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1
INTRODUCTORY MICROECONOMICSUNIT-IPRODUCTION POSSIBILITIES CURVEThe production possibilities (PP) curve is a graphical medium of highlighting the
central problem of
'what to produce'. To decide what to produce and in what quantities, it is first
necessary to know what
is obtainable. The PP curve shows the options that are obtainable, or simply the
production
possibilities.
What is obtainable is based on the following assumptions:
1. The resources available are fixed.
2. The technology remains unchanged.
3. The resources are fully employed.
4. The resources are efficiently employed.5. The resources are not equally efficient in production of all products. Thus if
resources are
transferred from production of one good to another, the cost increases. In other
words
marginal opportunity cost increases.
The last assumption needs explanation because it determines the shape of the
PP curve. If this
assumption changes, the shape changes.
Efficiency in production means productivity i.e. output per unit of an input. Let the
input be worker.Suppose an economy produces only two goods X and Y. Suppose a worker is
employed in
production of X because he is best suited for it. The economy decides to reduce
production of X
and increase that of Y. The worker is transferred to Y. He is not that efficient in
production of Y as
he was in X. His productivity in Y will be low, and so cost of production high.
The implication is clear. If the resources are transferred from one use to another,
the less and less
efficient resources will be transferred leading to rise in the marginal
opportunity cost which is
technically termed as marginal rate of transformation (MRT). What is
MRT?
Marginal Rate of Transformation (MRT)To simplify, let us assume that only two goods are produced in an economy. Let
these two goods be
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guns and butter, the famous example given by Samuelson. The guns symbolize
defense goods and
butter, the civilian goods. The example, therefore, symbolizes the problem of
choice between civilian
goods and war goods. In fact it is a problem of choice before all the countries of
the world.Suppose if all the resources are engaged in the production of guns, there will be
a maximum amount
of guns that can be produced per year. Let it be 15 units (one unit may be taken
as equal to 1000, or
one lakh and so on). At the other extreme suppose all the resources are
employed in production of
butter only. Let the maximum amount of butter that can be produced is 5 units.
These are the two
extreme possibilities. In between there are others if the resources are partly used
for the productionof guns and partly for production of butter. Given the extremes and the in-
between possibilities, a
schedule can be prepared. It can be called a production possibilities schedule.
Let the schedule be:
2
Production Possibilities SchedulePossibilities Guns Butter MRT = Guns
(units) (units) Butter
A 15 0 -
B 14 1 1G : IB
C 12 2 2G : IB
D 9 3 3G : IB
E 5 4 4G : IB
F 0 5 5G : IB
In the table the possibility A is one extreme. The society devotes all the resources
to guns and
nothing to butter. Suppose the society wants one unit of butter. Since resources
are limited and fully
and efficiently employed, to produce one unit of butter some of the resources
engaged in production
of guns have to be transferred to the production of butter. Let the resources worthone unit of gun are
enough to produce one unit of butter. This gives us the second possibility with
MRT = 1G/IB. Now
suppose that the society wants another unit of butter. This requires transfer of
more resources from
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the production of guns. Now we require transfer of resources worth 2 units of
guns to produce one
more unit of butter. The MRT rises to 2G/IB. MRT rises because now less
efficient resources are
being transferred. In this way MRT goes on rising.
We can now define MRT in general terms. MRT is the ratio of units of one goodsacrificed to produce
one more unit of the other good.
MRT = Units of one good sacrificed____ = Guns
More units of the other good produced Butter
Or, MRT is the rate at which the quantity of output of one good is sacrificed to
produce on more unit
of the other good.
Production Possibility CurveBy converting the schedule into a diagram, we can get the PP
curve. Refer to the figure I which is based on the PP schedule.Butter's production is shown on the x-axis and that of guns on the
y-axis.
We can measure MRT on the PP curve. For example MRT
between the possibilities C and D is equal to CG/GD. Between D
and E it is equal to DH/HE, and so on.3Diagrammatically, the slope of the PP curve is a measure of the MRT. Since the
slope of a concave
curve increases as we move downwards along the curve, the MRT rises as we
move downwards
along the curve.
CharacteristicsA typical PP curve has two characteristics:
(1) Downward sloping from left to rightIt implies that in order to produce more units of one good, some units of the other
good must
be sacrificed (because of limited resources).(2) Concave to the originA concave downward sloping curve has an increasing slope. The slope is the
same as MRT.
So, concavity implies increasing MRT, an assumption on which the PP curve isbased.
Can PP curve be a straight line.Yes, if we assume that MRT is constant, i.e. slope is constant.
When the slope is constant the curve must be a straight line. But
when is MRT constant? It is constant if we assume that all the
resources are equally efficient in production of all goods.
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Note that a typical PP curve is taken to be a concave curve
because it is based on a more realistic assumption that all
resources are not equally efficient in production of all goods.
Does production take place only on the PP curve?Yes and no, both. Yes, if the given resources are fully and
efficiently utilized. No, if the resources are underutilized orinefficiently utilized or both. Refer to the figure 3.
On point F, and for that matter on any point on the PP curve
AB, the resources are fully and efficiently employed. On point
U, below the PP curve or any other point but below the PP
curve, the resources are either underutilized or inefficiently
utilised or both. Any point below the PP curve thus highlights
the problem of unemployment and inefficiency in the economy.4
Can the PP curve shift?
Yes, if resources increase. More labor, more capital goods,better technology, all mean more production of both the goods.
A PP curve is based on the assumption that resources remain
unchanged. If resources increase, the assumption is broken, and
the existing PP curve is no longer valid. With increased resources
there is a new PP curve to the right of the existing PP curve.
It can also shift, to the left if the resources decrease. It is a rare
possibility but sometimes it may happen due to fall in population,
due to destruction of capital stock caused by large scale natural
calamities, war, etc.
5
UNIT-IICONSUMER'S EQUILIBRIUM_IntroductionA consumer is one who buys goods and services for satisfaction of wants.
The objective of a consumer is to get maximum satisfaction from spending his
income on various
goods and services, given prices.
We start with a simple example. Suppose a consumer wants to buy a commodity.
How much of it
should he buy? One of the approaches used for getting an answer to this
question is 'utility' analysis.Before using this approach, we would like to familiarize ourselves with some
basic concepts used in
this approach,_ConceptsThe term utility refers to the want satisfying power of a commodity. Commodity
will possess utility
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only if it satisfies a want. Utility differs from person to person, place to place, and
time to time.
Marginal Utility is the utility derived from the last unit of a commodity purchased.
It can also be
defined as the addition to the total utility when one more unit of the commodity is
consumed.Total Utility is the sum of the utilities of all the units consumed.
As we consume more units of a commodity, each successive unit consumed
gives lesser and lesser
satisfaction, that is marginal utility diminishes. It is termed as the Law of
Diminishing Marginal Utility.
The following utility schedule will make the Law clear.
Units of a commodity Total (utils) Utility Marginal (utils) Utility
1 4 4 (=4-0)
2 7 3 (=7-4)
3 9 2 (=9-7)4 10 1 (=10-9)
5 10 0 (=10-10)
6 9 -1 (=9-10)
Here we observe that as more units are consumed marginal utility declines. This
is termed as the
law of diminishing marginal utility. The law states that with each
successive unit consumed the
utility from it diminishes.
AssumptionsThe utility approach to consumer's equilibrium is based on certain assumptions.61. Utility can be cardinally measurable, i.e. can be expressed in exact units.
2. Utility is measurable in monetary terms
3. Consumers income is given
4. Prices of commodities are given and remain constant.
Equilibrium(a) One commodity caseSuppose the consumer wants to buy a good. Further suppose that price of goods
is Rs. 3 per unit.
Lel the utility be expressed in utils which are measured in rupees. We are given
the marginal utilityschedule of the consumer.
Quantity Price Marginal Utility
1 3 8
2 3 7
3 3 5
4 3 3
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5 3 2
When he purchases the first unit, the utility that he gets is 8 utils. He has to pay
only
Rs. 3/- for it. Will he buy the 1st unit? Obviously, yes, because he gets more than
what he gives.
