values of the variables – consumption, investment or output of final
goods – their ex ante measures.
In simple words, ex-ante depicts what has been planned, and ex-post
depicts what has actually happened. In order to understand the
determination of income, we need to know the planned values of different
components of aggregate demand. Let us look at these components now.

4.1.1. Consumption
The most important determinant of consumption demand is household
income. A consumption function describes the relation between
consumption and income. The simplest consumption function assumes
that consumption changes at a constant rate as income changes. Of
course, even if income is zero, some consumption still takes place. Since
this level of consumption is independent of income, it is called
autonomous consumption. We can describe this function as:

C = C + cY (4.1)
The above equation is called the consumption function. Here C is
54
the consumption expenditure by households. This consists of two
Introductory Macroeconomics

components autonomous consumption and induced consumption ( cY ).

Autonomous consumption is denoted by C and shows the consumption

which is independent of income. If consumption takes place even when
income is zero, it is because of autonomous consumption. The induced
component of consumption, cY shows the dependence of consumption
on income. When income rises by Re 1. induced consumption rises by
MPC i.e. c or the marginal propensity to consume. It may be explained
as a rate of change of consumption as income changes.
∆C
MPC = =c
∆Y
Now, let us look at the value that MPC can take. When income changes,
change in consumption ( ∆C ) can never exceed the change in income
( ∆ Y) . The maximum value which c can take is 1. On the other hand
consumer may choose not to change consumption even when income
has changed. In this case MPC = 0. Generally, MPC lies between 0 and 1
(inclusive of both values). This means that as income increases either

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the consumers does not increase consumption at all (MPC = 0) or use
entire change in income on consumption (MPC = 1) or use part of the
change in income for changing consumption (0< MPC<1).
Imagine a country Imagenia which has a consumption function
described by C=100+0.8Y .
This indicates that even when Imagenia does not have any income,
its citizens still consume Rs. 100 worth of goods. Imagenia’s autonomous
consumption is 100. Its marginal propensity to consume is 0.8. This
means that if income goes up by Rs. 100 in Imagenia, consumption will
go up by Rs. 80.
Let us also look at another dimension of this, savings. Savings is
that part of income that is not consumed. In other words,

S =Y − C

We define the marginal propensity to save (MPS) as the rate of change

in savings as income increases.
∆S
MPS = =s
∆Y

Since, S =Y − C ,

∆ (Y − C )
s=
∆Y
∆Y ∆C
= −
∆Y ∆Y
= 1− c 55

Income Determination
Some Definitions

Marginal propensity to consume (MPC): it is the change in

consumption per unit change in income. It is denoted by c and is
∆C
equal to ∆Y
.
Marginal propensity to save (MPS): it is the change in savings per
unit change in income. It is denoted by s and is equal to 1 − c . It
implies that s + c = 1 .
Average propensity to consume (APC): it is the consumption per
C
unit of income i.e., Y
.
Average propensity to save (APS): it is the savings per unit of income
S
i.e., .
Y

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 4.1.2. Investment
Investment is defined as addition to the stock of physical capital (such
as machines, buildings, roads etc., i.e. anything that adds to the future
productive capacity of the economy) and changes in the inventory (or
the stock of finished goods) of a producer. Note that ‘investment goods’
(such as machines) are also part of the final goods – they are not
intermediate goods like raw materials. Machines produced in an economy
in a given year are not ‘used up’ to produce other goods but yield their
services over a number of years.
Investment decisions by producers, such as whether to buy a new machine,
depend, to a large extent, on the market rate of interest. However, for simplicity,
we assume here that firms plan to invest the same amount every year. We can
write the ex ante investment demand as
I= I (4.2)
where I is a positive constant which represents the autonomous (given or
exogenous) investment in the economy in a given year.

4.2 DETERMINATION OF INCOME IN TWO-SECTOR MODEL

In an economy without a government, the ex ante aggregate demand for final
goods is the sum total of the ex ante consumption expenditure and ex ante
investment expenditure on such goods, viz. AD = C + I. Substituting the values of
C and I from equations (4.1) and (4.2), aggregate demand for final goods can be
written as
AD = C + I + c.Y
If the final goods market is in equilibrium this can be written as
Y = C + I + c.Y

56 where Y is the ex ante, or planned, ouput of final goods. This equation can be
further simplified by adding up the two autonomous terms, C and I , making it
Introductory Macroeconomics

Y = A + c.Y (4.3)
where A = C + I is the total autonomous expenditure in the economy. In
reality, these two components of autonomous expenditure behave in different ways.
C , representing subsistence consumption level of an economy, remains more or
less stable over time. However, I has been observed to undergo periodic fluctuations.
A word of caution is in order. The term Y on the left hand side of equation (4.3)
represents the ex ante output or the planned supply of final goods. On the other
hand, the expression on the right hand side denotes ex ante or planned aggregate
demand for final goods in the economy. Ex ante supply is equal to ex ante
demand only when the final goods market, and hence the economy, is in
equilibrium. Equation (4.3) should not, therefore, be confused with the
accounting identity of Chapter 2, which states that the ex post value of total
output must always be equal to the sum total of ex post consumption and ex
post investment in the economy. If ex ante demand for final goods falls short of
the output of final goods that the producers have planned to produce in a
given year, equation (4.3) will not hold. Stocks will be piling up in the warehouses
which we may consider as unintended accumulation of inventories. It should
be noted that inventories or stocks refers to that part of output produced which
is not sold and therefore remains with the firm. Change in inventory is called

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inventory investment. It can be negative as well as positive: if there is a rise in
inventory, it is positive inventory investment, while a depletion of inventory is
negative inventory investment. The inventory investment can take place due to
two reasons: (i) the firm decides to keep some stocks for various reasons (this is
called planned inventory investment) (ii) the sales differ from the planned level of
sales, in which case the firm has to add to/run down existing inventories (this is
called unplanned inventory investment). Thus even though planned Y is
greater than planned C + I, actual Y will be equal to actual C + I, with
the extra output showing up as unintended accumulation of inventories
in the ex post I on the right hand side of the accounting identity.
At this point, we can introduce a government in this economy. The major
economic activities of the government that affect the aggregate demand for final
goods and services can be summarized by the fiscal variables Tax (T) and
Government Expenditure (G), both autonomous to our analysis. Government,
through its expenditure G on final goods and services, adds to the aggregate
demand like other firms and households. On the other hand, taxes imposed by
the government take a part of the income away from the household, whose
disposable income, therefore, becomes Yd = Y – T. Households spend only a fraction
of this disposable income for consumption purpose. Hence, equation (4.3) has to
be modified in the following way to incorporate the government
Y = C + I + G + c (Y – T )
Note that G – c.T , like C or I , just adds to the autonomous term A . It does
not significantly change the analysis in any qualitative way. We shall, for the
sake of simplicity, ignore the government sector for the rest of this chapter.
Observe also, that without the government imposing indirect taxes and subsidies,
the total value of final goods and services produced in the economy, GDP, becomes
identically equal to the National Income. Henceforth, throughout the rest of the
chapter, we shall refer to Y as GDP or National Income interchangeably.
57
4.3 DETERMINATION OF EQUILIBRIUM INCOME IN THE SHORT RUN

Income Determination
You would recall that in microeconomic theory when we analyse the equilibrium
of demand and supply in a single market, the demand and supply curves
simultaneously determine the equilibrium price and the equilibrium quantity.
In macroeconomic theory we proceed in two steps: at the first stage, we work out
a macroeconomic equilibrium taking the price level as fixed. At the second stage,
we allow the price level to vary and again, analyse macroeconomic equilibrium.
What is the justification for taking the price level as fixed? Two reasons can
be put forward: (i) at the first stage, we are assuming an economy with unused
resources: machineries, buildings and labours. In such a situation, the law of
diminishing returns will not apply; hence additional output can be produced
without increasing marginal cost. Accordingly, price level does not vary even if
the quantity produced changes (ii) this is just a simplifying assumption which
will be changed later.

4.3.1 Macroeconomic Equilibrium with Price Level Fixed

(A) Graphical Method

As already explained, the consumers demand can be expressed by the equation
C = C + cY

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 Where C is Autonomous expenditure and c is the marginal propensity to
consume.
How can this relation be
Y
shown as a graph? To answer
this question we will need to recall
the “intercept form of the linear Y=a+bX
equation”,

Y = a + bX
θ
Here, the variables are X and
Y and there is a linear relation
between them. a and b are
constants. This equation is
a
{ X
Fig. 4.1
depicted in figure 4.1. The
constant ‘a’ is shown as the
“intercept” on the Y axis, i.e, the Intercept form of the linear equation.
value of Y when X is zero. The
constant ‘b’ is the slope of the line
i.e. tangent θ = b.
C
Consumption Function –
Graphical Representation
C=C+cY
Using the same logic, the
consumption function can be
shown as follows:
Consumption function,
α

58 where, C = intercept of the

consumption function
C
{
Introductory Macroeconomics

c = slope of consumption function Fig. 4.2

= tan α
Consumption function with intercept C .
Investment Function –
Graphical Representation
In a two sector model, there C, I
are two sources of final demand,
the first is consumption and the
second is investment.
The investment function was
shown as I = I
Graphically, this is shown as I=I

a horizontal line at a height equal

to I above the horizontal axis.
In this model, I is autonomous Y
which means, it is the same no Fig. 4.3
matter whatever is the level of
income. Investment function with I as autonomous.

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Aggregate Demand: Graphical Representation
The Aggregate Demand function shows the total demand (made up of
consumption + investment) at
each level of income. Graphically
Aggregate Demand=C+I+cY
it means the aggregate demand
function can be obtained by
vertically adding the
consumption and investment C=C+cY

function.
L
Here, OM = C I=I
J
OJ = I
M
OL = C + I
O
The aggregate demand Fig. 4.4
function is parallel to the
consumption function i.e., they Aggregate demand is obtained by vertically
have the same slope c. adding the consumption and investment
It may be noted that this functions.
function shows ex ante demand.
Supply Side of Macroeconomic Equilibrium
In microeconomic theory, we show the supply curve on a diagram with price on
the vertical axis and quantity supplied on horizontal axis.
In the first stage of
macroeconomic theory, we are
taking the price level as fixed.
Here, aggregate supply or the
GDP is assumed to smoothly
move up or down since they are
Aggregate Supply

Aggregate Supply
59
unused resources of all types

Income Determination
available. Whatever is the level
of GDP, that much will be
supplied and price level has no
role to play. This kind of supply 45
o

situation is shown by a 450 line. A

1000 GDP, Y
Now, the 450 line has the feature Fig. 4.5
that every point on it has the
same horizontal and vertical Aggregate supply curve with 45o line.
coordinates.
Suppose, GDP is Rs.1,000 at point A. How much will be supplied? The answer
is Rs.1000 worth of goods. How can that point be shown? The answer is that
supply corresponding to point A is at point B which is obtained at the intersection
of the 450 line and the vertical line at A.
Equilibrium
Equilibrium is shown graphically by putting ex ante aggregate demand and
supply together in a diagram (Fig. 4.6). The point where ex ante aggregate
demand is equal to ex ante aggregate supply will be equilibrium. Thus,

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 equilibrium point is E and
equilibrium level of income is

Ex ante Aggregate Demand and Supply

OY1. 45
o

(B) Algebraic Method E

Ex ante aggregate demand =

I + C + cY
Ex ante aggregate supply = Y L
α
M
Equilibrium requires that the
plans of suppliers are matched by
O Y
plans of those who provide final Y
Y1 1

demands in the economy. Thus, in Fig. 4.6

this situation, ex ante aggregate
Equilibrium of ex ante aggregate demand
demand = ex ante aggregate and supply
supply,

C + I + cY = Y
Y (1 − c) = C + I
C+I (4.4)
Y=
(1 − c )

4.3.2 Effect of an Autonomous Change in Aggregate Demand on Income

and Output
We have seen that the equilibrium level of income depends on aggregate demand.
Thus, if aggregate demand changes, the equilibrium level of income changes.
This can happen in any one or combination of the following situations:
60
1. Change in consumption: this can happen due to (i) change in C (ii) change
Introductory Macroeconomics

in c .
2. Change in investment: we have assumed that investment is
autonomous. However, it just means that it does not depend on
income. There are a number of variables other than income which
can affect investment. One important factor is availability of credit:
easy availability of credit encourages investment. Another factor is
interest rate: interest rate is the cost of investible funds, and at
higher interest rates, firms tend to lower investment. Let us now
concentrate on change in investment with the help of the following example.
Let C = 40 + 0.8Y , I = 10 . In this case, the equilibrium income (obtained by
equation Y to AD ) comes out to be 2501.
Now, let investment rise to 20. It can be seen that the new equilibrium will be
300. This can be seen by looking at the graph. This increase in income is due to
rise in investment, which is a component of autonomous expenditure here.
When autonomous investment increases, the AD1 line shifts in parallel
upwards and assumes the position AD2. The value of aggregate demand at

1
1 Y = C + I = 40 + 0.8Y + 10 , so that Y = 50 + 0.8Y , or Y= 50 = 2 50
1 − 0 .8

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output Y1* is Y1* F, which is greater than the value of output 0Y 1* = Y1* E1 by an
amount E1F. E1F measures the amount of excess demand that emerges in the
economy as a result of the increase in autonomous expenditure. Thus, E1 no
longer represents the equilibrium. To find the new equilibrium in the final
goods market we must look for the point where the new aggregate demand
o
line, AD2, intersects the 45 line. That occurs at point E2, which is, therefore,
the new equilibrium point. The
new equilibrium values of output
and aggregate demand are Y2* and
AD*2, respectively.
Note that in the new
equilibrium, output and aggregate
demand have increased by an
amount E 1G = E 2G, which is
greater than the initial increment
in autonomous expenditure, ∆ I
= E 1F = E 2 J. Thus an initial
increment in the autonomous
expenditure seems to have a
multiplier on the equilibrium Fig. 4.7
values of aggregate demand and Equilibrium Output and Aggregate Demand in
output. What causes aggregate the Fixed Price Model
demand and output to increase by
an amount larger than the size of the initial increment in autonomous
expenditure? We discuss it in section 4.3.3.

4.3.3 The Multiplier Mechanism

It was seen in the previous section that with a change in the autonomous
expenditure of 10 units, the change in equilibrium income is equal to 50 units
(from 250 to 300). We can understand this by looking at the multiplier mechanism, 61
which is explained below:

Income Determination
The production of final goods employs factors such as labour, capital,
land and entrepreneurship. In the absence of indirect taxes or subsidies, the
total value of the final goods output is distributed among different factors of
production – wages to labour, interest to capital, rent to land etc. Whatever is
left over is appropriated by the entrepreneur and is called profit. Thus the
sum total of aggregate factor payments in the economy, National Income, is
equal to the aggregate value of the output of final goods, GDP. In the above
example the value of the extra output, 10, is distributed among various factors
as factor payments and hence the income of the economy goes up by 10.
When income increases by 10, consumption expenditure goes up by (0.8)10,
since people spend 0.8 (= mpc) fraction of their additional income on
consumption. Hence, in the next round, aggregate demand in the economy
goes up by (0.8)10 and there again emerges an excess demand equal to
(0.8)10. Therefore, in the next production cycle, producers increase their
planned output further by (0.8)10 to restore equilibrium. When this extra
output is distributed among factors, the income of the economy goes up by
(0.8)10 and consumption demand increases further by (0.8)210, once again
creating excess demand of the same amount. This process goes on, round
after round, with producers increasing their output to clear the excess
demand in each round and consumers spending a part of their additional

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 income from this extra production on consumption items – thereby creating
further excess demand in the next round.
Let us register the changes in the values of aggregate demand and output at
each round in Table 4.1.
The last column measures the increments in the value of the output of
final goods (and hence the income of the economy) in each round. The second
and third columns measure the increments in total consumption expenditure
in the economy and increments in the value of aggregate demand in a similar
way. In order to find out the total increase in output of the final goods, we
must add up the infinite geometric series in the last column, i.e.,
10 + (0.8)10 + (0.8)2 10 + .........·∞
10
= 10 {1 + (0.8) + (0.8)2 + .......·∞} = = 50
1 – 0.8

Table 4.1: The Multiplier Mechanism in the Final Goods Market

Consumption Aggregate Demand Output/Income

Round 1 0 10 (Autonomous Increment) 10
Round 2 (0.8)10 (0.8)10 (0.8)10
Round 3 (0.8)210 (0.8)210 (0.8)210
Round 4 (0.8)310 (0.8)310 (0.8)310
. . . .
. . . .
. . . .
. . . etc.

