Business Economics

Business Economics

CONTENTS
Unit 1 Meaning, significance of
economics, decision making, goals of a

Firm

Unit 2 Demand analysis, law of demand,

elasticity of demand& Demand
Forecasting.

Unit 3 Production and cost analysis,

costing concepts, production
function.

Unit 4 Market structures& price

determination.

Unit 5 Inflation, Deflation, Theory of

Income & employment.

Unit 6 National Income and applications

Unit 7 International trade, Balance of trade

& payment, devaluation and
Its impact on trade

Unit 8 Monetary & Fiscal Policy, WTO

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understand why some nations prospered while others

Unit 1 : Meaning and Significance lagged behind in poverty. Others after him also
of Economics explored how a nation's allocation of resources affects
its wealth.
To study these things, economics makes the
Structure assumption that human beings will aim to fulfill their
self-interests. It also assumes that individuals are
What is Economics? rational in their efforts to fulfill their unlimited wants
and needs. Economics, therefore, is a social science,
1.1 Various definitions of economics. which examines people behaving according to their
1.2 Microeconomic analysis & Microeconomic self-interests.
analysis
1.3 Business economics meaning, scope. 1.2 Welfare oriented
1.4 Objectives of business economics The definition set out at the turn of the
1.5 Goals of a firm twentieth century by Alfred Marshall, author of "The
Principles of Economics" (1890), reflects the
1.1 Various definitions of economics. complexity underlying economics: "Thus it is on one
side the study of wealth; and on the other, and more
Economics may appear to be the study of important side, a part of the study of man."
complicated tables and charts, statistics and numbers,
but, more specifically, it is the study of what constitutes Scarcity oriented
rational human behavior in the endeavor to fulfill needs A definition that captures much of modern
and wants. economics is that of Lionel Robbins in a 1932 essay:
As an individual, for example, you face the "Economics is a science which studies human
problem of having only limited resources with which to behaviors as a relationship between ends and scarce
fulfill your wants and needs, as a result, you must means which have alternative uses.”
make certain choices with your money. You'll probably
spend part of your money on rent, electricity and food. Features of the definition
Then you might use the rest to go to the movies and/or 1. Ends
buy a new pair of jeans. 2. Means
Economists are interested in the choices you 3. Gradable Wants
make, and enquire into why, for instance, you might 4. Alternative Uses
choose to spend your money on a new DVD player
instead of replacing your old TV. They would want to Scarcity means that available resources are
know whether you would still buy a carton of cigarettes insufficient to satisfy all wants and needs. Absent
if prices increased by $2 per pack. scarcity and alternative uses of available resources,
The underlying essence of economics is trying there is no economic problem. The subject thus
to understand how both individuals and nations defined involves the study of choices as they are
behave in response to certain material constraints. affected by incentives and resources.
We can say, therefore, that economics, often referred
to as the "dismal science", is a study of certain aspects Areas of economics may be divided or classified into
of society. various types, including:
Economics is the social science that studies · Microeconomics and macroeconomics
the production, distribution, and consumption of goods · Positive economics ("what is") and normative
and services. The term economics comes from the economics ("what ought to be")
Greek for oikos (house) and nomos (custom or law), One of the uses of economics is to explain how
hence "rules of the house (hold)." economies, as economic systems, work and what the
relations are between economic players (agents) in the
Definitions:- larger society. Methods of economic analysis have
been increasingly applied to fields that involve people
Wealth oriented (officials included) making choices in a social context,
such as crime, education, the family, health, law,
Adam Smith (1723 - 1790), the "father of modern politics, religion, social institutions, and war.
economics" and author of the famous book "An Inquiry
into the Nature and Causes of the Wealth of Nations",
spawned the discipline of economics by trying to

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Microeconomics and Macroeconomics. Moreover, because of increased globalization of the

marketplace, there is more volatility in both input and
Macro and microeconomics are the two vantage points product prices. The continuous changes in the
from which the economy is observed. economic and business environment make it ever
more difficult to accurately evaluate the outcome of a
Macroeconomics looks at the total output of a business decision. In such a changing environment,
nation and the way the nation allocates its limited sound economic analysis becomes all the more
resources of land, labor and capital in an attempt to important as a basis of decision making. Managerial
maximize production levels and promote trade and economics is a discipline that is designed to provide a
growth for future generations. solid foundation of economic understanding in order
for business managers to make well-informed and
Microeconomics looks into similar issues, but well-analyzed managerial decisions.
on the level of the individual people and firms within
the economy. It tends to be more scientific in its The Nature of Managerial Economics
approach, and studies the parts that make up the There are a number of issues relevant to
whole economy. Analyzing certain aspects of human businesses that are based on economic thinking or
behavior, microeconomics shows us how individuals analysis. Examples of questions that managerial
and firms respond to changes in price and why they economics attempts to answer are: What determines
demand what they do at particular price levels. whether an aspiring business firm should enter a
particular industry or simply start producing a new
Micro and macroeconomics are intertwined; as product or service? Should a firm continue to be in
economists gain understanding of certain phenomena, business in an industry in which it is currently engaged
they can help nations and individuals make more or cut its losses and exit the industry? Why do some
informed decisions when allocating resources. The professions pay handsome salaries, whereas some
systems by which nations allocate their resources can others pay barely enough to survive? How can the
be placed on a spectrum where the command business best motivate the employees of a firm? The
economy is on the one end and the market economy is issues relevant to managerial economics can be
on the other. The market economy advocates forces further focused by expanding on the first two of the
within a competitive market, which constitute the preceding questions. Let us consider the first question
"invisible hand", to determine how resources should be in which a firm (or a would-be firm) is considering
allocated. The command economic system relies on entering an industry. For example, what led Frederick
the government to decide how the country's resources W. Smith the founder of Federal Express, to start his
would best be allocated. In both systems, however, overnight mail service? A service of this nature did not
scarcity and unlimited wants force governments and exist in any significant form in the United States, and
individuals to decide how best to manage resources people seemed to be doing just fine without overnight
and allocate them in the most efficient way possible. mail service provided by a private corporation.
Nevertheless, there are always limits to what the
economy and government can do. In order to answer pertinent questions,
managerial economics applies economic theories,
tools, and techniques to administrative and business
1.3 Managerial Economics decision-making. The first step in the decision-making
process is to collect relevant economic data carefully
Introduction: and to organize the economic information contained in
Decisions made by managers are crucial to data collected in such a way as to establish a clear
the success or failure of a business. Roles played by basis for managerial decisions. The goals of the
business managers are becoming increasingly more particular business organization must then be clearly
challenging as complexity in the business world grows. spelled out. Based on these stated goals, suitable
Business decisions are increasingly dependent on managerial objectives are formulated. The issue of
constraints imposed from outside the economy in central concern in the decision-making process is that
which a particular business is based—both in terms of the desired objectives be reached in the best possible
production of goods as well as the markets for the manner. The term "best" in the decision-making
goods produced. The impact of rapid technological context primarily refers to achieving the goals in the
change on innovation in products and processes, as most efficient manner, with the minimum use of
well as in marketing and sales techniques, figures available resources—implying there is no waste of
prominently among the factors contributing to the resources. Managerial economics helps the manager
increasing complexity of the business environment.

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 Business Economics

to make good decisions by providing information on While managerial economics is helpful in

waste associated with a proposed decision. making optimal decisions, one should be aware that it
only describes the predictable economic
1.4 Applications of Managerial Economics consequences of a managerial decision.

Some examples of managerial decisions have Economic Concepts used in Managerial Economics
been provided above. The application of managerial Managerial economics uses a wide variety of
economics is, by no means, limited to these examples. economic concepts, tools, and techniques in the
Tools of managerial economics can be used to decision-making process. These concepts can be
achieve virtually all the goals of a business placed in three broad categories:
organization in an efficient manner. Typical managerial (1) The theory of the firm, which describes how
decision making may involve one of the following businesses make a variety of decisions;
issues:
(2) The theory of consumer behavior, which describes
· Deciding the price of a product and the decision making by consumers; and
quantity of the commodity to be produced
(3) The theory of market structure and pricing, which
· Deciding whether to manufacture a product or describes the structure and characteristics of different
to buy from another manufacturer market forms under which business firms operate.

· Choosing the production technique to be Overview

employed in the production of a given product What is managerial economics?

· Deciding on the level of inventory a firm will Managerial economics is the use of economic analysis
maintain of a product or raw material to make business decisions involving the best use
(allocation) of an organization's scarce resources
· Deciding on the advertising media and the Managerial economics is (mostly) applied
intensity of the advertising campaign microeconomics (normative microeconomics)

· Making employment and training decisions Managerial economics deals with “How decisions
should be made by managers to achieve the firm's
· Making decisions regarding further business goals - in particular, how to maximize profit.” Also
investment and the mode of financing the investment government agencies and nonprofit institutions benefit
from knowledge of economics, i.e. efficient recourse
It should be noted that the application of managerial allocation is important for them too...
economics is not limited to profit-seeking business
organizations. Tools of managerial economics can be Relationship between Managerial Economics and
applied equally well to decision problems of nonprofit Related Disciplines
organizations. Mark Hirschey and James L. Pappas
cite the example of a nonprofit hospital. While a
nonprofit hospital is not like a typical firm seeking to Management
maximize its profits, a hospital does strive to provide
its patients the best medical care possible given its
limited staff (doctors, nurses, and support staff), Decision Sciences
equipment, space, and other resources. The hospital
administrator can use the concepts and tools of
managerial economics to determine the optimal
allocation of the limited resources available to the Managerial
hospital. In addition to nonprofit business Economics
organizations, government agencies and other
nonprofit organizations (such as cooperatives,
schools, and museums) can use the techniques of
managerial decision making to achieve goals in the
most efficient manner. Optimal Solutions to Managerial
Decision Problems

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 Business Economics

 Management Decision Problems

 Product Price and Output
 Make or Buy
 Production Technique
 Stock Levels
 Advertising Media and Intensity
 Labor Hiring and Training
 Investment and Financing

1.5 The Goals of a Firm

An economic principle that describes a

consumer's desire and willingness to pay a price for a
specific good or service. Holding all other factors
constant, the price of a good or service increases as
its demand increases and vice versa.
Think of demand as your willingness to go out and buy
a certain product. For example, market demand is the
total of what everybody in the market wants.

Businesses often spend a considerable

amount of money in order to determine the amount of
demand that the public has for its products and
services. Incorrect estimations will either result in
money left on the table if it's underestimated or losses
if it's overestimated.

Economic Goals:
Maximizing or Satisfying
1. Profit
2. Market share
3. Revenue growth
4. Return on investment
5. Technology
6. Customer satisfaction
7. Shareholder value

Non-economic Objectives:
1. “A good place for our employees to work”
2. “Provide good products/services to our customers”
3. “Act as a good citizen in our society”

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5. Technology:-
Unit 2 : Demand Analysis The technology used for production is a very important
factor for determining the demand of a commodity, as
it can be seen in case of electronic products that
Structure people do care for the technology instead of prices.

2.1 Demand
2.2 Determinants 2.3 Law of Demand
2.3 Law of demand.
2.4 Elasticity of demand The law of Demand states the relation ship between
2.5 Demand forecasting. price and demand of a commodity. The law of stares
that other thing remaining constant when price rise
demand false and price false demand rise.
This shows an inverse relationship between price and
2.1 Demand demand.

Introduction: Assumptions mean the following factors to remain

constant for the law to be applicable.
The concept of Demand was given by Alfred Marshall,
according to him demand is “want backed by 1) Income should remain constant:
willingness and capacity to pay for it, in the absence of Income of consumer change the demand will change
willingness or capacity the demand becomes a mere even at constant price
desire”.
The willingness and ability of the people within a 2) Taste and fashion should remain
market area to purchase particular amounts of a good constant:-
or service at a variety of alternative prices during a The taste of consumer and the fashion should remain
specified time period. constant as change in fashion taste will lead to fall in
demand even at constant price.
2.2 Factors affecting Demand/determinants of
Demand 3) Price of substitute and complementary
goods should remain constant:
1. Price: - The change in price of substitute and complementary
Price and demand have inverse relationship, when goods will affect the demand of a commodity e.g. If
price rise demand falls and vice versa, thus change in price of Pepsi falls the demand for coke decrease,
price affects the demand of a commodity. even if the cokes price didn't rise. Thus when price of
car rise demand for petrol will decrease even price of
2. Income:- petrol didn't rise.
Change in income of a consumer affects his demand
for goods and services, demand and income are 4) Population should remain constant:
directly related rise in income leads to rise in quantity The population should be constant because if
demand and vice versa. population increases demand will also increase even
at high price or constant price.
3. Fashion:-
People prefer to go with the current trend, goods in 5) Advertise should be constant:
fashion fetch more demand than outdated products, Powerful advertise creates more demand therefore
and thus fashion is one of the determinants of change in advertise will create increase in demand
demand. even at high prices. The law can be clearly Explained
with the help of a schedule and a diagram:-
4. Taste:-
Taste of a consumer affects the demand of a product,
if a consumer is habituated towards a particular
product particular commodity the demand for that
commodity will be more irrespective of other factors.

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Law of Demand phenomenon is known as Giffen pardox. A Giffen

Schedule goods refers to inferior goods. Switching from inferior
good to superior good is known as Giffen's paradox.

2) Speculation:-
In case of speculation more of item would be
purchased even at high prices eg. Share market
when prices of shares rise its demand also rise.

3) Prestigious Goods:-
Certain commodities like diamonds Ruby, pearls are
purchased when they are Very costly just for a
prestige a for snob appeal even at high prices them
the law do not apply in case of prestige our goods.

4) Impulsive Purchase:-
Some time consumes tend to makes impulsive
purchase even at light price. E.g. A black film tickets
are purchased out of impulse.

5) Ignorance:-
It the consumer is not aware of prices he may demand
As seen in the schedule price is rising from Rs.1 per more at high price.
kg and as a Result of rise in price the demand is falling
from 50 kgs to 10 kgs on the bases of the above 6) Bandwagon Effect:-
schedule we join point on a graph. On OX axis we People buy goods by watching the fashion even at
have taken demand we get a demand curve sloping high price.
downwards and on OY axis we have taken Price. from
left to right sharing an inverse relationship between
price and Quantity demand.. 2.4 Elasticity of Demand
The Elasticity of demand was given by Alfred
Criticisms of the Law Marshall the elasticity of Demand is responsiveness of
a commodity to change its demand due to changes its
1) Income is not always constant it changes. prices and other factors.
2) Population always changes. The other definition given by boulding was
3) Advertise are not constant. “Elasticity of demand measure the response of
4) Seasons cannot be constant. changes of demand for commodity to changes its
5) Fashion and taste of consumer is not always price.
constant.
Some elasticity concepts:
Exceptions of the Law of Demand
• Price elasticity of demand
There are certain exceptions where the law is • Elasticity of derived demand
not applicable they are • Cross-elasticity of demand
as follows:- • Income elasticity of demand
• Elasticity of supply
1) Giffens Paradox:-

Sir Robert Giffen s was surprised to find out the Price Elasticity of Demand
workers in Ireland purchased less of bread when
prices were low. The reason for this was that these low Responsiveness of a commodity to change its demand
paid workers consumed bread with a small quantity of due to change in price.
meat, when the price of bread went down they
purchased low quantity of bread and with the
remaining quantity of amount they purchased more of Price elasticity (ED) = proportionate change in quantity
meat though meat was a highly expensive item. This demand

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 Business Economics

Proportionate change in price

Or % change in QD
% change in price

Or D * P

D P

· Types of Price Elasticity of Demand

1. Unitary elastic demand

2. Relatively less elastic demand
Fig 1.4
3. Relatively more elastic demand
4. Inelastic demand/ Zero elastic demand
Relatively More Elastic Demand
5. Elastic demand / Infinite elastic demand
When the change in demand is more than change in
price it is known as relatively more elastic demand i.e
Unitary Elastic Demand
ED>1
When the change in demand is exactly proportionate
to change in price the demand is known as unitary
elastic demand. i.e. ED=1

Fig 1.5

Inelastic / Zero Elastic Demand

When there is no change in demand due to change in

price it is known as inelastic demand i.e ED = 0

Relatively Less Elastic Demand

When the change in demand is less than change in

price it is known as relatively less elastic demand i.e
ED<1
Fig 1.6

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 Business Economics

Perfectly Elastic / Infinite Elastic Demand

When a small change in price brings huge change in

demand which cannot be measured it is known as
perfect elastic demand. i.e. ED

Fig 1.8

Total Outlay Method

Under this method elasticity is measured by drawing

the relationship between price and outlay i.e
Fig 1.7 expenditure

· Methods of Measuring Price Elasticity of

Demand

Price elasticity can be measured by using various

methods they are:-

1. Proportionate method
2. Point or geometric method
3. Total outlay method
4. Arc method
Fig 1.9
Proportionate Method
Arc Method
Under this method ED can be measured with the help
of a formula which is This method is used to measure huge changes in
Proportionate change in demand. under this method
Price elasticity (ED) = quantity demand The change in demand due to change in price is taken
Proportionate change in price into consideration and then elasticity is measure by the
formula
Or % change in QD
% change in price ED= D1 –D2 * P1+P2
D1 +D2 P1 –P2
Or D * P

D P

Point or Geometric Method

Under this method the formula given to measure ED is

ED= Lower Segment
Upper Segment

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 Business Economics

Advantages of Demand Forecasting:-

(1) Demand forecasting helps to plan production

to match the predicted demand. As a result of this,
possibility of over production and under production
is ruled out.