Similarly, we compare the utility received from other units with the price paid. Wefind that he will buy
4 units. At the 4th unit, MU equals price. If he buys the 5th unit, he is a looser
because the utility that
he gets is 2 utils and what he has to pay is Rs. 3. Therefore, the consumer will
maximize his satisfaction
by buying 4 units of this commodity. The condition for maximization of satisfaction
if only one
commodity is purchased then is:
MU = Price.
(b) Two commodities caseSuppose a consumer consumes only two goods. Let these goods be X and Y.
Given income
and prices (Px and Py), the consumer will get maximum satisfaction by spending
his income in such
a way that he gets the same utility from the last rupee spent on each good. This
is satisfied when
MUx = MUy = M.U. of a rupee spent on a good.
Px Py
We can show that in order to maximise satisfaction this condition must be
satisfied. If it is not satisfied
what difference will it make. Suppose the two ratios are:
MUx > MUy
Px Py7It means that per rupee MUx is higher than per rupee MUy. It further means that
by transferring one
rupee from Y to X, the consumer gains more utility than he looses. This prompts
the consumer to
transfer some expenditure from Y to X. Buying more of X reduces MUx, Px
remaining unchanged,
MUx/Px, i.e. per rupee MUx, is also reduced. Buying less of Y raises MUy. Pyremaining unchanged
it raises, per rupee MUy. The change continues till per rupee MUx becomes
equal to per rupee MUy.
In other words :
MUx = MUy = per rupee MU
Px Py
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CONCEPTS OF DEMAND AND DEMAND SCHEDULEDemand for a good is the quantity of that good which a buyer is willing to buy
at a particular price,
during a period of time.
Demand schedule is a tabular presentation showing the different quantities
of a good that buyersof that good are willing to buy at different prices during a given period of time.Demand schedule of a commodityPrice (Rs. per unit) Quantity demanded (in units)
50 50
40 100
30 150
20 200
10 250
This schedule indicates that more is purchased as price falls. This inverse
relationship betweenprice and quantity demanded, other thing remaining the same is called the lawof demand.RELATIONSHIP BETWEEN PRICE ELASTICITY OF DEMAND ANDTOTAL EXPENDITUREAt this stage of learning it is sufficient to know the following about this
relationship:
1. When demand is elastic, a fall (rise) in the price of a commodity results in
increase (decrease)
in total expenditure on it. Or, when a fall (rise) in the price of a commodity results
in increase
(decrease) in total expenditure on it, its demand is elastic.2. When elasticity is unitary, a fall (rise) in the price of the commodity does not
result in any
change in total expenditure on it, or when a fall (rise) in price results in no
change in total
expenditure then its elasticity is unitary.
3. When demand is inelastic, a fall (rise) in the price of a commodity results in a
fall (rise) in total
expenditure on it, or when a fall (rise) in the price of a commodity results in
decrease (increase)
in total expenditure on it, its demand is inelastic.8
Unit IIIPRODUCERS BEHAVIOUR AND SUPPLYMeaning of supplySupply means the quantity of a commodity which a firm or an industry is willing to
produce at
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a particular price, during a given time period.
Law of supplyThis law states that 'other things remaining the same', an increase in the price of
a commodity
leads to an increase in its quantity supplied. Thus, more of a commodity is
supplied at higher pricesthan at lower prices.
This law can be explained with the help of a supply schedule and curve.
A supply schedule is a table which shows the quantities of a commodity supplied
at various
prices during a given time period.Supply Schedule Supply CurvePrice (Rs.) Supply (Units)
1 100
2 200
3 300As the price increases from Re. 1 to Rs. 3, the supply also rises from 100 units to
300
units, in response to the rising price. What is the basis of the law of supply?
Other things remaining
the same, an increase in price results in higher profits for the producer. The
higher the price of the
commodity, the greater are the profits earned by the firms and the greater is the
incentive to
produce more. Similarly when the price falls, profits decline, resulting in a
decrease in quantity
supplied of the commodity. Thus the price and quantity supplied of a commodity
are directly
related, other things remaining the same.
Change in supply versus change in quantity supplied(shift of supply curve versus movement along a supply curve)
The supply of a commodity depends on its own price and 'other factors' like input
prices,
technique of production, prices of other goods, goals of the firm, taxes on the
commodity etc.
Movement along a supply curve
The law of supply states the effect of a change in the own price of a commodityon its supply,
other things remaining constant. The supply curve also carries the same
assumption. Thus when
other factors influencing supply do not change, and only the own price of the
commodity changes, the9
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change in supply takes place along the curve only. This is what movement along
a supply curve
means. A movement from one point to another on the same supply curve is
also referred to as
a change in quantity supplied.In figure 7, OQ is the quantity supplied at price OP. When the price risesto OP1 the quantity supplied increases to OQ1. Thus there is an upward
movement along the supply curve from point A to B. It is extension of
supply.
Similarly, when the price of a commodity falls from OP to OP2, there is a
decrease in quantity supplied from OQ to OQ2 and thus a downward
movement along the supply curve from A to C. It is contraction of supply.
Movements along the supply curve are caused by a change in the own
price of the good only, other things remaining the same.
Shifts of the supply curve
When supply changes due to changes in factors other than the own price of thecommodity, it
results in a shift of the supply curve. This is also referred to as a change insupply.An increase in supply means more of the commodity is supplied at the same
price. As a
result the supply curve shifts to the right.
In figure 8, at price OP the previous supply was OQ which
increased to OQ1. This also means that OQ units can now be supplied
at a lower price OP1 with the new supply curve S1S1.
An increase in supply can take place due to many reasons. Forexample, if the input prices fall or there is an improvement in technology,
it will enable producers to produce and sell more at the same price
resulting in a rightward shift of the supply curve.
A decrease in supply means less of the commodity is supplied at
the same price, than previously. As a result, the supply curve shifts
inwards to the left.
In figure 9, at price OP, previously OQ units were supplied which
decreased to OQ1. This also means that OQ units can now be supplied
at a higher price OP1 with the new supply curve S1S1.10Shifts of the supply curve of a good are caused by a change inany one or more of the'other factors' affecting supply, own price remainingunchanged. For example, if the inputprices fall or there is a decrease in the prices of other relatedcommodities, the producers
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supply more at the same price resulting in a rightward shift ofthe supply curve.
PRODUCER'S EQUILIBRIUMThe primary objective of a producer is to earn maximum profits. Profit is the
difference between
total revenue and total cost. At that level of output, he is in equilibrium at whichhe is earning maximum
profit, and he has no incentive to increase or decrease his output. If he produces
less than this he
does not maximize total profits. Similarly, if produces beyond this, total profits
decline. Thus the
producer is in a 'state of rest' only at the level of output at which the difference
between the total
revenue and total cost of production is maximum i.e total profits are maximum.
(NOTE : How does a producer reach equilibrium under different market
conditions is not discussedat this stage of learning).
RELATIONSHIP BETWEEN MARGINAL COST (MC) ANDAVERAGE COST (AC)The relationship between marginal cost and average cost is an arithmetic
relationship. To understand
this relationship let us take a numerical example.
The table A shows the marginal costs, total costs and average costs at different
levels of output.
Table AOutput Total cost Marginal cost Average cost
(Units) (Rs.) (Rs.) (Rs.)
(1) (2) (3) (4)
1 60 60 60
2 110 50 55
3 162 52 54
4 216 54 54
5 275 59 55
Column 1 shows the level of output.
Column 2 shows the total cost of producing different levels of output.
Column 3 shows the increase in total cost resulting from the production of one
more unit of output.(It is called marginal cost. Thus MCn = TCn - TCn-1, where n and n-1 are levels of
output).
Column 4 shows the average cost at different levels of output (ACn = TCn )
n
11This table shows that :
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1. Average cost falls only when marginal cost is less than average cost. Upto the
third unit of
output, the marginal cost is less than the average cost and average cost is falling.
When 2
units are produced the marginal cost is Rs. 50 which is less than the previous
average cost(Rs.60), now average cost falls from Rs. 60 to Rs. 55. When 3 units are
produced, the marginal
cost is Rs. 52 which is less than the average cost of 2 units (Rs. 55) so once
again the
average cost falls from Rs. 55 to Rs. 54.
2. Average cost will be constant when marginal cost is equal to average cost.
When 4 units are
produced, average cost does not change (It is Rs. 54 when 3 units are produced
and remains
Rs. 54 when 4 units are produced) because marginal cost (Rs. 54) is equal toaverage cost
(Rs. 54).