The increment in equilibrium value of total output thus exceeds the initial
increment in autonomous expenditure. The ratio of the total increment in
62 equilibrium value of final goods output to the initial increment in autonomous
expenditure is called the investment multiplier of the economy. Recalling that
Introductory Macroeconomics

10 and 0.8 represent the values of ∆ I = ∆ A and mpc, respectively, the expression
for the multiplier can be explained as

∆Y 1 1
The investment multiplier = = = (4.5)
∆ A 1− c S
where ∆Y is the total increment in final goods output and c = mpc . Observe
that the size of the multiplier depends on the value of c . As c becomes larger the
multiplier increases.

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Paradox of Thrift
If all the people of the economy increase the proportion of income they
save (i.e. if the mps of the economy increases) the total value of savings in
the economy will not increase – it will either decline or remain unchanged.
This result is known as the Paradox of Thrift – which states that as
people become more thrifty they end up saving less or same as before.
This result, though sounds apparently impossible, is actually a simple
application of the model we have learnt.
Let us continue with the example. Suppose at the initial equilibrium
of Y = 250, there is an exogenous or autonomous shift in peoples’
expenditure pattern – they suddenly become more thrifty. This may
happen due to a new information regarding an imminent war or some
other impending disaster, which makes people more circumspect and
conservative about their expenditures. Hence the mps of the economy
increases, or, alternatively, the mpc decreases from 0.8 to 0.5. At the
initial income level of AD *1 = Y 1* = 250, this sudden decline in mpc will
imply a decrease in aggregate consumption spending and hence in
aggregate demand, AD = A + cY , by an amount equal to (0.8 – 0.5) 250
= 75. This can be regarded as an autonomous reduction in consumption
expenditure, to the extent that the change in mpc is occurring from some
exogenous cause and is not a consequence of changes in the variables
of the model. But as aggregate demand decreases by 75, it falls short of
the output Y *1 = 250 and there emerges an excess supply equal to 75 in
the economy. Stocks are piling up in warehouses and producers decide
to cut the value of production by 75 in the next round to restore
equilibrium in the market. But that would mean a reduction in factor
payments in the next round and hence a reduction in income by 75. As
income decreases people reduce consumption proportionately but, this
time, according to the new value of mpc which is 0.5. Consumption
expenditure, and hence aggregate demand, decreases by (0.5)75, which 63
creates again an excess supply in the market. In the next round,

Income Determination
therefore, producers reduce output further by (0.5)75. Income of the
people decreases accordingly and consumption expenditure and
aggregate demand goes down again by (0.5) 2 75. The process goes on.
However, as can be inferred from the dwindling values of the successive
round effects, the process is convergent. What is the total decrease in
the value of output and aggregate demand? Add up the infinite series 75
+ (0.5) 75 + (0.5)2 75 + ........ ∞ and the total reduction in output turns out
to be

75
= 150
1 – 0.5
But that means the new equilibrium output of the economy is only Y *2 =
100. People are now saving S *2 = Y 2* – C *2 = Y 2* – ( C + c2.Y2* ) = 100 – (40 + 0.5 ×
100) = 10 in aggregate, whereas under the previous equilibrium they
were saving S *1 = Y 1* – C *1 = Y 1* – ( C + c1.Y 1* ) = 250 – (40 + 0.8 × 250) = 10 at
the previous mpc, c1 = 0.8. Total value of savings in the economy has,
therefore, remained unchanged.
When A changes the line shifts upwards or downwards in parallel.
When c changes, however, the line swings up or down. An increase in mps,

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 or a decline in mpc, reduces the slope of the AD line and it swings
downwards. We depict the situation in Fig. 4.8.
At the initial values of
the parameters, A = 50 AD
and c = 0.8, the
equilibrium value of the AD1 = A + c1Y
output and aggregate AD1* E1
demand from equation AD2 = A + c2Y
*
(4.4) was AD2
E2
–
50 A
Y1* = = 250
1 – 0.8
Under the changed 45°
value of the parameter c =
0.5, the new equilibrium 0 Y2* Y1* Y
value of output and
aggregate demand is Fig. 4.8
50
Y 2* = = 100 Paradox of Thrift – Downward Swing of AD Line
1 – 0.5
The equilibrium output and aggregate demand have declined by 150.
As explained above, this, in turn, implies that there is no change in the
total value of savings.

4.4 SOME MORE CONCEPTS

The equilibrium output in the economy also determines the level of employment,
given the quantities of other factors of production (think of a production function
at aggregate level). This means that the level of output determined by the equality
64 of Y with AD does not necessarily mean the level of output at which everyone is
employed.
Introductory Macroeconomics

Full employment level of income is that level of income where all the factors
of production are fully employed in the production process. Recall that
equilibrium attained at the point of equality of Y and AD by itself does not signify
full employment of resources. Equilibrium only means that if left to itself the
level of income in the economy will not change even when there is unemployment
in the economy. The equilibrium level of output may be more or less than the
full employment level of output. If it is less than the full employment of output,
it is due to the fact that demand is not enough to employ all factors of
production. This situation is called the situation of deficient demand. It
leads to decline in prices in the long run. On the other hand, if the equilibrium
level of output is more than the full employment level, it is due to the fact
that the demand is more than the level of output produced at full employment
level. This situation is called the situation of excess demand. It leads to rise
in prices in the long run.

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 Summary

When, at a particular price level, aggregate demand for final goods equals
aggregate supply of final goods, the final goods or product market reaches its
equilibrium. Aggregate demand for final goods consists of ex ante consumption,
ex ante investment, government spending etc. The rate of increase in ex ante
consumption due to a unit increment in income is called marginal propensity
to consume. For simplicity we assume a constant final goods price and constant
rate of interest over short run to determine the level of aggregate demand for
final goods in the economy. We also assume that the aggregate supply is
perfectly elastic at this price. Under such circumstances, aggregate output is
determined solely by the level of aggregate demand. This is known as effective
demand principle. An increase (decrease) in autonomous spending causes
aggregate output of final goods to increase (decrease) by a larger amount
through the multiplier process.
Key Concepts

Aggregate demand Aggregate supply

Equilibrium Ex ante
Ex post Ex ante consumption
Marginal propensity to consume Ex ante investment
Unintended changes in inventories Autonomous change
Parametric shift Effective demand principle
Paradox of thrift Autonomous expenditure multiplier

? 1. What is marginal propensity to consume? How is it related to marginal

Exercises

propensity to save?
2. What is the difference between ex ante investment and ex post investment?
3. What do you understand by ‘parametric shift of a line’? How does a line
shift when its (i) slope decreases, and (ii) its intercept increases?
4. What is ‘effective demand’? How will you derive the autonomous expenditure
65
multiplier when price of final goods and the rate of interest are given?

Income Determination
5. Measure the level of ex-ante aggregate demand when autonomous
investment and consumption expenditure (A) is Rs 50 crores, and MPS is
0.2 and level of income (Y) is Rs 4000 crores. State whether the economy
is in equilibrium or not (cite reasons).

? 6. Explain ‘Paradox of Thrift’.

Suggested Readings
1 . Dornbusch, R. and S. Fischer. 1990. Macroeconomics, (fifth edition) pages
63 – 105. McGraw Hill, Paris.

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Chapter 5
Chapter 5
Governmentt Budget
Governmen
and the Economy
We introduced the government in chapter one as denoting
the state. We stated that apart from the private sector,
there is the government which plays a very important role.
An economy in which there is both the private sector and
the Government is known as a mixed economy. There are
many ways in which the government influences economic
life. In this chapter, we will limit ourselves to the functions
which are carried on through the government budget.
This chapter proceeds as follows. In section 5.1 we
present the components of the government budget to bring
out the sources of government revenue and avenues of
government spending. In section 5.2 we discuss the topic of
balanced, surplus or deficit budget to account for the
difference between expenditures and revenue collection. It
specifically deals with the meaning of different kinds of
budget deficits, their implications and the measures to
contain them. Box. 5.1 deals with fiscal policy and a simple
description of the multiplier. The role the government plays
has implications for its deficits which further affect its debt-
what the government owes. The chapter concludes with an
analysis of the debt issue.

5.1 GOVERNMENT BUDGET — MEANING AND ITS COMPONENTS

There is a constitutional requirement in India (Article 112) to
present before the Parliament a statement of estimated receipts
and expenditures of the government in respect of every financial
year which runs from 1 April to 31 March. This ‘Annual Financial
Statement’ constitutes the main budget document of the
government.
Although the budget document relates to the receipts
and expenditure of the government for a particular financial
year, the impact of it will be there in subsequent years.
There is a need therefore to have two accounts- those that
relate to the current financial year only are included in the
revenue account (also called revenue budget) and those that
concern the assets and liabilities of the government into
the capital account (also called capital budget). In order to
understand the accounts, it is important to first understand
the objectives of the government budget.

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5.1.1 Objectives of Government Budget
The government plays a very important role in increasing the welfare of
the people. In order to do that the government intervenes in the economy
in the following ways.
Allocation Function of Government Budget
Government provides certain goods and services which cannot be provided
by the market mechanism i.e. by exchange between individual consumers
and producers. Examples of such goods are national defence, roads,
government administration etc. which are referred to as public goods.
To understand why public goods need to be provided by the
government, we must understand the difference between private goods
such as clothes, cars, food items etc. and public goods. There are two
major differences. One, the benefits of public goods are available to all
and are not only restricted to one particular consumer. For example, if
a person eats a chocolate or wears a shirt, these will not be available to
others. It is said that this person’s consumption stands in rival
relationship to the consumption of others. However, if we consider a
public park or measures to reduce air pollution, the benefits will be
available to all. One person’s consumption of a good does not reduce the
amount available for consumption for others and so several people can
enjoy the benefits, that is, the consumption of many people is not
‘rivalrous’.
Two, in case of private goods anyone who does not pay for the goods
can be excluded from enjoying its benefits. If you do not buy a ticket,
you will not be allowed to watch a movie at a local cinema hall. However,
in case of public goods, there is no feasible way of excluding anyone
from enjoying the benefits of the good. That is why public goods are
called non-excludable. Even if some users do not pay, it is difficult and
sometimes impossible to collect fees for the public good. These non-
paying users are known as ‘free-riders’. Consumers will not voluntarily 67

and the Economy

Government Budget
pay for what they can get for free and for which there is no exclusive
title to the property being enjoyed. The link between the producer and
consumer which occurs through the payment process is broken and the
government must step in to provide for such goods.
There is, however, a difference between public provision and public
production. Public provision means that they are financed through the
budget and can be used without any direct payment. Public goods may
be produced by the government or the private sector. When goods are
produced directly by the government it is called public production.
Redistribution Function of Government Budget
From chapter two we know that the total national income of the country
goes to either the private sector, that is, firms and households (known
as private income) or the government (known as public income). Out of
private income, what finally reaches the households is known as personal
income and the amount that can be spent is the personal disposable
income. The government sector affects the personal disposable income
of households by making transfers and collecting taxes. It is through
this that the government can change the distribution of income and
bring about a distribution that is considered ‘fair’ by society. This is the
redistribution function.

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 Stabilisation Function of Government Budget
The government may need to correct fluctuations in income and employment.
The overall level of employment and prices in the economy depends upon the
level of aggregate demand which depends on the spending decisions of millions
of private economic agents apart from the government. These decisions, in turn,
depend on many factors such as income and credit availability. In any period,
the level of demand may not be sufficient for full utilisation of labour and other
resources of the economy. Since wages and prices do not fall below a level,
employment cannot be brought back to the earlier level automatically. The
government needs to intervene to raise the aggregate demand.
On the other hand, there may be times when demand exceeds available output
under conditions of high employment and thus may give rise to inflation. In
such situations, restrictive conditions may be needed to reduce demand.
The intervention of the government whether to expand demand or reduce it
constitutes the stabilisation function.

5.1.2 Classification of Receipts

Revenue Receipts: Revenue receipts are those receipts that do not lead to a
claim on the government. They are therefore termed non-redeemable. They are
divided into tax and non-tax revenues. Tax revenues, an important component
of revenue receipts, have for long been divided into direct taxes (personal income
tax) and firms (corporation tax), and indirect taxes like excise taxes (duties levied
on goods produced within the country), customs duties (taxes imposed on goods
imported into and exported out of India) and service tax1. Other direct taxes like
wealth tax, gift tax and estate duty (now abolished) have never brought in large
amount of revenue and thus have been referred to as ‘paper taxes’.
The redistribution objective is sought to be achieved through progressive
income taxation, in which higher the income, higher is the tax rate. Firms are
taxed on a proportional basis, where the tax rate is a particular proportion of
68 profits. With respect to excise taxes, necessities of life are exempted or taxed at
low rates, comforts and semi-luxuries are moderately taxed, and luxuries, tobacco
Introductory Macroeconomics

and petroleum products are taxed heavily.

Non-tax revenue of the central government mainly consists of interest receipts
on account of loans by the central government, dividends and profits on
investments made by the government, fees and other receipts for services rendered
by the government. Cash grants-in-aid from foreign countries and international
organisations are also included.
The estimates of revenue receipts take into account the effects of tax proposals
made in the Finance Bill2.
Capital Receipts: The government also receives money by way of loans or
from the sale of its assets. Loans will have to be returned to the agencies from
which they have been borrowed. Thus they create liability. Sale of government
assets, like sale of shares in Public Sector Undertakings (PSUs) which is referred

1
The India Tax system witnessed a dramatic change with the introduction of the GST
(Goods and Services Tax) which encompasses both goods and services and was be implemented by
the Centre, 28 states and 7 Union territories from 1 July, 2017.
2
A Finance Bill, presented along with the Annual Financial Statement, provides details on the
imposition, abolition, remission, alteration or regulation of taxes proposed in the Budget.

2020-21
 Government Budget

Revenue Capital
Budget Budget

Revenue Revenue Capital Capital

Receipts Expenditure Receipts Expenditure

Tax Non-tax Plan Revenue Non-plan Revenue Plan Capital Non-plan Capital
Revenue Revenue Expenditure Expenditure Expenditure Expenditure

Chart 1: The Components of the Government Budget

to as PSU disinvestment, reduce the total amount of financial assets of the

government. All those receipts of the government which create liability or reduce
financial assets are termed as capital receipts. When government takes fresh
loans it will mean that in future these loans will have to be returned and interest
will have to be paid on these loans. Similarly, when government sells an asset,
then it means that in future its earnings from that asset, will disappear. Thus,
these receipts can be debt creating or non-debt creating.

5.1.3. Classification of Expenditure

Revenue Expenditure 69

and the Economy

Government Budget
Revenue Expenditure is expenditure incurred for purposes other than
the creation of physical or financial assets of the central government. It
relates to those expenses incurred for the normal functioning of the
government departments and various services, interest payments on
debt incurred by the government, and grants given to state governments
and other parties (even though some of the grants may be meant for
creation of assets).
Budget documents classify total expenditure into plan and non-plan
expenditure 3. This is shown in item 6 on Table 5.1 within revenue
expenditure, a distinction is made between plan and non-plan. According
to this classification, plan revenue expenditure relates to central Plans
(the Five-Year Plans) and central assistance for State and Union Territory
plans. Non-plan expenditure, the more important component of revenue
expenditure, covers a vast range of general, economic and social services of the

3
A case against this kind of classification has been put forth on the ground that it has
led to an increasing tendency to start new schemes/projects neglecting maintenance of
existing capacity and service levels. It has also led to the misperception that non-plan
expenditure is inherently wasteful, adversely affecting resource allocation to social sectors
like education and health where salary comprises an important element.