(2) The Demand forecasting helps in evolving an

appropriate pricing policy because the price is
determined keeping in view the expected demand.

(3) Demand forecasting helps in reducing the cost

of purchasing raw material because the size of
inventory of raw materials will be harmony with the
size of production planned.
Fig 1.10
(4) Demand forecasting help a multi product firm
in the planning of production according to the
· Determinants of Price Elasticity of Demand predicted demand for different units.

1. The number and availability of substitutes (5) Demand forecasting helps in financial planning
2. The expenditure on the commodity in relation to to avoid under capitalization and over capitalization.
the consumer’s Budget
3. The durability of the product (6) Demand forecasting also provide a guideline
4. The length of the time period under consideration for proper manpower planning because the demand
5. Consumer's preferences for labour is influenced by the size of production which
itself is influenced by predicted demand. It would avoid
over Staffing and under staffing.
The concept of elasticity of demand is useful in many
ways. It helps the manager for determination of the Methods of Demand Forecasting:-
prices i.e. it helps the manager in determining the
appropriate pricing policy like if a certain product have 1) Survey of buyers Intention:-
elasticity demand in the markets its price will be kept It is the most direct method where customers
low as its demand is affected by changes in prices and are asked about their purchases of the future. Thus in
if certain commodity have inelastic demand its price theism ethos the burden of forecasting is put on the
are kept high as the consumer will buy it at any price. customers. This method can give misleading
conclusion as customers may themselves misjudge
Elasticity measures the sensitivity of the quantity their requirements due to the following reasons.
demanded to changes in the determinants of demand
a) Irregularity in customers buying intensions,
b) The consumers inabilities to foresee their choice
2.5 Demand Forecasting when faced with multiple alternative, and
c) The possibility that the buyer’s plans may not be
Demand Forecasting (D.F) real but only wishful thinking.

Demand forecasting is the art of predicting demand for 2) Collective opinion method:-
a product or service at some future date on the basis In this method salesman are required to
of certain present and past behavior pattern of related estimate expected sales in their respective territories.
items. In other words, demand forecasting is an The rationale of this method is those salesmen being
estimation of future demand. Since the future is close to the customer are likely to have the most
uncertain therefore no demand forecast can be made intimate feel of the market. These estimates of
with 100 percent Demand forecasting thus just a salesman are consolidated to find out the total
probability distribution of demand. estimated sales. The revised estimates are further
examined in the light of factors like proposed changes
in the selling prices, product designs, advertisement
changes, population changes, etc. Although this

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method is simple and is based on the first hand risky too because they may lead to unfavorable
information of those who are directly connected with reactions from dealers, consumers and competitors.
sales but this method is subjective as personal opinion
can possibility influence the forecasting? Therefore, 6) Study of general economic environment:-
forecasting through the method can be used in the The various methods suggested till now are
shot run, but for long run analysis a better technique is related with the product concerned. These methods
to be applied. are based on the past experiments and try to project
the failure from the past . But such projection is not
3) Expert opinion method:- effective where there are ups & down particularly, the
This method is also known as Delphi method projection of trend cannot indicate the turning point
of investigation. In this method instead of depending from boom to recession.
upon the opinion on buyers and salesman, firms can Therefore, to study the same it is necessary to
obtain sought and their identity is kept secret. These find out the general behavior of the economy. For this
opinions are then exchanged among the various purpose, an eye is kept on certain indicators: Like the
unanimity is arrived at among all the experts. heavy advance order for capital goods and machines
give an advance indication of economic prosperity.
Similarly, better infrastructure in the rural areas will
mean increase in demand of automobiles.
4) Statistical Method

a) Trend Projection Method:- A firm, which has Assignment-I

been in existence for some time, will have
accumulated considerable data on sales pertaining to Q.1. Explain the Law of Demand?
different time periods. Such data when arranged Q.2. How the concept of Elasticity does helps the
chronologically gives 'time series' the time series manager in taking
relating to sales represent the past pattern of effective decision of the business?
demand for a particular product. Such data can be Q.3. Explain Demand Forecasting?
used to project the trend of times series. Q.4. Write short notes on the following:-
a. Demand analysis.
b) Graphical Method:- Old values of sales for b. Methods of measuring elasticity of
different areas are plotted on a graph and a free hand demand.
curve is drawn passing through as many points as Q.5. Explain the meaning & scope of business
possible and the direction of free hand curve shows economics?
the trend.

c) Regression analysis:-
This is a very common method of forecasting demand,
under this method a relationship is established
between quantity demanded.( dependent variable) and
independent variables such as incomes, price of the
good, prices of the related goods, etc.

5) Controlled Experiments:-
Under this method, an effort is made to vary
separately certain determinants of demand which can
be manipulated, for example, price, advertising, etc.
and to conduct the experiments assuming that the
other factors remain constant. Thus, the effect of
demand determinants like price, advertisement,
packaging, etc. on sales can be assessed by either
varying them over different markets or by varying them
over different time periods on the same market. But,
this method is used relatively less because this
method of demand forecasting is expensive as well as
time consuming. Moreover, controlled experiments are

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market to earn profit. Production function always refers

Unit-3: Production and Cost to a period of time and a state of technology which is
constant.
Structure E.g.; A textile manufacturing industry produces 10,000
mts of cloth per day, the inputs required is labour,
Chapter 1. Theory of production yarn, dyes, chemicals and the output is 10,000 mts of
cloth. The function can be explained in the form of an
1.1 Production function. equation i.e.
1.2 The law of variable proportion Q = f(X1, X2… Xk)
1.3 Returns to scale
1.4 Internal and external economies and Where
diseconomies. Q = output
X1… Xk = inputs
Chapter 2. Costing concepts

2.1 cost function and determinants

2.2 Implicit and Explicit cost Assumptions:
2.3 Opportunity cost
2.4 Traditional costs 1. It refers to a period of time.
2. It refers to a state of technology which is constant.
Chapter 1: Estimation of Production and Cost 3. Factors are considered to be homogeneous.
Function 4. Only physical inputs and outputs considered

For practical decision-making purposes it is necessary The Cobb-Douglas Production Function

to obtain estimates of production and cost functions. In
economics, it is usually hard to perform controlled This production function was given by Cobb &
laboratory experiments. Instead, actual operating data Douglas in the year 1928, by doing the empirical
are used with some statistical procedures to derive studies of the manufacturing industries. Earlier the
these estimates function was applicable to the American manufacturing
industries but now it is applicable to the whole of
The Theory of Production manufacturing industries.

Production theory forms the foundation for the theory Cobb and Douglas:
of supply, Managerial decision making involves four Q = a Lb K c
types of production decisions:
b + c = 1, constant returns
1. Whether to produce or to shut down b + c > 1, increasing returns
2. How much output to produce b + c < 1, decreasing returns
3. What input combination to use
4. What type of technology to use? Can only use one of these at a time… so which one to
choose?
Production involves transformation of inputs Properties of the Cobb-Douglas function that have
such as capital, equipment, labor, and land into output kept it so popular for 90 years Both inputs have to be
- goods and services, in this production process; the used simultaneously to get an output
manager is concerned with efficiency in the use of the
inputs Limitations

1.1 Production Function 1. Only two factors Labour and capital considered
A production function is a table or a mathematical rest ignored
equation showing the maximum amount of output that 2. Factors are considered to be homogeneous
can be produced from any specified set of inputs,
given the existing technology. It expresses the
functional relationship between physical inputs and
outputs. Inputs refer to investment whereas output is
the finished product which a firm sells in the

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1.2 The Law of Variable Proportion Schedule:

Introduction:

Production function expresses the functional

relationship between physical inputs and outputs.
There are two types of production function.

1. Short run production function/law of variable

proportion
2. Long run production function/Returns to scale.

Explanation:-

The law of variable proportion is the short run

production Function, it states that if a producer
produces under short run he Cannot Vary all the
factors, only one factor can be varied i.e. labour in the
initial stage he will get increasing returns, diminishing
returns in the Second stage and then negative returns The law can be explained by dividing the behavior of
in the third stage. output into three distinct stages:

Assumptions:- Stage 1: The law of increasing returns:

1. Short run: In this stage, total product increases at an increasing

The law is applicable only in short run and fails to rate. Marginal product also rises and reaches its
operate in long run maximum and then starts’ falling but still it is more than
average product. Average product throughout rises
2. One factor varies: though the rise is less than marginal product.
The law assumes that quantity of some inputs is kept
fixed and only one varies.

3. Variable factor varies in equal proportion: Causes of increasing returns:

The law assumes that the factors are used in fixed
proportion, then an increase in one factor would not 1. Fixed factors: The fixed factors are indivisible, so
lead to any increase in output. they require a certain amount of variable factors if they
are to be fully used. Hence in the initial stage the
4. Homogeneous : employment of every additional unit of variable factors
The variable factors are assumed to be homogeneous there are increasing returns. This is due to better use
and divisible. of factors like machinery, managerial staff etc.

5. Technology remains constant: 2. Division of Labour: With increase in labour

The state of technology is assumed to be given and division of labour results as a result of which internal
unchanged, if there is an improvement in technology, economies set in and therefore increasing returns
then marginal and average product may rise instead of occur.
falling.
Stage 2: The Law Of Diminishing Returns:
6. Only physical inputs and outputs considered: Total product continues to increase at a diminishing
The law considers only physical inputs and outputs rate until it reaches maximum at a point where second
and not economic profitability in monetary terms The stage ends. Here marginal as well as average product
law states that as we increase the quantity of one input decreases but both are positive. At the end of this
which is combined with other fixed inputs, causes stage the marginal product of variable is Zero.
outputs to increase, but after a point the extra output
resulting from the same addition of extra inputs will
eventually decline.

13
 Business Economics

Causes of diminishing returns: 1. Total product curve:

TP curve in the 1st stage increases at a steep rate, in
1. Beyond the optimum point: After reaching a the 2nd stage increases at a diminishing rate and in the
maximum point if more units of variable factor are 3rd stage falls reaching maximum.
employed it gives rise to diminishing returns, this is
due to over utilization of the plant and under utilization 2. Marginal product curve:
of variable factor. It increases at a rapid rate, in the 1st stage, falls in the
2nd stage and finally becomes negative I the 3rd stage.
2. Wrong proportion: After the optimum point, the
indivisible fixed factor is being used with variable 3. Average product curve:
factors in a wrong proportion, which causes a decline It rises initially but the rise is less compared to the
in the efficiency of the variable factor. marginal product in the 1st stage in the 2nd stage it falls
but again the fall is less than compared to that of
Stage 3: The law of negative returns: marginal product curve and in the 3rd stage it goes on
In this stage total product declines, marginal product is falling but does not become negative like the marginal
negative and average product is diminishing. This product curve.
stage is called negative returns since the marginal
product of the variable factor is negative during this Stage of Operation
stage. An important question is in which stage a rational
producer will seek to produce? A rational producer will
Causes of negative returns: never produce in stage three, as the marginal product
of the variable factor is negative. He will also not
The negative returns are caused as the amount of produce in stage one.
variable factor is more than that of fixed factors. The He will produce in at stage two as here he can utilize
efficiency of the fixed factors is reduced and the both fixed and variable factor and his total product
marginal returns become negative. In this case if the increases to maximum.
certain amount of variable factors is withdrawn, the
output will increase.
1.3 Returns to Scale

Diagram Introduction:
Y Production function expresses the functional
I II III relationship between physical inputs and outputs.
Increasing Diminishing Negative There are two types of production function.
Returns returns returns 3. Short run production function/law of variable
TP
proportion
TP 4. Long run production function/Returns to scale.
MP
AP Explanation:
Returns to scale is a long run production function, this
function states that all factors become variable to
increase the production. If a producer produces under
long run in the initial stage he will get increasing
returns, then the returns becomes constant and then it
starts diminishing.

Assumptions:
AP
1. Long run:
Variable proportion Returns to scale is where production is studied in the
MP long run where the factors can be varied.

2. All factors vary:

All the factors which are used for production are
assumed to vary in long run and the variable factors
are homogeneous.

14
 Business Economics

There are three types of laws of returns to scale:

3. Factors are in equal proportion: 1. Law of increasing returns to scale: When all the
The variable factors are assumed to vary in equal inputs are increased the output increase is more than
proportion. the increase in the input
2. Law of constant returns to scale: Constant
4. Technology constant: returns to scale are where inputs are increased and in
The technology is assumed to be constant and is the the and in same proportion outputs also increase.
optimum one. 3. Law of Diminishing returns to scale: Diminishing
returns to scale are where inputs are increased the
5. Physical units: increase in output is less than increase in inputs.
The law considers only physical inputs and outputs
and not economic profitability in monetary terms.
1.4 Economies and Diseconomies to the Scale of
Schedule: Production

When the scale of production increases up to a point,

one gets increasing returns. Thereafter diseconomies
of scale ensure. Increasing returns to scale is a result
of these economies. Marshall has divided economies
into two parts.

1. Internal economies
2. External economies

Internal Economies

1. Labour economies:
Increase in the scale of production of a firm result into
many economies of labour, like specialization, which
increase the productivity of labour.

2 Technical Economies:
Diagram: These economies influence the size of the firm. These
Y I II III economies result from greater efficiency of the capital
Increasing Constant Diminishing goods of superior technique used by big firms.
Returns to Returns to returns to
Scale Scale Scale
TP 3. Selling and marketing economies:
A firm producing on a large scale also enjoys several
marketing economies in respect of sale of this large
output.

4. Managerial economies:
TP
A firm producing on a large scale can engage efficient
MP
and talented managers. The task of management is
decentralized into different departments headed by an
expert who looks after his department.

5. Risk bearing economies:

It is said that a large business with multiproduction
capability is in a better position to withstand
economies fluctuations and therefore enjoys
economies of risk bearing.
Combination MP

15
 Business Economics

External Economies
3 Commercial diseconomies:
1. Growth of ancillary units: When a business is significantly large, division of
When several firms of an industry establish labour can be introduced on a commercial side, with
themselves at one place, than they enjoy many the expert buyers and sellers being employees. These
benefits together, like availability of developed means economies become diseconomies after an optimum
of communication & transportation, mutual scale
consultation by the entrepreneurs when faced with a
general crises and financial institutions etc. External diseconomies:

2. Better transportation and marketing facilities: These diseconomies are suffered by all the firms in an
The expansion of an industry resulting from entry of industry. These are not confined to any particular firm.
new firms. May make possible the development of When an industry in a given area expands beyond
transportation and marketing network to a great extent certain limits then firms operating in that industry suffer
which will greatly reduce cost of production of the external diseconomies. There are several reasons for
firms. it like regular power cuts, political conditions,
transportation problem etc.
3. Development of skilled labour:
When an industry expands in an area the labour in that
area is well accustomed to do the various productive Chapter 2: Costing Concepts
processes and learns a good deal from the
experience. Cost Function

4. Technological economies: The concept cost function refers to the mathematical

When the whole industry expands, it may result in the relation between cost of a product and the various
discovery of new technical knowledge and in determinants of costs. In cost function the dependent
accordance with that, the use of improved and better variable is unit cost or total cost and the independent
machinery than before, results in external economies. variables are the price of a factor, the size of the
output or any other relevant phenomenon, which has a
5 Cheap raw materials: bearing on cost.
The expansion of an industry may result in exploration Symbolically,
of new and cheaper sources of raw material, C – f(O, S, T, U,P…………) where C is cost, O is level
machinery and other types of capital equipment. This of output, S is the size of plant, T is time under
reduces their cost of production and their prices. Thus consideration, U is the utilization of the production
the firms using these materials and capital equipments capacity, P is the prices of factors of production.
may be able to get them at lower price.

Determinants of costs:
Internal and External Diseconomies
The following are the determinants of cost behavior
Internal diseconomies:
These can arise due to: 1. Laws of returns:
An important determinant of cost is the law of
1. Unwieldy management: returns operating. In case of law of diminishing returns
One of the main causes of internal diseconomies is the the cost will show a tendency to rise, the reverse will
difficulty of large scale management. In a big firm, it be the law of increasing returns is applicable.
becomes pretty difficult to coordinate the work of
different sections. It becomes a tough problem to 2. Size of the plant:
supervise the work spread all over. With a bigger size of the plant, the initial fixed
costs are high, but variable costs tend to be low
2. Technical difficulties: compared with a small sized plant.
Another cause of internal economies is the Emergence
of technical difficulties. There is an optimum point up 3. Period:
to which technical improvements can be carried out. If the period under consideration is a short one,
Beyond this optimum point, improved technology then cost curve will rise steeply but in case of long
becomes uneconomical. period, cost would not increase that steeply.