3. Average cost will rise when marginal cost is greater than average cost. When 5
units are
produced average cost rises from Rs. 54 to Rs. 55, because the marginal cost
(Rs. 59) is
greater than the average cost (Rs. 54).
This relationship between marginal cost and average cost is a generalized
relationship and holds
good in case of the marginal and average values of any variable, be it revenue or
product etc.
In the box a simple proof of the relationship is given : This is for reference only
For Reference only
Suppose AC falls. Then :
TCn < TCn-1
n n-1
Multiplying both sides by n we get,
TCn < TCn-1 x n
n-1
TCn < TCn-1 x (1 + 1 )
n-1TCn < TCn-1 + TCn-1
n-1
TCn - TCn-1 < TCn-1
n-1
Since the left hand side is MC, and the right hand side is AC, it proves that
MC < AC
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Thus a fall in average cost means marginal cost is less than average cost. It can
similarly be proved
that a rise in average cost means, marginal cost is greater than average cost and
a constant average
cost means marginal cost is equal to average cost.
The relationship between marginal cost and average variable cost is similar to therelationship between
marginal cost and average cost because marginal cost is not affected by fixed
cost.
(For proof see box which is for reference only)12MCn = TCn - TCn-1
= [TFCn + TVCn] - [TFCn-1 + TVCn-1]
Since TFCn and TFCn are equal
MCn = TVCn - TVCn-1
LAW OF VARIABLE PROPORTION IN TERMS OF TP AND MPCURVES.(i) In terms of TPAs more and more units of variable factor are employed with fixed factor, total
product initially
increases at an increasing rate then increases at decreasing rate and ultimately
starts decreasing.13On the TP curve in the diagram, upto point A, TP is increasing at an increasing
rate. If more than 3
units of variable factor are employed, total product still increases till 7units are
employed but this
increase is at a diminishing rate. If beyond 7 units of variable factor are employed
then TP starts
falling. These are the three respective phases of the law.
(ii) In terms of MPMP increases upto 3 units. This is phase 1. MP falls after 3 units but is positive
upto 7 units.
This is phase 2. MP continues to fall but is negative after 7 units. This is phase 3.
Therefore, in
phase 1 the MP curve is upward sloping; downward sloping but above the X-axis
in phase 2; anddownward sloping but below the X-axis in phase 3.
(Note that TP is convex in phase 1; concave in phase 2; and downward sloping in
phase 3. This is
how we can identify the three phases.)
Returns to ScaleIntroduction
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This topic is a part of study of production function. A production function is an
expression of
quantitative relation between change in inputs and the resulting change in output.
It is expressed as
:
Q = f (i1, i2 ......in)Where Q is output of a specified good and i1, i2 .in are the inputs usable in
producing this good. To
simplify let us assume that there are only two inputs, labour (L) and capital (K),
required to produce
a good. The production function then takes the form :
Q = f (K,L)
In microeconomics, conventionally, we study two aspects of relation between
inputs and output. One
aspect is : in what manner the change takes place in output of a good, if only one
of the inputsrequired in producing that good is increased, i.e. other inputs kept unchanged?
The manner of
change in output is summed up in the law of variable proportions which you have
already studied.
The second aspect is : in what manner the output of a good changes, if all the
inputs required in
producing that good are increased simultaneously and in the same proportion.
This aspect is
technically termed as returns to scale, and is the subject matter of this study. The
word 'return' refers
to the change in physical output. The word 'scale' refers to the scale of operation
expressed in terms
of quantum of inputs employed.
MeaningReturns to scale means the manner of change in physical output caused by the
increase in all
the inputs required simultaneously and in the same proportion. Elaborating,
suppose one unit of
capital and one unit of labour (1K + 1L), produce 100 units of output. Further
suppose that both the
14inputs are doubled, i.e. 2K + 2L. The point of interest is : will output increase by
just 100%; by more
than 100%, or by less than 100%. There is no unique answer. All the three states
are possible. The
three states are respectively called Constant Returns to Scale (CRS), Increasing
Returns to Scale
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(IRS) and Decreasing Returns to Scale (DRS). Let us first illustrate the three
states and then explain
reasons.
Constant Returns to Scale (CRS)Suppose 1K+1L produce 100 units of output, and 2K+2L produce 200 units of
output. It is100 percent increase in inputs leading to just 100 percent increase in output. This
manner of change
in output is called CRS.
Increasing Returns to Scale (IRS)Suppose 1K+1L produce 100 units of output and 2K+2L produce 250 units of
output. It is 100
percent increase in inputs in leading to 125 percent increase in output. This
manner of change in
output is called IRS.
Decreasing Returns to Scale (DRS)Suppose 1K+1L produce 100 units of output, and 2K+2L produce 180 units of
output. It is
100 percent increase in inputs leading to only 80% increase in output. This
manner of change in
output is called DRS.
Which of the above states actually results depends to a great extent on the type
of technology
used. There are technologies which result in IRS from the beginning and
continue upto a large output
level. Similarly, there are technologies leading to CRS almost throughout. There
can also be
technologies leading to DRS from the very beginning.
Besides, it is also possible that a technology is such that it gives IRS in the
beginning, followed
by CRS and then DRS. For example:
Returns to ScaleInputs %change Output %change Returns to scale
1K+1L - 100 - -
2K+2L 100% 250 125% IRS
3K+3L 50% 375 50% CRS
4K+4L 33.3% 450 20% DRSWhy do IRS arise?There are two possible reasons:15
1. More division of labourDivision of labour means subdividing a task into many small sequential
operations, with each
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worker (or a group of workers) assigned each operation. A single worker, instead
of doing all the
operations, concentrates on only one operation and specializes. This raises
efficiency of the worker.
Returns to scale means increasing the number of workers along with other
inputs. Moreworkers mean more division of labour. If one task can be divided into 20 small
operations, with each
worker assigned only one operation, the worker becomes an expert in the
operation he is assigned.
Efficiency increases and so the production. In business circles, the division of
labour type production
is called assembly line production.
2. Use of specialized machinesMore capital means more capital goods and bigger capital goods. Fully automatic
machinescan replace the semi-automatic or the hand operated machines. Bigger machines
can be used in
place of small machines. Bigger capital goods can be used in place of smaller
capital goods. It is
a common knowledge that a double size capital input may produce more than
double the output.
Let us take an interesting example.
Suppose a firm needs a wooden box to store goods. Suppose initially the firm
goes in for
1'x1'x1' (LxBxH) size box. Let us see the input requirement and the resulting
output. Let the wood
be the only input required. A box has 6 sides. Each side requires 1 sq. ft. of wood
(=1'x1'). Then
the input requirement = 1'x1'x6 = 6 sq.ft.
The storing capacity of the box is measured by its volume. Then :
Output of the box : 1'x1'x1' = 1 cubic ft.
Let us now see what happens when the size of the box is increased to 2'x2'x2'.
Input requirement = 2'x2'x6 = 24 sq.ft.
Output = 2'x2'x2' = 8 c.ft.
Now compare. Input of the box rises from 6 sq.ft. to 24 sq.ft. i.e. by 300%. Output
of the boxrises from 1c.ft. to 8 c.ft., i.e. by 700%. Increasing returns to scale arise.
Remember that it may not go on for ever, i.e. we go on increasing the size and
continue to get
IRS. A stage may reach when IRS may give way to CRS or DRS.
Why do DRS arise?
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Economists do not find any specific reason. DRS is a puzzle. Why output rises in
a smaller
proportion when all inputs are increased? The probable explanation is that the
firm finds it difficult
to manage and coordinate the activities arising out of larger scale. The difficulties
may lead to wastage,inefficiency etc. and cause DRS.16
EQUILIBRIUM PRICE UNDER PERFECT COMPETITIONMeaning of equilibriumEquilibrium, in general terms. implies (a) a balance between the opposite forces
and (b) a
state of rest or a situation that has a tendency to persist. Let us take examples to
show the application
of these meanings in microeconomics.
Let us take a market situation in which buyers and sellers are negotiating to buyand sell a
good. Both have different prices to offer. But the good will be sold only when both
agree to a common
price and a common quantity at that price. If both agree, a market equilibrium is
said to emerge.