2020-21
 government. The main items of non-plan expenditure are interest payments,
defence services, subsidies, salaries and pensions.
Interest payments on market loans, external loans and from various reserve
funds constitute the single largest component of non-plan revenue expenditure.
Defence expenditure, is committed expenditure in the sense that given the national
security concerns, there exists little scope for drastic reduction. Subsidies are
an important policy instrument which aim at increasing welfare. Apart from
providing implicit subsidies through under-pricing of public goods and services
like education and health, the government also extends subsidies explicitly on
items such as exports, interest on loans, food and fertilisers. The amount of
subsidies as a per cent of GDP was 2.02 per cent in 2014-15 and is 1.7 percent
of GDP in 2015-16 (B.E).
Capital Expenditure
There are expenditures of the government which result in creation of
physical or financial assets or reduction in financial liabilities. This
includes expenditure on the acquisition of land, building, machinery,
equipment, investment in shares, and loans and advances by the central
government to state and union territory governments, PSUs and other
parties. Capital expenditure is also categorised as plan and non-plan in
the budget documents. Plan capital expenditure, like its revenue
counterpart, relates to central plan and central assistance for state
and union territory plans. Non-plan capital expenditure covers various
general, social and economic services provided by the government.
The budget is not merely a statement of receipts and expenditures.
Since Independence, with the launching of the Five-Year Plans, it has
also become a significant national policy statement. The budget, it has
been argued, reflects and shapes, and is, in turn, shaped by the country’s
economic life. Along with the budget, three policy statements are
mandated by the Fiscal Responsibility and Budget Management Act,
70 2003 (FRBMA)4. The Medium-term Fiscal Policy Statement sets a three-
year rolling target for specific fiscal indicators and examines whether
Introductory Macroeconomics

revenue expenditure can be financed through revenue receipts on a

sustainable basis and how productively capital receipts including market
borrowings are being utilised. The Fiscal Policy Strategy Statement sets
the priorities of the government in the fiscal area, examining current
policies and justifying any deviation in important fiscal measures. The
Macroeconomic Framework Statement assesses the prospects of the
economy with respect to the GDP growth rate, fiscal balance of the central
government and external balance5.

5.2 BALANCED, SURPLUS AND DEFICIT BUDGET

The government may spend an amount equal to the revenue it collects. This is
known as a balanced budget. If it needs to incur higher expenditure, it will have

4
Box 5.2 provides a brief account of this legistation and its implication for Government
finances.
5
The 2005-06 Indian Budget introduced a statement highlighting the gender sensitivities
of the budgetary allocations. Gender budgeting is an exercise to translate the stated gender
commitments of the government into budgetary commitments, involving special initiatives
for empowering women and examination of the utilisation of resources allocated for women
and the impact of public expenditure and policies of the government on women. The 2006-
07 budget enlarged the earlier statement.

2020-21
to raise the amount through taxes in order to keep the budget balanced. When
tax collection exceeds the required expenditure, the budget is said to be in surplus.
However, the most common feature is the situation when expenditure exceeds
revenue. This is when the government runs a budget deficit.

5.2.1 Measures of Government Deficit

When a government spends more than it collects by way of revenue, it
incurs a budget deficit 6 . There are various measures that capture
government deficit and they have their own implications for the economy.
Revenue Deficit: The revenue deficit refers to the excess of government’s
revenue expenditure over revenue receipts
Revenue deficit = Revenue expenditure – Revenue receipts

Table 5.1: Receipts and Expenditures of the Central Government, 2018-19 (PA)

(As per cent of GDP)

1. Revenue Receipts (a+b) 8.2
(a) Tax revenue (net of states’ share) 6.9
(b) Non-tax revenue 1.3
2. Revenue Expenditure of which 10.6
(a) Interest payments 3.1
(b) Major subsidies 1.0
(c) Defence expenditure 1.0
3. Revenue Deficit (2–1) 2.3
4. Capital Receipts (a+b+c) of which 3.9
(a) Recovery of loans 0.1
(b) Other receipts (mainly PSU1 disinvestment) 0.4
(c) Borrowings and other liabilities 3.4
5. Capital Expenditure 1.6
6. Non-debt Receipts 8.8
[1+4(a)+4(b)] 71
7. Total Expenditure 2.2

and the Economy

Government Budget
[2+5=7(a)+7(b)]
(a) Plan expenditure –
(b) Non-plan expenditure –
8. Fiscal deficit [7-1-4(a)-4(b)] 3.4
9. Primary Deficit [8–2(a)] 0.3
1
Source: Economic Survey, 2018-19 Public Sector Undertaking

Item 3 in Table 5.1 shows that revenue deficit in 2018-19 was 2.3 per cent
of GDP. The revenue deficit includes only such transactions that affect the current
income and expenditure of the government. When the government incurs a
revenue deficit, it implies that the government is dissaving and is using up the
savings of the other sectors of the economy to finance a part of its consumption
expenditure. This situation means that the government will have to borrow not
only to finance its investment but also its consumption requirements. This will
lead to a build up of stock of debt and interest liabilities and force the government,

6
More formally, it refers to the excess of total expenditure (both revenue and capital)
over total receipts (both revenue and capital). From the 1997-98 budget, the practice of
showing budget deficit has been discontinued in India.

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 eventually, to cut expenditure. Since a major part of revenue expenditure is
committed expenditure, it cannot be reduced. Often the government reduces
productive capital expenditure or welfare expenditure. This would mean lower
growth and adverse welfare implications.
Fiscal Deficit: Fiscal deficit is the difference between the government’s total
expenditure and its total receipts excluding borrowing
Gross fiscal deficit = Total expenditure – (Revenue receipts +
Non-debt creating capital receipts)
Non-debt creating capital receipts are those receipts which are not borrowings
and, therefore, do not give rise to debt. Examples are recovery of loans and the
proceeds from the sale of PSUs. From Table 5.1 we can see that non-debt creating
capital receipts equals 8.8 per cent of GDP, obtained by subtracting, borrowing
and other liabilities from total capital receipts [1+4(a)+4(b)]. The fiscal deficit,
therefore turn out to be 3.4 per cent of GDP. The fiscal deficit will have to be
financed through borrowing. Thus, it indicates the total borrowing requirements
of the government from all sources. From the financing side
Gross fiscal deficit = Net borrowing at home + Borrowing from
RBI + Borrowing from abroad
Net borrowing at home includes that directly borrowed from the public
through debt instruments (for example, the various small savings
schemes) and indirectly from commercial banks through Statutory
Liquidity Ratio (SLR). The gross fiscal deficit is a key variable in judging
the financial health of the public sector and the stability of the economy.
From the way gross fiscal deficit is measured as given above, it can be
seen that revenue deficit is a part of fiscal deficit (Fiscal Deficit =
Revenue Deficit + Capital Expenditure - non-debt creating capital
receipts). A large share of revenue deficit in fiscal deficit indicated that
72
a large part of borrowing is being used to meet its consumption
Introductory Macroeconomics

expenditure needs rather than investment.

Primary Deficit: We must note that the borrowing requirement of the
government includes interest obligations on accumulated debt. The goal
of measuring primary deficit is to focus on present fiscal imbalances.
To obtain an estimate of borrowing on account of current expenditures
exceeding revenues, we need to calculate what has been called the
primary deficit. It is simply the fiscal deficit minus the interest payments
Gross primary deficit = Gross fiscal deficit – Net interest liabilities
Net interest liabilities consist of interest payments minus interest
receipts by the government on net domestic lending.

Box 5.1: Fiscal Policy

One of Keynes’s main ideas in The General Theory of Employment, Interest and
Money was that government fiscal policy should be used to stabilise the level of
output and employment. Through changes in its expenditure and taxes, the
government attempts to increase output and income and seeks to stabilise the
ups and downs in the economy. In the process, fiscal policy creates a surplus
(when total receipts exceed expenditure) or a deficit budget (when total expenditure

2020-21
exceed receipts) rather than a balanced
budget (when expenditure equals
receipts). In what follows, we study the
effects of introducing the government
sector in our earlier analysis of the
determination of income.
The government directly affects
the level of equilibrium income in two
specific ways – government
purchases of goods and services (G)
increase aggregate demand and
taxes, and transfers affect the
relation between income (Y) and How does the Fiscal Policy try to achieve
disposable income (YD) – the income its basic objectives?
available for consumption and
saving with the households.
We take taxes first. We assume that the government imposes taxes that
do not depend on income, called lump-sum taxes equal to T. We assume
throughout the analysis that government makes a constant amount of
—
transfers, TR . The consumption function is now
—
C = C + cYD = C + c(Y – T + TR ) (5.1)

where YD = disposable income.

We note that taxes lower disposable income and consumption. For instance,
if one earns Rs 1 lakh and has to pay Rs 10,000 in taxes, she has the same
disposable income as someone who earns Rs 90,000 but pays no taxes. The
definition of aggregate demand augmented to include the government will be
—
AD = C + c(Y – T + TR ) + I + G (5.2)

Graphically, we find that the lump-sum tax shifts the consumption

schedule downward in a parallel way and hence the aggregate demand
73
curve shifts in a similar fashion. The income determination condition in

and the Economy

Government Budget
the product market will be Y = AD, which can be written as
—
Y = C + c (Y – T + TR ) + I + G (5.3)

Solving for the equilibrium level of income, we get

1 —
Y* = ( C – cT + c TR + I + G) (5.4)
1– c

Changes in Government Expenditure

We consider the effects of increasing government purchases (G) keeping
taxes constant. When G exceeds T, the government runs a deficit. Because
G is a component of aggregate spending, planned aggregate expenditure
will increase. The aggregate demand schedule shifts up to AD′. At the
initial level of output, demand exceeds supply and firms expand production.
The new equilibrium is at E′. The multiplier mechanism (described in
Chapter 4) is in operation. The government spending multiplier is derived
as follows:
Suppose G changes to a new level (G+∆G) and as a result Y changes to a new
*
level (Y + ∆Y ) . The new levels of G and Y can also be put into equation (5.4).

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 1
*
So (Y + ∆Y ) =
1− c
(
C − cT + cTR + I + G + ∆G) (5.4a)

Subtracting equation (5.4) from equation (5.4a) we get

1
∆Y = ∆G (5.5)
1– c
or
∆Y 1
= (5.6)
∆G 1 − c
In Fig. 5.1, government expenditure increases from G to G’ and causes
equilibrium income to increase from Y to Y’.

Changes in Taxes
We find that a cut in taxes increases
disposable income (Y – T ) at each
AD
level of income. This shifts the E'
Y = AD
aggregate expenditure schedule C + I + G' – cT
upwards by a fraction c of the
decrease in taxes. This is shown in E C + I + G – cT
Fig 5.2.
From equation 5.3, we can calculate
the tax multiplier using the same
method as for the government
expenditure multiplier. Y
Y* Y'
1 Fig. 5.1
∆Y * = ( − c) ( ∆T ) (5.7)
1− c Effect of Higher Government
Expenditure
The tax multiplier

74 ∆Y –c
= = (5.8)
∆T 1– c
Introductory Macroeconomics

Because a tax cut (increase) will

cause an increase (reduction) in AD
Y = AD
consumption and output, the tax E'
multiplier is a negative multiplier. C + I + G – cT'
Comparing equation (5.6) and (5.8),
we find that the tax multiplier is E C + I + G – cT
smaller in absolute value compared
to the government spending
multiplier. This is because an
increase in government spending
directly affects total spending
whereas taxes enter the multiplier Y* Y' Y
process through their impact on Fig. 5.2
disposable income, which
influences household consumption Effect of a Reduction in Taxes
(which is a part of total spending).
Thus, with a ∆T reduction in taxes, consumption, and hence total spending,
increases in the first instance by c∆T. To understand how the two multipliers
differ, we consider the following example.

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EXAMPLE 5.1
Assume that the marginal propensity to consume is 0.8. The government
expenditure multiplier will then be
1 1 1
= = = 5. For an
1– c 1 – 0.8 0.2
increase in government spending by
100, the equilibrium income will
1
increase by 500 ( ∆G = 5 × 100) .
1−c
The tax multiplier is given by
–c –0.8 –0.8
= = = –4.
1– c 1 – 0.8 0.2

A tax cut of 100 ( ∆ T= –100) will

increase equilibrium income by 400.
Thus, the equilibrium income Why is the poor man crying? Suggest
increases in this case by less than measures to wipe off his tears.
the amount by which it increased
under a G increase.

Within the present framework, if we take different values of the marginal

propensity to consume and calculate the values of the two multipliers, we
find that the tax multiplier is always one less in absolute value than the
government expenditure multiplier. This has an interesting implication. If an
increase in government spending is matched by an equal increase in taxes,
so that the budget remains balanced, output will rise by the amount of the
increase in government spending. Adding the two policy multipliers gives
∆Y * 1 –c 1– c
The balanced budget multiplier = = + = =1 (5.9)
∆G 1–c 1– c 1– c
A balanced budget multiplier of unity implies that a 100 increase in G financed 75
by 100 increase in taxes increases income by just 100. This can be seen from

and the Economy

Government Budget
Example 1 where an increase in G by 100 increases output by 500. A tax
increase would reduce income by 400 with the net increase of income equal
to 100. The equilibrium income refers to the final income that one arrives at
in a period sufficiently long for all the rounds of the multipliers to work
themselves out. We find that output increases by exactly the amount of
increased G with no induced consumption spending due to increase in taxes.
To see why the balanced budget multiplier is 1, we examine the multiplier
process. The increase in government spending by a certain amount raises
income by that amount directly and then indirectly through the multiplier
chain increasing income by
∆Y = ∆G + c∆G + c2∆G + . . . = ∆G (1 + c + c2 + . . .) (5.10)
But the tax increase only enters the multiplier process when the cut in
disposable income reduces consumption by c times the reduction in taxes.
Thus the effect on income of the tax increase is given by
∆Y = – c∆T – c2∆T + . . . = – ∆T(c + c2 + . . .) (5.11)
The difference between the two gives the net effect on income. Since ∆G =
∆T, from 5.10 and 5.11, we get ∆Y = ∆G, that is, income increases by the amount
by which government spending increases and the balanced budget multiplier
is unity. This multiplier can also be derived from equation 5.3 as follows

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 ∆Y = ∆ G + c (∆Y – ∆T) since investment does not change (∆I = 0)
(5.12)

Since, ∆ G = ∆T, we have

∆Y 1– c
= =1 (5.13)
∆G 1– c

Case of Proportional Taxes: A more realistic assumption would be that the

government collects a constant fraction, t, of income in the form of taxes so
that T = tY. The consumption function with proportional taxes is given by

—
C = C + c (Y – tY + TR ) = C + c
—
AD
(1 – t ) Y + c TR Y = AD
(5.14) AD = C + cY + I + G
We note that proportional taxes not
only lower consumption at each
AD' = C + c(1 – t)Y + I + G
level of income but also lower the
slope of the consumption function.
The mpc out of income falls to c (1
– t). The new aggregate demand
schedule, AD′, has a larger
intercept but is flatter as shown in
Y
Fig. 5.3.
Fig. 5.3
Now we have Government and Aggregate Demand
—
AD = C + c(1 – t)Y + c TR + I + G (proportional taxes make the AD schedule
flatter)
= A + c(1 – t)Y (5.15)
—
76 Where A = autonomous expenditure and equals C + c TR + I + G. Income
determination condition in the product market is, Y = AD, which can be written
Introductory Macroeconomics

as
Y = A + c (1 – t )Y (5.16)
Solving for the equilibrium
level of income
1
Y * = 1 – c(1 – t ) A (5.17)
so that the multiplier is given
by
∆Y 1
= 1 – c (1 – t ) (5.18)
∆A
Comparing this with the
value of the multiplier with
lump-sum taxes case, we find
that the value has become
smaller. When income rose as
a result of an increase in
government spending in the
case of lump-sum taxes, Increase in Government Expenditure (with
proportional taxes)

2020-21
consumption increased by c
times the increase in income. AD = Y
With proportional taxes, AD
consumption will rise by less, (c AD' = C + c(1 – t')Y
– ct = c (1 – t)) times the increase +I+G
E'
in income.
For changes in G, the multiplier AD = C + c(1 – t)Y + I + G
will now be given by
E
∆Y = ∆ G + c (1 – t)∆Y (5.19)
1
∆Y = 1 – c (1 – t ) ∆G (5.20) Y Y' Y

The income increases from Y * Fig. 5.5

to Y ′ as shown in Fig. 5.4.
The decrease in taxes works in Effects of a Reduction in the Proportional Tax
effect like an increase in Rate
propensity to consume as
shown in Fig. 5.5. The AD curve shifts up to AD ′. At the initial level of
income, aggregate demand for goods exceeds output because the tax
reduction causes increased consumption. The new higher level of income
is Y ′.

