ECONOMICS

Chapter 01
Production possibility frontier (also called production possibility curve) is a plot that shows the maximum outputs
that an economy can produce from the available inputs (i.e. factors of production).

Inefficient Production and Infeasible Production

If an economy’s total production falls within or below the production possibility frontier, i.e. as in Point G in the PPF
plotted above, it is producing at below their potential. It is referred to as inefficient production.(inward shift) It is
because at Point G, the country is producing 2 nukes and 2,500 megawatts of electricity while it has the potential to
produce 2 nukes and 3,300 megawatts of electricity. Many countries produce at a point inside their production
possibility fronteir due to business cycles because the market system is not able to correctly match the supply and
demand.

Similarly, an economy can’t produce a combination of products outside their production possibility frontier. Point H
in the chart above is an infeasible production (outward shift)goal because it falls outside the PPF. The country can’t
produce 2 nukes and 4,000 megawatts of electricity at the same time. However, by investing in new technology and
thereby improving productivity, a country can shift its production possibility outwards and achieve the production
goal in future.

Chapter 02

the supply curve slopes upwards i.e. at higher price, quantity supplied is high.

The demand curve generally slopes downwards as a consequence of law of demand.

The market clearing price (also called equilibrium price) is the price at which quantity supplied equals quantity
demanded.

The supply curve is upward sloped showing the direct relationship between the price and the quantity
supplied.

both price and quantity supply cannot be negative numbers.

It is important to note that supply is affected by a number factors in addition to price and the law of supply applies
only under the assumption that these other factors remain constant. The factors affecting supply are
called determinants of supply.

The above supply line has a positive slope thus indicating that there is direct relationship between the price of a
product and the quantity supplied. As the price increases, producers and resource owners will supply more.

The result is a downward sloped demand curve showing the inverse relationship between price and quantity
demanded as stated in the law of demand.
Determinants of demand

Other potential factors are the determinants of demand including price of substitutes i.e. price of the public
transportation or competing cab services, whether it is a working day or a weekend, whether it is a clear or a rainy
day, etc.

Multiple regression analysis One method of creating a demand function to use multiple regression analysis to
find out the relationship between quantity demanded, the product price and all other factors. The multiple
regression analysis assigns different coefficients to each of the factor that affects the demand. The sign of the
coefficient (i.e. positive or negative) tells us whether the demand and the factor are positively-related or
negatively-related.

Quantity supplied is the quantity of a product which producers are willing to supply at a given price while change in
supply refers to the overall shift in supply schedule due to technological changes, input prices, government
regulations, etc.

A supply schedule or a supply curve refers to a plot of quantities supplied by the producer at different prices. The
quantity supplied changes only in response to changes in the price of the product. When the whole supply curve
shifts inwards or outwards i.e. it decreases or increases, it is referred to as a change in supply or a shift in
supply curve.

Such a change in supply (from the blue curve to the orange curve) in response to a change in external factors is
referred to as a shift in supply. Factors that bring about such shift in supply are called determinants of supply.

Shifts in Demand
When there is an increase or decrease in demand due to factors other than the product's own price, there is a shift in
demand curve inwards or outwards. In the plot above, a movement form demand curve for the first survey to a
demand curve for the survey represent an increase in demand. Change in demand results not from change in price of
the product plotted but due to other determinants of demand such as prices of substitute, prices of complements,
etc. In the example discussed above, the increase in demand for your mass transit system increases due to increase in
the price of substitute goods (i.e. ride-sharing app due to additional taxes).

This excess of quantity supplied over quantity demanded represents a market surplus.

This excess of quantity demanded over quantity supplied represents a market shortage.

1. (MCQ)
increase supply and shift the supply curve rightwards

2. decrease the supply and shift the supply curve leftwards. (MCQ)
(Quanatity supplied on X axis and Price
on Y axis)
Greater the number of sellers, greater will be the quantity of a product or service supplied in a market and vice versa.
Thus increase in number of sellers will increase supply and shift the supply curve rightwards whereas decrease in
number of sellers will decrease the supply and shift the supply curve leftwards.
Increase in resource prices reduces the supply and the supply curve is shifted leftwards whereas decrease in resource
prices increases the supply and the supply curve is shifted rightwards.