16
 Business Economics

by him if he had let his labour, building and money to

4. Capacity Utilization: someone else. Implicit costs are frequently ignored in
With higher capacity utilization, fixed cost per calculating the expenses of production.
unit of output is bound to be low. Leftwich defines cost of production as “cost of
self-owned, self employed resources that are
5. Prices of factors of production: frequently overlooked in computing the expenses of a
The cost of product is affected by the prices firm”.
of factors of production. If the prices of the factors are
high the cost will be high of producing the goods. 2.3 Opportunity Costs

6. Technology: The Austrian economists, Wieser first

Technology has also a big influence on the developed the concept of opportunity cost. The other
cost of a product. In fact, most technological notable contributors are Daven port, Knight, and
innovations aim at reducing the costs. Robbins. According to them, the real cost of
production of a given commodity is the price of the
7. Efficiency: next best alternative sacrificed in order to obtain that
Cost is also affected by efficiency in the use commodity and this is called opportunity cost. The
of inputs as well as choice off relatively cheaper inputs concept is based on fundamental fact that factors of
which are equally efficient so far as the product quality production are scarce and versatile.
is concerned. The opportunity cost of anything is the
alternative that has been foregone. In the words of
8. Size of the product: prof. Perrow “opportunity cost is the amount of the
If the production is done in large volume, the next best produce that must be given up in order to
cost is low and low volume of production results in produce a commodity.
relatively higher cost.
Limitations
9. Stability:
Overall costs are generally lower where 1. Specific factors: Opportunity cost dose not apply
output is stable and constant over a period of time. to specific factors like blast furnace in the steel factory
Production by sudden breaks and disruption is bound which can be used for a particular purpose only and
to be costly. has no other use.

2.2 Explicit Cost and Implicit Cost 3. Perfect competition: The concept rest on the
assumption of perfect competition. But it’s actually
Explicit costs refer to those costs, which are a myth.
actually paid by the firm. In other words, explicit costs
are monetary payment made by the entrepreneur for 4. Homogeneous factors of production: it is
purchasing or hiring the services of various productive assumed that factors of production are not
factors, which do not belong to him or are paid out of homogeneous.
costs. Explicit costs are considered in the calculation 5. Alternative uses are not clearly known: The
of the expenses of production. This cost is in the foregone opportunities are often not ascertainable.
nature of contractual payment and includes rent for This also poses a serious limitation on the concept.
land, wages to the labour, interest on capital, payment
for the raw materials, fuel, power, etc. Leftich defines 6. Cannot be recorded: This cost cannot be shown
explicit cost as “those outlays made by a firm that we in the books of accounts.
usually think of as its expenses. They consist of
resources bought or hired by the firm”. This cost is 2.4 Traditional Theory of Cost
recorded in firms account book and is also known as
accounting cost. Under traditional theory cost are mainly of three types.
Implicit costs are the costs of an
entrepreneurs own factors or resources. These are 1. Total cost
imputed value of the entrepreneur’s own resources 2. Average cost
and services. In other words, implicit costs are costs 3. Marginal cost.
which self-owned and self employed resources could
have earned in their best alternative use. It refers to
the highest income, which might have been received

17
 Business Economics

Costs In The Short Run Variable costs are those cost, which are incurred on
the use of variable factors of production. Variable cost
Total Cost varies with level of output. In other words costs
The amount of money spent on the production of undergo a change with the change in output. As output
different levels of a good is called total cost. It is the falls these costs also falls if output rises these costs
sum of all expenditure incurred in producing a given also rises. These are also called prime cost or direct
volume of output. In the short period, total cost are of costs.
two types. E.g. raw materials, wages, electricity charges etc.
Variable cost is the sum of marginal cost
a) Total fixed cost
b) Total variable cost Marginal cost
Cost of producing every additional single unit is
TC=TFC+TVC marginal cost. It diminishes with the increase in output
in the initial stage and starts increasing.
Where TC is the total cost, TFC is the total fixed cost
and TVC is the total variable cost. Schedule

Total Fixed Cost or supplementary cost Output Marginal cost Total variable
cost
In the short period, costs of fixed factors are called 0 0 0
fixed cost. It is the costs which do not change with the 1 10 10
change in output. Production may be maximum or zero
2 8 18
unit, but fixed cost remain same. These costs are
supplementary cost or indirect cost. 3 6 24
E.g. Rent, interest on capital, property tax etc. 4 4 28
5 4 32
Schedule:
6 6 38
Output Fixed cost 7 8 46
0 10 8 16 62
1 10
2 10
3 10
4 10
5 10 Diagram: Variable cost
6 10
Y TVC
Y

Total 10 TFC TVC

Fixed
Cost

O 1 2 3 4 5 6 7 X
Output O output X

Total variable cost or prime cost

18
 Business Economics

AFC= TFC/Q
Marginal cost
Y
Y
MC

AFC
MC

O Output X
AFC
O OUTPUT X
Schedule: Total cost Average Variable cost AFC:

AVC refers to variable expenses per unit of output. It

increases with the increase in output.
AVC=TVC/Q

Y
AVC

AVC

Diagram O OUTPUT X
TC
Y
VC AVERAGE COST or average total cost
It is the cost per unit. It is the sum of per unit fixed cost
and per unit variable cost.
ATC=TC/Q

TC
TFC
TVC Y
AC
TFC
AC
O X
Output

Average fixed cost AFC:

AFC is the fixed cost per unit of output; it diminishes
with the increases in output. O X
OUTPUT

19
 Business Economics

a) Local Market: Local market refers to a market in

Unit-4: Market Structures & a particular village or locality. Generally
Price Information perishable goods have local market.

b) Regional Market: Regional market refers to a

Structure market, which covers a particular region.
Generally bulky articles like bricks and stones
Chapter 3: Market Structures have regional market

3.1 Introduction to market c) National Market: It refers to a market which is

3.2 Perfect competition market spread over the entire country. Generally
3.3 Price & output determination under perfect commodities like wheat, rice etc. have national
competition market.
3.4 Monopoly
3.5 Price and output determination under monopoly d) International Market: When the market is
3.6 Monopolistic competition spread over the globe it is said to be an
3.7 Price determination under monopolistic market international market. Generally valuable metals
3.8 Oligopoly. like gold, silver etc. have an international market.
3.9 Price determination under Oligopoly
2. On the basis of time

a) Very short period: A very short period is one in

3.1 Meaning of Market which supply cannot be increased or decreased to
adjust as per demand. Examples for very short
In ordinary language market refers to place where period markets are vegetables, fruits etc.
commodities are bought and sold. E.g. Chennai
market, Mumbai market, etc. But in economics market b) Short period: Short period market refers to a
has no reference to a place, it refers to a particular period of time in which the rate of production is
commodity which is being bought and sold. In variable.
economics, market refers to a group of buyers and
sellers taking part in the exchange of a commodity. c) Long period: Long period is a period of time in
The buyers and sellers may be scattered within a which the supply of the commodity can be varied
country or may be abroad. But there must be some according to the conditions of demand. Long
contact by means of fairs, or other means of period involves many years.
communication.
3. Classification on the basis of volume of
Features of a market business
1. Buyers and sellers: The existence of buyers and a) Wholesale market: It is a market where
sellers is the first feature of a market. The number transactions in large quantities take place.
of buyers and sellers may be large or small.
2. Contact: The next feature is the existence of b) Retail market: It is a market where goods in
some contact among the buyers and seller. The small quantities are transacted.
contact may be direct or indirect.
3. A Commodity: A commodity should be there to 4. Classification on the basis of competition
deal with. In the case of different commodities, a) Perfect market: A perfect market is where there
there will be different markets. is perfect competition.
4. A Price: There should be a price for the
commodity that is bought and sold in the market. b) Imperfect market: A market is imperfectly
competitive if the action of one or more buyers and
Classification Of Market sellers have a perceptible influence on price.
1. On the basis of area 5. Classification on the basis of commodity

a) Bullion Market: Bullion market is a market for

valuable metals like gold, silver, diamonds etc.

20
 Business Economics

6. Mobility of factors or production: Facilities exist

b) Share Market: Share market is a place in which for the perfect movement of the factors which
shares are brought and sold, e.g. New York Stock means factors can move from one occupation to
Market. the other

c) Money Market: Money market is a place in which 7. No transport costs: It is convenient, under
short term credit instruments are bought and sold, perfect competition to make the assumption that
e.g. London money market. all the producers work sufficiently close to one
another for there to be not transport costs.
3.2 Perfect Competition
8. No Government interference: Perfect
Perfect Competition Market competition also implies that there is no
Perfect competition refers to the market government intervention in the working of the
structure where competition among the sellers and working of the marker.
buyers prevails in its most perfect from. In a perfectly
competitive market, a single market price prevails for a 3.3 Price Determination Under Perfect Competition
commodity, which is determined by the forces of total
demand and total supply in the market. Under the Equilibrium of the industry:
perfect competition, a buyers or a seller is a price taker
and not a price maker. Everyone has to accept the Under perfect competition, the equilibrium
prevailing market price as no one is in a position to price for a given product is determined by the
influence the price individually. interaction of forces of demand and supply as shown
According to Prof. Left witch, “Perfect competition is a in the schedule and figure.
market in which there are many firms selling identical
products with no firms large enough relative to the
entire market to be able to influence market price.” Price (in Rs) Quantity Quantity
demanded Supplied (In
Features of Perfect Competition Market (in Kgs) Kgs)
10 300 100
1. Large number of buyers and sellers: There
are large numbers of buyers and sellers who compete 20 200 200
among themselves and their number is so large that 30 100 300
no one buyer or seller can influence demand or supply
in the market.
Quantity Demanded and Quantity Supplied (In
2. Homogenous product: The commodity Kgs) Diagram Fig
dealt in is homogenous in the sense that the goods
Y
produced by different firms are identical in nature,
therefore the buyers has no choice among the goods D S
as they are same in colour, taste, size, quality etc. 30 _
P
3. Free entry and exit: Every firm is free to
enter the market or to leave it. It means complete R 20 _
freedom is there for the producer as well as the E
consumer. I
C 10 _
S D
Note: If only the first three conditions exist, the E
competition will be treated as pure or free one. O X
100 200 300
4. Perfect knowledge: There is a perfect knowledge
on the part of buyers and sellers as regards to Demand & supply
market condition and price prevailing in the market.
As shown in the schedule and the diagram,
5. Uniform knowledge: The goods dealt in are of demand and supply of the commodity are shown at
uniform price throught the market at a given point various level of price. When price Rs.10 per kg,
of time. demand is 300 kgs and the supply is 100 kgs. Here,

21
 Business Economics

demand becomes greater than supply. So, the price A firm will continue its production as long as its
will start to increase and it will reach the level of Rs.20 marginal revenue is equal to its marginal cost
per kg, demand and supply of the commodity become (MR=MC). The MC curve should cut the MR curve
equal, i.e. 200 kgs. If the prices become Rs.30 per kg, from below. In other words, the slope of MC should be
the demand is 100 kg and the supply is a 300 kgs. positive.
Here, supply become greater than demand, So, the As can be seen from the following figure the firm’s
price will start to decline and it will again reach the equilibrium is at point since it is here that the above
level of Rs.20. Thus, in the schedule 16.1 the demand two conditions are being satisfied. At point ‘A’ MC
and supply become equal only at the price Rs.20, curve is equal to MR but the second condition is not
which is the equilibrium price. From the diagram also it being satisfied here. It is only when the firm produces
is clear that equilibrium price is determined at the point more output than ON that is marginal cost will go on
where demand and supply curves interest each other. falling and adds to the profits of the firm. If the firm
produces more than OM units of output, its MC will
Equilibrium of the firm: exceed MR and will have to incur losses. Thus point E
The firm is said to be in equilibrium when it will represent equilibrium of the firm.
maximizes its profit. Firms in a competitive market are Conditions of Equilibrium of the firm
price takers. This is because there are a large number
of firms in the market who are producing identical or Y MC
homogeneous products. As such these firms cannot
influence the price in their individual capacities. They
have to accept the price fixed by the industry as a
whole through the interaction of total demand and total A E P=AR=MR
supply, which are OP as shown in the figure which is MC
also its average and marginal revenue.

INDUSTRY FIRM
Y Y
D S
30 _
Price price O N M X
P 20 _
E P Output
10 _
S D
O 100 200 300 X O X
In the Short run, a firm can face any of the three
situations:
c) Supernormal Profits.
Demand & supply d) Normal Profits.
Trends of revenue for the firm e) Minimum Losses.

1. Super Normal Profits.

Price Quantity Total Average Marginal A firm is an equilibrium when MC=MR, and the
(in sold Revenue Revenue Revenue marginal cost curve cuts the marginal revenue curve
Rs.) from below. A firm in equilibrium earns super normal
20 1 20 20 20 profit, and then average revenue is greater than its
20 2 40 20 20 average cost. The situation is shown in the figure.
Equilibrium output is OM. At this output ME is the
20 3 60 20 20
average revenue and the average cost is MS, thus it
gets SE per unit of profit. So its total super normal
As shown in the schedule a firm price, average profit will be equal to PQSE.
revenue and marginal revenue is equal to Rs.20
Therefore the firms AR=MR=price.

Conditions of the Equilibrium of the Firm.

A firm in order to attain equilibrium position must
satisfy two conditions:

22
 Business Economics

part of the fixed cost, it will be beneficial for it to

Super Normal Profits Diagram AC<AR continue production because fixed costs such as costs
towards plant and machinery, building etc. are already
incurred and in such a case it will be able to recover
Y MC art of it. But if a firm is unable to meet its average
AC variable cost it will be better for it to shut down. In the
figure, E is the equilibrium point the average revenue
is ME and the average cost is MS, the firm is earning
Es per unit loss and total loss is PESQ.
MC E P=AR=MR
P Minimum Losses Diagram AC>AR
AC
Y MC AC
S
Q
Q S

O M X
MC P P=AR=MR
Output AC E

Supernormal profits

2. Normal Profits.
A firm is in equilibrium when MC=MR. And the O M X
marginal cost curve cuts the marginal revenue curve Output
from below. A firm in equilibrium earns normal profit.
When average revenue is equal to its average cost. Minimum losses
The situation is shown in the figure. Equilibrium output
is OM. At this output ME is the average revenue and
the average cost is also ME, thus it gets normal profit. 3.4 Monopoly

Normal Profits Diagram AC=AR Monopoly

Monopoly refers to that situation of the market
Y MC in which there is only one seller of a given commodity.
AC ‘Mono means single and poly refers to seller.’ A
monopolist is the sole supplier of a product for which
there are no close substitutes.
E P=AR=MR
In the words of Ferguson,” A pure monopoly exists
MC when there is only one producer in a market. There in
AC so direct competition.”

Features of Monopoly
1. Single Seller: In a monopoly market there is only
one firm producing or supplying the product. This
single firm constitutes the industry and as such there is
O M X no distinction between the firm and the industry in a
Output
monopoly market.
2. Monopoly is also an industry: There is only one
3. Minimum Losses firm under monopoly and it constitutes the industry as
The firm can be in equilibrium position well. Difference between firm and industry comes to an
and still make losses. This is the position when the end.
firm minimizing losses. When the firm is able to meet
its variable cost and a part of fixed cost it will try to 3. Restriction to entry: In a monopoly market there
continue production in the short run. If it recovers a are strong barriers to entry. The barriers to entry could

23
 Business Economics

be economic, institutional, legal or artificial In the 1. Strategic raw materials: A monopoly may arise on
words of J.S. Bains. “A firm assumes monopoly account of some natural causes. A single firm may
character when it has no near competitor.” control the supply of key raw materials, which are
needed for the production of a product. For many
4. No close substitutes: The monopoly generally years the Aluminum company of America (ALCOA)
sells a product which has no close substitutes. He owned almost every source of bauxite in the U.S.
therefore determines the price of the good himself.
2. Patents over inventions: Firm that acquires
5. Price maker: A monopolist is a price maker and patent right for the production of a particular
not a price taker. He does not have to take into commodity gets an absolute monopoly over that
account any other firms decision with respect to price. product. This leads to legal monopoly.

6. Restriction in context to price or output: A 3. Fiscal Monopolies: There are certain monopolies
monopolist can either fix price or output. He cannot like post offices, minting of money and printing of
control both. notes which are owned by the state itself, known as
fiscal monopoly. These monopolies are undertaken to
Types of Monopoly conduct smooth.