Note that buyers and sellers have opposite interests. The buyers will like to pay
as low a price as
possible. The sellers will like to charge as high a price as possible. Agreement on
a common price
and quantity creates a balance between the two opposite interests. This
equilibrium price and quantity
has a tendency to persist.
Equilibrium priceEquilibrium price is the price at which the sellers of a good are willing to sell the
same quantity
which buyers of that good are willing to buy. We can explain this meaning with
the help of market
demand and supply schedule of a good, given below :
Price per unit Market demand Market supply Equilibrium
(Rs.) (units) (units)
1 1000 200 Excess demand2 800 400 Excess demand3 600 600 Market Equilibrium4 400 800 Excess supply
5 200 1000 Excess supply
Refer to the schedule. The market equilibrium is established at a price of Rs. 3
per unit,
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because at this price both the market demand and market supply are equal. This
is the price
which has a tendency to persist.
Why is not any other price an equilibrium price?Take, for example, a price less than the equilibrium price. Suppose it is Rs. 2 per
unit. Atthis price market demand is greater than market supply. It is called an excess
demand situation. But
this price cannot persist. It will change. Why?
It is because the buyers will not be able to buy all what they want to buy. The
pressure of
excess demand will push the market price up. This will have two effects. Supply
will go up because
the producers are willing to supply more at a higher price. Demand will go down
because the buyers
are willing to buy less at a higher price. In fact, this is what is required to restoreequilibrium. The
tendency of supply going up and demand going down will continue till market
supply becomes equal17to market supply once again and the excess demand becomes zero. This is
achieved at Rs. 3 per
unit. The equilibrium is restored.
Let us now take a price higher than the equilibrium price. Suppose it is Rs. 4 per
unit. At this
price now the market supply is greater than market demand. It is called an excess
supply situation.
Even this price cannot persist. It is because the sellers will not be able to sell all
what they want to sell.
The excess supply pressure will push the price downwards. This will have two
effects. Supply will go
down and demand will go up. The tendency will continue till market demand
becomes equal to
market supply once again, and the price settles at Rs. 3 per unit.
To sum up, the equilibrium price is the price at which market demand equals
market supply.
This price has a tendency to persist. If at a price the market demand is not equalto market supply
there will be either excess demand or excess supply and the price will have
tendency to change until
it settles once again at a point where market demand equals market supply.
Graphic PresentationThe equilibrium is at E the intersection of supply and
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demand curves representing the two schedules given above.
The equilibrium price is Rs. 3 and equilibrium quantity 600 units.
The price higher than Rs. 3, creates excess supply and ultimately
returns to Rs. 3 on account of the effects explained above. The
arrows indicate the tendencies. The price below the equilibrium
price creates excess demand and has a tendency to return toRs. 3 per unit on account of the effects explained above and
indicated by the arrows.
Can the equilibrium price change?Yes, when demand or supply or both increase or decrease. 'Increase', as you
know, means
rise in demand or supply due to factors other than the own price of the good.
Similarly the term
'decrease' is defined. Graphically, it means shift of demand curve, or supply
curve or both. You are
familiar with these terms. You are expected to study the chain effects of shifts indemand and supply
on equilibrium price and quantity.
18UNIT IV
FEATURES OF PERFECT COMPETITIONIntroductionPerfect competition is a state of a market. Anything which facilitates contact
between buyers
and sellers constitutes a market. It may be a face to face meeting at some place
or simply verbal
negotiations through telephone, internet, etc.
Conventionally, in microeconmoics the markets are classified into these states:
perfect
competiton, monopoly, monopolistic competition and oligopoly. There are many
criteria of
classification, the number of sellers, similarity of products, availability of
information, mobility of firms
and the inputs engaged in the firm, etc. Whatever the criteria the end result is
reflected in one thing :
how much influence an individual seller, on his own, is able to exercise on the
market. Lower theinfluence more the competitive nature of the market it indicates. If the influence of
an individual seller
is zero, or virtually zero, the market is said to be perfectly competitive.
MeaningPerfect competition can be defined either in terms of its characteristic features, or
in terms of
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the unique end result of these characteristics. Unique in the sense that it is
specific to a perfectly
competitive market. In terms of its features, a perfectly competitive is a market
where there are
large number of buyers and sellers, the firms produce homogeneous products,
the buyers and sellershave perfect knowledge and the firm are free to entry or make an exit in and out
of industry. In terms
of the end result of these features which is unique to this market, a perfectly
competitive market is
one in which an individual firm cannot influence the prevailing market price of the
product on its own.
Features and their implicationsA perfectly competitive market has the following features:
1. Large number of sellers and buyers
Note that 'large number' is not a specifically defined number. However, it has aspecific
implication. Let us talk about the large number of sellers first. The words 'large
number' imply that
the number of sellers is large enough to render a single seller's share in total
market supply of the
product insignificant. It has a further implication. Insignificant share means that if
only one individual
firm reduces or raises its own supply, the prevailing market price remains
unaffected. The prevailing
market price is the one which was set through the interaction of market demand
and market
supply forces, for which all the sellers and all the buyers together are responsible.
One single
seller has no option but to sell what it produces at this market determined price.
This position of
an individual firm in the total market is referred to as price taker. This is a
unique feature of a
perfectly competitive market.
Similarly, the 'large number' of buyers also has the same implication. A single
buyer's
share in total market demand is so insignificant that the buyer cannot influencethe market price
on his own by changing his demand. This makes a single buyer also a price
taker.
19To sum up, the feature 'large number' indicates ineffectiveness of a single seller
or a
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single buyer in influencing the prevailing market price on its own, rendering him
simply a price
taker.
2. The products of all the firms in the industry arehomogenous
It means that the buyers treat the products of all the firms in the industry ashomogenous. The
products produced by the firms are identical, or treated as identical, or perfectly
standardized. The
buyers do not distinguish the output of one firm from that of the other.
The implication of this feature is that since the buyers treat the products as
identical they are
not ready to pay a different price for the product of any one firm. They will pay the
same price for the
products of all the firms in the industry. On the other hand, any attempt by a firm
to sell its product ata higher price will fail.
To sum up, the 'homogenous products' feature ensures a uniform price for the
products of all
the firms in the industry.
3. Perfect knowledge about markets for outputs andinputs.The firms have all the knowledge about the product market and the input
markets. Buyers
also have perfect knowledge about the product market.
Let us take the product market first. The implication of perfect knowledge aboutthe product
market is that any attempt by any firm to charge a price higher than the prevailing
uniform price will
fail. The buyers will not pay because they have perfect knowledge. There is no
ignorance factor
operating in the market. The sellers do not charge a lower price due to ignorance.
The buyers do not
pay a higher price due to ignorance. A uniform price prevails in the market.
As regards the knowledge about the input markets, the implicit assumption is that
each firm
has an equal access to the technology and the inputs used in the technology. Nofirm has any cost
advantage. Cost structure of each firm is the same. All the firms have a uniform
cost structure.
Since there is uniform price and uniform cost in case of all firms, and since profits
equals cost
less price, all the firms earn uniform profits.
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4. Freedom to firms to enter or to leave the industry inthe long runFreedom of entry means that there are no artificial barriers and natural barriers in
the way of
a new firm wishing to enter into industry. The artificial barriers may take the form
of patent rights,legal restrictions, etc. The natural barrier may take the form of huge capital
expenditure required to
start a new firm, which the firm wishing to enter is not able to arrange.
Freedom of exit means no barriers in the way of a firm deciding to leave the
industry.
Government rules, labour laws, loss of huge fixed capital etc. do not come in the
way.
The freedom of entry and exit of firms has an important implication. This ensures
that no
firm can earn above normal profits in the long run. Each firm earns just thenormal profits, i.e.
minimum necessary to carry on business. In Microeconomics, normal profits is
treated as an20opportunity cost, and therefore, counted in calculation of total cost. Since profit
equals total revenue
minus total cost, normal profit means zero economic profit. Why? Let us explain.
Suppose the existing firms are earning above normal profits, i.e. positive
economic profits.
Attracted by the positive profits, the new firms enter the industry. The industry's
output, i.e. market
supply, goes up. The price comes down. New firms continue to enter and the
price continues to
fall till economic profits are reduced to zero.
Now suppose the existing firms are incurring losses. The firms start leaving. The
industry's
output starts falling, price starts going up, and all this continues till losses are
wiped out. The remaining
firms in the industry then once again earn just the normal profits.