EXAMPLE 5.2
In Example 5.1, if we take a tax rate of 0.25, we find consumption will now
rise by 0.60 (c (1 – t) = 0.8 × 0.75) for every unit increase in income instead of
the earlier 0.80. Thus, consumption will increase by less than before. The
1 1 1
government expenditure multiplier will be 1 – c (1 – t ) = = = 2.5
1 – 0.6 0.4
which is smaller than that obtained with lump-sum taxes. If government
expenditure rises by 100, output will rise by the multiplier times the rise in
government expenditure, that is, by 2.5 × 100 = 250. This is smaller than the
increase in output with lump-sum taxes. 77

and the Economy

Government Budget
The proportional income tax, thus, acts as an automatic stabiliser – a
shock absorber because it makes disposable income, and thus consumer
spending, less sensitive to fluctuations in GDP. When GDP rises, disposable
income also rises but by less than the rise in GDP because a part of it is
siphoned off as taxes. This helps limit the upward fluctuation in
consumption spending. During a recession when GDP falls, disposable
income falls less sharply, and consumption does not drop as much as it
otherwise would have fallen had the tax liability been fixed. This reduces
the fall in aggregate demand and stabilises the economy.
We note that these fiscal policy instruments can be varied to offset the
effects of undesirable shifts in investment demand. That is, if investment
falls from I 0 to I 1, government spending can be raised from G0 to G1 so that
autonomous expenditure (C + I 0 + G0 = C + I 1 + G1) and equilibrium income
remain the same. This deliberate action to stabilise the economy is often
referred to as discretionary fiscal policy to distinguish it from the inherent
automatic stabilising properties of the fiscal system. As discussed earlier,
proportional taxes help to stabilise the economy against upward and
downward movements. Welfare transfers also help to stabilise income.

2020-21
 During boom years, when employment is high, tax receipts collected to
finance such expenditure increase exerting a stabilising pressure on high
consumption spending; conversely, during a slump, these welfare
payments help sustain consumption. Further, even the private sector has
built-in stabilisers. Corporations maintain their dividends in the face of a
change in income in the short run and households try to maintain their
previous living standards. All these work as shock absorbers without the
need for any decision-maker to take action. That is, they work
automatically. The built-in stabilisers, however, reduce only part of the
fluctuation in the economy, the rest must be taken care of by deliberate
policy initiative.
Transfers: We suppose that instead of raising government spending in goods
—
and services, government increases transfer payments, TR . Autonomous
—
spending, A , will increase by c∆ TR , so output will rise by less than the amount
by which it increases when government expenditure increases because a part
of any increase in transfer payments is saved. Using the method used earlier
for deriving the government expenditure multipier and the taxation multiplier
the change in equilibrium income for a change in transfers is given by
c
∆Y = ∆TR (5.21)
1–c
or
∆Y c
= (5.22)
∆TR 1– c

EXAMPLE 5.3
We suppose that the marginal propensity to consume is 0.75 and we have
lump-sum taxes. The change in equilibrium income when government
1
purchases increase by 20 is given by ∆Y = ∆ G = 4 × 20 = 80. An
1 − 0.75
78
0.75
increase in transfers of 20 will raise equilibrium income by ∆Y = ∆TR
Introductory Macroeconomics

1 – 0.75
= 3 × 20 = 60. Thus, we find that income increases by less than it increased
with a rise in government purchases.

Debt

Budgetary deficits must be financed by either taxation, borrowing or printing

money. Governments have mostly relied on borrowing, giving rise to what is
called government debt. The concepts of deficits and debt are closely related.
Deficits can be thought of as a flow which add to the stock of debt. If the
government continues to borrow year after year, it leads to the accumulation
of debt and the government has to pay more and more by way of interest.
These interest payments themselves contribute to the debt.
Perspectives on the Appropriate Amount of Government Debt: There
are two interlinked aspects of the issue. One is whether government debt
is a burden and two, the issue of financing the debt. The burden of debt
must be discussed keeping in mind that what is true of one small trader’s
debt may not be true for the government’s debt, and one must deal with
the ‘whole’ differently from the ‘part’. Unlike any one trader, the government
can raise resources through taxation and printing money.

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 By borrowing, the government transfers the burden of reduced
consumption on future generations. This is because it borrows by issuing
bonds to the people living at present but may decide to pay off the bonds
some twenty years later by raising taxes. These may be levied on the young
population that have just entered the work force, whose disposable income
will go down and hence consumption. Thus, national savings, it was argued,
would fall. Also, government borrowing from the people reduces the savings
available to the private sector. To the extent that this reduces capital
formation and growth, debt acts as a ‘burden’ on future generations.
Traditionally, it has been argued that when a government cuts taxes and
runs a budget deficit, consumers respond to their after -tax income by
spending more. It is possible that these people are short-sighted and do not
understand the implications of budget deficits. They may not realise that at
some point in the future, the government will have to raise taxes to pay off
the debt and accumulated interest. Even if they comprehend this, they may
expect the future taxes to fall not on them but on future generations.
A counter argument is that consumers are forward-looking and will base
their spending not only on their current income but also on their expected
future income. They will understand that borrowing today means higher
taxes in the future. Further, the consumer will be concerned about future
generations because they are the children and grandchildren of the present
generation and the family which is the relevant decision making unit,
continues living. They would increase savings now, which will fully offset
the increased government dissaving so that national savings do not change.
This view is called Ricardian equivalence after one of the greatest
nineteenth century economists, David Ricardo, who first argued that in
the face of high deficits, people save more. It is called ‘equivalence’ because
it argues that taxation and borrowing are equivalent means of financing
expenditure. When the government increases spending by borrowing today,
which will be repaid by taxes in the future, it will have the same impact on
the economy as an increase in government expenditure that is financed by
a tax increase today.
It has often been argued that ‘debt does not matter because we owe it 79
to ourselves’. This is because although there is a transfer of resources

and the Economy

Government Budget
between generations, purchasing power remains within the nation.
However, any debt that is owed to foreigners involves a burden since we
have to send goods abroad corresponding to the interest payments.
Other Perspectives on Deficits and Debt: One of the main criticisms of
deficits is that they are inflationary. This is because when government
increases spending or cuts taxes, aggregate demand increases. Firms may
not be able to produce higher quantities that are being demanded at the
ongoing prices. Prices will, therefore, have to rise. However, if there are
unutilised resources, output is held back by lack of demand. A high fiscal
deficit is accompanied by higher demand and greater output and, therefore,
need not be inflationary.
It has been argued that there is a decrease in investment due to a reduction
in the amount of savings available to the private sector. This is because if
the government decides to borrow from private citizens by issuing bonds to
finance its deficits, these bonds will compete with corporate bonds and other
financial instruments for the available supply of funds. If some private savers
decide to buy bonds, the funds remaining to be invested in private hands will be
smaller. Thus, some private borrowers will get ‘crowded out’ of the financial
markets as the government claims an increasing share of the economy’s total
savings. However, one must note that the economy’s flow of savings is not really

2020-21
 fixed unless we assume that income cannot be augmented. If government deficits
succeed in their goal of raising production, there will be more income and,
therefore, more saving. In this case, both government and industry can borrow
more.
Also, if the government invests in infrastructure, future generations may
be better off, provided the return on such investments is greater than the
rate of interest. The actual debt could be paid off by the growth in output.
The debt should not then be considered burdensome. The growth in debt
will have to be judged by the growth of the economy as a whole.
Deficit Reduction: Government deficit can be reduced by an increase in
taxes or reduction in expenditure. In India, the government has been
trying to increase tax revenue with greater reliance on direct taxes (indirect
taxes are regressive in nature – they impact all income groups equally).
There has also been an attempt to raise receipts through the sale of
shares in PSUs. However, the major thrust has been towards reduction
in government expenditure. This could be achieved through making
government activities more efficient through better planning of
programmes and better administration. A recent study7 by the Planning
Commission has estimated that to transfer Re1 to the poor, government
spends Rs 3.65 in the form of food subsidy, showing that cash transfers
would lead to increase in welfare. The other way is to change the scope
of the government by withdrawing from some of the areas where it
operated before. Cutting back government programmes in vital areas
like agriculture, education, health, poverty alleviation, etc. would
adversely affect the economy. Governments in many countries run huge
deficits forcing them to eventually put in place self-imposed constraints
of not increasing expenditure over pre-determined levels (Box 5.2 gives the
main features of the FRBMA in India). These will have to be examined keeping
in view the above factors. We must note that larger deficits do not always
signify a more expansionary fiscal policy. The same fiscal measures can
give rise to a large or small deficit, depending on the state of the economy.
For example, if an economy experiences a recession and GDP falls, tax
80 revenues fall because firms and households pay lower taxes when they earn
less. This means that the deficit increases in a recession and falls in a
Introductory Macroeconomics

boom, even with no change in fiscal policy.

7
“Performance Evaluation of the Targeted Public Distribution System” by the Programme
Evaluation Organisation, Planning Commission.

2020-21
Summary

1. Public goods, as distinct from private goods, are collectively consumed.

Two important features of public goods are – they are non-rivalrous in that
one person can increase her satisfaction from the good without reducing
that obtained by others and they are non-excludable, and there is no
feasible way of excluding anyone from enjoying the benefits of the good.
These make it difficult to collect fees for their use and private enterprise
will in general not provide these goods. Hence, they must be provided by
the government.
2. The three functions of allocation, redistribution and stabilisation operate
through the expenditure and receipts of the government.
3. The budget, which gives a statement of the receipts and expenditure of the
government, is divided into the revenue budget and capital budget to
distinguish between current financial needs and investment in the country’s
capital stock.
4. The growth of revenue deficit as a percentage of fiscal deficit points to a
deterioration in the quality of government expenditure involving lower capital
formation.
5. Proportional taxes reduce the autonomous expenditure multiplier because
taxes reduce the marginal propensity to consume out of income.
6. Public debt is burdensome if it reduces future growth in output.
Key Concepts

Public goods
Automatic stabiliser
Discretionary fiscal policy
Ricardian equivalence

Box 5.2: Fiscal Responsibility and Budget Management Act, 2003 (FRBMA)
In a multi-party parliamentary system, electoral concerns play an 81
important role in determining expenditure policies. A legislative provision,

and the Economy

Government Budget
it is argued, that is applicable to all governments – present and future –
is likely to be effective in keeping deficits under control. The enactment
of the FRBMA, in August 2003, marked a turning point in fiscal reforms,
binding the government through an institutional framework to pursue a
prudent fiscal policy. The central government must ensure inter-
generational equity and long-term macro-economic stability by achieving
sufficient revenue surplus, removing fiscal obstacles to monetary policy
and effective debt management by limiting deficits and borrowing. The
rules under the Act were notified with effect from July, 2004.
Main Features
1. The Act mandates the central government to take appropriate measures
to reduce fiscal deficit to not more than 3 percent of GDP and to eliminate
the revenue deficit by March 31, 20098 and thereafter build up adequate
revenue surplus.
2. It requires the reduction in fiscal deficit by 0.3 per cent of GDP each
year and the revenue deficit by 0.5 per cent. If this is not achieved

8
This has been rescheduled by one year to 2009-10, primarily on account of a shift in
plan priorities in favour of revenue expenditure - intensive programmes and schemes.

2020-21
 through tax revenues, the necessary adjustment has to come from a
reduction in expenditure.
3. The actual deficits may exceed the targets specified only on grounds of
national security or natural calamity or such other exceptional grounds
as the central government may specify.
4. The central government shall not borrow from the Reserve Bank of India
except by way of advances to meet temporary excess of cash disbursements
over cash receipts.
5. The Reserve Bank of India must not subscribe to the primary issues of
central government securities from the year 2006-07.
6. Measures to be taken to ensure greater transparency in fiscal operations.
7. The central government to lay before both Houses of Parliament three
statements – Medium-term Fiscal Policy Statement, The Fiscal Policy
Strategy Statement, The Macroeconomic Framework Statement along
with the Annual Financial Statement.
8. Quarterly review of the trends in receipts and expenditure in relation to
the budget be placed before both Houses of Parliament.
The act applies to the central government. However, 26 states have
already enacted fiscal responsibility legislations which have made the
rule based fiscal reform programme of the government more broad
based. Although the government has emphasised that the FRBMA is an
important instituional mechanism to ensure fiscal prudence and support
macro economic balance there have been fears that welfare expenditure
may get reduced to meet the targets mandated by the Act.
FRBM Review Committee
In the last thirteen years since the FRBM act was enacted, the Indian
economy has graduated to a middle income country. At the time of
enactment of the FRBM, there was a general thinking that fiscal rules
were better than discretion. However, since then the advanced countries
have moved away from this but in India, the government has affirmed its
faith in the fiscal policy principles set out in the FRBM. Therefore, there
82
is support for retaining the basic operational framework designed in
Introductory Macroeconomics

2003 but to revamp it to incorporate the changing scenario in India and

also with an eye for the future path of growth – the task that has been
handed to the FRBM Review Committee.

Box 5.3: GST: One Nation, One Tax, One Market

Goods and Service Tax (GST) is the single comprehensive indirect tax,
operational from 1 July 2017, on supply of goods and services, right from the
manufacturer/ service provider to the consumer. It is a destination based
consumption tax with facility of Input Tax Credit in the supply chain. It is
applicable throughout the country with one rate for one type of goods/service.
It has amalgamated a large number of Central and State taxes and cesses. It
has replaced large number of taxes on goods and services levied on production/
sale of goods or provision of service.
As there have been a number of intermediate goods/services, which
were manufactured/provided in the economy, the pre GST tax regime
imposed taxes not on the value added at each stage but on the total value
of the commodity/service with minimal facility of utilisation of Input Tax

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 Credit (ITC). The total value included taxes paid on intermediate goods/services.
This amounted to cascading of tax. Under GST, the tax is discharged at every
stage of supply and the credit of tax paid at the previous stage is available for
set off at the next stage of supply of goods and/or services. It is thus effectively
a tax on value addition at each stage of supply. In view of our large and fast
growing economy, it addresses to establish parity in taxation across the
country, and extend principles of ‘value- added taxation’ to all goods and
services.
It has replaced various types of taxes/cesses, levied by the Central
and State/UT Governments. Some of the major taxes that were levied by
Centre were Central Excise Duty, Service Tax, Central Sales Tax, Cesses
like KKC and SBC. The major State taxes were VAT/Sales Tax, Entry Tax,
Luxury Tax, Octroi, Entertainment Tax, Taxes on Advertisements, Taxes
on Lottery /Betting/ Gambling, State Cesses on goods etc. These have
been subsumed in GST.
Five petroleum products have been kept out of GST for the time being
but with passage of time, they will get subsumed in GST. State Governments
will continue to levy VAT on alcoholic liquor for human consumption.
Tobacco and tobacco products will attract both GST and Central Excise
Duty. Under GST, there are 6 (six) standard rates applied i.e. 0%, 3%,5%,
12%,18% and 28% on supply of all goods and/or services across the
country.
GST is the biggest tax reform in the country since independence and
was rolled out on the mid-night of 30 June/1 July, 2017 during a special
midnight session of the Parliament. The 101th Constitution Amendment Act
received assent of the President of India on 8 September, 2016. The amendment
introduced Article 246A in the Constitution cross empowering Parliament and
Legislatures of States to make laws with reference to Goods and Service Tax
imposed by the Union and the States. Thereafter CGST Act, UTGST Act and
SGST Acts were enacted for GST. GST has simplified the multiplicity of taxes
on goods and services. The laws, procedures and rates of taxes across the
country are standardised. It has facilitated the freedom of movement of goods
and services and created a common market in the country. It is aimed at 83
reducing the cost of business operations and cascading effect of various taxes

and the Economy

Government Budget
on consumers. It has also reduced the overall cost of production, which will
make Indian products/services more competitive in the domestic and
international markets. It will also result into higher economic growth as GDP
is expected to rise by about 2%. Compliance will also be easier as all tax payment
related services like registration, returns, payments are available online
through a common portal [Link]. It has expanded the tax base,
introduced higher transparency in the taxation system, reduced human
interface between Taxpayer and Government and is furthering ease of
doing business.