There are various kinds of monopoly. 4. Ignorance or control of a secret process: A

monopolies may survive and persist as his rival
1. Natural Monopoly: It is due to creation of nature competitors may not be aware of the abnormal profits
Factors like geographical condition helps in creating being enjoyed by him or they may not be able to
such natural monopoly. Arab countries have monopoly acquire the necessary technical knowledge involved in
in crude oil. In the word of Baumol, “A natural the production of that particular product.
monopoly is an industry in which economics of scale
and other related forms of saving make it cheaper to 5. Restricted market for a product: Sometimes the
produce when there is one firm rather than several.” demand for a product is such that it will not permit the
operation of more than one efficient firm. On the basis
2. Social Monopoly: It is granted by the state in the of Darwin’s principle of survival, the efficient firm alone
interest of the society in case of goods and service can operate.
essential for the people. It is sometimes called as
welfare monopoly. e.g. Defense and Railways in India. 6. Transportation Cost: Sometimes the cost of
transporting goods to a potential market may be so
3. Legal Monopoly: Law grants legal monopoly is great that most of the firms remain out of the area and
created to firms for them to enjoy the fruits of their give a degree of monopoly power to the local producer
labour. Trade mark, copyrights and patents are best there.
example of legal monopoly.
7. Reputation: If a firm acquires a very high
4. Voluntary Monopoly: Voluntary monopoly is reputation for the production of a particular commodity,
created to eliminate competition and to reap abnormal it gains a certain degree of monopoly power whether
profits, trusts and holding companies are examples are such a reputation is justified or not.
example of this type of monopoly.
3.5 Price and Output Decision in the Short Run
5. Simple Monopoly: It is where the monopolist
charges the same price for the product from all the The aim of monopolist like every other producer is to
customers. maximize his profit, like competitive equilibrium, the
monopoly equilibrium can be analyzed in terms of:
6. Discriminating Monopoly: A discriminating c) Total Revenue – Total cost approach.
monopoly is one in which different prices are charged d) Marginal Revenue – Marginal cost approach.
for the some product from different customers. E.g.
Doctors charging different rates from different patients. 1. Total Revenue – Total cost approach: In the
figure, TC is the total cost curve showing a constant
Causes of Monopoly Power Or Bases Of Monopoly rise in the total costs as output increases. TR is the
The main cause of monopoly power is: total revenue curve which goes on rising to begin with
then flattens and later on slopes downward fall in total
receipts after a given point. The monopolist will

24
 Business Economics

maximize his profits at that output where the difference The monopolist can face three situation in the
between TR and TC is the greatest. This will be the in the short period, viz (1) Super Normal Profits, (2)
level at which the slopes of TR and TC curves equal. Normal Profit and (3) Minimum Loss.
Accordingly, P is the equilibrium point as determined
by the tangents at points P and T on the TR and TC 1. Super Normal Profits: If the price (AR) fixed by
curve respectively. The monopolist will sell OM output the monopolist in equilibrium is more that his average
at MP Price. His profit will be PT. Any other level of cost (AC) then he will get super normal profits. The
output will decrease rather than increase his profits. monopolist will produce up to the extent where MC =
MR. This limit will indicate equilibrium output. If the
Diagram average revenue of equilibrium output is more than the
monopolist is in equilibrium at point E, because at this
Y P point MC is equal to MR.
The monopolist will produce OQ units of
output sell it at OP which is more than average cost
TC
OR or QT by PR per unit. Thus, the total supernormal
TC
TR
profits of the monopolist are PRTS.
Super Normal Profits Diagram:
AC<AR
T TR
Y
MC AC
O OUTPUT X

2. Marginal Revenue (MR) - Marginal cost (MC) MR

approach: MC P S
AC
The monopolist faces a negatively sloped market AR R T
demand curve, which means that he, can sell more E
units of the product only be reducing the prices. AR
Because of the same the marginal revenue is smaller
than the product price and the marginal revenue curve MR
is below the demand curve.
The monopolist’s profits are maximum when two O Q
conditions are fulfilled: OUTPUT X
1. Marginal Cost (MC) = Marginal Revenue (MR) Super Normal Profits
AND
2. MC curve cuts MR curve from below. Profits = TR – TC
= AR x total output – AC x total output
= OP x OQ – OR x OQ
Y = OPSQ – ORTQ
MC
= PRTS (supernormal profit)
MR
MC 2. Normal Profits: As shown in the figure the firm is
earning normal profits. When the firm earns only
E normal profits its price i.e. average revenue is equal to
average cost.
MR Profits = TR – TC
= AR x total output – AC x total output
O OUTPUT X
= OP x OQ – OR x OQ
= OPSQ – ORTQ
= Normal Profits.

25
 Business Economics

Normal Profit Diagram: AC=AR Long Run Equilibrium under Monopoly

Y Long run is a period long enough to allow the

MC monopolist to adjust his plant size or use his existing
plant at any level that maximizes his profit. In the
AC absence of competition, the monopolist need not
produce at the optimal level. He can produce at sub-
MR optimal scale also. In other word, he need not reach
MC P the minimum of LAC curve he can stop at any place
AC where his profits are maximum.
AR
E
AR Long Run Equilibrium under Monopoly Diagram

MR

O Q X Y
OUTPUT MC
AC

3. Minimum Loss: When the average revenue is less

than average cost it is a case losses. As shown in the MR
figure the shaded area is the loss area. MC P S
AC
Profits = TR – TC AR R T
= AR x total output – AC x total output E
= OP x OQ – OR x OQ AR
= OPSQ – ORTQ
= PRST (Loss). MR

Minimum Losses Diagram O Q

OUTPUT X
AC>AR
MC AC
However, one thing is certain. The monopolist will not
Y continue if the makes losses in the long run. He will
continue to make super-normal profits even in the long
run as entry of outside firms is blocked.

R T Distinguish Between Perfect Competition And

MR Monopoly
MC P S
AC 1. Assumption regarding number of seller and
AR buyers: In the perfect competition there are a large
E number of sellers selling a homogenous product. The
AR twin force of demand and supply determine the price
MR of the commodity. Every firm is a price taker. On the
O Q X other hand a monopolist is the sole producer of a
Output commodity which does not have close substitutes. The
demand curve facing the monopolist firm is negatively
sloped. It means that more output can be sold by the
Minimum losses lowering the prices.

2. Distinction between a firm and an industry: The

distinction between a firm and an industry is more

26
 Business Economics

visible under conditions of perfect competition. But 5. Fear of government regulation: Regulating
under monopoly, this distinction disappears. monopoly pricing is done in case the monopolist
charges high prices. A tax is another way of controlling
3. Nature product and prices: Under perfect monopoly power. The tax may be levied lump sum
competition due to the homogeneous nature of line without any regard to the monopolist.
commodity same prices tend to prevail in the market.
But a monopolist can practice the policy of price Practical Application Of Monopoly
discrimination. The following are the practical significance of
monopoly:
4. Profits: Under perfect competition a firm earns
only normal profits. But a monopoly firm normally 1. Economics of large scale production: A
enjoys supernormal profits even in the long run. monopoly firm reflects of the significance of large
production. Monopoly firm secures economics of scale
5. Entry of firms: Under perfect competition, firm due to large scale production.
are free to enter the industry to reap profits, in the
case of monopoly free entry of firms is not possible. 2. Selling cost avoided: Wasteful advertisement
expenditure can be avoided due to lack of competition.
6. Monopoly price is generally higher and output
lower than under perfect competition. 3. Minimization cost avoided: Competing firms
increase the element of risk. The larger the number of
firms the resultant is cut throat competition which
Control of Monopoly Power Or Limits To The makes it all the more difficult the task of management
Power Of Monopolist for a firm and its chances for survival. But all this is
avoided under monopoly.
The monopolist cannot always exercise absolute
monopoly power and charge a very high to earn large 4. Stability in production and prices: According to
supernormal profits. The following are the limiting force prof. Taussing Monopolies bring about steadiness in
to the power of a monopolist. output and prices. As a volume of output is more or
less fixed in monopoly, there is stability in production.
1. Potential Competition: If abnormal prices are Similarly, due to absence of competition it is not
charged and abnormal profits reaped by monopolist necessary for a monopoly firm to change the price
than other firms will try to enter the line and thus the every now and than. Thus monopoly avoids
competition will take away abnormal profit. fluctuations and brings stability in output and prices.

2. Substitutes: The fear of substitutes is the most 5. Production adjustment during depression:
potent factor, which prevents factor, which prevents During periods of depression when there is a fall in the
monopoly firms from charging very high prices and effective demand, a monopoly firm can very easily
thereby earning huge supernormal profit. It is only reduce its production and thereby prevent the prices
under pure monopoly product has some substitutes for from failing. Such a decision is rather difficult to
the product. But pure monopoly like pure competitions implement when there is a large number of firm
being unreal the monopoly product has some actively competing with each other. During the great
substitutes is always uppermost in the mind of the economic depression of the 30’s in many countries of
monopolist, which acts as a restraint on his absolute the world the Government had itself encouraged
power. monopoly combination of firms.

3. Foreign Competition: If monopolist charges too Price Discrimination under Monopoly

high prices, foreigners will be tempted to step in the Price Discrimination
market. Thus, his monopoly will disappear.
A monopolist may be able to engage in a policy of
4. Fear of Nationalization: If too high price are price discrimination. This occurs when a firm charges
charged and the product or service is a public utility a different price to different group of consumers for an
service, there is every likelihood of the state taking identical good or service, for reasons not associated
over the monopoly firm in parliament to press for anti with the costs of production. It is important to stress
monopoly legislation. that simply charging different price for similar goods is
not price discrimination. For example, price
discrimination does not occur when a rail company

27
 Business Economics

charges a higher price for a first class seat. This is Monopolistic Competition
because the price premium over a second-class seat
can be explained by difference in the cost of providing The concept of monopolistic competition was
the service. presented by American economist Prof. E.H.
Chamberlain. Monopolistic competition refers to a
Simply charging different price for similar goods is not market situation in which a large number of sellers are
price discrimination. For example, price discrimination offering similar but not identical products. In other
does not occur when a rail company charges a higher words it refers to a market situation where there are
price for a first class seat. This is because the price many sellers of a differentiated product. Some of the
premium over a second-class seat can be explained examples of monopolist competition in the Indian
by difference in the cost of providing the service. context are in Shampoo, such as Sun silk, Clinic Plus,
Lux, Nyle, etc.
Examples of Price discrimination According to [Link], “Monopolistic competition is
There are numerous good examples of discriminatory found in the industry where there are a large number
pricing policies. of small sellers, selling differentiated but close
Some example worth considering includes: substitute product.”
Cinemas and theatres cutting price to attract younger
and older audiences; Characteristics of monopolistic competition
Student discounts for rail travel, restaurant meals and
holidays; Car rental firms cutting prices at weekends; 1. Large number of sellers: The number of firm
Hotels offering cheap weekend break. under monopolistic competition is relatively large but it
is not as large as under perfect competition. Since
Types Of Price Discrimination there is homogeneity of goods, competition is keen
through not perfect.
1. Personal Discrimination: It is where different
prices are charged from different persons. Like a 2. Product differentiation: Product differentiation is
dentist charges high fee from a rich man and the foundation stone of monopolistic competition.
less from a poor man for the same treatment. Chamberlain pointed out, the products are
heterogeneous rather than homogeneous. But the
2. Local Discrimination: It is local when prices products are only marginally differentiated. Product
charged change from place to place, or in other differentiation is the process of altering goods that
words price varies according to locality. Like serve almost identical purposes so that they differ in
saffron is cheaper in Kashmir and dear in other minor ways. Product differentiation creates brand
parts of India. loyalty. The products may be differentiated in the
following ways:

3. Trade Discrimination: It is also known as use a) By changing the quality of the product through
discrimination where different price are charged changes in design, materials etc.
for different uses of the same commodity. Like, b) By advertisement and sales promotion measures
electric current is usually sold cheaper for which creates imaginary or artificial differences.
agricultural uses and dear for industrial uses. c) By patent fight and trade marks.

4. Age Discrimination: If discrimination is on the 3. Non Price Competition: Product variations and
basis of age it is referred to as age selling costs are alternative methods adopted by firms
discrimination. Like, railway fears are low for to increase sales. As the products are lightly
children and old. differentiated, selling cost is an inevitable, which
affects the sales pattern.
5. Size Discrimination: On the basis of quantity of
transactions, different rates are charged, e.g. 4. Freedom of entry and exit: The firms under
prices in the retail market are higher than monopolist competition are free to enter or leave the
wholesale market. industry. When firms in an industry are making super
normal profits, new firms with a slight difference in the
3.6 Monopolistic Competition product will enter and the excess profit will be wiped
away. Therefore the firms will earn only normal profit in
the ling run.

28
 Business Economics

5. Independent Behavior: Another feature of MC=MR. OM is the equilibrium output price of

monopolistic competition is that it has an independent equilibrium output is OP. At point ‘A’ AR is equal to
price policy. Since the number of firms under AC. When average cost become equal to average
monopolistic competition is large, if a firm lowers its revenue. In equilibrium situation, than firm earns
price war as under oligopoly. normal profits.

3.7 Price Output Determination Under Monopolistic Normal Profits Diagram

Competition AC=AR

A. Short –run equilibrium MC

Short period refers to that time period in which Y
production can be increased in response to increase in AC
demand, only up to existing production capacity. The
time is short to make any change in the fixed factors of A
production like machines, building premises etc. MC P
In the short period a firm is in equilibrium when; MR
2. MC=MR and AC
3. MC curve cuts MR from below. AR E
The firm may face any of the three situations in this
time period:

(1) Supernormal Profits (2) Normal Profits and (3)

Minimum Loss.
1. Supernormal Profits: In the figure firms O Output X
equilibrium is at point E, where MC=MR and OM is the
equilibrium output. OP is the price of equilibrium
output. This price is more than average cost BM, so
the firm enjoys super normal profit of the firm in 3. Minimum Loss: In short period, a firm could incur
equilibrium is ABCP. losses because its price(AR) is less than its short run
average cost at the equilibrium level of output, BM is
Supernormal Profits Diagram the average cost and AM is the average revenue. The
total losses are equal to the area ABCD. This loss may
AC<AR cause the inefficient firms to leave from the industry.

Y Minimum Loss Diagram

MC AC AC>AR
MR
MC P A
AC Y MC AC
AR C B
E B
AR MC C
AC
AR A
MR MR D
O Q
OUTPUT X
E

Super Normal Profits AR

Q MC X
O
2. Normal Profits: A firm may earn normal profits Output
when in equilibrium in short period. It is shown in the
figure. The firm is in equilibrium at point E where its Minimum Loss

29
 Business Economics

Prof. Chamberlain defined selling cost as “cost

Comparison Between Monopolistic And Perfect incurred in order to alter the position or shape of the
Competition demand curve for a product.”
Economists are sharply divided over the necessity of
1. Product: Under perfect competition it is assumed selling costs. While some economists are in favor of
that all firms produce homogeneous products. Under advertisement others are against.
monopolistic competition there is produce
differentiation. Goods produced by the firms differ in Difference between ‘Production Cost’ and ‘Selling
one way or the other. Cost’.

Cost of production includes all expenses which must

2. Number of buyers and sellers: Under perfect be incurred in order to provide the commodity or
competition there are large numbers of sellers of service, transport it so the buyer, and place it in to his
homogeneous product. Group of such sellers hands ready for consumption. Selling costs on the
constitutes industry. Under monopolistic competition, other hand includes all outlays made in order to secure
number of sellers is more than one. Many sellers demand or a market for the product.
constitute the ‘group’.
Increase in the production cost decreases the supply
3. Degree of knowledge: Under perfect competition of the product. On the other hand, selling costs
it is assumed that buyers and sellers have perfect increase demand for the product.
knowledge of the market conditions. On the country,
buyers and sellers under monopolistic competition are Production cost depends upon the quantity of
not fully aware of the market conditions. production. On the other hand the amount of selling
cost depends upon the nature of competition.
4. Shape of demand curve: Under perfect
competition, due to large number of firms, Production costs are meant for the creation of utilities.
homogeneous product and one price, demand curve is Selling costs on the other hand create demand.
perfectly elastic. It means AR=MR.
Under monopolistic competition, the average revenue The average selling cost is ‘U’ shaped. The analysis of
curve slopes downward. Under monopolistic selling cost is similar to that of the average cost. In the
competition is the price maker. figure at OQ level of output the advertising cost per
unit is OP. the firm has the lowest selling cost OP2 at
5. Selling cost: There is no selling problem under OQ1 level of output. If the firm wants to sell OQ2 level
perfect competition where the product is of output the average selling cost rises to OP1.
homogeneous. However, in monopolistic competition
where product differentiation exists selling costs are Therefore the ‘U’ shape is due to the operations of
essential to push up the sales. There are incurred to economies and diseconomies in advertisement. But
persuade a buyer to purchase on product in after reaching the saturation point in sales, the curve
preference to another. becomes vertical indicating the ineffectiveness of
certain advertisements.
Selling Cost
Combined Cost = Production Cost + Selling Cost.
Selling costs are the advertisement, salesmanship free
sampling, free service, door to door canvassing, and 3.8 Oligopoly
so an. There is no selling problem under perfect
competition where the product is homogeneous. Under Meaning of Oligopoly
monopoly also, selling costs are not required, as there
are no competition. With the help of advertisement a Oligopoly is a market situation in which there are a few
firm under monopolistic competition balances the firms selling homogeneous or differentiated products.
delicate problem of homogeneity and heterogeneity It is difficult to pinpoint the number of firms in the
tries show that its product is a close substitute for the oligopolist market. There may be three, four of five
product of others. Heterogeneity tries to prove that its firms. It is also known as competition among the few.
product is superior to that of others. With only a few firms in the market, the action of one
firm is likely to affect the others. An oligopoly industry
produces either a homogeneous product or
heterogeneous products. The former is called pure or

30
 Business Economics

perfect oligopoly and the latter is called imperfect or oligopolists leads to two conflicting motives. Each
differentiated oligopoly. Pure oligopoly is found wants to retain independent and to get the maximum
primarily among producers of such industrial products possible profit. Towards this end, they act and react on
as aluminum, cement, copper, steel, zinc, etc. the price-output movements of one another in a
Imperfect oligopoly is found among producers of such continuous element of uncertainty.
consumer goods as automobiles, cigarettes, soaps
and detergents, TVs, rubber tubes, refrigerators, 3.9 Price determination under Oligopoly
typewriters, etc.
The Sweezy Model of Kinked Demand Curve:
Characteristics of Oligopoly
In his article published in 1939, Prof
In addition to fewness of sellers, most oligopolist Sweezy presented the kinked demand curve analysis
industries have several common characteristics which to explain price rigidities often observed in oligopolistic
are explained below. markets. Sweezy assumes that if the oligopolistic firm
lowers its prices, its rivals will react by matching that
1. Interdependence-There is recognized price cut in order to avoid losing their customers. Thus
interdependence among the sellers in the oligopolistic the firm lowers its prices, its rival will react by matching
market. Each oligopolist firm knows that changes in its that price cut in order to avoid losing their customers.
price advertising, products characteristics, etc. may thus the firm lowering the price will not be able to
lead to counter moves by rivals. increase its demand much. This portion of its demand
curve is relatively inelastic. On the other hand if the
2. Advertisement-The main reason for this mutual oligopolistic firm increases its prices, its rival will not
interdependence in decision making is that one follow it and change their prices. Thus the quantity
producer’s fortunes are dependent on the policies and demanded of this firm will fall considerably. This
the fortunes of the other producers in the industry. As portion of the demand curve is relatively elastic. In
pointed out by Professor Baumol, “Under oligopoly these two situations, the demand curve of the
advertising can become a life-and-death matter.’ oligopolistic firm has a kink at the prevailing market
price which explains price rigidity.
3. Competition- This leads to another feature of the
oligopolist market, the presence of competition. Since Assumptions
under oligopoly, there are a few sellers, a move by one
seller immediately affects the rivals. So each seller is The kinked demand curve hypothesis of price rigidity is
always on the alert and keeps a close watch over the based on the following assumptions:
moves of its rivals in order to have a counter-move.
1. There are few firms in the oligopolistic industry.
4. Barriers to Entry of Firms-As there is keen 2. The product produced by one firm is close
competition in an oligopolistic industry, there are no substitute of the other firms.
barriers to entry into or exit from it, however, in the
long-run; there are some types of barriers to entry 3. The product is of same quality. There is no
which tend to restrain new firms from entering the product differentiation.
industry. 4. There are no advertising expenditures.