1. increase DEMAND and shift the DEMAND curve rightwards (MCQ)

decrease the DEMAND and shift the DEMAND curve leftwards. (MCQ)
(Quantity demanded on X axis and Price on Y
axis)
substitute goods: The price change of a substitute of a product usually affects the demand of the product
directly.

For example, price drop of solar power technology will decrease the demand for traditional electric power.

Complementary goods: The demand for a product changes inversely with a price change of a complementary
good. For example decrease in price of cars will increase the demand for cars. More cars will need more fuel
and demand for fuel will be increased.

Because quantity demanded decreases with increases in price, price elasticity of demand for normal goods is
negative. However, the negative sign is usually ignored, and price elasticity is quoted as a positive number.

(MCQ)
When the price elasticity is greater than 1, equal to 1 or lower than one, the product is said to have

1. elastic greater than 1

2. unit-elastic is equal to 1and
3. inelastic demand curve less than 1

Normal good :If the quantity demanded increases with increase in income, the income elasticity of demand is
positive, and the product is a normal good.

Inferior good: However, when the quantity demanded decreases with increase in income, the income elasticity is
negative, and the product is an inferior good.

1. Substitutes (positive): If the quantity demanded of a product increases with increase in price of the related
good, the cross elasticity of demand is positive, and the products are substitutes. (move in same direction)

2. Complements (negative): Similarly, if the quantity demanded decreases with increases in price of the related
good, the cross elasticity of demand is negative, and the products are complements. (move in opposite direction)
Point elasticity of demand is the ratio of percentage change in quantity demanded of a good to percentage change
in its price calculated at a specific point on the demand curve.

Arc elasticity of demand is the ratio of percentage change in quantity demanded of a good to percentage change in
its price calculated between two points on the demand curve.

If the price elasticity of demand is (a) higher than 1, demand is considered elastic, (b) equal to 1, demand is
unit-elastic and (c) lower than 1, demand is inelastic.

Total revenue of a producer equals the product of quantity demanded and price. Change in revenue due to a change
in price depends on the price elasticity of demand of the product. Following are the effect on total revenue under
different price elasticity scenarios:

 If demand is elastic, price elasticity of demand is greater than 1 and a one percentage increase in price
will result in more than one percentage change in quantity demanded.
 If demand is unit-elastic, price elasticity is equal to 1 and a one percentage increase in price will result
in exactly one percentage change in quantity demanded.
 If demand is inelastic, price elasticity of demand is lower than 1 and a one percentage increase in price
will result in less than one percentage change in quantity demanded.

A product or service has elastic demand when its price elasticity of demand is greater than 1, unit-elastic
when price elasticity is 1 and inelastic when the price elasticity is less than 1.

When the demand is inelastic, producers can increase their revenue by increasing price. It is because the
percentage drop in quantity demanded in response to price increase is lower.

Perfectly-elastic demand is an extreme case in which quantity demanded changes infinitely in response to an
infinitesimal (smaller) change in price.

It is represented by a horizontal demand curve. (MCQ)

Perfectly-Inelastic Demand
Demand is perfectly-inelastic if it the quantity demanded doesn’t change regardless of any change in price. It means
that the quantity demanded of such a product will not change in response to any change in its price.

it is represented a vertical demand curve. (MCQ)

Perfectly-inelastic price elasticity is another extreme case and it is represented a vertical demand curve. Theoretically,
a producer with a product that has perfectly-inelastic price elasticity can increase the product price as much as he
wants without any loss in units sold.

Unit-Elastic Demand
Unit-elastic demand is where the price elasticity of demand is 1. A unit-elastic demand means that the
percentage change in quantity demand and percentage change in price are equal.
The total revenue of a unit-elastic product remains the same because any change in price is exactly offset by a
corresponding opposite change in quantity demanded.

Iso elastic Demand

A product has iso elastic demand when its price elasticity is the same at each point on the demand curve. Such a
demand curve is constant elasticity demand curve.

In case of a linear demand curve, the price elasticity can be worked out using the following formula:

1. Substitutes (positive): If the quantity demanded of a product increases with increase in price of the related
good, the cross elasticity of demand is positive, and the products are substitutes.

2. Complements (negative): Similarly, if the quantity demanded decreases with increases in price of the related
good, the cross elasticity of demand is negative, and the products are complements.

A positive income elasticity of demand stands for a normal (or superior) good.