? 1. Explain why public goods must be provided by the government.

Exercises

2. Distinguish between revenue expenditure and capital expenditure.

3. ‘The fiscal deficit gives the borrowing requirement of the government’.
Elucidate.
4. Give the relationship between the revenue deficit and the fiscal deficit.
5. Suppose that for a particular economy, investment is equal to 200,
government purchases are 150, net taxes (that is lump-sum taxes minus
transfers) is 100 and consumption is given by C = 100 + 0.75Y (a) What

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 is the level of equilibrium income? (b) Calculate the value of the government
expenditure multiplier and the tax multiplier. (c) If government expenditure
increases by 200, find the change in equilibrium income.
6. Consider an economy described by the following functions: C = 20 +
0.80Y, I = 30, G = 50, TR = 100 (a) Find the equilibrium level of income
and the autonomous expenditure multiplier in the model. (b) If government
expenditure increases by 30, what is the impact on equilibrium income?
(c) If a lump-sum tax of 30 is added to pay for the increase in government
purchases, how will equilibrium income change?
7. In the above question, calculate the effect on output of a 10 per cent
increase in transfers, and a 10 per cent increase in lump-sum taxes. Compare
the effects of the two.
8. We suppose that C = 70 + 0.70Y D, I = 90, G = 100, T = 0.10Y (a) Find
the equilibrium income. (b) What are tax revenues at equilibrium income?
Does the government have a balanced budget?
9. Suppose marginal propensity to consume is 0.75 and there is a 20 per
cent proportional income tax. Find the change in equilibrium income for
the following (a) Government purchases increase by 20 (b) Transfers
decrease by 20.
10. Explain why the tax multiplier is smaller in absolute value than the
government expenditure multiplier.
11. Explain the relation between government deficit and government debt.
12. Does public debt impose a burden? Explain.
13. Are fiscal deficits inflationary?

?
14. Discuss the issue of deficit reduction.
15. What do you understand by G.S.T? How good is the system of G.S.T as
compared to the old tax system? State its categories.

84
Suggested Readings
Introductory Macroeconomics

1. Dornbusch, R. and S. Fischer. 1994. Macroeconomics, sixth edition.

McGraw-Hill, Paris.
2. Mankiw, N.G., 2000. Macroeconomics, fourth edition. Macmillan Worth
publishers, New York.
3. Economic Survey, Government of India, various issues.

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 Open Economy
Macroeconomics

An open economy is one which interacts with other countries

through various channels. So far we had not considered
this aspect and just limited to a closed economy in which
there are no linkages with the rest of the world in order to
simplify our analysis and explain the basic macroeconomic
mechanisms. In reality, most modern economies are open.
There are three ways in which these linkages are
established.
1. Output Market: An economy can trade in goods and
services with other countries. This widens choice in the
sense that consumers and producers can choose between
domestic and foreign goods.
2. Financial Market: Most often an economy can buy
financial assets from other countries. This gives
investors the opportunity to choose between domestic
and foreign assets.
3. Labour Market: Firms can choose where to locate
production and workers to choose where to work. There
are various immigration laws which restrict the
movement of labour between countries.
Movement of goods has traditionally been seen as a
substitute for the movement of labour. We focus on the
first two linkages. Thus, an open economy is said to be one
that trades with other nations in goods and services and
most often, also in financial assets. Indians for instance,
can consume products which are produced around the world
and some of the products from India are exported to other
countries.
Foreign trade, therefore, influences Indian aggregate
demand in two ways. First, when Indians buy foreign goods,
this spending escapes as a leakage from the circular flow
of income decreasing aggregate demand. Second, our exports
to foreigners enter as an injection into the circular flow,
increasing aggregate demand for goods produced within the
domestic economy.
When goods move across national borders, money must
be used for the transactions. At the international level there
is no single currency that is issued by a single bank. Foreign

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 economic agents will accept a national currency only if they are convinced that
the amount of goods they can buy with a certain amount of that currency will
not change frequently. In other words, the currency will maintain a stable
purchasing power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is no
international authority with the power to force the use of a particular currency
in international transactions.
In the past, governments have tried to gain confidence of potential
users by announcing that the national currency will be freely convertible
at a fixed price into another asset. Also, the issuing authority will have
no control over the value of that asset into which the currency can be
converted. This other asset most often has been gold, or other national
currencies. There are two aspects of this commitment that has affected
its credibility — the ability to convert freely in unlimited amounts and the price
at which this conversion takes place. The international monetary system has
been set up to handle these issues and ensure stability in international
transactions.
With the increase in the volume of transactions, gold ceased to be the
asset into which national currencies could be converted (See Box 6.2).
Although some national currencies have international acceptability, what is
important in transactions between two countries is the currency in which
the trade occurs. For instance, if an Indian wants to buy a good made in
America, she would need dollars to complete the transaction. If the price of
the good is ten dollars, she would need to know how much it would cost her
in Indian rupees. That is, she will need to know the price of dollar in terms of
rupees. The price of one currency in terms of another currency is known as
the foreign exchange rate or simply the exchange rate. We will discuss
this in detail in section 6.2.

6.1 THE BALANCE OF PAYMENTS

86
The balance of payments (BoP) record the transactions in goods, services and assets
Introductory Macroeconomics

between residents of a country with the rest of the world for a specified time period
typically a year. There are two main accounts in the BoP — the current account
and the capital account1.

6.1.1 Current Account

Current Account is the record of trade in goods and services and transfer
payments. Figure 6.1 illustrates the components of Current Account.
Trade in goods includes exports and imports of goods. Trade in services
includes factor income and non-factor income transactions. Transfer
payments are the receipts which the residents of a country get for
‘free’, without having to provide any goods or services in return. They
consist of gifts, remittances and grants. They could be given by the
government or by private citizens living abroad.

1
There is a new classification in which the balance of payments have been divided into three
accounts — the current account, the financial account and the capital account. This is as per the
new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of
the Balance of Payments and International Investment Position Manual (BPM6). India has also
made the change but the Reserve Bank of India continues to publish data accounting to the old
classification.

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 Buying foreign goods is expenditure from our country and it becomes the
income of that foreign country. Hence, the purchase of foreign goods or imports
decreases the domestic demand for goods and services in our country. Similarly,
selling of foreign goods or exports brings income to our country and adds to the
aggregate domestic demand for goods and services in our country.

Fig. 6.1: Components of Current Account

Balance on Current Account

Current Account is in balance when receipts on current account are
equal to the payments on the current account. A surplus current account
means that the nation is a lender to other countries and a deficit current
account means that the nation is a borrower from other countries.
87

Macroeconomics
Open Economy
Current Account Balanced Current Current Account
Surplus Account Deficit

Receipts > Payments Receipts = Payments Receipts < Payments

Balance on Current Account has two components:

• ·Balance of Trade or Trade Balance
• ·Balance on Invisibles
Balance of Trade (BOT) is the difference between the value of exports
and value of imports of goods of a country in a given period of time.
Export of goods is entered as a credit item in BOT, whereas import of
goods is entered as a debit item in BOT. It is also known as Trade
Balance.
BOT is said to be in balance when exports of goods are equal to the
imports of goods. Surplus BOT or Trade surplus will arise if country
exports more goods than what it imports. Whereas, Deficit BOT or Trade
deficit will arise if a country imports more goods than what it exports.
Net Invisibles is the difference between the value of exports and value

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 of imports of invisibles of a country in a given period of time. Invisibles
include services, transfers and flows of income that take place between
different countries. Services trade includes both factor and non-factor
income. Factor income includes net international earnings on factors
of production (like labour, land and capital). Non-factor income is net
sale of service products like shipping, banking, tourism, software
services, etc.

6.1.2 Capital Account

Capital Account records all international transactions of assets. An
asset is any one of the forms in which wealth can be held, for example:
money, stocks, bonds, Government debt, etc. Purchase of assets is a
debit item on the capital account. If an Indian buys a UK Car Company,
it enters capital account transactions as a debit item (as foreign
exchange is flowing out of India). On the other hand, sale of assets like
sale of share of an Indian company to a Chinese customer is a credit
item on the capital account. Fig. 6.2 classifies the items which are a
part of capital account transactions. These items are Foreign Direct
Investments (FDIs), Foreign Institutional Investments (FIIs), external
borrowings and assistance.

Fig. 6.2: Components of Capital Account

88
Introductory Macroeconomics

Balance on Capital Account

Capital account is in balance when capital inflows (like receipt of loans
from abroad, sale of assets or shares in foreign companies) are equal to
capital outflows (like repayment of loans, purchase of assets or shares
in foreign countries). Surplus in capital account arises when capital
inflows are greater than capital outflows, whereas deficit in capital
account arises when capital inflows are lesser than capital outflows.

6.1.3 Balance of Payments Surplus and Deficit

The essence of international payments is that just like an individual
who spends more than her income must finance the difference by selling
assets or by borrowing, a country that has a deficit in its current account

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(spending more than it receives from sales to the rest of the world)
must finance it by selling assets or by borrowing abroad. Thus, any
current account deficit must be financed by a capital account surplus,
that is, a net capital inflow.
Current account + Capital account ≡ 0
In this case, in which a country is said to be in balance of payments
equilibrium, the current account deficit is financed entirely by
international lending without any reserve movements.
Alternatively, the country could use its reserves of foreign exchange
in order to balance any deficit in its balance of payments. The reserve
bank sells foreign exchange when there is a deficit. This is called official
reserve sale. The decrease (increase) in official reserves is called the
overall balance of payments deficit (surplus). The basic premise is that
the monetary authorities are the ultimate financiers of any deficit in
the balance of payments (or the recipients of any surplus).
We note that official reserve transactions are more relevant under a
regime of fixed exchange rates than when exchange rates are floating.
(See sub heading ‘Fixed Exchange Rates’ under section 6.2.2)
Autonomous and Accommodating Transactions
International economic transactions are called autonomous when
transactions are made due to some reason other than to bridge the gap
in the balance of payments, that is, when they are independent of the
state of BoP. One reason could be to earn profit. These items are called
‘above the line’ items in the BoP. The balance of payments is said to be
in surplus (deficit) if autonomous receipts are greater (less) than
autonomous payments.
Accommodating transactions (termed ‘below the line’ items), on the
other hand, are determined by the gap in the balance of payments, that
is, whether there is a deficit or surplus in the balance of payments. In 89
other words, they are determined by the net consequences of the

Macroeconomics
Open Economy
autonomous transactions. Since the official reserve transactions are
made to bridge the gap in the BoP, they are seen as the accommodating
item in the BoP (all others being autonomous).
Errors and Omissions
It is difficult to record all international transactions accurately. Thus,
we have a third element of BoP (apart from the current and capital
accounts) called errors and omissions which reflects this.
Table 6.1 provides a sample of Balance of Payments for India.
Note in this table, there is a trade deficit and current account deficit
but a capital account surplus. As a result, BOP is in balance.

BoP Deficit Balanced BoP BoP Surplus

Overall Balance < 0 Overall Balance = 0 Overall Balance > 0
Reserve Change > 0 Reserve Change = 0 Reserve Change < 0

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 Box 6.1: The balance of payments accounts presented above divide the
transactions into two accounts, current account and capital account.
However, following the new accounting standards introduced by the
International Monetary Fund in the sixth edition of the Balance of Payments
and International Investment Position Manual (BPM6) the Reserve Bank of
India also made changes in the structure of balance of payments accounts.
According to the new classification, the transactions are divided into three
accounts: current account, financial account and capital account. The most
important change is that almost all the transactions arising on account of
trade in financial assets such as bonds and equity shares are now placed
in the financial account. However, RBI continues to publish the balance of
payments accounts as per the old system also, therefore the details of the
new system are not being given here. The details are given in the Balance of
Payments Manual for India published by the Reserve Bank of India in
September 2010.

Table 6.1: Balance of Payments for India (in million USD)

No. Item Million USD

1. Exports (of goods only) 150

2. Imports (of goods only) 240
3. Trade Balance [2 – 1] –90
4. (Net) Invisibles [4a + 4b + 4c] 52
a. Non-factor Services 30
90
b. Income –10
Introductory Macroeconomics

c. Transfers 32
5. Current Account Balance [ 3+ 4] –38
6. Capital Account Balance 41.15
[6a + 6b + 6c + 6d + 6e + 6f]
a. External Assistance (net) 0.15
b. External Commercial Borrowings (net) 2
c. Short-term Debt 10
d. Banking Capital (net) of which 15
Non-resident Deposits (net) 9
e. Foreign Investments (net) of which 19
[6eA + 6eB]
A. FDI (net) 13

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 B. Portfolio (net) 6
f. Other Flows (net) –5
7. Errors and Omissions 3.15
8. Overall Balance [5 + 6 + 7] 0

9. Reserves Change 0

6.2 THE FOREIGN EXCHANGE MARKET

So far, we have considered the accounting of international transactions on the
whole, we will now take up a single transaction. Let us assume that a single
Indian resident wants to visit London on a vacation (an import of tourist services).
She will have to pay in pounds for her stay there. She will need to know where to
obtain the pounds and at what price. As mentioned at the beginning of this
chapter, this price is known as the exchange rate. The market in which national
currencies are traded for one another is known as the foreign exchange market.
The major participants in the foreign exchange market are commercial banks,
foreign exchange brokers and other authorised dealers and monetary authorities.
It is important to note that although participants themselves may have their
own trading centres , the market itself is world-wide. There is a close and
continuous contact between the trading centres and the participants deal in
more than one market.

6.2.1 Foreign Exchange Rate

Foreign Exchange Rate (also called Forex Rate) is the price of one currency in
terms of another. It links the currencies of different countries and enables
comparison of international costs and prices. For example, if we have to pay Rs 91
50 for $1 then the exchange rate is Rs 50 per dollar.

Macroeconomics
Open Economy
To make it simple, let us consider that India and USA are the only countries
in the world and so there is only one exchange rate that needs to be determined.
Demand for Foreign Exchange
People demand foreign exchange because: they want to purchase goods and
services from other countries; they want to send gifts abroad; and, they want to
purchase financial assets of a certain country.
A rise in price of foreign exchange will increase the cost (in terms of
rupees) of purchasing a foreign good. This reduces demand for imports
and hence demand for foreign exchange also decreases, other things
remaining constant.
Supply of Foreign Exchange
Foreign currency flows into the home country due to the following
reasons: exports by a country lead to the purchase of its domestic
goods and services by the foreigners; foreigners send gifts or make
transfers; and, the assets of a home country are bought by the foreigners.
A rise in price of foreign exchange will reduce the foreigner’s cost (in terms of
USD) while purchasing products from India, other things remaining constant.
This increases India’s exports and hence supply for foreign exchange may

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 increase (whether it actually increases depends on a number of factors,
particularly elasticity of demand for exports and imports.