5. Lack of Uniformity-Another feature of oligopoly 5. There is an established or prevailing market price

market is the lack of uniformity in the size of firms. for the product at which all the sellers are satisfied.
Firms differ considerably in size. Some may be small, 6. Each seller’s attitude depends on the attitude of
others very large. his rivals.

6. Demand Curve-It is not easy to trace the demand 7. Any attempt on the part of a seller to push up his
curve for the product of an [Link] under sales by reducing the price of his product will be
oligopoly the exact behavior pattern of the producer counteracted by other sellers who will follow his
cannot be ascertained with certainity, his demand move.
curve cannot be drawn accurately, and with
definiteness.

7. No Unique Pattern of Pricing Behaviour-The

rivalry arising from interdependence among the

31
 Business Economics

The Model
The price and output relationship is explained in the
following graph

Y
D

Price P P1
&
Cost

D1

O X
Output

As seen from the figure DD is the demand curve, OP

is the price any increase in the price above this point
will considerably reduce the sales.
The portion DP1 is elastic and below it is less elastic.

32
 Business Economics

in production of goods. As a consequence, prices

begin to rise and inflation is the result. This
Unit-5 : Inflation, Deflation, situation can arise even before the stage of full
Theory of Income & Employment employment if production process is slow.

3. Deficit financing: When government covers its

Structure deficit by resorting to the policy of deficit financing
it leads to increase in the monetary income of the
Chapter 4: Inflation and Deflation people. However Production does not increase to
that extent, when the demand for goods increases
4.1 Inflation: and it causes the prices to rise.
Inflation is associated with high prices which causes
decline in purchasing power or value of money. 4. Increase in Population: Many a times the
Crowther defines inflation as a state in which the value demand of goods is higher that the growth rate of
of money is falling i.e. prices are rising prices rise output in the country. This also causes the prices
though is only a symptom, of the disease – inflation to rise.
and not the cause.
5. Increase in exports: Rising exports pushup
Characteristics of inflation: prices on two counts. Firstly by increasing the
income of the exporters through exports who in
turn demand more goods and services and
1. Inflation is a dynamic process, which can be secondly by creating scarcity for domestic
observed only over a more or less lengthy period. consumption through exports. Increase in export
could be due to devaluation.
2. inflation is always associated with rise in prices
3. inflation is a monetary phenomenon i.e. 6. Black Money: Unaccounted money is called
associated with excessive money supply black money. It is the outcome of tax evasion.
Holders of black money squander it on luxuries
4. cyclical movement is not inflation
and other flaunting items and consequently
5. Excess demand in relation to the supply of demand increase causing inflation.
everything is the essence of inflation.
7. Paying off debts: When the government pays off
Causes of Inflation: it old debts to the public, it results in an increase of
Inflation is the result of disequilibrium between purchasing power with the public. This will be used
demand and supply forces and is attributed to; of buy more goods and services for consumption
purpose. Thus increasing the demand in the
economy leading to a rise in prices.
a) An increase in the demand for goods and services
in the country
B) Supply Side:
b) A decrease in the supply of goods in the economy.
1. Production lags: when the production falls due to
a) Demand Side: strikes , lockout, scarcity of raw materials etc, it
leads to reduction of supply of the goods and
1. Increase in money supply: An increase in the services even though the demand for the goods
money supply leads to an increase in money remain constant, thus leading to increase in the
income. The increase in money income raises the price level.
monetary demand for goods and services. This
increasing pressure in demand creates 2. Speculation: Speculation results in artificial
disequilibrium between demand and supply thus scarcity of goods by hoarding of the same and
resulting into high prices. thus causing the prices to rise.

2. Increase in Public Expenditure: Increase in 3. Natural Calamity: Agricultural production is

Public expenditure in a country leads to an occasionally exposed to such natural calamities as
increase in the purchasing power which in turn earthquake, flood [Link] causes a heavy fall of
leads to more demand for goods and services. But the same and the result is rise in prices.
after full employment situation there is no increase

33
 Business Economics

4. War: Production of consumer goods falls heavily whereas the shareholders gain since the amount
during wartime, causing diversion of productive of Profits fluctuates with profits.
resource to the production of unproductive goods.
It causes the prices of these goods to rise. v) Farmers: The farmers gain during inflation as they
belong to producer class. Prices of agricultural
5. Gestation Period: Gestation period is the time products increase more than their costs.
interval between inputs and outputs. In the
gestation period there is no rise in production but vi) Balance of payment: Because of rising prices
price level rises because the disposal income with under the impact of inflation exports fall and
people rises imports rise. Soon the country faces an adverse
balance of payment.
6. Imported Inflation: Here scarcity of goods and
services are felt when a foreign country purchases Social and Political effects of Inflation:
goods from its neighboring country during inflation.
This in turn will create scarcity in that country 1. Rise in inequalities of income: Inflation is
pushing up the prices. socially unjust because it widens the gap between
the have and have not and creates conflicts in the
Economic effects of Inflation: society. Thus inflation results in serious ill will.

1. Effects on production: the producer class gain 2. Favours black marketers: Inflation adversely
during inflation because they produce more to affects business morality and ethics as the
meet the rising demand, wages increase less than businessmen indulge in black marking in order to
the prices, the rise in prices give them more profit earn windfall profits.
margin, anything produced easily finds a market. It
though also has an adverse effect on production
since inflation not only reduces domestic saving; it 3. Encourages speculation: Inflation give rise to
also discourages the inflow of foreign capital into speculation and making profits be one way or
the country. another rather than with genuine production
activity.
2. Effects on Distribution:
4. Quality of goods deteriorates: In order to
i) Debtor and creditor: Debtor gain and creditor increase the profit margin, the producers reduce
lose. Debtor gains because they repay their debt the quality of goods.
in money when purchasing power is lower than
when they borrowed. Creditor loses as they
receive less in goods and services than they 5. Political effect: Inflation has a dangerous effect
would have received in times of low prices. on the political scenario. Social inequality and
moral degradation results in increase in the
ii) Business community: Business community gains general discontentment in the public, which may
as they stand to profit from the rising prices, result in the loss of faith in the government.
because the prices raise faster than the cost of General dissatisfaction sometime also results in
production therefore profit margin is greatly political revolution.
enhanced. Thus business community prices rise
faster than the cost of production therefore profit Remedies to control inflation:
margin is greatly enhanced. Thus, business
community gets super normal profits. 1. Monetary Policy: central Bank use monetary
management methods for controlling the supply of
iii) Fixed Income Group: Wages earns and salaried money and through it credit for monetary stability.
people are worst affected during inflation as Central bank generally uses the following
wages do not rise at the same rate as the rise in methods:
prices.
a) Increase in Bank rate: Increase of bank rate
iv) Investors: There are two types of investors, by the central bank would mean rise in the market
debenture holders and shareholders. The rate of interest which creates a decrease in the
debenture holders lose as interest amount is fixed monetary supply as borrowing decrease by the
businessmen and the consumers.

34
 Business Economics

prove to be effective in controlling the increase of

b) Open market operations: under the OMO the prices of certain scarce commodities.
central bank sells the government securities,
which leads to reduction of money supply from the 3) Price control: Another direct weapon to control
economy. inflation is controlling prices of same important
commodities by the government.
c) Varying reserve ratio: Every commercial bank
has to keep cash with the central bank. Inorder to 4) ports of same of the commodities can be curtailed
control inflation the central bank increases the and import of the some can be increased as per
cash reserve ratio, which reduces the deposits of the balance of payment situation.
the commercial bank thus reducing their credit
creation and money supply in the economy in 4.2 Deflation
order to control inflation.
Deflation:
d) Selective measures: Under the selective Deflation is the opposite of inflation just as inflation is a
measure the central bank use methods like, phenomenon of rising prices; deflation is a
curbing excessive spending by the consumers by phenomenon of falling prices. Crowther has defined
controlling the consumer credit. It also increases deflation as “state of the economy where the value of
the margin requirements during inflation. money is rising or the prices are falling.” Thus, value of
money goes up and prices fall in deflation. In deflation
2. Fiscal Policy: Policy of the government relating to falling prices are accompanied by falling level of
taxes, public borrowing and expenditure is known employment output and income, thus each and every
as fiscal policy. The following are the methods fall in prices cannot be termed as deflation.
adopted under fiscal policy.
Causes of Deflation:
a) Increase in taxes: During the inflation
government usually increase the direct taxes [Link] in money supply: contraction in currency
without hampering production. Increase in taxes by monetary authority causes contraction of bank
withdraws excess money from the people thus loans as a result of the same the income with people
decreasing the disposable income in their hands falls, leading to the decrease in demand of goods and
and reducing the pressure of demand on prices. services and with supply of goods remaining the same
, the result is decrease in the prices.
b) Reduction in public expenditure:
Government reduces its expenditure as it means 2. Rise in production: Though supply of money may
increase in income of the people. be the same production of goods and services can rise
suddenly causing the prices to fall.
C) To incur public debt: During inflation
government incurs public debt. Thus the 3. Central Bank’s Monetary Policy: When the central
disposable income with the people is automatically bank raises the bank rate, it results in the rise of
withdrawn. interest rate in the economy by the commercial banks
leading to decrease in demand and fall in the prices. It
D) Delay in the payment of old debts: during may also be due to selling of securities by the central
inflation the government should not repay its old bank.
debt to the people as it may leads to extra
purchasing power. 4. Over valuation of currency: Due to overvaluation
of the domestic currency the imports can rise and
Other Measures: exports fall, creating excess of goods on one hand and
decrease of money supply on the other hand since
1) Increase in Production: Increase in production is increase in imports results in flowing out of money
a most effective method of checking inflation. supply from the economy.
Those goods can be produced more whose prices
are likely to rise rapidly, and for the production of 5. Decrease in Public Expenditure: Government
the same the government can fix incentives. expenditure results in increase in the money supply in
the economy and as a result it increases the
2) Rationing: control on consumption of certain purchasing power in the hands of general public. But
goods, fixing of consumption quotes, can also the effect is reverse in case of decrease in public

35
 Business Economics

expenditure which results in decrease in money supply

causing disequilibrium between demand and supply Remedies to Control Deflation:
with supply exceeding the demand for goods and
service which reduces the general price level in the 1. Monetary Policy: Central bank uses monetary
economy. management methods for increasing the supply of
money and credit for monetary stability. Central bank
6. Imported deflation: As a result of deflation in the generally uses the following methods:
neighboring countries, deflation can set in the
domestic economy. Lets us assume a deflationary a) Decrease in bank rate: Decrease of bank rate by
situation in the economy of a country a the domestic central bank results in decrease in market rate of
country B, will finds goods and services cheaper in interest which in turn creates a increase in the
country A and will try and import in large volume of monetary supply and borrowing s increase by the
goods and services as a result of which the demand businessmen and the consumers.
will fall of domestic goods and services creating
deflationary pressure. b) Open market operations: Under the OMO the
central bank purchases back the government
7. Speculation: Speculation regarding future fall in securities which leads to increase in the money
prices can actually lead to deflation with other thing supply in the economy.
remaining constant. Speculation regarding fall in the
price level in the future leads to a disequilibrium c) Varying reserve ratio: Every commercial bank has
between the two forces of demand and supply to keep cash with the central bank. In order to
resulting in slashed prices. control deflation the central bank decreases the
cash reserve ratio, which increases the deposits of
Effects of Deflation: the commercial bank thus increasing their credit
creation and money supply in the economy in order
1. Effect on Production: Deflation adversely affects to control deflation.
the producers since the cost of production does not fall
as rapidly as the prices of finished goods. Further the 2. Fiscal Policy:
demand for commodity goes on falling due to deflation. Policy of the government as relating to taxes public
As a result of this the profit of the producer will fall and borrowing and expenditure is known as fiscal policy.
there will be overproduction of the commodities. The following are the methods adopted under fiscal
policy.
2. Investors: During deflation the fixed income
investors gain because income remains constant while a) Decrease in taxes: During deflation government
the prices are falling. The share holders on the other usually decreases the direct taxes thus
hand lose since the business profit fall during deflation encouraging production. Decrease in taxes
thus decreasing the dividend on shares. creates excess money for the people thus
increasing the disposal income in their hands and
3. Salaried and labour classes: Wage earners and increasing the demand in order to control the
salaried Persons gain during deflation. The reason is prices.
that with the fall in price the wages and salaries cannot
be reduced such will be strongly opposed by the trade b) Increase in public expenditure: Government
unions. increases its expenditure as it means increase in
income of people.
4. Consumers: The consumers generally gain due to
falling prices because the purchasing power of their c) Repayment of old debts: During deflation the
money rises. government repays its old debt to the people as it
may lead to extra purchasing power.
5. Creditors and debtors: During deflation the prices
fall and the value of money rises. As a result the Other Measures:
creditors tend to gain and the debtors tend to lose.
1) Regulation of Production: Production in the
6. Tax Payers: Tax payers are adversely affected in economy should be regulated in such a way that the
the deflationary period because due to falling prices problem of over Production does not arise, and it
the value of money rises and the real burden of matches with the existing demand.
taxation increase.

36
 Business Economics

2) Relaxation on exports and reduction of imports: Schedule:

This kind of policy will go a long way in solving the
problem of overproduction and help in overcoming Employment Aggregate supply
deflation. (in lakh) price (in crore)

4.3 Theory of Income And Employment 1 12

Keynesian Economics- Theory Of Income 2 24

Determination
3 36
1. Aggregate Effective Demand.
4 48
Principle of effective demand is the starting point of
Keynes ‘General theory of employment’. According to 5 60
Keynes, volume of employment depends on the level
of effective demand in the short run. Greater effective
demand, greater will be the volume of employment Diagram
and vice versa. Thus employment is due to a
deficiency of total demand (i.e. effective demand) Y
Effective demand represents the total demand for ASP
goods and services in the economy. Both for 70
consumption and investment. Effective demand also
means total income since, one mans expenditure is 60
another mans income. ASP
Therefore Effective demand=Total demand or total 50
expenditure or total income OR Effective demand =
Consumption + Investment (C+I) When C & I are more 40
in the economy effective demand will also be more
and employment will also be more and employment 30
will also be high. To maintain effective demand both C
& I must be high. I should compensate if C is less it 20
should be compensated by C.
10
Determination of effective demand:

Aggregate demand price and aggregate supply O 1 2 3 4 5 X

price together determine effective demand which in
turn determine the level of employment in the Employment
economy at a particular time.

Aggregate supply price function: At a given level

of employment of labour, aggregate supply price is the
total amount of money which all the entrepreneurs in As seen in the AS function is a schedule showing that
the economy, taken together, must receive from the as the level of employment increases aggregate
sale of output produced by that number of workers supply also increases. After reaching full employment,
which is just worthwhile employing them. A certain there will be no change in the level of employment but
minimum amount of proceed is necessary to induce ASP will increase.
employers as a whole to offer any given aggregate
amount of employment. This minimum price which will Aggregate Demand Price or Function:-
just induce employment on a given scale is called the Aggregate demand price at any level of employment is
aggregate supply price of that amount of employment. the amount of money which all the entrepreneurs in
Thus the aggregate supply function is a schedule of the economy taken together do expect that they will
various minimum amounts of proceeds which receive if they sell the output produced by the given
entrepreneurs must receive from the sale of output number of workers. Thus Aggregate demand price
resulting at varying level of employment. represents the “expected receipts” when a given
volume of employment is offered to the workers.

37
 Business Economics

Aggregate demand price represents a schedule of in the economy. At this point though the output
proceeds expected from the sale of the output determined need not necessarily be full employment
produced by different amount of employment. The output.
greater the number of workers employed the larger will
be the output. Aggregate demand price will increase
as amount of employment increases and vice-versa as
shown in the diagram. Employment Aggregate supply Aggregate
Employment Aggregate Demand (in lakh) price (in crore) Demand
(in lakh) price (in crore) Price (in crore)

1 12 36
1 36
2 24 42
2 42

3 48 3 36 48

4 54
4 48 54
5 60

5 60 60
Y

70
In the schedule the equilibrium level of employment is
60 5 lakh workers. At this level both the ASP and ADP are
ADP equal at Rs.60 [Link] employment level less than 5
50 ADP lakh workers, ADP is grater than ASP. Hence
employment will tend to increase. On the other hand,
40 at an employment level more than 5 lakh workers,
ASP exceeds [Link] employment will tend to
30 decrease.