When the quantity demanded of a product or service decreases in response to an increase in the income level, the
income elasticity of demand is negative and the product is an inferior good.

If the quantity demanded of a product increases with increase in consumer income, the product is a normal good and
if the quantity demanded decreases with increase in income, it is an inferior good.

1. A normal good has positive and an

2. inferior good has negative elasticity of demand.

Substitute goods (or simply substitutes) are products which all satisfy a common want and complementary goods
(simply complements) are products which are consumed together.

Demand for a product’s substitutes increases and demand for its complements decreases if the product’s price
increases.

. If the cross elasticity of demand is positive, the products are substitute goods. On the other hand, if cross
elasticity is negative, the products are complements.

A price floor is a minimum price enforced in a market by a government or self-imposed by a group. It tends to
create a market surplus because the quantity supplied at the price floor is higher than the quantity demanded.

Price ceiling (also known as price cap) is an upper limit imposed by government or another statutory body on the
price of a product or a service. A price ceiling legally prohibits sellers from charging a price higher than the
upper limit.

Binding price ceiling:A price ceiling is typically below equilibrium market price in which case it is known
as binding price ceiling because it restricts price below equilibrium point. Binding price ceilings interrupt
natural market equilibrium forces.

Non-binding price ceiling :Rarely, a price ceiling may be above market price in which case it is called non-
binding price ceiling because it does not affect market equilibrium.
When price ceiling is below equilibrium market price, the quantity supplied by producers is below the
equilibrium quantity, as governed by law of supply. But the quantity demanded by consumers is above the
equilibrium quantity, as governed by law of demand. This results in excess of quantity demanded over quantity
supplied thus creating shortage in the market.

Chapter 03

Production Functions
A production function is an equation that establishes relationship between the factors of production (i.e. inputs) and
total product (i.e. output). There are three main types of production functions:

(a) the linear production function, (b)

(b) the Cobb-Douglas production and
(c) (c) fixed-proportions production function (also called Leontief production function).

The linear production function and the fixed-proportion production functions represent two extreme case scenarios.

1. The linear production function represents a production process in which the inputs are perfect
substitutes i.e. one, say labor, can be substituted completely with the capital.
2. The fixed-proportion production function reflects a production process in which the inputs are required
in fixed proportions because there can be no substitution of one input with another.

The Cobb-Douglas production function represents the typical production function in which labor and capital can be
substituted, if not perfectly.

A linear production function is represented by a straight-line isoquant.

A fixed-proportion production function corresponds to a right-angle isoquant.

The Cobb-Douglas production function is represents the typical convex isoquant

Cost elasticity (also called cost-output elasticity) measures the responsiveness of total cost to changes in output.

It is calculated by dividing the percentage change in cost with percentage change in output.

A cost elasticity value of less than 1 means that economies of scale exists.

Minimum Efficient Scale

Minimum efficient scale (MES) is the smallest output level at which LONG RUN AVERAGE COST is at its minimum.

It provides insight about competitiveness of an industry: an industry with high MES typically has few large firms.

Long-run average cost (LRAC) curve is a graph that plots average cost of a firm in the long-run when all inputs can be
changed.
LRAC is determined by the firm’s expansion path i.e. the combination of labor and capital and other inputs which
minimize the firm’s costs at each production level.

Downward sloping: LRAC initially slopes downward due to economies of scale but as soon as diseconomies
of scale set in, it bottoms out and starts to rise. The minimum point of the LRAC represent the firm’s minimum
efficient scale.

Minimum efficient scale is an important indicator of an industry’s competitiveness and barriers to entry.

If the MES is high, it means that each firm must produce a high proportion of the industry’s output in order to
reach the minimum efficient scale.

This potentially creates barriers to entry and the industry is expected to be dominated by a few large firms.

IMPORTANT MCQs:

One of the property of the long-run cost curves is that the average cost curve is minimum at a point at which the
marginal cost curve intersects it from below.

IMPORTANT MCQs:

It means that the LRAC is minimum at a point at which LRAC and long-run marginal cost (LMC) are equal.

MCQ

Since the marginal cost equals the slope i.e. the first derivative of the total cost curve, the equation for LMC can be
written as follows:

MCQ

Let’s verify that the minimum efficient scale occurs at the lowest point on the LRAC by plotting the LRAC and LMC
curves.