Only zero economic profit in the long run is the basic outcome of a perfectly
competitivemarket.
Average Revenue and marginal revenue curves of aperfectly competitive firmThe forces of market supply (i.e. supply by industry) and market demand
(demand by all the
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buyers) determine the market price. The firm, being a price taker, adopts this
price and is free to sell
any quantity it likes at this price. The price taker feature determines the shape of
the firms AR and
MR curves. Refer to the figure -12 b
The figure 12a shows the intersection of demand and supply curves at Edetermining the
price OP. The figure 12b shows the adoption of price by the price taker firms who
are free to sell any
quantity, at this price. This makes the AR curve perfectly elastic and thus parallel
to the
X-axis. As per the average marginal relationship, when AR is constant, MR must
be equal to AR.
Therefore, AR curve is also the MR curve of the firm.
1
PART B : INTRODUCTORY MACROECONOMICSUNIT 6 - NATIONAL INCOME AND RELATED AGGREGATESSOME CONCEPTSCONCEPT OF ECONOMIC TERRITORY
INTRODUCTIONNational income accounting is a branch of macroeconomics of which estimation
of national
income and related aggregates is a part. National income, or for that matter any
aggregate
related to it, is a measure of the value of production activity of a country. But,
production activity
where and by whom? Is it on the territory of the country? Or, is it by those who
live in the
territory? In fact it is both. This raises further question. What is the scope of
territory? Is it simplypolitical frontiers? Or, is it something else? Who are those who live in the
territory? Is it simply
citizens? Or, it is something else. The answer to these questions leads us to the
concepts of (i)
economic territory and (ii) resident. The two have an important bearing on the
estimation of
national income aggregates. How? We will explain it a little later.
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DefinitionThe first thing to note is that economic territory of a country is not simply political
frontiers
of that country. The two may have common elements, but still they are
conceptually different. Let
us first see how it is defined. According to the United Nations :Economic territory is the geographical territory administered by a
government within which persons, goods and capital circulate freely.
The above definition is based on the criterion freedom of circulation of persons,
goods and
capital. Clearly, those parts of the political frontiers of a country where the
government of that,
country does not enjoy the above freedom are not to be included in economic
territory of that
country. One example is embassies. Government of India does not enjoy the
above freedom inthe foreign embassies located within India. So, these are not treated as a part of
economic
territory of India. They are treated as part of the economic territories of their
respective countries.
For example the U.S. embassy in India is a part of economic territory of the
U.S.A. Similarly, the
Indian embassy in Washington is a part of economic territory of India.
ScopeBased on freedom criterion, the scope of economic territory is defined to cover:
(i) Political frontiers including territorial waters and air space.
(ii) Embassies, consulates, military bases, etc located abroad,but excluding those
located
within the political frontiers.
(iii) Ships, aircrafts etc, operated by the residents between two or more countries2
(iv) Fishing vessels, oil and natural gas rigs, etc operated by the residents in the
international
waters or other areas over which the country enjoys the exclusive rights or
jurisdiction.Implication
National income and related aggregates are basically measures of productionactivity.
There are two categories of national income aggregates : domestic and national,
or domestic
product and national product. Production activity of the production units located
within the economic
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territory is domestic product. Gross domestic product, net domestic product are
some examples.
We will learn more about the implications after studying the concept of resident.CONCEPT OF RESIDENTIntroduction
Note that citizen and resident are two different terms. This does not mean that acitizen is
not a resident, and a resident not a citizen. A person can be a citizen as well as a
resident, but it is
not necessary that a citizen of a country is necessarily the resident of that
country. A person can be
a citizen of one country and at the same time a resident of another country. For
example a NRI,
Non-resident Indian. A NRI is citizen of India but a resident of the country in
which he lives.
Citizenship is basically a legal concept based on the place of birth of the personor some
legal provisions allowing a person to become a citizen. On the other hand
residentship is basically
an economic concept based on the basic economic activities performed by a
person.
DefinitionA resident is defined as follows:
A resident, whether a person or an institution, is one whose
centre of economic interest lies in the economic territory of the country
in which he lives.
The centre of economic interest implies two things: (i) the resident lives or islocated
within the economic territory and (ii) the resident carries out the basic economic
activities of
earnings, spending and accumulation from that location
ImplicationsProduction activity of the residents of an economic territory is national product.
GNP, NNP,
are some examples. National product includes production activities of residents
irrespective of
whether performed within the economic territory or outside it.In comparison, domestic product inludes production activity of the production
units located
in the economic territory irrespective of whether carried out by the residents or
non-residents.3
Relation between national product and domestic product
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The concept of domestic product is based on the production units located within
economic
territory,operated both by residents and non-residents. The concept of national
product is based
on residents, and includes their contribution to production both within and outside
the economicterritory.Normally, in practical estimates, domestic product is estimated first.
National product is
then derived from the domestic product by making certain adjustments.Let us see
how?
National product is derived in the following way:
National product = Domestic product
+ residents contribution to production outside the economic
territory
- non-residents contribution to production inside the economic
territoryIn practical estimates the residents contribution outside the economic territory is
called
factor income received from abroad. The non-residents contribution inside the
economic territory
is called factor income paid to residents. Therefore,
National product = Domestic product
+ Factor income received from abroad
- Factor income paid to abroad.
Factor income received from abroad is added to domestic product because this
contribution
of residents is in addition to their contribution to domestic product. Factor income
paid to abroad
is subtracted because this part of domestic product, does not belong to the
residents. By subtracting
factor income paid from factor income received from abroad, we get a net
figure Net factor
income from abroad popularly abbreviated as NFIA.
National product = Domestic product
+ Net factor income from abroad
= Domestic product + NFIA
INDUSTRIAL CLASSIFICATIONIntroductionIt means grouping production units into distinct industrial groups, or sectors. This
is the
first step required to be taken in estimating national income, irrespective of the
method of
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estimation. It is statistically more convenient to estimate national income
originating in a group of
similar production units rather than for each production unit separately.4
It is now a matter of general practice to group all the production units of the
economicterritory into three broad groups : primary sector,secondary sector and tertiary
sectors. Each of
these sector can be further subdivided into smaller groups depending upon the
requirement. Let
us now explain each sector.Primary SectorPrimary sector includes production units exploiting natural resources like land,
water, subsoil
assets,etc. Growing crops, catching fish, extracting minerals, animal husbandry,
forestry, etc.are some examples. Primary means of first importance. It is primary because it is
a source of
basic raw materials for the secondary sector.
Secondary SectorSecondary sector includes production units which are engaged in transforming
one good
into another good. Such an activity is called manufacturing activity. These units
convert raw
materials into finished goods. Factories, construction, power generation, water
supply are the
examples. It is called secondary because it is dependent upon the primary sectorfor raw materials.
Tertiary SectorTertiary sector includes production units engaged in producing services.
Transport, trade
education, hotels and restaurant, finance, government administration, etc are
some examples.This
sector finds third place because its growth is primarly dependent onthe primary
and secondary
sectors.
NATIONAL INCOME AGGREGATESThere are many aggregates in national income accounting. The basic among
these is
Gross Domestic Product at Market Price (GDPmp). By making adjustments in
GDPmp, we can
derive other aggregates like Net Doemstic product at Market Price (NDPmp) and
NDP at factor
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cost (NDPfc).
Net Domestic ProductWhy is GDPmp called gross? GDPmp is final products valued at market price. This
is what
buyers pay. But this is not what production units actually receive. Out of what
buyers pay theproduction units have to make provision for depreciation and payment of indirect
tax like excise,
sales tax, etc. This explains why GDPmp is called gross. It is called gross
because no provision
has been made for depreciation. However, if depreciation is deducted from the
GDP, it becomes
Net Domestic Product (NDP). Therefore,
GDPmp - depreciation = NDPmpDomestic product at Factor Cost
Why is GDPmp called at market price ?Out of what buyers pay, the production units have to make payments of indirect
taxes,if5
any. Sometimes production units receive subsidy on production. This is in
addition to the market
price which production units receive from the buyers. Therefore what production
units actually
receive is not the market-price but market price - indirect tax + subsidies This
is what is actually
available to production units for distribution of income among the owners of
factors of production.Therefore,
Market price - indirect tax (I.T.) + subsidies = Factor payments (or factor costs)
By making adjustment of indirect tax and subsidies we derive GDP at factor cost
(GDPfc)
from GDPmp..