6.2.2 Determination of the Exchange Rate

Different countries have different methods of determining their currency’s
exchange rate. It can be determined through Flexible Exchange Rate, Fixed
Exchange Rate or Managed Floating Exchange Rate.
Flexible Exchange Rate
This exchange rate is determined by the market forces of demand and supply. It
is also known as Floating Exchange Rate. As depicted in Fig. 6.1, the
exchange rate is determined where the demand curve intersects with the supply
curve, i.e., at point e on the Y – axis. Point q on the x – axis determines the
quantity of US Dollars that have been demanded and supplied on e exchange
rate. In a completely flexible
system, the Central banks do not
intervene in the foreign exchange
market.
Suppose the demand for
foreign goods and services
increases (for example, due to
increased international
travelling by Indians), then as
depicted in Fig. 6.2, the demand
curve shifts upward and right to
the original demand curve. The
increase in demand for foreign
goods and services result in a
change in the exchange rate. The Equilibrium under Flexible Exchange Rates
initial exchange rate e 0 = 50,
92 which means that we need to exchange Rs 50 for one dollar. At the new
equilibrium, the exchange rate becomes e 1 = 70, which means that we need
Introductory Macroeconomics

to pay more rupees for a dollar now (i.e., Rs 70). It indicates that the value of
rupees in terms of dollars has fallen and value of dollar in terms of rupees
has risen. Increase in exchange
rate implies that the price of
foreign currency (dollar) in Rs/$ D
terms of domestic currency D
(rupees) has increased. This is S
called Depreciation of domestic
currency (rupees) in terms of e1
foreign currency (dollars). e*
Similarly, in a flexible D'
exchange rate regime, when the
price of domestic currency D
(rupees) in terms of foreign S
currency (dollars) increases, it is
called Appreciation of the $
Fig. 6.2
domestic currency (rupees) in
t e r m s o f f o r e i g n c u r r e n c y Effect of an Increase in Demand for Imports in
(dollars). This means that the the Foreign Exchange Market

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value of rupees relative to dollar has risen and we need to pay fewer rupees
in exchange for one dollar.
Speculation
Money in any country is an asset. If Indians believe that British pound is going
to increase in value relative to the rupee, they will want to hold pounds. Thus
exchange rates also get affected when people hold foreign exchange on the
expectation that they can make gains from the appreciation of the currency.
This expectation in turn can actually affect the exchange rate in the following
way. If the current exchange rate is Rs. 80 to a pound and investors believe that
the pound is going to appreciate by the end of the month and will be worth
Rs.85, investors think if they gave the dealer Rs. 80,000 and bought 1000
pounds, at the end of the month, they would be able to exchange the pounds for
Rs. 85,000, thus making a profit of Rs. 5,000. This expectation would increase
the demand for pounds and cause the rupee-pound exchange rate to increase
in the present, making the beliefs self-fulfilling.
Interest Rates and the Exchange Rate
In the short run, another factor that is important in determining exchange rate
movements is the interest rate differential i.e. the difference between interest
rates between countries. There are huge funds owned by banks, multinational
corporations and wealthy individuals which move around the world in search of
the highest interest rates. If we assume that government bonds in country A pay
8 per cent rate of interest whereas equally safe bonds in county B yield 10 per
cent, the interest rate differential is 2 per cent. Investors from country A will be
attracted by the high interest rates in country B and will buy the currency of
country B selling their own currency. At the same time investors in country B
will also find investing in their own country more attractive and will therefore
demand less of country A’s currency. This means that the demand curve for
country A’s currency will shift to the left and the supply curve will shift to the
right causing a depreciation of country A’s currency and an appreciation of 93
country B’s currency. Thus, a rise in the interest rates at home often leads to an

Macroeconomics
Open Economy
appreciation of the domestic currency. Here, the implicit assumption is that no
restrictions exist in buying bonds issued by foreign governments.
Income and the Exchange Rate
When income increases, consumer spending increases. Spending on imported
goods is also likely to increase. When imports increase, the demand curve for
foreign exchange shifts to the right. There is a depreciation of the domestic
currency. If there is an increase in income abroad as well, domestic exports will
rise and the supply curve of foreign exchange shifts outward. On balance, the
domestic currency may or may not depreciate. What happens will depend on
whether exports are growing faster than imports. In general, other things
remaining equal, a country whose aggregate demand grows faster than the rest
of the world’s normally finds its currency depreciating because its imports grow
faster than its exports. Its demand curve for foreign currency shifts faster than
its supply curve.
Exchange Rates in the Long Run
The purchasing Power (PPP) theory is used to make long-run predictions about
exchange rates in a flexible exchange rate system. According to the theory, as
long as there are no barriers to trade like tariffs (taxes on trade) and quotas

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 (quantitative limits on imports), exchange rates should eventually adjust so that
the same product costs the same whether measured in rupees in India, or dollars
in the US, yen in Japan and so on, except for differences in transportation. Over
the long run, therefore, exchange rates between any two national currencies
adjust to reflect differences in the price levels in the two countries.

EXAMPLE 6.1
If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar exchange rate
should be Rs 50. To see why, at any rate higher than Rs 50, say Rs 60, it costs
Rs 480 per shirt in the US but only Rs 400 in India. In that case, all foreign
customers would buy shirts from India. Similarly, any exchange rate below Rs
50 per dollar will send all the shirt business to the US. Next, we suppose that
prices in India rise by 20 per cent while prices in the US rise by 50 per cent.
Indian shirts would now cost Rs 480 per shirt while American shirts cost $12
per shirt. For these two prices to be equivalent, $12 must be worth Rs 480, or
one dollar must be worth Rs 40. The dollar, therefore, has depreciated.

Fixed Exchange Rates

In this exchange rate system, the Government fixes the exchange rate
at a particular level. In Fig. 6.3, the market determined exchange rate
is e. However, let us suppose that for some reason the Indian Government wants
to encourage exports for which it needs to make rupee cheaper for foreigners it
would do so by fixing a higher exchange rate, say Rs 70 per dollar from the
current exchange rate of Rs 50 per
dollar. Thus, the new exchange
rate set by the Government is e1,
where e1 > e. At this exchange rate,
the supply of dollars exceeds the
demand for dollars. The RBI
94 intervenes to purchase the dollars
for rupees in the foreign exchange
Introductory Macroeconomics

2
market in order to absorb this
excess supply which has been
marked as AB in the figure. Thus,
through intervention, the
Government can maintain any
exchange rate in the economy. But
it will be accumulating more and
more foreign exchange so long as Foreign Exchange Market with Fixed Exchange
this intervention goes on. On the Rates
other hand if the goverment was to
set an exchange rate at a level such as e2, there would be an excess demand for
dollars in the foreign exchange market. To meet this excess demand for dollars,
the government would have to withdraw dollars from its past holdings of dollars.
If it fails to do so, a black market for dollars may come up.
In a fixed exchange rate system, when some government action increases the
exchange rate (thereby, making domestic currency cheaper) is called Devaluation.
On the other hand, a Revaluation is said to occur, when the Government decreases
the exchange rate (thereby, making domestic currency costlier) in a fixed exchange
rate system.

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6.2.3 Merits and Demerits of Flexible and Fixed Exchange Rate Systems
The main feature of the fixed exchange rate system is that there must be
credibility that the government will be able to maintain the exchange rate at the
level specified. Often, if there is a deficit in the BoP, in a fixed exchange rate
system, governments will have to intervene to take care of the gap by use of its
official reserves. If people know that the amount of reserves is inadequate, they
would begin to doubt the ability of the government to maintain the fixed rate.
This may give rise to speculation of devaluation. When this belief translates into
aggressive buying of one currency thereby forcing the government to devalue, it
is said to constitute a speculative attack on a currency. Fixed exchange rates
are prone to these kinds of attacks, as has been witnessed in the period before
the collapse of the Bretton Woods System.
The flexible exchange rate system gives the government more flexibility and
they do not need to maintain large stocks of foreign exchange reserves. The
major advantage of flexible exchange rates is that movements in the exchange
rate automatically take care of the surpluses and deficits in the BoP. Also,
countries gain independence in conducting their monetary policies, since they
do not have to intervene to maintain exchange rate which are automatically
taken care of by the market.

6.2.4 Managed Floating

Without any formal international agreement, the world has moved on to what can
be best described as a managed floating exchange rate system. It is a mixture of a
flexible exchange rate system (the float part) and a fixed rate system (the managed
part). Under this system, also called dirty floating, central banks intervene to buy
and sell foreign currencies in an attempt to moderate exchange rate movements
whenever they feel that such actions are appropriate. Official reserve transactions
are, therefore, not equal to zero. 95

Macroeconomics
Open Economy
Box 6.2 Exchange Rate Management: The International Experience
The Gold Standard: From around 1870 to the outbreak of the First World
War in 1914, the prevailing system was the gold standard which was the
epitome of the fixed exchange rate system. All currencies were defined in
terms of gold; indeed some were actually made of gold. Each participant
country committed to guarantee the free convertibility of its currency into
gold at a fixed price. This meant that residents had, at their disposal, a
domestic currency which was freely convertible at a fixed price into another
asset (gold) acceptable in international payments. This also made it possible
for each currency to be convertible into all others at a fixed price. Exchange
rates were determined by its worth in terms of gold (where the currency
was made of gold, its actual gold content). For example, if one unit of say
currency A was worth one gram of gold, one unit of currency B was worth
two grams of gold, currency B would be worth twice as much as currency A.
Economic agents could directly convert one unit of currency B into two
units of currency A, without having to first buy gold and then sell it. The
rates would fluctuate between an upper and a lower limit, these limits being
set by the costs of melting, shipping and recoining between the two

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 Currencies3. To maintain the official parity each country needed an adequate
stock of gold reserves. All countries on the gold standard had stable exchange
rates.
The question arose – would not a country lose all its stock of gold if it
imported too much (and had a BoP deficit)? The mercantilist4 explanation
was that unless the state intervened, through tariffs or quotas or subsidies,
on exports, a country would lose its gold and that was considered one of the
worst tragedies. David Hume, a noted philosopher writing in 1752, refuted
this view and pointed out that if the stock of gold went down, all prices and
costs would fall commensurately and no one in the country would be worse
off. Also, with cheaper goods at home, imports would fall and exports rise (it
is the real exchange rate which will determine competitiveness). The country
from which we were importing and making payments in gold would face an
increase in prices and costs, so their now expensive exports would fall and
their imports of the first country’s now cheap goods would go up. The result
of this price-specie-flow (precious metals were referred to as ‘specie’ in the
eighteenth century) mechanism is normally to improve the BoP of the
country losing gold, and worsen that of the country with the favourable
trade balance, until equilibrium in international trade is re-established at
relative prices that keep imports and exports in balance with no further
net gold flow. The equilibrium is stable and self-correcting, requiring no
tariffs and state action. Thus, fixed exchange rates were maintained by an
automatic equilibrating mechanism.
Several crises caused the gold standard to break down periodically.
Moreover, world price levels were at the mercy of gold discoveries. This
can be explained by looking at the crude Quantity Theory of Money, M
= kPY, according to which, if output (GNP) increased at the rate of 4 per
cent per year, the gold supply would have to increase by 4 per cent per
year to keep prices stable. With mines not producing this much gold, price
levels were falling all over the world in the late nineteenth century, giving
rise to social unrest. For a period, silver supplemented gold introducing
96 ‘bimetallism’. Also, fractional reserve banking helped to economise on gold.
Paper currency was not entirely backed by gold; typically countries held
Introductory Macroeconomics

one-fourth gold against its paper currency. Another way of economising on

gold was the gold exchange standard which was adopted by many countries
which kept their money exchangeable at fixed prices with respect to gold but
held little or no gold. Instead of gold, they held the currency of some large
country (the United States or the United Kingdom) which was on the gold
standard. All these and the discovery of gold in Klondike and South Africa
helped keep deflation at bay till 1929. Some economic historians attribute
the Great Depression to this shortage of liquidity. During 1914-45, there was
no maintained universal system but this period saw both a brief return to
the gold standard and a period of flexible exchange rates.
The Bretton Woods System: The Bretton Woods Conference held in
1944 set up the International Monetary Fund (IMF) and the World Bank
and reestablished a system of fixed exchange rates. This was different from
the international gold standard in the choice of the asset in which national
currencies would be convertible. A two-tier system of convertibility was
established at the centre of which was the dollar. The US monetary

3
If the difference in the rates were more than those transaction costs, profits could be
made through arbitrage, the process of buying a currency cheap and selling it dear.
4
Mercantilist thought was associated with the rise of the nation-state in Europe during
the sixteenth and seventeenth centuries.

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authorities guaranteed the convertibility of the dollar into gold at the fixed
price of $35 per ounce of gold. The second-tier of the system was the
commitment of monetary authority of each IMF member participating in
the system to convert their currency into dollars at a fixed price. The latter
was called the official exchange rate. For instance, if French francs could
be exchanged for dollars at roughly 5 francs per dollar, the dollars could
then be exchanged for gold at $35 per ounce, which fixed the value of the
franc at 175 francs per ounce of gold (5 francs per dollar times 35 dollars
per ounce). A change in exchange rates was to be permitted only in case of
a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a
chronic deficit in the BoP of sizeable proportions.
Such an elaborate system of convertibility was necessary because the
distribution of gold reserves across countries was uneven with the US
having almost 70 per cent of the official world gold reserves. Thus, a credible
gold convertibility of the other currencies would have required a massive
redistribution of the gold stock. Further, it was believed that the existing
gold stock would be insufficient to sustain the growing demand for
international liquidity. One way to save on gold, then, was a two-tier
convertible system, where the key currency would be convertible into gold
and the other currencies into the key currency.
In the post–World War II scenario, countries devastated by the war
needed enormous resources for reconstruction. Imports went up and
their deficits were financed by drawing down their reserves. At that
time, the US dollar was the main component in the currency reserves
of the rest of the world, and those reserves had been expanding as a
consequence of the US running a continued balance of payments deficit
(other countries were willing to hold those dollars as a reserve asset
because they were committed to maintain convertibility between their
currency and the dollar).
The problem was that if the short-run dollar liabilities of the US
continued to increase in relation to its holdings of gold, then the belief
in the credibility of the US commitment to convert dollars into gold at 97
the fixed price would be eroded. The central banks would thus have an
overwhelming incentive to convert the existing dollar holdings into gold,

Macroeconomics
Open Economy
and that would, in turn, force the US to give up its commitment. This
was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton
Woods system. Triffin suggested that the IMF should be turned into a
‘deposit bank’ for central banks and a new ‘reserve asset’ be created
under the control of the IMF. In 1967, gold was displaced by creating
the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the
IMF with the intention of increasing the stock of international reserves.
Originally defined in terms of gold, with 35 SDRs being equal to one
ounce of gold (the dollar-gold rate of the Bretton Woods system), it has
been redefined several times since 1974. At present, it is calculated
daily as the weighted sum of the values in dollars of four currencies
(euro, dollar, Japanese yen, pound sterling) of the five countries (France,
Germany, Japan, the UK and the US). It derives its strength from IMF
members being willing to use it as a reserve currency and use it as a
means of payment between central banks to exchange for national
currencies. The original installments of SDRs were distributed to member
countries according to their quota in the Fund (the quota was broadly related
to the country’s economic importance as indicated by the value of its
international trade).