20
Y
10

Aggregate ASP
O 1 2 3 4 5 X Supply ADP
Price E
Employment &
Demand
As shown in the schedule and the diagram as the level Price
of employment goes on increasing, AD is also (in crores)
[Link], on reaching full employment situation
the rate of increase in AD is less than the rate of
increase in the level of employment.
O Employment (in lakhs) X
DETERMINATION OF EFFECTIVE DEMAND

Keynes says the intersection point of the Aggregate

Demand price with Aggregate supply price determines Point of determination of effective demand by the
the actual level of employment and the point is called intersection of aggregate supply function and the
the point of Effective Demand. It is the equilibrium aggregate demand function is ‘E’ as shown in the
point determining the level of employment and output diagram.

38
 Business Economics

due to increase in production, it should be taken as

Unit-6 National income real increase.
GDP at constant price: Constant price means
base year’s price. Base year is an average standard
Structure previous year in which major economic changes have
not taken place. Increase in GDP due to increase in
price should not be treated as real but illusionary. In
1.1 Introduction order to calculated real increase in GDP, it should be
1.2 Methods of estimation calculated at constant price.
1.3 Problems of estimation
1.4 Increase in NY vs. Increase in welfare National income at National income at
1.5 Methodology of estimation of national income in constant price = current price X 100
India __________________

Index number of
1.1 Introduction national income
National income (NY) refers to the total income of a
country for a given period of time. There are various
concepts of national income, they are explained as GDP at Factor and GDP at Market Price: GDP
follows:- at factor cost is estimated as the sum of net value
added by the different producing units and the
Basic Concepts in National Income consumption of fixed capital. Since the net value
Gross Domestic Product (GDP): Gross domestic added gets distributed as income to the owners of
product in the money value of all final goods and factors of production, we can also estimate GDP as
services produced in the domestic territory of a country the sum domestics factor incomes and consumption of
during an accounting year. GDP takes for its frame of fixed capital. GDP at factors cost does not include
reference the production occurring within a given indirect taxes thoughts it includes subsidies. GDP at
geographic area irrespective of whether the productive factor cost + GDPmp-IT+S, where IT is indirect taxes
resources are owned of that area or not. and S is subsidies.
GDP at market price includes indirect taxes
GDP includes the following: Territory lying within the excludes the subsidies given by the government.
political frontiers, including territorial waters of the GDP at market price is generally higher than GDP at
country, Ships and aircraft’s operated by the resident factor cost.
of the country between two or more countries, fishing GDPmp=GDPfc+IT-S
vessels, oil and natural gas rigs, and floating platforms
operated by the residents of the country in the Net Domestic Product:
international waters, consulates, embassies and While calculating GDP no provision is made for
military establishments of the country located aboard. depreciation allowance. In such a situation gross
GDP may be either larger or smaller than GNP. If the product will not reveal complete flow of goods and
Indian nationals have large foreign investment and services through various sectors. Capital goods like
own fabulous property like oil wells, etc. then India’s machines, equipment, tools, buildings, Tractors etc.
GNP may be far higher than GDP. get depreciated during the process of production. After
some time these capital goods need replacement, part
GDP at constant prices and at current prices: of capital is therefore, set aside in the form of
GDP at current prices: Current prices mean the depreciation allowance. When depreciation allowance
prevailing price of goods and services in the market. In is subtracted from GDP we get net domestic product.
order to calculate GDP at current price, goods and NDP=GDP-depreciation.
services produced during the year are valued in terms
of prevailing valued in terms of prevailing price of the Gross National Product:
year. GNP is defined as the sum of the gross domestic
Increase in the value of GDP as compared to product and the net factor income from abroad.
the value of previous year shows economics Whatever is produced within the domestic territory of a
development and a favorable trend. It should be country will constitute the gross domestic product of
clearly studies, whether the increase is due to increase that country. No matter that even the foreigners who
in the quantity of goods and services produced or are temporarily employed in a country might have
increase in the price. If the increase has been caused contributed something to its output. On the other hand,

39
 Business Economics

while considering national product we have to identity + Net factor income from abroad
the residential status of the individual engaged in the (Income received- Income paid)
production activity whatever is produced by the =Gross national product at factor cost
residents of a country whether inside the country or -Capital consumption or depreciation
outside will form the gross national product of that =Net national Product cost or national Income
country. Thus, in order to estimate the gross national
product of the India we have to add or subtract net
factor income from aboard i.e., income carried by The Expenditure Method:
Indian residents aboard minus income earned by non
resident in India to get the gross domestic product of National expenditure is the total amount spent on
India. consumer goods and services and on net additional to
Net National Product: Adding the net factor capital goods and stocks in the course of the year.
income from abroad to the net domestic product we Method of estimating national income via the
can derive NNP. If the net factors income from abroad expenditure approach has been taken below:
is positive i.e. the inflow of factor income from abroad
is more than the outflow NNP will be more than NDP. Consumer’s expenditure (c)
In case the net factor income from abroad is negative +Government current expenditures on goods and
NNP will be less than NDP and it would be equal to services (G)
NDP in case the net factor income from abroad is +Gross domestic fixed capital formation (I)
zero. +Value of physical increase in stocks and work in
NNP at factor cost or national income: NNP at progress (I)
factor cost is the volume to commodities and services =Total domestics’ expenditure at market prices
turned out during an accounting year, counted without +Exports and factor income from abroad (E)
duplication. It can also be defined as the net value -Imports and factor income paid abroad (M)
added at factor cost in a cost in an economy during an =GNP mp
accounting year. It terms of incomes earned by the -Indirect taxes
factors of production, NNP at factor cost or national +Subsidies
income is defined as the sum of domestic factor =Gross national product at factor cost
incomes and net factor income from abroad. If NNP
figure is available at market prices we well subtract The Income Method:
indirect taxes and add subsidies to this figure to get
NNP at factors cost or national income of the In case of Income approach we aggregate the income
economy. of all the factors of production obtained for
participating in the generation of national product.
National Income then becomes the total money value
Methods of Measuring National Income: of the incomes received by factor owners during the
year in return for current contribution to the output.
Output method: The output method is followed Such incomes may be in the form of wages, salaries,
either by valuing all the finals goods and services rent or profit. In practice, the income figures are
produced during a year or by aggregating the values obtained mostly from books of accounts, income tax
imparted to the intermediate products at each stage of returns and published reports.
production by the industries and productive enterprises
in the economy. The sum of these values added given Following points should be taken into consideration:
added given the gross domestic product at factor cost Transfer incomes are to be excluded.
which after similar adjustment to include net factor Income earned by the government activities must be
income from abroad gives gross national product at included.
factors cost. This approach is used to estimate gross All unpaid services are excluded
and net value added in the primary sectors-Ex. Financial transactions with respect sale of old property
Agriculture, and allied activities, forestry and logging, are to be excluded
fishing, registered manufacturing, etc, of the Indian Incomes earned by non-residents but are remitted
economy. periodically are to be added whereas incomes paid
factor owner’s abroad should be deducted.
The agricultural and extractive industries The income received from exports should be added
+Manufacturing industries whereas the payments for imports should be
-Services and construction deducted.
-Gross domestic product at factor cost

40
 Business Economics

Direct taxes of the government as well as subsides are Increase in national income (GNP) does not
to be deducted necessarily mean an increase in the welfare of the
The undistributed profits should be added in the year people.
the profits were generated. An increase in the national income in real terms refers
to economic growth. But, it does not mean that
1.3 Problems in the Estimation of National Income economic welfare has also increased. This is so
because economic welfare along with the factors also
1. Lack of statistical data: Reliable facts and figures depends upon
on national income are generally not available. In Composition of GNP and
absence of such information it is difficult to get correct
idea about national income. Distribution of GNP among people.
If GNP mainly consists of war goods and
2. Conceptual difficulty: National income is a very services related to a war only, and there is an increase
wide and broad concept. It is difficult to define it in GNP due to an increase in production of war goods
precisely. etc., we can not say that the general welfare of the
people has necessary increased. In the same way, the
3. II legal Income: Information of income received by increase in the national income may be due to an
people from illegal activities, such as black marketing, increase in the goods, which are not socially desirable
Smuggling, theft, corruption, etc. is not available, In such as drugs and other intoxicants, which surely do
absence of it, it is difficult to Include them in national not result in an increase in the welfare of the people. It
income. is also imperative for the share of wage goods in total
national product to increase in order to create welfare.
4. Calculation of depreciation: To get net national In case a rise in the national income creates
product, it is necessary to deduct depreciation value of inequitable distribution in the national income, a rise in
capital national income may further the disparities. Thus, with
goods. In absence of common and standard rates of an increase in national income if the yields of
depreciation, calculation of national income becomes economic growth do not reach the poor or have-nots,
difficult. economic welfare cannot be promoted.
Welfare to be promoted is it also necessary
5. Double counting: In order to avoid double that the increase in the population should not exceed
counting, it is said that value of only final goods and the growth of national income, since it will mean fewer
services must be taken into account. But, it is difficult gains per head.
to determine final and intermediate goods, for e. g. for It should also be noted that for welfare to be
fertilizer factory, fertilizer is final commodity, while for promoted there should be economic stability in the
farmers, it is intermediate good. Due to his, it is difficult economy. This means that the economy should not
to avoid double counting. pass through inflationary phase, which will decrease
the purchasing power of the people in the economy.
6. Barter transactions: In underdeveloped countries, Another important point to be noted is that welfare
considerable part of income is directly exchange cannot be promoted if the increase in GNP takes place
without use of money. Information of such exchange is at the cost of ecological degradation. Thus, if
not available and it is also difficult to express the same industrialization results in noise, air and water
in money. pollution, then welfare will deteriorate since it
adversely affects the health of the people. Thus, it can
7. Self Consumption: In underdeveloped country like be concluded that economic growth and economic
India, particularly in agriculture, large part of farm welfare are not positively related.
produce is directly consumed at family level. Since it is
not exchange in market, this part cannot be included in 1.5 Methodology of Estimation Of National Income
national income. In India

8. Transfer incomes: It nay also be difficult to The following is the methodology of measuring
calculate the exact amount of the transfer expenditure national income in India.
in the form old age pensions, scholarships etc. by
private and public sectors. 1. Agriculture and Allied Activities: The product
method is used for the sector. For measuring the
contribution of agricultural sector to national income,
the data regarding 68 agricultural crops is collected by

41
 Business Economics

Random Sampling Technique; Census Method obtains

Value of output of livestock like milk, butter, ghee, and
poultry.

2. Forestry and logging: To calculate the value of

output of this sector, product or value added method is
used. In order to obtain the value of output of the
major forest products like timber, round wood, fuel
wood, the total production is multiplied by the
wholesale prices.

3. Fishing sector: To calculate the value of output of

fishing, the product method or value added method is
used.

4. Mining and Quarrying: In India, the value of the

output of mining and quarrying sector is measured by
Indian Bureau of Mines by using product method.

5. Registered manufacturing or Industries: In the

registered manufacturing, the income is measured by
the product method. The value of output under this
sector is measured by National Sample Survey
Organization.

6. Unregistered manufacturing or Industries:

Income method is used in unregistered manufacturing
sector to measure the contribution of this sector to
gross value added.

7. Electricity, gas and water supply: The income

method is used to estimate the net value added by this
sector. The factor income is measured in the form of
compensation of employees and operating surplus.

8. Transport, communication and storage, banking

and insurance: The income method is used to use to
estimate the value added by this sector. In the
organized sector the factor incomes are estimated by
analyzing the accounts of the companies.
9. Public administration and defence: To calculate
the value of the sever vices of the sector, income
method is used. The value added by public
administration and defence is equal to the
compensation of employees only.

10. Construction: The commodity flow method and

expenditure method is used estimate the value added
by the construction sector

42
 Business Economics

effect compared to the treatment given to good

imported or exported. When the capital is imported it is
Unit-7 International Trade recorded on the credit side of balance of payment as it
increases the country’s foreign receipt and on the
contrary, when capital is exported it is recorded on the
debit’s side of the balance of payment as it decrease
Structure the country’s foreign receipts.
Balance Of Trade and Payment Items included in balance of payment:
Items of current account: Real natured transactions
2.1 Introduction to Balance of trade & Balance of are included in current account. Transactions in the
payment current account are called real transactions because
2.2 Disequilibrium in balance of payment they are concerned with actual transfer of good and
2.3 Methods of correcting disequilibrium of balance of services, which affect income, output and expenditure
Payment of the country. According to IMF, the current account
of the balance of payments includes the following
Foreign Exchange items:
2.4 Foreign exchange rate
2.5 Determination of foreign exchange rates.
2.6 Causes of fluctuations in exchange rate Merchandise:
Exports and imports of goods form the visible account
Exchange Control and have a dominant position in the current account of
2.7 Introduction BOP. Exports are taken on the credit side and imports
2.8 Foreign exchange payments on the debit side.
Travel and Tourism: It is an invisible item in BOP.
Travel may be for business, education, health or
Balance Of Trade & Balance Of Payment Theory pleasure. Expenditure of foreign tourist in our country
is taken on the credit side expenditure by our tourists
2.1 Introduction aboard is taken on the debit side.

Balance of Trade: - Government Transactions:

Countries trade with one another their export for their This includes expenditure of embassies. Such
imports. Balance of trade refers to the recording of the amounts received by a government from aboard
value of imports and commodities i.e. of visible items constitute the credit item and made to the foreign
only. Balance of trade is also described as the governments form the debit item.
difference between the values of import; it is know as Insurance: Insurance premium and payments of claims
unfavorable balance of trade. Thus balance of trade is also an invisible transaction in a country’s balance of
refers to the visible items only i.e. goods and not payments account. Insurance policies sold to
invisible items like banking services, insurance foreigners is a credit item and the polices purchased
services, tourist’s revenue etc. Balance of trade is also by domestics users from the foreigners is a debit item.
a narrow term as compared to balance of payment. Miscellaneous: It includes other invisible items like
transportation, investments, advertisements, etc. Such
Balance of payment: payments received are credited and paid are debited.
Balance of payment is a more comprehensive than
balance of trade for it includes not only imports and Items of Capital Account:
exports which are visible items but also such invisible This accounts deals with the financial transaction Of a
items such as charges for shipping services, banking country, short as well as long term.
services, insurance, service, tourists, gifts, etc.
Balance of payment includes items of balance of trade Private loans:
i.e. visible items plus invisible items too. Balance of Foreign loans received by the private sector are
payment is to be at balance when total credit and debit credited whereas foreign loans repaid by the private
side balances. Any excess in either side is likely to sector are debited.
give a credit or debit balance. When debits are more
than the credits it is a deficit balance and when the Movements in banking capital:
credit side is more than the debit it is a surplus Inflow of banking capital is taken in the credit side and
balance. Capital imported or exported has a different outflow of bank capital is taken on the debits side.

43
 Business Economics

and embassies in the foreign countries which results in

Official capital transactions: outflow of foreign exchange. Thus making BOP
This includes foreign loans and credits received and adverse.
extended by IMF, World Bank, Central bank etc. When
the loans are received the amount is taken on the Population explosion:
credit side of BOP and incases of repayment of official Another important reason of adverse BOP in poor
loans the amount is taken on the debit side. countries is population explosion. Rapid growth of
population in countries like India increase their imports
Disequilibrium in Balance Of Payments: and decrease the exports since the surplus is
Balance of payment is in equilibrium when there is no consumed within the economy.
debit or credit balance of payment or in other word the
credit and debit sides are the same. Equilibrium in the Natural Factors:
balance is a sign of the soundness of a country’s Natural calamities such as earthquakes floods etc.
economy. When difference arises it is known as adversely affects the production in the country and as
‘disequilibrium’ in the balance of payment. When the result of the same the exports decrease whereas
credit balances exceeds it gives a ‘favorable’ balance import increase resulting in adverse BOP.
of payment or it can be said that the disequilibrium is
in favors of the country since exports being more than Methods of Correcting disequilibrium of balance of
imports of goods. On the other hand when the debit Payment:-
balance is in excess it is said to have created a deficit’
and gives an ‘unfavorable’ balance of payment. Stimulating export and adverse balance: -
To correct adverse balance of payments, the exports
Causes for adverse balance of payment: of the country should be encouraged. In order to the
exports by, adopting various export promotion
Fall in export demand: programs, such as, the reduction of duties. Provision,
A decline in the demand for the primary products of of export subsidies, quantity controls, incentives for
the developing economies with their imports being exports etc. also increases the exports.
high, result in adverse BOP.
Import Quotas and import Restriction and adverse
Development: balance: -
For development large volume and value of technical Another method to correct the disequilibrium is to
equipment’s and capital goods are imported by the reduce or discourage import of the country.
developing economies which also makes BOP Levying import duties may discourage import; Import
adverse. duties are better than all other methods as they cut
down the demand for imports and thereby reduce the
Cost Price Structure: adverse balance of payment.
The cost production of exportable goods of the country Import Quotas are of advantage as compared to other
may rise and as a result of the same the price of the methods as the produces known exactly what
same goods will rise in the international market which quantities of import will come in. They are more
will give them a disadvantage in competing with the suitable for negotiation trade concessions with other
other firms in selling the produce. countries.
Import substitution is another method correcting
Changes in foreign exchange rate: disequilibrium in balance of payment through reducing
An overvaluation of the domestic currency makes the imports is to encourage industries producing import
imports cheap and exports dear as a result of the substitutes. It also helps the national economy to
same the imports increase and the exports decrease become more self sufficient and reduces the
making the BOP adverse. dependence of the nation on imports.