GDPmp - I.T. + subsidies = GDPfc
or GDP - net I.T. = GDPfcNet Domestic Product at Factor CostIf we make adjustment of both the net I.T and depreciation (also called
consumption offixed capital) we get one more aggregate called Net Domestic Product at Factor
Cost (NDPfc)
GDPmp - I.T. + Sub-depreciation = NDPfc.
or NDPfc+ I.T. - Sub+depreciation = GDPmpNet National Product at Factor Cost (NNPfc) or National IncomeNet factor income from abroad (NFIA) provides the link between NDP and NNP.
Therefore,
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NDPfc + NFIA = NNPfc
or NNPfc - NFIA = NDPfc
Similarly,
NDPmp + NFIA = NNPmp
GDPmp + NFIA = GNPmp
Summing upThe three crucial adjustments required for deriving one aggregate from the other
are:
Gross - depreciation = Net
Market price - I.T. + Subsidies = Factor cost
Domestic + NFIA = National
METHODS OF ESTIMATION OF NATIONAL INCOME (N.I.) ANDOTHER RELATEDAGGREGATESThere are three methods of estimation of national income : production (value
added),6
income-distribution and final expenditure methods. You are familiar with the
various steps required
to be taken in each. Let us see what aggregates are arrived through each
method.(I) Production method (value added method)In this method we first find out Gross Value Added at Market Price (GVAmp) in
each sector
and then take their sum to arrive at GDPmp
Sum total of GVAmp
by all the sectors = GDPmp
Then we make adjustments to arrive at national income or NNPfc
GDPmp - Consumption of fixed capital = NDPmp
NDPmp - I.T. + Subsidies = NDP fc
NDPfc + NFIA = NNPfc
(2) Income distribution methodIn this method we first estimate factor payments by each sector. The sum of such
factor
payments equals Net value Added at Factor Cost (NVAfc) by that sector. Then we
take sum total
of NVAfc by all the sectors to arrive at NDPfc. The components of NDPfc are:1. Compensation of employees
2. Rent and royalty
3. Interest
4. Profits
NDPfc
System of National Accounts 1993, a joint publication of the United Nations and
the World
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Bank,has elaborated the above components and recommended their use by all
the countries in
preparing national income estimates.
Compensation of employees is defined as : the total remuneration in cash
or in kind, payable by
an enterprise to an employee in return for work done by the latter during theaccounting period.
The main components of compensation of employees are :
(1) Wages and salaries
(a) in cash
(b) in kind7
(2) Social security contributions by the employers.
Rent is defined as the amount receivable by a landlord from a tenant for the use
of land.
Royalty is defined as the amount receivable by the landlord for granting theleasing rights of subsoil
assets.
Interest is defined as the amount payable to the owners of financial assets in
the production
unit. The production unit uses these assets for production and in turn makes
interest payment,
imputed or actual.
Profit is a residual factor payment to the owners of a production unit. The
production unit
uses profit for (i) payment of corporation tax, (ii) dividend payments and (iii)
undistributed profits/
retained earnings.
The main source of factor payments are the accounts of production units. Since
accounts
of most production units are not available to the estimators, and also since the
accounting practices
differ, it is not possible for the estimators to clearly identify the components.
Therefore, in cases
where total factors payment is estimable but not its different components, an
additional factor
payment item called mixed income is added. Since this problem arises mainly incase of selfemployed
people like doctors, chartered accountants, consultants, etc, this factor payment
is
popularly called mixed income of the self employed. In case there is such item
then,
NDPfc = Compensation of employees
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+ Rent and royalty
+ Interest
+ Profit
+ Mixed income (if any)
There is another term used in factor payments. It is operating surplus. It is
defined as thesum of rent and royalty, interest and profits. In that case then:
NDPfc = Compensation of employees
+ operating surplus
+ mixed income (if any)
Once we estimate NDPfc, we can find NNPfc, or national income, by adding NFIA.
NDPfc + NFIA = NNPfc.
(3) Final expenditure methodIn this method we take the sum of final expenditures on consumption and
investment.
This sum equals GDPmp. These final expenditures are on the output producedwithin the economic
territory of the country. Its main components are:
Private final Consumption expenditure (PFCE)
+ Government final consumption expenditure (GFCE)
+ Gross domestic Capital formation (GDCF)8
+ Net exports (= Export - imports) (X-M)
= GDPmp
By making the usual adjsutments we can arrive at national income
OFCE
+ GFCE
+ GDCF
+ (X-M)
= GDPmp
- Consumption of fixed capital
= NDPmp
- indired Tax
+ Subsidies
= NDPfc
+ NFIA
= NNPfc (National income)Note that GDCF is composed of the following:
GDCF= Net domestic fixed capital formation
+ Closing stock
- Opening stock
+ Consumption of fixed capital
Also note that. Clossing stock - opening stock equals net change in stocks.
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PRECAUTIONS IN MARKINGESTIMATES OF NATIONAL INCOMEThere are a large number of conceptual and statistical problem that orise in
estimating
national income of a country. To minimize error, it is necessary that certain
precautions are takenin advance. Some of the methodwise precautions are:
(1) Value added (Production) method(i) Avoid double countingValue added equals value of output less intermediate cost. There is a possibility
that
instead of counting value added one may count value of output. You can verify
by taking some
imaginary numerical example that counting only values of output will lead to
counting the same
output more thanonce. This will lead to overestimation of national income. There
are two alternative
ways of avoiding double counting: (a) count only valueadded and (b) count only
the value of final
products.9
(ii) Do not include sale of second hand goods.Sale of the used goods is not a production activity. The good should not treated
as fresh
production, and therefore doesnt should not treated as fresh production, and
therefore doesnt
qualify for inclusion in national income however, any brokerage or commissionpaid to facilitate
the sale is a fresh production activity. It should be included in production but to
the extent of
brokerage or commission only.
(iii) Self-consumed output must be included.Output produced but retained for self-consumption, rather than selling in market,
is output
and must be included in estimates. Services of owner-occupied buildings, farmer
consuming its
own produce, etc are some examples.(2) Income distribution method(i) Avoid transfersNational income includes only factor payments, i.e. payment for the services
rendered to
the production units by the owners of factors. Any payment for which no service
is rendered is
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For example, a house owner using the house for seef. Although explicitly he does
not
incur any expenditure, implicitly he is making payment of rent to himself. Since
the house is
producing a service, the imputed value of this service must be include in national
income.(iv) Avoid transfer expendituresA transfer payment is a apayment against which no services are rendered.
Therfore no
production takes place. Since no production takes place it has no place in
national income.
Charities, donations, gifts, scholarships, etc are some examples.DISPOSABLE INCOMEIntroductionDisposable income refers to the income actually available for use as consumption
expenditure and saving. It includes both factor contrast national income includesonly factor
incomes. Broadly, therefore, if we are given national income we can find
disposable income by
making adjustments of non factor incomes.National Disposable IncomeGiven GNPmp, we can derive Gross National Disposable income (GNDI) and Net
National
Disposable income (NNDI).
GNPmp
+ Net current transfers from abroad
= GNDI- Consumption of fixed capital
= NNDI
aLTERNATIVELY,
NNDI = NNPmp
+ Net current transfers from abroad
Disposable income aggregate of the private sectorGNDI and NNDI are the disposable income aggregates of the nation. Let us now
derive
the disposable income of the private sector of the nation. As a first step, given
national income,11
we deduct-national income accring to the government. Then as a second step we
make
adjustments of non-factor incomes in various stages to ultimately arrive at
personal disposable
income. These steps are summed up in the following table.
NDPfc
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Less : Income from property and entrepreneurship accruing to the government
administrative departments
Less : Saving of non-departmental enterprises= NDPfc accruing to the private sectorAdd : Net factor income from abroad
Add : National debt interestAdd : Current transfers from the government administrative departments.
Add : Net current transfers from the rest of the world.= Private IncomeLess : Saving of private corporate sector
(net of retained earnings of foreign companies)
Less : Corporation tax
= Personal IncomeLess : Direct taxes paid by households
Less : Miscellaneous receipts of government administrative departments
= Personal disposable incomeof the above national debt interest is the interest paid by government on loans
taken to
meet its administrative expenditure, a consumption expenditure, a consumption
expenditure.