Expansion Path
Expansion path is a graph which shows how a firm’s cost minimizing input mix changes as it expands its
production.

It traces out the points of tangency of the isocost lines and isoquants.

An expansion path provides a long-run view of a firm’s production decision and can be used to create its long-run
cost curves. Since we define long-run as a time period in which a firm can change all its inputs including capital, the
expansion path depends on how the firm changes its input mix.

MCQS

An isocost line plots such combinations of inputs at which the firm’s total cost is constant.
 An isoquant represents such combination of inputs which generate the same amount of output.

MCQS

This occurs at a
A profit-maximizing firm is interested in producing maximum output at minimum cost.
point at which its isocost line is tangent (touches) to the relevant isoquant.

IMPORTANT MCQ

As the firm increases its input budget while the unit costs of inputs remain the same, the firm’s isocost lines
shift outwards such that they touch higher and higher isoquants. If we connect all such points at which isocost
lines are tangent to the isoquants, we get the firm’s expansion path.

Normal Input vs Inferior Input

A firm’s expansion path tells us whether the firm’s inputs are normal inputs or inferior inputs.

An input is a normal input if the firm increases its proportion in its production mix as it increases production. An
inferior input, on the other hand, is an input whose proportion decreases as the firm switches to other inputs at
higher production level.

MCQ

The expansion path slopes away from an inferior input i.e. it has negative slope. But in case of a normal
input, the expansion path has a positive slope.

Isocost Line (ISO MEAN SAME )

(DOWNWARD SLOPING)
An isocost line is a graph of combinations of labor and capital, or any other two factors of production, such that the
total cost remains the same.

MCQ

An isocost line is to the producers what a budget line is to a consumer. While a budget line shows a consumer’s
maximum income,

an isocost line shows the maximum amount which a firm is willing to expend on production.

The interplay of a firm's isocost line and its isoquants determine the firm's production.

MCQ
 The point at which the isocost line is tangent to the highest-possible isoquant is the point at which the firm
maximizes its output keeping in view its cost constraints.

A firm’s isocost line can shift if there is (a) a change in total expenditure of the firm on inputs and (b) change in price
of the inputs.

MCQ

If a firm decides to spend more money on production, its isocost line shifts outwards/rightwards
parallel to the original isocost line. It is because more budget allows the firm to simultaneously employ more
capital and labor at the same time.

MCQ

A reduction in budget would have an exactly opposite effect i.e. it would move the isocost line inwards.

A parallel shift can also happen if prices of both inputs change by equal proportion. However, where the change
in prices of inputs is not proportionate, it changes the slope of the isocost line (recall the fact that the slope of the
isocost line equals the ratio of price of one factor to the other). Such a change in slope rotates the isocost line.

Economies of scope represent the production efficiency which enables a firm to produce more than one
products at a cost which is lower than the sum of stand-alone costs of each product.

Economies of scope can be represented graphically by plotting a production possibility frontier. Where the

economies of scope exist, the production possibility frontier is bowed out i.e. it is concave. This curve is also called
product transformation curve.
When the value of degree of economies of scope is negative, there are diseconomies of scope i.e. it is better to
produce both products independently because the combined cost is higher than the sum of stand-alone costs.

MCQ

Isoquants are usually downward sloping convex curves whose shape depend on the degree of substitution
between different inputs.

MCQ

1. straight line: When both inputs are perfect substitutes, isoquants are straight line and have a constant
slope because one input can be replaced with the other at the same rate.
2. Right Angled:Similarly, when no substitution is possible at all, the isoquants take the shape of a right
angle which means that a fixed proportion must always be maintained between the two inputs.
3. Curved isoquants are the most typical isoquants which represent inputs which are neither perfect
substitutes nor perfect complements. They are convex in shape which means that they are steeper near the
y-axis and gets flatter as they reach x-axis.

Isoquants are to producers what indifference curves are to consumers.