Demonstration effect: Deflation: -

The less developed countries many a times follow the Deflation means fall in prices and also income.
consumption pattern of the developed countries and It attempts to restrict demand for foreign goods.
his unnecessarily increase their imports making their Reduction of money income will be followed by
BOP adverse. reduction in demand of imports. Besides export may
New Independent Countries: be stimulated since the cost may decline of goods and
The Newly independent countries in order to establish services along with the decline in money incomes.
and improve foreign Relationship setup missionaries

44
 Business Economics

Exchange Depreciation and Adverse balance: -

By the exchange depreciation we mean a 2.5 Determination Of Foreign Exchange Rates.
decline in the rate of exchange of one currency in
terms on another. If India experiences an adverse Under Gold standard-The Mint Par.
balance of payment with regards to USA dollar, the
value of Indian rupee will fall and of the USA dollar will Rate of exchange under gold standard is
rise. Appreciation in the value will increase the determined simply by referring to the gold contents of
purchasing power of the dollar in India, which nay the two countries. If two countries are on gold standard
increases the exports on India. But on the other hand and if their currencies are expressed in terms of a
reduction in the value of Indian rupee decreases its weight of gold the rate of exchange will be determined
purchasing power against the dollar thus making the as following:
imports expensive the over all effect is that the exports Taking an imaginary example let us assume
may rise and import may fall, this may help in rectifying that India and United States are on the gold standard
the adverse balance of payment in the case of and the rupee contains 1 grams of gold dollar consists
exchange depreciation. of 10 grams of gold.
The rate of exchange, between these two countries
Devaluation and Adverse Balance: - will be:-
Devaluation of a currency means lowering the
value of a currency in terms of Gold or in terms of $1 = 10 grams/ 1 grams = 10/1 Rs. 10/-
other currencies. The difference between devaluation OR
and depreciation stands that the government 1 Rupee = 1 grams/10 gram = 0.10 dollars or 10 cents.
deliberately undertakes devaluation whereas
exchange depreciation is an automatic reduction in the Determination of foreign Exchange Rate under
value of currency by market forces. Thus by Purchasing Power Theory-Gustav Cassel
devaluation of a currency imports becomes expensive When countries have in convertible paper currencies.
and export stimulate. In India devaluation has adopted The rate of exchange in the long run is determined by
has been adopted from time to time by the government the relative purchasing powers of the two currencies in
to cure adverse balance of payment in 1949, 1966and terms of goods and services. Gustav Cassel, the
1991. Swedish economist, used the terms purchasing power
in an article in the economic journal in 1918 to explain
Exchange Control and adverse Balance of that the exchange rate between two countries should
Payment: - be in the same ratio as the price levels of those
Exchange control is where the government countries.
controls the foreign exchange. Here all the exporters
are ordered to surrender their foreign exchange to the Absolute Version:
central bank which is then rationed out among the Under the purchasing power theory rate of
licensed importers. Under exchange control exports exchange between two countries can be determined
are not allowed without a license. Thus BOP is by referring to their purchasing power in their
corrected by keeping the imports within limits. respective countries.
Suppose that two countries say India and USA
2.4 Foreign Exchange Rate: are on free or inconvertible paper currencies. The rate
The rate at which one currency buys or exchange for of exchange of the Rupee and the Dollar will be
another currency is known as the rate of exchange. determined by their respective purchasing powers.
Suppose one rupee exchange for 5 pence of England This is known as the purchasing power parity theory of
it means that what one rupee can buy in India 5 pence foreign exchange. Internally, the purchasing power of
can buy in England. The rate of exchange expresses a currency will depend on the price level in that
the external purchasing power of a currency. country. It the price level rises, the purchasing power
The rate of exchange in other words is the price of one of the currency would decrease and hence its value in
currency in terms of another currency. terms of Foreign currency (i.e. its rate of exchange)
The rate of exchange depends upon the demand and would also fall and vice-versa.
the supply of the local currency in terms of the foreign
currency. Really speaking the rate of exchange of a Let us take an imaginary illustration:- If a bale of
currency simply express its external value of its Cotton is sold for Rs.1000 in India if the same bale of
external purchasing power. The rupee, therefore can Cotton is sold for $100 in USA rate of exchange
buy goods in a foreign country not directly but (ignoring transport costs) will be $100 = Rs.1000 or $1
indirectly, through the help of foreign currency. = Rs.10. Thus the rate of exchange can be easily

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determined by one currency in terms of another instances where changes in rate of exchanges have
provided the purchasing power of the two currencies in brought about changes in price levels in the two
terms of one common commodity traded in both the countries.
countries is known.
Unrealistic assumption of free trade: -
Relative Version: The theory is based on the unrealistic assumption of
This version is connected with the relationship free trade and absence of exchange control.
between changes in the domestic prices in respective
countries and the changes in exchange rate. The rates Transport costs ignored: - The theory does not take
of exchange will the changes in the ratio of price into account the transport costs of trading goods
indices of the respective countries. Some past between countries.
exchange rate is assumed to be an equilibrium rate
and is adopted as the base rate. The new exchange Long period theory: -
rate can be known y relative the variations in the price The theory is applicable only in the long period. It does
level in the two countries to the base rate. provide solution to the short run problems of exchange
rate and as such is not practical.

2.6 Causes Of Fluctuations In The Foreign

Exchange Rates:

Rate of exchange does not fluctuate under the gold

standard. On the other hand, rate of exchange under
In a particular year say 1990 index number of prices
free paper currencies fluctuates accordingly to
both in India and USA was 100 and that in the same
demand and supply fords. Suppose the Indian demand
year the rate of exchange between the Rupee and
for the Dollar is greater than the American demand for
Dollar was Rs.1$. Suppose, now in January 1997 the
index number of Indian prices has risen to 350 while the Rupee, the price of the Dollar will rise in terms of
the Rupee. Thus changes in the rate of exchange are
American prices has risen to 250, the rate of exchange
result of changes in the mutual demand for each
will be,
other’s currencies.
350/100
$1 = 1 Rupee X --------------- = Rs.1.4 The factors, which are responsible for the fluctuations
250/100 in the rate of exchange, are:-
Criticisms of Purchasing power Parity Theory:-
Course of International trade: -
If the export of a country is equal to the
No direct link between Purchasing power and rate of
imports of that country, there will be no demand of
exchange:- There is no direct link between purchasing
power and rate of exchange as exchange can be foreign exchange. But suppose Indian demand for
influenced by many other consideration too such as American goods is greater than the USA demand for
Indian goods, it will lead to a greater demand for the
tariffs, speculation and capital movements.
Dollar by the Indians to meet the excess of import from
Difficulty in price indices:- The main defects of price
America; consequently the price of the Dollar in terms
index number are
of Rupee will rise.
The base years are different in different countries.
The price index numbers in different countries include
Monetary Policy: -
different sets of commodities.
Price index numbers also include those commodities
Suppose India follows an inflationary policy, the price
which are not traded internationally.
level in India will rise while purchasing power will fall.
Capital Movement Ignored: - The price level in America remaining the same,
The purchasing power parity theory ignores the Indians will like to buy more from America and this will
increase its demand for Dollar, where as the America
influence of capital movements. Capital flows between
would prefer to buy less form India which would
countries disturb their rate of exchange.
decrease their demand for Rupee. This would lead to
Change in the Exchange Ratio: - increase in import by India and decrease of its exports
The theory implies that changes in exchange rates to USA. The rate of exchange will fluctuate in favour of
have no effect over price level. But there are many America, and vice-versa in case of contraction of
money supply.

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Objectives of Exchange Control:- (merits of

Capital Movement: - exchange control)
Suppose a large amount of capital is shifted from
America to India this would initially increase the 1) Overvaluation: - Some countries resort to
demand for Rupee and thus push up the value of exchange control to keep their currencies overvalued.
Rupee in terms of Dollar. But when the capital gets This is done mainly to increase imports for three
back to America the effect on the exchange rate will reasons:-
just the opposite. i) Country in war needs large quantities of imports.
Speculative Activities: If speculators imagine now ii) Country engaged in development process needs
some reason, for the Rupee to appreciate they will capital and raw material from abroad.
purchase it to sell in the future but the rate of iii) Country has to reply large foreign debt.
exchange will go up now.
2) Under valuation: - Under valuation restored to
Political Condition: - mainly simulate exports and reduce imports. Under
If there is political stability in the economy and the valuation refers to the fixing of the value of currency at
government is strong, the foreign investment will a rate lower than the market rate. It ins also known as
increase and a result of inflow of capital demand for pegging down.
domestic currency will rise and the exchange rate will
be more in favour of the country. 3) Stabilization of Exchange Rates:- Exchange
control is also restored to keep a stable exchange rate
Protection: - as fluctuation exchange rate hampers the commerce
When the government of a country gives protection to and industry of the country.
the domestic industries, it tends to discourage import
from other countries. As a consequence, the demand 4) Prevention of Capital Flight:- Gold and capital
for foreign currency will decrease and the rate of flight cannot be exchange without the permission of
exchange will move in favour of the home currency the exchange control authority. Thus exchange control
and against the foreign currency. Foreign Exchange not only prevents the flight of capital but also
Control conserves precious foreign exchange.
Monetary Standard:- If the country is on the gold
standard, then the exchange rate will move within the 5) Protection of Domestic Industries:- Exchange
limits set by upper and lower gold points. But in the control is resorted for giving protection to domestic
case of inconvertible paper currency there is no limit to industries against foreign produces. This is done by
the fluctuations in the rate exchange. controlling the imports of such goods which compete
with domestic producers.
Exchange Control
6) Remedying Unfavorable Balance of Payments:-
2.7 Introduction: Exchange control is exercised to remedy the
unfavorable balance of payments by checking imports
Exchange control in one of the important device to of goods and regulation foreign exchange.
control international trade and payment. Exchange
control aims at equilibrating foreign receipts and 7) Earning Revenue:- Exchange control is also used
payments through direct an indirect control of foreign to earn revenue by the government. The Central Bank
exchange. of the country sells foreign currencies to traders at
Thus, exchange control means that all foreign receipts higher rates than at which it buys in the international
and payments in the form of foreign currencies are market.
controlled by the government. An exchange control
system involves complete government control over the 8) To check enemy nations:- Exchange control is
foreign exchange market in the sense that foreign also used by some countries to prevent the enemy
currencies are required to be surrendered to the countries from using their foreign assets.
Central bank, which in turn sanctions and allocates all
foreign payments in respect of different currencies. As 9) To check undesirable imports:- Exchange control
the controlling authority, the central bank regulates is also needed to check the import of certain non
demand and supply so as to maintain the official essential, harmful and society undesirable goods in
exchange rate. the country.

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10) Development in the planned manner:- exchange in favour of his exporter at a bank in the
Exchange control forms an integral part of economic export’s country. The bank against the payment issues
policy in a planned economy where expansion, the letter of credit in domestic currency. The
conversion and proper sue of foreign exchange arrangement provides security to both the exporter
reserves of the country according to the national and the importer.
priorities is to be made.
Problems of Foreign Exchange Payment:-
2.8 Foreign Exchange Payments:
The problem of foreign exchange payments
Methods of Foreign Exchange Payments. arises as a result of absence of some international
The payments in foreign currencies are money, which is not universal. Different currencies are
not affected by the physical movement of currencies freely used in different countries like Rupee in India,
from one country to another but rather, it is through Dollar in USA etc, through these are not of universal
banks. The debtor makes the payment to a bank in nature.
national currency and the bank then issues a credit The second problem of foreign payment arises as
instrument effecting the payment. currency of one country is not generally accepted in
The various credit instrument use in the market other countries therefore the problem of converting
are:- one currency into the terms of another.
Telegraphic Transfer or Cable Transfer(T.T.):- The third problem arises due to unacceptability of
Telegraphic message sent by a bank or a authorized countries in accepting the currencies of other
foreign exchange agent to its branch or foreign countries, the problem that arises is that of
associate informing him to make the payment to the convertibility.
designated payee. The geniuses of the transactions Fourthly determining the exchange rate is
can be tested by system of private code. another problem of foreign exchange payments.
Mail Transfer (M.T.):- Transfer is just like a Fifthly determining the exchange rate is not only
telegraphic transfer. It is an order given by a bank to problem, after determining it the next problem is that
its agent in the foreign country by mail to pay a the keeping the exchange rate stable.
specified sum to the designated payee of the creditor. Lastly in the case of international
But it is sent by mail and not by telegraph or cable. It is payment adequate care is to be taken, otherwise trade
just like a cheque but is not negotiable or transferable misunderstandings between concerned countries can
freely. develop. The care needs to be taken as regards to the
Bank Drafts:- Bank Draft is issued and drawn date of payment, commission to be given etc.
by a bank on its associate branch on a center where
payments is to be made. The debtor who like to get
draft issued deposits the equivalent amount in national
currency in a bank. The bank issues then a draft or
cheques, which the debtor sends to the creditor in the
foreign country. The creditor may encase it from the
banker on which the cheque or draft has been drawn
in his own currency.
Bills of Exchange (B/E):- Bill Of Exchange is
the oldest and the most common method of making
foreign payments. Here, creditors whose goods have
been purchased (exporter) draws a bill on the debtor
for the amount of debt and for a specified period. The
after having acknowledgement the debt by assigning
his acceptance on the bill completes his side of
formality. The bill now is payable on maturity. The
debtor returns the bill to the drawer after acceptance.
The drawer may hold the bill till maturity and collect
the payment on maturity through a bank or may get it
discounted with the bank before the maturity date for a
discount amount.
Letter of Credit:- A bank issues a letter of
credit to a customer in this request and importer may
request his banker to open a credit account in foreign

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1.2 Objectives Of Monetary Policy:-

Unit-8 Monetary & Fiscal Policy
Price Stability:- With the abandonment of gold
standard after the world war II exchange stability which
Chapter 1. Monetary And Fiscal Policy was primary objectives of the monetary policy came to
be replace by price stability and greater attention was
Monetary policy paid to the problem of removing violent fluctuations in
Objectives of Monetary Policy the domestic fluctuation of prices through varies
Limitations and problems of monetary policy. monetary control & price regulation. Price stability
Fiscal policy refers to the absence of any market trend or sharp
Objectives of Fiscal policy short run moments in the general price level. Price
stability does not mean that each & every price should
be kept fixed. It means that the average of prices or
1.1 Monetary Policy:- the general price level should not be allowed to
fluctuation beyond a certain minimum limit. Thus
Monetary Policy refers to the policy of the stable price does not mean frozen price level.
central bank regarding the control of & regulation of
the money supply in the economic. Economic Development:- Development countries
The central bank of any economy on the strive for economic development for which the
behalf of the govt. or controlling authority plans & monetary policy can be used. Appropriate monetary
formulates policies in order to govern an optimum level policy can increase investment. Monetary policy can
of money supply in the economy for smooth running of also control the rate of interest and money supply for
trade & commerce in the economic system. investment. This objective of economic development of
Inability of the central bank to maintain a correct level the M.P. has quite recently acquired importance & has
of money supply can result in shock effect & instability been made the primary objective of monetary policy.
in the economy, thus adversely affecting the trade Economic growth has been defined as the process
cycle. whereby the real national income of a country
The monetary policy is a tool of a developing increases over the ling period of time & in this process
economy in order generate employment & creating money can play an important role as a mobilizing
stability of domestic prices & foreign exchange. agent. Thus M.P. accelerates the process of economic
growth.
According to a [Link] monetary policy is
the “the exercise of the central banks control over the Economic Stabilization:- Economic stabilization is
money supply as an instrument for achieving the achieved with appropriate monetary and fiscal policy in
objectives of economic policy.” the country as every country is subject to constant
economic fluctuation arising out of business cycle.
The monetary policy is of two types:- Economic stabilization is the pre-condition for
a) Cheap Money Policy b) Dear Money Policy economic development. It becomes as important
objective of monetary policy.
Cheap Money Policy:- Cheap money policy means
making money inexpensive in the general economy. Monetary policy has many devices for bring about
This policy acts as a stabilizer by creating an increase economic stability viz. rate of interest, weapons of
in the supply of money in order to rectify the credit control, open market operations etc. These are
deflationary pressures & also to increase the level of called built in stabilizers with the help of which a good
investment, production and employment in the deal of economic stability can be brought. Thus
economy. Thus cheap money Policy is where money monetary policy aims at stabilizing the economic in
is made cheap & abundant. Cheap money Policy is in order to avoid economic fluctuation like booms &
favors of increasing money supply as weapon to depression. Thus a good monetary policy, aims at
neutralize the scarcity of money in the economy. maintaining a correct level of money supply which in
Dear Money Policy:- Dear money policy is itself acts as a stabilizer.
generally associated with inflation. As in inflation
money supply is in excess of demand for it. If central Exchange Stability:- Exchange stability means rate of
Bank reduces the money supply money becomes exchange in the international trade is kept sufficiently
decrease. Therefore it is called Dear money policy. stable over a fairly long period of time. Exchange
stability has an overall impact on the economic
development of the country as well. More over price