Since interest on loans taken to meet consumption expenditure is not a factor
income it was not
included in NDPfc. But since it is a disposable income it is added to NDP fc to arrive
at disposable
income of which private income is a part.
Miscellaneous receipts of government administrative departments are small
compulsorypayments by the people to the government in the form of fees, fines, etc and
treated like a tax,
and therefore deducted.12
UNIT 7 - Determination of Income and EmploymentInvoluntary unemployment : Involuntary unemployment occurs when
those who are able and
willing to work at the going wage rate do not get work.
Aggregate demand : Aggregated demand means the total demand for final goods
in an economy.It also means the aggregate expenditure on final goods in an economy.
The components of aggregate demand are :
1. Demand for goods and services for private consumption also called private
final
consumption expenditure.
2. Demand for private investment
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3. Demand for goods and services by the government
4. Net exports.
Since the determination of income and employment is to be studied in the context
of two
sector model, the third and fourth components of aggregate demand are not
discussed indetails. The two sectors taken are households and firms.
1. Demand for goods and services for private consumption is made by household
sector. It
is also called private final consumption expenditure and will be refered to as
consumption
expenditure. It must be kept in mind that the consumption expenditure we are
discussing
is ex-ante i.e. planned consumption expenditure.
This demand is influenced by many variables such as price of the goods or
services,income, wealth, expected income, tastes and preferences of individuals and so
on. Keynes
formulated his fundamental Psychological Law of Consumption to lay down a
behavioural rule to
the process of consumption activity.
Keynes stated that men are disposed, as a rule and on the average, to increase
their
consumption as their income increases, but not by as much as the increase in
their income. This
relationship between consumption and income is called the consumption
function.
The consumption function may be represented by the following equation.
C =
C + bY
C > 0, 0 < b < I.
Where,13
C = Consumption
C = Autonomous Consumption
b = Marginal Propensity to Consume
Y = Level of income
The intercept
C represents autonomous consumption, that is, the amount of consumption
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expenditure when income is zero.
C is assumed to be positive, that is there is consumption even
in the absence of any income. Hence, it is not possible to think of a situation
where there is no
comsumption at all.The slope of the consumption function is b. It measures the rate of change in
consumption
per unit change in income and is also known as the Marginal Propensity to
Consume (MPC). For
example, if b is 0.6, then a rupee change in income causes a 0.60 rupee change
in consumption.
If b is 0.45, then a rupee change in income will cause a 0.45 rupee change in
consumption.
By assumption, the MPC is positive, and its value ranges between 0 and 1. This
meansthat consumption increases with income, but a rupee increase in income causes
less than a
rupee increase (of b) in consumption. For example, if b is 0.90, a rupee increase
in income
causes a 0.90, a rupee increase in consumption.
The consumption function may be plotted on a graph with the help of a numerical
example.
Figure 1 shows the graph of the hypothetical consumption function.
Consider a consumption function given by
C = 100 + 0.8 Y
Since this is an equation of a straight line, the consumption function will have a
constant
slope.
Table 1 shows the level of consumption for various levels of income.
Column (1) shows the consumption expenditure at various levels of income. The
values in
column (1) are obtained from the consumption function. Column (5) in table 1
shows how MPC is
calculated. As income increases from Rs. 600 to Rs. 700 (an increase of 100
rupees), the
consumption increases from Rs. 580 to Rs. 660 (an increase of 80rupees). TheMPC is therefore
80/100 = 0.8. The MPC at all levels of income is the same because of the
particular consumption
function we have used in our example. (Constant slope and therefore constant
MPC is a feature
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of all straight line consumption functions). The information given in the Table 1
can be plotted in
a graph, as shown in Fig. 1.14
Table 1 : Consumption, Income and Marginal Propensity to
ConsumeConsumption Change in Income Change in Marginal Prpensity
C Consumption Y Y to consume (MPC)
C = (2)/(4) = C/ Y
(1) (2) (3) (4) (5)
100 - 0 - -
180 80 100 100 (80/100) = 0.8
260 80 200 100 (80/100) = 0.8
340 80 300 100 (80/100) = 0.8
420 80 400 100 (80/100) = 0.8
500 80 500 100 (80/100) = 0.8580 80 600 100 (80/100) = 0.8
660 80 700 100 (80/100) = 0.8
740 80 800 100 (80/100) = 0.8
820 80 900 100 (80/100) = 0.8
900 80 1000 100 (80/100) = 0.8
Fig. 1 shows, the graph of the consumption function C = 100 + 0.8Y.
To understand the figure, it is helpful to look at the 45o line drawn from the origin.
Since the
vertical and horizontal axes have the same scale, the 45o line has the property
that at any point
on it, the distance up from the horizontal axis (which is consumption expenditure)exactly equals
the distance across from the vertical axis (which is income).
Thus, at any point on the 45o line, consumption expenditure exactly equals
income. The
45o line therefore immediately tells us whether consumption spending (as per the
consumption
function) is equal to, greater than, or less than the level of income.
The consumption function crosses the 45o line at point B. This point is known as
the
breakeven point. Here households are just breaking even, because theconsumption is exactly
equal to the income. In our example, the income and consumption at the
breakeven point is Rs.
500.
At any point other than B on the consumption function, consumption is not equal
to income.
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At points to the left of B, the consumption function lies above the 45o line.
Therefore consumption
expenditure is greater than income. For example, at an income level of Rs. 200,
the consumption15
is Rs. 260. The household must find funds to meet this consumption expenditure.The shortage
in income will make them to sell the assets acquired in the past, or to resort to
borrowing so that
Rs. 60 could be raised for consumption. This act on the part of the household to
liquidate their
own assets or to go in for a loan is referred to as the process of dissaving.
Dissaving is in order
to help the households to finance the consumption over and above the level of
income.
Fig. 1 : The Consumption Function C = 100 + 0.8 YAt any point to the right of B, the consumption function lies below the 45oline;therefore
consumption expenditure is less than the level of income. The part of income,
which is not
consumed, is saved. This must be so, because income is either consumed or
save, there is no
other use to which it can be put. Savings can be measured in the graph as the
vertical distance
between the consumption function and the 45o line. For example, at an income
level of Rs. 900.
consumption is Rs. 820. Therefore, the amount of savings is the diference
between the two, that
is, Rs. 80.
To sum up: when the consumption functiuon lies above the 45o line, consumption
is greater
than income at each level of income. This means that there is dissaving, Where
the two lines
intersect, the level of consumption is exactly equal to the level of income, When
the consumption
function lies below the 45o line, the level of consumption is less than the level of
income. Thismeans that there is positive saving. The amount of dissaving or saving is always
measured by
the vertical distance between the consumption function and the 45o line.16
Consumption and Savings
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We shall now look into the relationship between consumption and saving. We
may obtain
the savings function from this relationship.
The equation below says that income that is not spent on consumption is saved,
that is
S = Y - CThis equation tells us that by definition, saving is equal to income minus
consumption.
The consumption function, along with the above equation, implies a savings
function. The
savings function relates the level of saving to the level of income. Substituting the
consumption
function into the above equation we can get the saving function.
S = Y - C
= Y - (
C + bY) (Since C =
C + bY)
= Y -
C - bY
S = -
C + (1 - b)Y
This is the savings function. The intercept term
C is the amount of savings done when
there is zero level of income. It is already shown that
C is positive. Therefore
C savings is negative.
Thus, there is negative savings
C at zero level of income. Since negative savings is nothing but
dissaving, this means that at zero level of income, there is a dissaving of amount
C. Note that the
amount of autonomous consumption is exactly equal to the amount of dissaving
at zero level of
income. This is because of the fact that Y = C + S (whether S is positive or
negative).
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The slope of the savings function is (1 - b). The slope of the savings function
gives the
increase in savings per unit increase in income. This is known as the Marginal
Propensity to
Save (MPS) Since b is less than one it follows that (1 - b) and therefore MPS is
positive. Therefore,savings is an increasing function of income.Suppose the MPC, that is, b is 0.8,
then the MPS, tha
is (1 - b) is 0.2. This means that for every one rupee increase in income, savings
increase by 0.2
rupee.