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 The breakdown of the Bretton Woods system was preceded by many
events, such as the devaluation of the pound in 1967, flight from dollars to
gold in 1968 leading to the creation of a two-tiered gold market (with the
official rate at $35 per ounce and the private rate market determined), and
finally in August 1971, the British demand that US guarantee the gold
value of its dollar holdings. This led to the US decision to give up the link
between the dollar and gold: USA announced it would no longer be willing
to convert dollars into gold at 35$ per ounce.
The ‘Smithsonian Agreement’ in 1971, which widened the permissible band
of movements of the exchange rates to 2.5 per cent above or below the new
‘central rates’ with the hope of reducing pressure on deficit countries, lasted
only 14 months. The developed market economies, led by the United Kingdom
and soon followed by Switzerland and then Japan, began to adopt floating
exchange rates in the early 1970s. In 1976, revision of IMF Articles allowed
countries to choose whether to float their currencies or to peg them (to a single
currency, a basket of currencies, or to the SDR). There are no rules governing
pegged rates and no de facto supervision of floating exchange rates.
The Current Scenario: Many countries currently have fixed exchange rates.
The creation of the European Monetary Union in January, 1999, involved
permanently fixing the exchange rates between the currencies of the
members of the Union and the introduction of a new common currency, the
Euro, under the management of the European Central Bank. From January,
2002, actual notes and coins were introduced. So far, 12 of the 25 members
of the European Union have adopted the euro.
Some countries pegged their currency to the French franc; most of these
are former French colonies in Africa. Others peg to a basket of currencies,
with the weights reflecting the composition of their trade. Often smaller
countries also decide to fix their exchange rates relative to an important
trading partner. Argentina, for example, adopted the currency board system
in 1991. Under this, the exchange rate between the local currency (the
peso) and the dollar was fixed by law. The central bank held enough foreign
98 currency to back all the domestic currency and reserves it had issued. In
such an arrangement, the country cannot expand the money supply at
Introductory Macroeconomics

will. Also, if there is a domestic banking crisis (when banks need to borrow
domestic currency) the central bank can no longer act as a lender of last
resort. However, following a crisis, Argentina abandoned the currency board
and let its currency float in January 2002.
Another arrangement adopted by Equador in 2000 was dollarisation
when it abandoned the domestic currency and adopted the US dollar.
All prices are quoted in dollar terms and the local currency is no longer
used in transactions. Although uncertainty and risk can be avoided,
Equador has given the control over its money supply to the Central
Bank of the US – the Federal Reserve – which will now be based on
economic conditions in the US.
On the whole, the international system is now characterised by a
multiple of regimes. Most exchange rates change slightly on a day-to-day
basis, and market forces generally determine the basic trends. Even those
advocating greater fixity in exchange rates generally propose certain ranges
within which governments should keep rates, rather than literally fix them.
Also, there has been a virtual elimination of the role for gold. Instead, there
is a free market in gold in which the price of gold is determined by its
demand and supply coming mainly from jewellers, industrial users, dentists,
speculators and ordinary citizens who view gold as a good store of value.

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Summary

1. Openness in product and financial markets allows a choice between domestic

and foreign goods and between domestic and foreign assets.
2. The BoP records a country’s transactions with the rest of the world.
3. The current account balance is the sum of the balance of merchandise
trade, services and net transfers received from the rest of the world. The
capital account balance is equal to capital flows from the rest of the
world, minus capital flows to the rest of the world.
4. A current account deficit is financed by net capital flows from the rest of
the world, thus by a capital account surplus.
5. The nominal exchange rate is the price of one unit of foreign currency in
terms of domestic currency.
6. The real exchange rate is the relative price of foreign goods in terms of
domestic goods. It is equal to the nominal exchange rate times the foreign
price level divided by the domestic price level. It measures the international
competitiveness of a country in international trade. When the real exchange
rate is equal to one, the two countries are said to be in purchasing power
parity.
7. The epitome of the fixed exchange rate system was the gold standard in
which each participant country committed itself to convert freely its currency
into gold at a fixed price. The pegged exchange rate is a policy variable
and may be changed by official action (devaluation).
8. Under clean floating, the exchange rate is market-determined without
any central bank intervention. In case of managed floating, central banks
intervene to reduce fluctuations in the exchange rate.
9. In an open economy, the demand for domestic goods is equal to the
domestic demand for goods (consumption, investment and government
spending) plus exports minus imports.
10. The open economy multiplier is smaller than that in a closed economy
because a part of domestic demand falls on foreign goods. An increase in
autonomous demand thus leads to a smaller increase in output compared
to a closed economy. It also results in a deterioration of the trade balance.
11. An increase in foreign income leads to increased exports and increases
domestic output. It also improves the trade balance. 99
12. Trade deficits need not be alarming if the country invests the borrowed

Macroeconomics
Open Economy
funds yielding a rate of growth higher than the interest rate.

Open economy Balance of payments

Key Concepts

Current account deficit Official reserve transactions

Autonomous and accommodating Nominal and real exchange rate
transactions
Purchasing power parity Flexible exchange rate
Depreciation Interest rate differential
Fixed exchange rate Devaluation
Managed floating Demand for domestic goods
Marginal propensity to import Net exports
Open economy multiplier

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 Box 6.3: Exchange Rate Management: The Indian Experience

India’s exchange rate policy has evolved in line with international and
domestic developments. Post-independence, in view of the prevailing
Bretton Woods system, the Indian rupee was pegged to the pound sterling
due to its historic links with Britain. A major development was the
devaluation of the rupee by 36.5 per cent in June, 1966. With the
breakdown of the Bretton Woods system, and also the declining share of
UK in India’s trade, the rupee was delinked from the pound sterling in
September 1975. During the period between 1975 to 1992, the exchange
rate of the rupee was officially determined by the Reserve Bank within a
nominal band of plus or minus 5 per cent of the weighted basket of
currencies of India’s major trading partners. The Reserve Bank intervened
on a day-to-day basis which resulted in wide changes in the size of
reserves. The exchange rate regime of this period can be described as an
adjustable nominal peg with a band.
The beginning of 1990s saw significant rise in oil prices and
suspension of remittances from the Gulf region in the wake of the Gulf
crisis. This, and other domestic and international developments, led to
severe balance of payments problems in India. The drying up of access
to commercial banks and short-term credit made financing the current
account deficit difficult. India’s foreign currency reserves fell rapidly from
US $ 3.1 billion in August to US $ 975 million on July 12, 1991 (we may
contrast this with the present; as of January 27, 2006, India’s foreign
exchange reserves stand at US $ 139.2 billion). Apart from measures
like sending gold abroad, curtailing non-essential imports, approaching
the IMF and multilateral and bilateral sources, introducing stabilisation
and structural reforms, there was a two-step devaluation of 18 –19 per
cent of the rupee on July 1 and 3, 1991. In march 1992, the Liberalised
Exchange Rate Management System (LERMS) involving dual exchange
100
rates was introduced. Under this system, 40 per cent of exchange
Introductory Macroeconomics

earnings had to be surrendered at an official rate determined by the

Reserve Bank and 60 per cent was to be converted at the market-
determined [Link] dual rates were converged into one from March 1,
1993; this was an important step towards current account convertibility,
which was finally achieved in August 1994 by accepting Article VIII of
the Articles of Agreement of the IMF. The exchange rate of the rupee
thus became market determined, with the Reserve Bank ensuring orderly
conditions in the foreign exchange market through its sales and
purchases.

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 ? 1. Differentiate between balance of trade and current account balance.
Exercises

2. What are official reserve transactions? Explain their importance in the balance
of payments.
3. Distinguish between the nominal exchange rate and the real exchange rate. If
you were to decide whether to buy domestic goods or foreign goods, which rate
would be more relevant? Explain.
4. Suppose it takes 1.25 yen to buy a rupee, and the price level in Japan is 3 and
the price level in India is 1.2. Calculate the real exchange rate between India
and Japan (the price of Japanese goods in terms of Indian goods). (Hint: First
find out the nominal exchange rate as a price of yen in rupees).
5. Explain the automatic mechanism by which BoP equilibrium was achieved
under the gold standard.
6. How is the exchange rate determined under a flexible exchange rate regime?
7. Differentiate between devaluation and depreciation.
8. Would the central bank need to intervene in a managed floating system?
Explain why.
9. Are the concepts of demand for domestic goods and domestic demand for
goods the same?
10. What is the marginal propensity to import when M = 60 + 0.06Y? What is
the relationship between the marginal propensity to import and the
aggregate demand function?
11. Why is the open economy autonomous expenditure multiplier smaller
than the closed economy one?
12. Calculate the open economy multiplier with proportional taxes, T = tY ,
instead of lump-sum taxes as assumed in the text.
13. Suppose C = 40 + 0.8Y D, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y
(a) Find equilibrium income. (b) Find the net export balance at equilibrium
income (c) What happens to equilibrium income and the net export balance
when the government purchases increase from 40 and 50 ? 101
14. In the above example, if exports change to X = 100, find the change in

Macroeconomics
Open Economy
equilibrium income and the net export balance.
15. Suppose the exchange rate between the Rupee and the dollar was Rs.
30=1$ in the year 2010. Suppose the prices have doubled in India over
20 years while they have remained fixed in USA. What, according to the
purchasing power parity theory will be the exchange rate between dollar
and rupee in the year 2030.
16. If inflation is higher in country A than in Country B, and the exchange
rate between the two countries is fixed, what is likely to happen to the
trade balance between the two countries?
17. Should a current account deficit be a cause for alarm? Explain.
18. Suppose C = 100 + 0.75Y D, I = 500, G = 750, taxes are 20 per cent of income,
X = 150, M = 100 + 0.2Y . Calculate equilibrium income, the budget deficit or

?
surplus and the trade deficit or surplus.
19. Discuss some of the exchange rate arrangements that countries have entered
into to bring about stability in their external accounts.

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 Suggested Readings
1. Dornbusch, R. and S. Fischer, 1994. Macroeconomics, sixth edition,
McGraw-Hill, Paris.
2. Economic Survey, Government of India, 2006-07.
3. Krugman, P.R. and M. Obstfeld, 2000. International Economics, Theory
and Policy, fifth edition, Pearson Education.

DETERMINATION EQUILIBRIUM INCOME OPEN ECONOMY

Appendix 6.1

OF IN

With consumers and firms having an option to buy goods produced at home and
abroad, we now need to distinguish between domestic demand for goods and the
demand for domestic goods.

National Income Identity for an Open Economy

In a closed economy, there are three sources of demand for domestic goods –
Consumption (C ), government spending (G ), and domestic investment (I ).
We can write
Y = C + I + G (6.1)
In an open economy, exports (X ) constitute an additional source of demand
for domestic goods and services that comes from abroad and therefore must
be added to aggregate demand. Imports ( M ) supplement supplies in domestic
markets and constitute that part of domestic demand that falls on foreign
goods and services. Therefore, the national income identity for an open economy
is
Y + M = C + I + G + X (6.2)
Rearranging, we get
Y = C + I + G + X – M (6.3)
or
102 Y = C + I + G + NX (6.4)
Introductory Macroeconomics

where, NX is net exports (exports – imports). A positive NX (with exports

greater than imports) implies a trade surplus and a negative NX (with imports
exceeding exports) implies a trade deficit.
To examine the roles of imports and exports in determining equilibrium
income in an open economy, we follow the same procedure as we did for the
closed economy case – we take investment and government spending as
autonomous. In addition, we need to specify the determinants of imports and
exports. The demand for imports depends on domestic income (Y) and the
real exchange rate (R ). Higher income leads to higher imports. Recall that the
real exchange rate is defined as the relative price of foreign goods in terms of
domestic goods. A higher R makes foreign goods relatively more expensive,
thereby leading to a decrease in the quantity of imports. Thus, imports depend
positively on Y and negatively on R. The export of one country is, by definition,
the import of another. Thus, our exports would constitute of foreign imports. It
would depend on foreign income, Yf , and on R. A rise in Yf will increase foreign
demand for our goods, thus leading to higher exports. An increase in R, which
makes domestic goods cheaper, will increase our exports. Exports depend positively
on foreign income and the real exchange rate. Thus, exports and imports depend
on domestic income, foreign income and the real exchange rate. We assume price

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levels and the nominal exchange rate to be constant, hence R will be fixed. From
the point of view of our country, foreign income, and therefore exports, are considered
exogenous (X = X ).
The demand for imports is thus assumed to depend on income and have
an autonomous component
M = M + mY, where M > 0 is the autonomous component, 0 < m < 1. (6.5)
Here m is the marginal propensity to import, the fraction of an extra rupee
of income spent on imports, a concept analogous to the marginal propensity to
consume.
The equilibrium income would be
Y = C + c(Y – T ) + I + G + X – M – mY (6.6)
Taking all the autonomous components together as A , we get
Y = A + cY – mY (6.7)
or, (1 – c + m )Y = A (6.8)
1 A
or, Y* = (6.9)
1 – c +m
In order to examine the effects of allowing for foreign trade in the income-
expenditure framework, we need to compare equation (6.10) with the equivalent
expression for the equilibrium income in a closed economy model. In both
equations, equilibrium income is expressed as a product of two terms, the
autonomous expenditure multiplier and the level of autonomous expenditures.
We consider how each of these change in the open economy context.
Since m, the marginal propensity to import, is greater than zero, we get a
smaller multiplier in an open economy. It is given by

∆Y 1
The open economy multiplier = = 1 – c +m (6.10)
∆A
EXAMPLE 6.2 103
If c = 0.8 and m = 0.3, we would have the open and closed economy multiplier

Macroeconomics
Open Economy
respectively as
1 1 1
= = = 5 (6.11)
1– c 1 – 0.8 0.2
and
1 1 1
1 – c + m = 1 – 0.8 + 0.3 = 0.5 = 2 (6.12)

If domestic autonomous demand increases by 100, in a closed economy output

increases by 500 whereas it increases by only 200 in an open economy.
The fall in the value of the autonomous expenditure multiplier with the opening
up of the economy can be explained with reference to our previous discussion of
the multiplier process (Chapter 4). A change in autonomous expenditures, for
instance a change in government spending, will have a direct effect on income and
an induced effect on consumption with a further effect on income. With an mpc
greater than zero, a proportion of the induced effect on consumption will be a demand
for foreign, not domestic goods. Therefore, the induced effect on demand for domestic
goods, and hence on domestic income, will be smaller. The increase in imports per
unit of income constitutes an additional leakage from the circular flow of domestic
income at each round of the multiplier process and reduces the value of the
autonomous expenditure multiplier.

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 The second term in equation (6.10) shows that, in addition to the elements for
a closed economy, autonomous expenditure for an open economy includes the
level of exports and the autonomous component of imports. Thus, the changes in
their levels are additional shocks that will change equilibrium income. From
equation (6.10) we can compute the multiplier effects of changes in X and M .

∆Y * 1
= (6.13)
∆X 1 – c +m

∆Y * –1
= 1– c +m (6.14)
∆M
An increase in demand for our exports is an increase in aggregate demand for
domestically produced output and will increase demand just as would an increase
in government spending or an autonomous increase in investment. In contrast,
an autonomous rise in import demand is seen to cause a fall in demand for domestic
output and causes equilibrium income to decline.

104
Introductory Macroeconomics

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 Average cost Total cost per unit of output.
Average fixed cost Total fixed cost per unit of output.
Average product Output per unit of the variable input.
Average revenue Total revenue per unit of output.
Average variable cost Total variable cost per unit of output.
Break-even point is the point on the supply curve at which a firm
earns normal profit.
Budget line consists of all bundles which cost exactly equal to the
consumer’s income.
Budget set is the collection of all bundles that the consumer can
buy with her income at the prevailing market prices.
Constant returns to scale is a property of production function that
holds when a proportional increase in all inputs results in an increase
in output by the same proportion.
Cost function For every level of output, it shows the minimum cost
for the firm.
Decreasing returns to scale is a property of production function
 that holds when a proportional increase in all inputs results in an
increase in output by less than the proportion.


Demand curve is a graphical representation of the demand function.

It gives the quantity demanded by the consumer at each price.
Demand function A consumer’s demand function for a good gives
the amount of the good that the consumer chooses at different levels
of its price when the other things remain unchanged.
Duopoly is a market with just two firms.
Equilibrium is a situation where the plans of all consumers and
firms in the market match.
Excess demand If at a price market, demand exceeds market supply,
it is said that excess demand exists in the market at that price.
Excess supply If at a price market, supply is greater than market
demand, it is said that there is excess supply in the market at that
price.
Firm’s supply curve shows the levels of output that a profit-
maximising firm will choose to produce at different values of the
market price.
Fixed input An input which cannot be varied in the short run is
called a fixed input.