49
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stability and exchange stability are interconnected, as Fiscal policy refers to the manner in which
both are inter-dependent also. Thus economic stability Government raises revenue by measures of taxation
being the primary objectives of monetary policy, it also public borrowings for public expenditure for the
helps tp maintain a healthy trade with the foreign purpose of development.
countries. Exchange stability helps in the following. Thus, fiscal policy of the Government gets reflected in
Smooth international trade is promoted. the manner in which revenue is raised annually and
Speculation in exchange market is avoided. the pattern of Government expenditure.
Fluctuations in internal price level are also avoided. Role of fiscal policy for a developed economy is to
Healthy political and economic relationship among the stabilize the growth rate whereas for a developing
country. economy it is to accelerate the growth rate.
According to Nurkse Fiscal policy assumes a new
Employment Generation:- Employment generation significance in the face of the problem of capital
means generating employment opportunities for the formation in underdeveloped countries.
people. Therefore it is an important objective of In a developing economy where monetary policy alone
monetary policy. Although monetary policy cannot is ineffective due to non-existence of a developed
attain full employment, it can certainly generate more money and capital market, fiscal policy works as an
employment, thus removing to some extent adjunct to monetary policy in the acceleration of the
unemployment in the economy. As long as rate of capital formation.
unemployment prevails in the economy economic
developments become difficult. With the publication of 1.5 Objectives Of Fiscal Policy
Keynes General Theory of Employment 1936, full As a means to promote economic development Fiscal
employments become the ideal goal of monetary Policy performs the following objectives:
policy. Though full employment not necessarily means
100% employment in the economy. According to 1. Acceleration The Rate Of Capital Formation
Keynes, Unemployment is mainly due to the deficiency Fiscal policy assists in the increase of the total
of investment which can be rectified by increasing the volume of savings available for economic
money supply in the economy which will in turn development. Fiscal policy encourages some and
increase the investment level. discourages other forms of investment. In order to
The policy of full employment is a increase the rate of investment, government should,
humanitarian policy as a if tries solve the human undertake a policy of planned investment in the public
problem of employment. sector. This will have the effect of increasing the
By fully employing the resources, this volume of investment in the private sector. The
objectives aims at maximization of social welfare. problem though in an underdeveloped country is to tap
adequate financial resources for investment purpose in
1.3 Limitations And Problems Of Monetary Policy: the absence of sufficient voluntary saving.
On the other hand conspicuous consumption needs to
Conflicting Goals:- The goals of the monetary policy be curtailed and investment in unproductive channels
can be in conflict since reduction of money supply can can also be curtailed with the same resources being
stabilizer the prices but this may increase diverted for productive purpose.
unemployment and reduce the rate economic growth. Dr. R.N. Tripathy suggested six methods to do
Changes in velocity of money:- Change in the velocity adopted by the government to increase the saving
of money held by the public is another factor which ratio:
restricts the effectiveness of the monetary policy.
a) Direct fiscal controls
Target Problem:- Target problem arises because the b) Increase in the rates of existing taxes
monetary policy cannot directly and quickly affect the c) Imposition of new taxes
ultimate objectives through its instruments. Monetary d) Surplus from public enterprises
policy in order to be effective must affect spending e) Public borrowing of non- inflationary nature
decisions. By using certain intermediate targets, the f) Deficit financing
central bank hopes to achieve the ultimate objectives 2. Accelerating The Level Of Investment For Social
more effectively. Betterment
Fiscal policy also aims at encouraging the flow of
Fiscal Policy investment into those channels, which are considered
socially desirable. This relates to the optimum pattern
1.4 Role Of Fiscal Policy In A Developing Economy of investment and it is the responsibility of the state to
promote investment in social and economic

50
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overheads. Investment in transport, communication, 5. Economic Stability

river and power development, and soil conservation Fiscal policy aims at counteracting
fall under economic overheads. While investment in inflationary tendencies inherent in a developing
education , public and technical training facilities come economy. In such an economy, there is always an
under social overheads. Investment in these two imbalance between the demand for and supply of real
categories creates external economics, which leads to resources. With an increase in the money supply in the
increase in marginal productivity of private investment. economy there is an increase in the demand of goods
and services but the supply remaining the same, it
3. Employment Generation leads to inflationary pressures. The inflationary
Fiscal policy aims at one of the principle pressure will be greater if large investments are
objective of employment generation. For the same the
government spends on social and economic directed to the capital goods industry goods
overheads creating more employment and increasing industry to the neglect of the consumer goods sector in
the productive efficiency of the economy in the long the economy. Direct taxes on a progressive level in
run. one of the effective fiscal measures for counteracting
Taking of public works in the rural areas inflationary pressures. Through this measure should
creates an employment base for the large rural not adversely affect the levels of private investment in
population. Public enterprises can also be set up. the economy. Public expenditure also needs to be
Which would encourage private enterprise through incurred in a cautious manner. During depression
facilities by the government in the form of subsidies, through the public expenditure needs to be increased
tax holidays, etc. Expenditure on these various short and taxes reduced in order to combat the decrease in
tem long term measures will go a long way in money supply.
eradication unemployment and underdevelopment.
Though it needs to be said that above measures alone 6. Equitable Distribution of Income and Wealth
may not prove to be effective in intensity, if efforts are One of the roles of fiscal policy is to decrease
not taken to control the growing labour force, Fiscal the inequalities of income and wealth in the economy.
policy should, therefore, provide more social amenities An inequality of income and wealth creates social
with a grater emphasis on family planning. Unless upheavals, leading to economic and political instability
population is controlled the objective of increasing and stands in the way of economic development.
employment opportunities cannot be fulfilled. The redistributive role of fiscal policy consists in
increasing the real income of the masses and reducing
4. Exchange Stability higher income levels. Direct Government investment in
A developing economy is prone to exchange social and economic overheads tends to increase
instability. Therefore, the fiscal policy should promote employment, real income of the people, thus improving
a reasonably stable exchange rate in the face of short the standard of living in a developing economy.
run international cyclical fluctuations. A developing High and progressive taxes should be levied on the
economy mainly exports primary products and imports higher income group, which transfer the resource from
manufactured articles and capital goods. The hands of the haves to that of the have-nots. Though
devaluation of the rupee in 1991, aimed at making the care should be taken to avoid adverse effect on private
imports expensive and reducing the same, whereas on investment due to the increase in taxation.
the export side the devaluation is an incentive for Fiscal policy has made an attempt in India to
export. In the case of a fall in the prices of agricultural effectively mobilize resources for development and for
and mineral products in the world market, the terms of achieving other objectives. A major part of expenditure
trade becomes adverse, foreign exchange earnings has been on development projects as per the priority
decline and national income falls. Due to the inelastic given to different sectors in the various five year plans.
supply of agricultural goods, a developing country The Indian fiscal policy though has to its credit various
cannot take advantage of increasing its exports when achievements it is also responsible for accentuating
their process falls. In the same way, it is not able to inflationary pressures in the economy, improper
take advantage of a boom in the world market. Fiscal allocation of resource, increase in inequalities of
policy should aim at the diversification of the economy income and wealth, inability to tackle the problem of
viz, balanced growth of the various sectors of the increasing unemployment and creating a parallel
economy. In order to reduce the effects of international economy.
cyclical movements, a contra-cyclical fiscal policy of
deficit budgeting during depressions and surplus
should be adopted.

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of international trade corresponding to their

Chapter 2 World Trading developmental needs.
Organization(WTO) To demolish all hurdles to an open world trading
system and usher international economic renaissance
because the world trade is an effective instrument to
foster economic growth.
2.1 Introduction To enhance competitiveness among all trading
2.2 Objectives partners so as to benefit consumers and help in global
2.3 Structure integration.
2.4 Major Agreements To increase the level of production and productivity
2.5 Benefits To India with a view to ensure high level of employment in the
2.6 Shortcomings world.
2.7 Relevance In India To expand and utilize would resources to the best.
To improve the level of living for the global population
and speedup economic development of the member
2.1 Introduction nations.
General Agreement on Tariff and Trade (GATT) was
established in Geneva by 223 countries including 2.3 Structure Of WTO
India. It comprised of a trade pact among the member
countries to promote the world trade by reducing The Ministerial Conference: It is the highest
barriers like custom duties and quotas with some body which has representatives of the member
special and differential treatment to the developing countries and has the authority to take decision under
countries. the relevant multilateral trade agreement. It meets
WTO came into existence on Jan 1, 1995 every once at least two years.
when WTO replaced GATT, which had acted as an The General Council: It is an executive forum
interim world trading organization a watchdog since having representative of all member countries. It
1948. discharges the functions of the ministerial conference
The WTO now comes as the third economic during interval between the meetings of ministerial
pillar of worldwide dimension along with the World conference. It shall meet as and when necessary. It
Bank and IMF. has the following three functional councils which it
The decision-making under WTO is carried out guides and supervises;
by consensus, the lack of which requires voting where Council for trade in goods.
one country has one vote. The council for trade in services.
Council for trade related aspects of intellectual
Nature Of Agreement property rights.
The WTO agreement will regulate the trade of
commodities in addition also dealing with services Functional Committee: Functional committees are
across borders. The WTO also protects intellectual under ministerial council. Following are the three
property like patents, brands, and copyrights. functional committees under ministerial committees:
Agriculture and textiles are completely covered under Committee on tread and development.
WTO agreements. The WTO envisages the reducing
of tariffs by more than 1/3rd and is concerned with Committee on balance of payment restriction.
further opening of market. It is expected that the world Committee on budget finance administrations.
trade would be stimulated strongly in the long run as a Committees discharge functions also of the general
result of the coming into being of the WTO estimated council assigned to it.
to be high as $510 billion annually, in the year 2005.
2.4 WTO-Major Agreements
Objectives Of WTO
The main objectives of WTO are: The major agreements of WTO are briefly as follows:
To implement the new world trade system as I. Trade in Agriculture
visualized in the agreement. The agreement for agriculture conveys that
To promote world trade in a manner that benefits participating Governments do not maintain, resort to
every country. any measures of the kind which have been converted
To ensure that developing countries secure a better into ordinary customs duties. The major features are.
share in the advantages resulting from the expansion

52
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Reduction in Domestic Subsidies: According to the IV. Trade Related Investment Measures (TRIMS)
proposals, the value of subsidy payment should not A TRIM is applicable to investment in trade of
exceed 10% in the developing countries of the value of goods. It provides for the removal of restrictions of
gross agricultural output. Though this 10% excludes foreign investment, which distort free trade. Usually,
subsides to the low income and resource poor farms these restrictions are found in developing countries. In
who are those with less than 2.5 hectares of land. other words, the agreement ensure that all units
whether indigenous or foreign shall be treated at per
Reduction in export subsidies: Countries give high without any discrimination in terms of regulations and
subsidies to exporters which are to be reduced both on policies. However, certain conditions can be imposed
value and quantity. On value it is to be reduced by regarding fulfillment of export obligations to balance
36% in 6years and on quantity basis 21% during forex.
6years. For the developing countries, the limit is 24%
and 14% respectively during the period of 10 years. V. General Agreement on Trade and services
(GATS)
Public Distribution System: Here, restrictions exist The Uruguay Round brought the
as to public stock holding and food aid operations. services sector into the multilateral trade rules for the
Though developing countries are exempted from the first time. As per the GATS the treatment to services is
disciplines. wither Transparency or most Favored Nation
Treatment (MEN). GATS aims at promoting growth in
II. Textile and Clothing the developed countries by providing lager markets
The WTO has adopted discriminatory quantitative and in developing countries by transfer of advanced
restrictions in the textiles and clothing sector by over technologies. Free trade in services like banking,
30years under Short Term Arrangements. Long Terms shipping transport, telecommunication, etc. MNC a are
Arrangements and Multifibre Arrangement up to 30 free to operate with the other member countries and
December, 1994. are to be treated at par with the domestic companies.
The Arrangement on Textiles and Clothing has
the provision for prohibitions of any such restrictions VI. Dispute Settlement
on tree exports and elimination of MFA arrangement. WTO offers powerful mechanism to resolve
The agreement would mean the elimination of MFA or disputes over trade, arising out of growing competition
the elimination of all non-tariff measures in textile and among the members. The developing countries are
clothing industries over a period of 10 years. seen to be emerging more as active users of the
The division of 10 years will be in three stages 19% in multilateral dispute settlement mechanism rather than
the first 3 years 17% by 4 nest years another 18% by the developed countries.
next 3 years. The agreement gives the facility of automatic
The interest of developing countries has been access to the good offices of the Direct General of the
kept safe where they are allowed to follow non-tariff WTO by the developing countries to mediate and seek
measures in circumstances, if imports are threat to a satisfactory solution to the dispute.
domestic industries.
2.5 Expected Benefits From The Agreement For
III. Trade Related Intellectual Property Rights India
(TRIPS) The benefits to procure to India form the agreements
TRIPS provide nine types of intellectual are: An export of India is expected to increase due to
property. The countries are free to adopt either the restrictions in developed countries on the import of
patenting of varieties or Sui-Generis or combination of agricultural goods. Also exports are expected to
both. In countries where is no provision for patents increase due to free trade.
grace period of 10years has been grated. India has The agreements of WTO are expected in
accepted Sui-Generis system. It is referred to as plant improving the efficiency of the manufacturing houses
breeder’s right. It allows farmers to retain the seed, and of goods and services.
use them on their own farm and exchange with the It attracts foreign capital and is quite instrumental in
neighboring farmers. The restriction being on the the inflow of technology.
commercial sale of branded seeds. Only the owners of It removes the trade barriers resulting in the
the plant breeders right will produce and market their increase of volume and value of trade.
breaded plants. The treaty is expected to diversify Indian agriculture as
trade in agricultural goods and services are to be
brought within the limit of negotiation of reduction in
barriers.

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India’s exports have nearly doubled to % 51.7 billion in

2.6. Short Comings 2002-03 from $26.3 billion in 1994-95, in less than a
decade since it because the member of the World
It is argued that the domestic units will suffer due to Trade Organization in1995.
the proposals of GATT with the Dunkel Draft.
It is argued that the agreements are more suitable for Agricultural Sector : The Dunkal proposal as
the developed economies rather than the developing accepted by the member countries has impact on four
economics. It can result in adverse balance of different areas of agriculture namely as follows:
payment especially for the developing economies.
It can result in the structural readjustment, which many Reduction of farm subsidies: This rule will not be of
a times can be detrimental to the economy. real impact on the Indian agriculture since is a non-
The increase in competition would result in economies commercial activity in India.
adopting capital intensive technology to survive in
competition which could result in unemployment in Provision of minimum access to imports: A country
labour abundant countries like India. like India gets exemption from the minimum
The Dunkel proposal brings little for the small and compulsory access in agricultural trade where at least
marginal farmers who constitute about 76% of total 3% of the market is to be made accessible for imports
holding in the country. This is due to no special of agricultural goods on ground of its balance of
concessions for marginal and small farmers expect low payment problem.
percentage of general subsidy. Disbanding public distribution system: This agreement
The trade reforms are incomplete in India, which gives does not apply to India since the PDS is run for the
a hazed picture of the implications of the agreement weaker sections and people below poverty line.
on India. Seed Patenting: Under the agreement the farmers are
free to exchange their seeds with the others. They
2.7. Relevance Of WTO AND INDIA therefore need not necessarily buy seeds from the
open market.
By being a WTO member, India also avails of the Most
Favored Nation treatment for its exports to other WTO Textile and Clothing Industry: The textile industry I
members. India would gain favorably due to the multi-fibre
Regarding textiles, in accordance with the arrangements. Quota restrictions on the import of
WTO agreement on textile and clothing, all WTO Indian textiles will be withdrawn within the coming
member countries were required it integrate specific years, which will stimulate India’s export and also
volumes of their textiles and clothing trade into the generate employment opportunities.
WTO framework.
In addition, the size of quotas was expanded Trade in service: India here has made a commitment
annually by the restarting countries that maintained the in 33 activities. This would involve the inflow of capital,
quota. The Indian government is aware of the technology and laborers though doubts were raised on
emerging scenario for the small-scale industry (SSI) the adversity of this agreement on the Indian domestic
units and has taken several steps to help them services, which are less efficient and competitive.
become globally competitive. These include special Intellectual property Rights: The GATT proposal has
focus on areas such as technology up gradation and stated a switch over from the product patenting in the
infrastructure assistance. These measures have led to present to the process patenting. The Threat in this
increase in market infrastructure assistance. These regard is only on the new drug. Already 85% of the
measures have led to increase in market access, to a essential drugs are off patent.
certain extent, although most of these quotas would be
removed only at the stage of integration on December Investment Measure: According to this AGREEMENT
31, 2004. With effect from January 2005, the entire India shall not impose restrictions on external
textiles and clothing trade would get integrated into investment. This is feared to adversely affect the
multilateral framework of the WTO, with the completion domestic units. Though the other picture could be that
of the phase-out of the regime of textile quotas. TRIMS may generate employment in the economy and
As per the World Investment Report, Foreign increase the investment and the level of production.
Direct Investment in India has increased over the last The Government here has the right to exercise control
three years to $3.4 billion in 2002 from $2.32 billion in wherein necessary.
the 2000.

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