Note that MPS = 1 - b = 1 - MPC. This means that the part of the increase in
income, which
is not consumed, is saved, This is because income is either consumed or saved.
Therefore, it is
always the case that MPC + MPS = 1.Using the numerical example of the consumption function we had earlier given,
we can
derive the corresponding savings function.
S =
C + (1 - b) Y
= - 100 + (1 - 0.8)Y
S = -100 + 0.2Y17
Table 2 : Consumption - Saving Relationship
Y Change C Change MPC Saving Change MPS C+S MPC+
in Y in C C/ Y S in S S/ Y MPS
Y C S
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
0 - 100 - - -100 - - 0 -
100 100 180 80 0.8 -80 20 0.2 100 1
200 100 260 80 0.8 -60 20 0.2 200 1
300 100 340 80 0.8 -40 20 0.2 300 1
400 100 420 80 0.8 -20 20 0.2 400 1
500 100 500 80 0.8 0 20 0.2 500 1
600 100 580 80 0.8 20 20 0.2 600 1700 100 660 80 0.8 40 20 0.2 700 1
800 100 740 80 0.8 60 20 0.2 800 1
900 100 820 80 0.8 80 20 0.2 900 1
1000 100 900 80 0.8 100 20 0.2 100 1
Table 2 shows the levels of consumption and savings for various levels of
income.
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Note that (a) consumption plus saving everywhere equals income, and (b) MPC +
MPS = 1.
Columns (1) to (5) are repeated from Table 1. Column (6) shows the level of
savings at different
levels of income. The values in this column are obtained from the savings
function. Column (8) intable 2 shows how MPS is calculated. As income increases from Rs. 600 to Rs.
700 (an increase
of Rs. 100), the savings rises from Rs. 20 to Rs. 40 (an increase of Rs. 20). The
MPS is therefore
(20/100) = 0.2.
The MPS is the same at all levels of income because of the particular savings
function
(a linear curve with constant slope) we used in our example (constant slope and
therefore constant
MPS is a feature of all straight line savings functions).Column (9) of the table shows the sum of consumption expenditure and savings
at
every level of income. Note that column (9) is identical to column (1). This is
because income is
either consumed or saved, there is no other use to which it can be put. Thus, the
sum of
consumption expenditure and saving must be identically equal to income.
Column (10) of the table shows the sum of the MPC and MPS. Note that the sum
of
MPC and MPS is equal to one. This means that the part of the increase in
income, which is not
consumed, is saved. This is because income is either consumed or saved.
The information given in table 2, can be plotted in a graph, as shown in Fig. 218
The information given in table 2 can be plotted in a graph, as shown in Fig 2.
Fig 2 : The consumption Function and its associated Savings Function
Part A of Fig 2 shows the consumption function, Part B shows the savings
function.
This is the counterpart of the consumption shown in part A. In part A, the amount
of saving at any
level of income is the vertical distance between the consumption function and the45o line. The
saving function shown in part B can therefore be directly derived from part A.
When income is 500, we see in part A that consumption is 500 and saving equals
0.
This is depicted in part B by the intersection of the savings function with the
horizontal axis at
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point B, which corresponds to an income level of 500. When income is 200,
consumption is 260
and saving is -60 (dissaving is 60); the savings function lies 60 below the
horizontal axis at an
income level of 200.
When income is 900, consumption is 820 and saving is 80; the saving functionlies 80
above the horizontal axis at an income level of 900.
In general, to the left of points B in part A, the consumption function lies above
the 45o
line (consumption is more than income). Hence to the left of point B in part B,
savings is negative
and the savings function lies below the horizontal axis.19
To the right of point B in part A, the consumption function lies below the 45o line
(consumption is less than income). Hence to the right of point B in part B,savings is positive and
the savings function lies above the horizontal axis.
Average Propensities to Consume and SaveFrom the consumption function, we can find out the value of the consumption
income ratio
C/Y, at every level of income. At any particular level of income. the ratio of
consumption to income
is called the Average Propensity to Consume (APC). The APC gives the average
consumption -
income relationship at different levels of income.
Similarly, from the savings function, we can find out the average savings - income
ratio. At
any particular level of income, the Average Propensity to Save (APS) is the ratio
of savings to
income.
We have
APC = C/Y and APS = S/Y
Now, the sum of the APC and APS is always equal to one. This is because
income is either
consumed or saved. The proof of this statement is as follows; From the
relationship betweenincome, consumption and saving,
We have
Y = C + S
Dividing both sides of the equation by Y we have
Y/Y = C/Y + S/Y
Thus, I = APC + APS
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Using the earlier examples of consumption function and savings function we can
calculate
the values of APC and APS for every level of income. This is done in Table 3.Table 3 Average Propensities to Consume and SaveY C APC S APS APC+APS
(2)/(1) (4)/(1)(1) (2) (3) (4) (5) (6)
0 100 - -100 - -
100 180 1.8 -80 -0.8 1
200 260 1.3 -60 -0.3 1
300 340 1.13 -40 -0.13 1
400 420 1.05 -20 -0.05 1
500 500 1 0 0 1
600 580 0.97 20 0.03 1
700 660 0.94 40 0.06 1
800 740 0.92 60 0.08 1900 820 0.91 80 0.09 1
1000 900 0.90 100 0.10 1
Note : Figures in table are rounded upto two decimal points20
Column (3) shows how APC is calculated. At a particular income level, the APC
is the corresponding
level of consumption divided by that level of income. Similarly: APS is calculated
in column (5). At
a particular income level, the APS is the corresponding level of saving divided by
that level of
income. Column (6) shows the sum of APC and APS. As expected, at every level
of income, the
sum of APC and APS is equal to one. This is because income is either
consumed or saved.
Therefore the proportion of income that is not consumed must be saved.
As we can see from the above table. APC is continuously declining as income
increases;
and APS is continuously increasing as income increases. This means that as
income increases,
the proportion of income saved increases and the proportion of income
consumed decreases.2. Demand for Private InvestmentDemand for private investment refers to the planned or ex-ante investment
expenditure
by the firms. It includes addition to the stock of physical capital and change in
inventory. For
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simplicity sake it is assumed in our study that the investment expenditure is
autonomous. This
means investment decisions are not influenced by any of its determinants,
including output.
Aggregate Supply : It is total quantity of goods and services produced in the
economic teritory ofa country. It refers to the planned aggregate output in the economy. It is assumed
that in the short
run the prices of goods do not change and the elasticity of supply is infinite. At
the given price
level, output can be increased till all resources are fully employed. So how much
will be the
aggregate output will primarily depend upon how much is the aggregate demand
in the economy.
The level of output income and employment in an economy move together in the
samedirection till full employment is reached. Increase in output means, increase in
level of employment
and increase in level of income. Decrease in output means less employment and
lower level of
income.Determination of Equilibrium Level of Output, Income &EmploymentWe shall confine our analysis of the determination of the equilibrium level of
output to an
economy with only two sectors, households and firms. Hence, the only
components of aggregate
demand will be consumption demand and investment demand.
Consumption plus Investment ApproachWe may show output determination using the consumption plus investment (C+I)
approach.
This is illustrated in Fig. 3, which shows total spending or aggregate demand
plotted against
output or income. The line CC is the consumption function, showing the desired
(planned level)
of consumption corresponding to each level of income. We now add desired
(planned) investment(which is at fixed level I) to the consumption function. This gives the level of total
desired spending
or aggregate demand, represented by the C+Io curve. At every point, the (C+Io)
curve lies above
the CC curve by an amount equal to Io.
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The 45o line will enable us to identify the equilibrium. At any point on the 45 o line,
the
aggregate demand(measured vertically) equals the total level of output
(measured
horizontally).
The economy is in equilibrium when aggregate demand, represented by the C+Iocurve is
equal to the total output.21
Fig. 3 : Output Determination by Consumption plus Investment approach
The aggregate demand or (C + Io) curve shows the desired level of expenditure
by consumers
and firms corresponding to each level of output. The economy is in equilibrium at
the point where
the C + Io curve interseets the 45o line - point E in Fig. 3. At point E, the economy
is in equilibriumbecause the level of desired spending on consumption and investment exactly
equals the level
of total output. The level of output corresponding to point E, is the level of output
OM. Thus, OM
is the equilibrium level of out