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Income effect The change in the optimal quantity of a good when the purchasing
power changes consequent upon a change in the price of the good is called the
income effect.
Increasing returns to scale is a property of production function that holds when a
proportional increase in all inputs results in an increase in output by more than
the proportion.
Indifference curve is the locus of all points among which the consumer is indifferent.
Inferior good A good for which the demand decreases with increase in the income
of the consumer is called an inferior good.
Isoquant is the set of all possible combinations of the two inputs that yield the
same maximum possible level of output.
Law of demand If a consumer’s demand for a good moves in the same direction as
the consumer’s income, the consumer’s demand for that good must be inversely
related to the price of the good.
Law of diminishing marginal product If we keep increasing the employment of an
input with other inputs fixed then eventually a point will be reached after which the
marginal product of that input will start falling.
Law of variable proportions The marginal product of a factor input initially rises
with its employment level when the level of employment of the input is low. But after
reaching a certain level of employment, it starts falling.
Long run refers to a time period in which all factors of production can
be varied.
Marginal cost Change in total cost per unit of change in output.
Marginal product Change in output per unit of change in the input when all other
inputs are held constant.
Marginal revenue Change in total revenue per unit change in sale of output.
Marginal revenue product(MRP) of a factor Marginal Revenue times Marginal
Product of the factor.
Market supply curve shows the output levels that firms in the market produce in
aggregate corresponding to different values of the market price. 
Monopolistic competition is a market structure where there exit a very large


number of sellers selling differentiated but substitutable products.
Monopoly A market structure in which there is a single seller and there are sufficient
restrictions to prevent any other seller from entering the market.
Monotonic preferences A consumer’s preferences are monotonic if and only if
between any two bundles, the consumer prefers the bundle which has more of at
least one of the goods and no less of the other good as compared to the other bundle.
Normal good A good for which the demand increases with increase in the income of
the consumer is called a normal good.
Normal profit The profit level that is just enough to cover the explicit costs and
opportunity costs of the firm is called the normal profit.
Oligopoly A market consisting of more than one (but few) sellers is called a oligopoly.
Opportunity cost of some activity is the gain foregone from the second best activity.
Perfect competition A market environment wherein (i) all firms in the market
produce the same good and (ii) buyers and sellers are price-takers.
Price ceiling The government-imposed upper limit on the price of a good or service
is called price ceiling.
Price elasticity of demand for a good is defined as the percentage change in
demand for the good divided by the percentage change in its price.

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 Price elasticity of supply is the percentage change in quantity supplied due to a
one per cent change in the market price of the good.
Price floor The government-imposed lower limit on the price that may be charged
for a particular good or service is called price floor.
Price line is a horizontal straight line that shows the relationship between market
price and a firm’s output level.
Production function shows the maximum quantity of output that can be produced
by using different combinations of the inputs.
Profit is the difference between a firm’s total revenue and its total cost of production.
Short run refers to a time period in which some factors of production cannot be
varied.
Shut down point In the short run, it is the minimum point of AVC curve and in the
long run, it is the minimum point of LRAC curve.
Substitution effect The change in the optimal quantity of a good when its price
changes and the consumer’s income is adjusted so that she can just buy the bundle
that she was buying before the price change is called the substitution effect.
Super-normal profit Profit that a firm earns over and above the normal profit is
called the super-normal profit.
Total cost is the sum of total fixed cost and total variable cost.
Total fixed cost The cost that a firm incurs to employ fixed inputs is called the total
fixed cost.
Total physical product Same as the total product.
Total product If we vary a single input keeping all other inputs constant, then for
different levels of employment of that input we get different levels of output from the
production function. This relationship between the variable input and output is
referred to as total product.
Total return Same as the total product.
Total revenue is equal to the market price of the good multiplied by the quantity of
the good sold by a firm.
 Total revenue curve shows the relationship between firm’s total revenue and firm’s
output level.


Total variable cost The cost that a firm incurs to employ variable inputs is called
the total variable cost.
Value of marginal product (VMP) of a factor Price times Marginal Product of
the factor.
Variable input An input the amount of which can be varied.

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Adam Smith (1723 – 1790) Regarded as the father of modern
Economics. Author of Wealth of Nations.
Aggregate monetary resources Broad money without time deposits
of post office savings organisation (M3).
Automatic stabilisers Under certain spending and tax rules,
expenditures that automatically increase or taxes that automatically
decrease when economic conditions worsen, therefore, stabilising
the economy automatically.
Autonomous change A change in the values of variables in a
macroeconomic model caused by a factor exogenous to the model.
Autonomous expenditure multiplier The ratio of increase (or
decrease) in aggregate output or income to an increase (or decrease)
in autonomous spending.
Balance of payments A set of accounts that summarise a country’s
transactions with the rest of the world.
Balanced budget A budget in which taxes are equal to government
spending.
Balanced budget multiplier The change in equilibrium output that
results from a unit increase or decrease in both taxes and government
spending.
Bank rate The rate of interest payable by commercial banks to RBI
if they borrow money from the latter in case of a shortage of reserves.
Barter exchange Exchange of commodities without the mediation
of money.
Base year The year whose prices are used to calculate the real GDP.
Bonds A paper bearing the promise of a stream of future monetary
returns over a specified period of time. Issued by firms or
governments for borrowing money from the public.
Broad money Narrow money + time deposits held by commercial
banks and post office savings organisation.
Capital Factor of production which has itself been produced and
which is not generally entirely consumed in the production process.
Capital gain/loss Increase or decrease in the value of wealth of a
bondholder due to an appreciation or reduction in the price of her
bonds in the bond market.
Capital goods Goods which are bought not for meeting immediate
need of the consumer but for producing other goods.

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 Capitalist country or economy A country in which most of the production is
carried out by capitalist firms.
Capitalist firms These are firms with the following features (a) private ownership
of means of production (b) production for the market (c) sale and purchase of labour
at a price which is called the wage rate (d) continuous accumulation of capital.
Cash Reserve Ratio (CRR) The fraction of their deposits which the commercial
banks are required to keep with RBI.
Circular flow of income The concept that the aggregate value of goods and services
produced in an economy is going around in a circular way. Either as factor
payments, or as expenditures on goods and services, or as the value of aggregate
production.
Consumer durables Consumption goods which do not get exhausted immediately
but last over a period of time are consumer durables.
Consumer Price Index (CPI) Percentage change in the weighted average price
level. We take the prices of a given basket of consumption goods.
Consumption goods Goods which are consumed by the ultimate consumers or
meet the immediate need of the consumer are called consumption goods. It may
include services as well.
Corporate tax Taxes imposed on the income made by the corporations (or private
sector firms).
Currency deposit ratio The ratio of money held by the public in currency to that
held as deposits in commercial banks.
Deficit financing through central bank borrowing Financing of budget deficit
by the government through borrowing money from the central bank. Leads to
increase in money supply in an economy and may result in inflation.
Depreciation A decrease in the price of the domestic currency in terms of the
foreign currency under floating exchange rates. It corresponds to an increase in
the exchange rate.
Depreciation Wear and tear or depletion which capital stock undergoes over a
106 period of time.
Devaluation The decrease in the price of domestic currency under pegged exchange
Introductory Macroeconomics

rates through official action.

Double coincidence of wants A situation where two economic agents have
complementary demand for each others’ surplus production.
Economic agents or units Economic units or economic agents are those individuals
or institutions which take economic decisions.
Effective demand principle If the supply of final goods is assumed to be infinitely
elastic at constant price over a short period of time, aggregate output is determined
solely by the value of aggregate demand. This is called effective demand principle.
Entrepreneurship The task of organising, coordinating and risk-taking during
production.
Ex ante consumption The value of planned consumption.
Ex ante investment The value of planned investment.
Ex ante The planned value of a variable as opposed to its actual value.
Ex post The actual or realised value of a variable as opposed to its planned value.
Expenditure method of calculating national income Method of calculating the
national income by measuring the aggregate value of final expenditure for the
goods and services produced in an economy over a period of time.
Exports Sale of goods and services by the domestic country to the rest of the world.

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External sector It refers to the economic transaction of the domestic country with
the rest of the world.
Externalities Those benefits or harms accruing to another person, firm or any
other entity which occur because some person, firm or any other entity may be
involved in an economic activity. If someone is causing benefits or good externality
to another, the latter does not pay the former. If someone is inflicting harm or bad
externality to another, the former does not compensate the latter.
Fiat money Money with no intrinsic value.
Final goods Those goods which do not undergo any further transformation in the
production process.
Firms Economic units which carry out production of goods and services and employ
factors of production.
Fiscal policy The policy of the government regarding the level of government
spending and transfers and the tax structure.
Fixed exchange rate An exchange rate between the currencies of two or more
countries that is fixed at some level and adjusted only infrequently.
Flexible/floating exchange rate An exchange rate determined by the forces of
demand and supply in the foreign exchange market without central bank
intervention.
Flows Variables which are defined over a period of time.
Foreign exchange Foreign currency, all currencies other than the domestic
currency of a given country.
Foreign exchange reserves Foreign assets held by the central bank of the country.
Four factors of production Land, Labour, Capital and Entrepreneurship. Together
these help in the production of goods and services.
GDP Deflator Ratio of nominal to real GDP.
Government expenditure multiplier The numerical coefficient showing the size
of the increase in output resulting from each unit increase in government spending.
Government The state, which maintains law and order in the country, imposes
taxes and fines, makes laws and promotes the economic wellbeing of the citizens.
107

Glossary
Great Depression The time period of 1930s (started with the stock market crash
in New York in 1929) which saw the output in the developed countries fall and
unemployment rise by huge amounts.
Gross Domestic Product (GDP) Aggregate value of goods and services produced
within the domestic territory of a country. It includes the replacement investment
of the depreciation of capital stock.
Gross fiscal deficit The excess of total government expenditure over revenue
receipts and capital receipts that do not create debt.
Gross investment Addition to capital stock which also includes replacement for
the wear and tear which the capital stock undergoes.
Gross National Product (GNP) GDP + Net Factor Income from Abroad. In other
words GNP includes the aggregate income made by all citizens of the country,
whereas GDP includes incomes by foreigners within the domestic economy and
excludes incomes earned by the citizens in a foreign economy.
Gross primary deficit The fiscal deficit minus interest payments.
High powered money Money injected by the monetary authority in the economy.
Consists mainly of currency.
Households The families or individuals who supply factors of production to the
firms and which buy the goods and services from the firms.

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 Imports Purchase of goods and services by the domestic country to the rest of the
world.
Income method of calculating national income Method of calculating national
income by measuring the aggregate value of final factor payments made (= income)
in an economy over a period of time.
Interest Payment for services which are provided by capital.
Intermediate goods Goods which are used up during the process of production of
other goods.
Inventories The unsold goods, unused raw materials or semi-finished goods which
a firm carries from a year to the next.
John Maynard Keynes (1883 – 1946) Arguably the founder of Macroeconomics as
a separate discipline.
Labour Human physical effort used in production.
Land Natural resources used in production – either fixed or consumed.
Legal tender Money issued by the monetary authority or the government which
cannot be refused by anyone.
Lender of last resort The function of the monetary authority of a country in which
it provides guarantee of solvency to commercial banks in a situation of liquidity
crisis or bank runs.
Liquidity trap A situation of very low rate of interest in the economy where every
economic agent expects the interest rate to rise in future and consequently bond
prices to fall, causing capital loss. Everybody holds her wealth in money and
speculative demand for money is infinite.
Macroeconomic model Presenting the simplified version of the functioning of a
macroeconomy through either analytical reasoning or mathematical, graphical
representation.
Managed floating A system in which the central bank allows the exchange rate to
be determined by market forces but intervene at times to influence the rate.
Marginal propensity to consume The ratio of additional consumption to additional
108 income.
Introductory Macroeconomics

Medium of exchange The principal function of money for facilitating commodity

exchanges.
Money multiplier The ratio of total money supply to the stock of high powered
money in an economy.
Narrow money Currency notes, coins and demand deposits held by the public in
commercial banks.
National disposable income Net National Product at market prices + Other Current
Transfers from the rest of the World.
Net Domestic Product (NDP) Aggregate value of goods and services produced
within the domestic territory of a country which does not include the depreciation
of capital stock.
Net interest payments made by households Interest payment made by the
households to the firms – interest payments received by the households.
Net investment Addition to capital stock; unlike gross investment, it does not
include the replacement for the depletion of capital stock.
Net National Product (NNP) (at market price) GNP – depreciation.
NNP (at factor cost) or National Income (NI) NNP at market price – (Indirect
taxes – Subsidies).
Nominal exchange rate The number of units of domestic currency one must give

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up to get an unit of foreign currency; the price of foreign currency in terms of
domestic currency.
Nominal (GDP) GDP evaluated at current market prices.
Non-tax payments Payments made by households to the firms or the government
as non-tax obligations such as fines.
Open market operation Purchase or sales of government securities by the central
bank from the general public in the bond market in a bid to increase or decrease
the money supply in the economy.
Paradox of thrift As people become more thrifty they end up saving less or same
as before in aggregate.
Parametric shift Shift of a graph due to a change in the value of a parameter.
Personal Disposable Income (PDI) PI – Personal tax payments – Non-tax payments.
Personal Income (PI) NI – Undistributed profits – Net interest payments made by
households – Corporate tax + Transfer payments to the households from the
government and firms.
Personal tax payments Taxes which are imposed on individuals, such as income
tax.
Planned change in inventories Change in the stock of inventories which has
occurred in a planned way.
Present value (of a bond) That amount of money which, if kept today in an interest
earning project, would generate the same income as the sum promised by a bond
over its lifetime.
Private income Factor income from net domestic product accruing to the private
sector + National debt interest + Net factor income from abroad + Current transfers
from government + Other net transfers from the rest of the world.
Product method of calculating national income Method of calculating the
national income by measuring the aggregate value of production taking place in
an economy over a period of time.
Profit Payment for the services which are provided by entrepreneurship.
Public good Goods or services that are collectively consumed; it is not possible to 109
exclude anyone from enjoying their benefits and one person’s consumption does

Glossary
not reduce that available to others.
Purchasing power parity A theory of international exchange which holds that the
price of similar goods in different countries is the same.
Real exchange rate The relative price of foreign goods in terms of domestic goods.
Real GDP GDP evaluated at a set of constant prices.
Rent Payment for services which are provided by land (natural resources).
Reserve deposit ratio The fraction of their total deposits which commercial banks
keep as reserves.
Revaluation A decrease in the exchange rate in a pegged exchange rate system
which makes the foreign currency cheaper in terms of the domestic currency.
Revenue deficit The excess of revenue expenditure over revenue receipts.
Ricardian equivalence The theory that consumers are forward looking and
anticipate that government borrowing today will mean a tax increase in the future
to repay the debt, and will adjust consumption accordingly so that it will have the
same effect on the economy as a tax increase today.
Speculative demand Demand for money as a store of wealth.
Statutory Liquidity Ratio (SLR) The fraction of their total demand and time deposits
which the commercial banks are required by RBI to invest in specified liquid assets.
Sterilisation Intervention by the monetary authority of a country in the money

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 market to keep the money supply stable against exogenous or sometimes external
shocks such as an increase in foreign exchange inflow.
Stocks Those variables which are defined at a point of time.
Store of value Wealth can be stored in the form of money for future use. This
function of money is referred to as store of value.
Transaction demand Demand for money for carrying out transactions.
Transfer payments to households from the government and firms Transfer
payments are payments which are made without any counterpart of services
received by the payer. For examples, gifts, scholarships, pensions.
Undistributed profits That part of profits earned by the private and government
owned firms which are not distributed among the factors of production.
Unemployment rate This may be defined as the number of people who were unable
to find a job (though they were looking for jobs), as a ratio of total number of people
who were looking for jobs.
Unit of account The role of money as a yardstick for measuring and comparing
values of different commodities.
Unplanned change in inventories Change in the stock of inventories which has
occurred in an unexpected way.
Value added Net contribution made by a firm in the process of production. It is
defined as, Value of production – Value of intermediate goods used.
Wage Payment for the services which are rendered by labour.
Wholesale Price Index (WPI) Percentage change in the weighted average price
level. We take the prices of a given basket of goods which is traded in bulk.

110
Introductory Macroeconomics

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