While the indifference curves tell us about different combinations of two products that give a consumer same level
of satisfaction, isoquants tell us about different mixtures of inputs that generate the same level of output. Many
properties of the isoquants are like those of indifference curves, namely

MCQ

 Isoquants that are to the left represent a higher production level than isoquants which are closer to the
vertex (i.e. origin): an isoquant that represent 6 units produced is to the left of an isoquant that represent
production of 4 units.
 Isoquants do not cross each other: an isoquant representing 6 units can’t cross an isoquant representing 4
units because if they do, it would mean two production levels corresponding to a single combination of
labor and capital. We need to stick to the more efficient production point.
 Isoquants are downward sloping and their slope change as we move along the curves

MRTS
Marginal rate of technical substitution (MRTS) is the rate at which a firm can substitute capital with labor. It
equals the change in capital to change in labor which in turn equals the ratio of marginal product of labor to
marginal product of capital.
 MCQ
 MRTS equals the slope of an isoquant.
 An isoquant is a curve which represents combinations of different factors of production i.e. labor and capital
that yield the same total production.
 MCQ
 The concept behind MRTS is similar to that of marginal rate of substitution (MRS). While the marginal rate of
substitution tells us the rate at which a consumer is willing to replace one product with another, the marginal
rate of technical substitution tells us the rate at which a producer is willing to switch one input (i.e. factor of
production) with another.
MRTS is relevant to producers and MRS is relevant to consumers.

Cobb-Douglas Production Function

Cobb-Douglas production function is a model that tells us about the relationship between total product, total
factor productivity, quantities of labor and capital and their output elasticities.

The Cobb-Douglas production function is the most widely used production function because it allows
different combination of labor and capital. Other versions of the production functions such as the linear
production function and fixed-proportion (Leontief) production function represent extreme case-scenarios i.e. perfect
substitution between labor and capital and zero substitution respectively.

MCQ

The Cobb-Douglas production function was developed by Paul Douglas, an economist, and Charles Cobb, a
mathematician.

Total Factor Productivity

Total factor productivity (TFP) is a measure of productivity calculated by dividing economy-wide total production
by the weighted average of inputs i.e. labor and capital. It represents growth in real output which is in excess of
the growth in inputs such as labor and capital.

Productivity is a measure of the relationship between outputs (total product) and inputs i.e. factors of production
(primarily labor and capital). It equals output divided by input. There are two measures of productivity:

(a) labor productivity, which equals total output divided by units of labor and

(b) total factor productivity, which equals total output divided by weighted average of the inputs.

Returns to Scale
Returns to scale tell us how production changes in response to an increase in all inputs in the long run. An
industry can exhibit constant returns to scale, increasing returns to scale or decreasing returns to scale.

Constant Returns to Scale

Constant returns to scale mean that total product changes proportionately with increase in all inputs. In other words,
the percentage increase in total product under the constant returns to scale is the same as the percentage increase in
all inputs.

If the sum of a and b in the Cobb-Douglas production function equals 1, it represents constant returns to
scale.

Increasing Returns to Scale

In industries subject to increasing returns to scale, a 1% increase in total inputs will result in a more than 1% increase
in total product i.e. total product increases at a rate higher than the rate in which all inputs increase. Increasing
returns to scale are also referred to as economies of scale.

Decreasing Returns to Scale

In case of decreasing returns to scale, total product increases at a rate lower than the rate of increase in inputs. In
other words, additional investment generates progressively less and less additional production.

If the sum of a and b in the Cobb-Douglas production function is less than 1, it represents decreasing
returns to scale. Decreasing returns to scale are also referred to as diseconomies of scale.

Law of Diminishing Returns

Law of diminishing returns states that as we increase units of a factor of production, say labor, while keeping
all other factors, such as land and capital, constant, there will be progressively less and less increase in total
product.

The increase in total product that results from each additional unit of an input is called marginal product. Hence, law
of diminishing returns can also be defined as follows: the marginal product of a factor of production decreases as we
increase that factor while keeping the other factors constant. Mathematically speaking, the additional output that the
nth unit of an input generates is less than the additional output generated by the unit preceding it i.e. by (n-1)th unit.

Producer Surplus
Producer surplus is the amount which a producer gains by participating in the market. It equals the excess of
the amount which a unit of a good fetches in the market over the minimum amount at which the producer is
willing to supply it.

The loss of producer or consumer surplus is called deadweight loss.

Chapter 04

Marginal cost equals the slope of the total cost curve and it can be calculated using the following formula:

MCQs VERY IMPORTANT

 The average fixed cost (AFC) decreases continuously with increase in output. Since AFC = TC/Q, increase in
Q decreases AFC indefinitely.
 The average variable cost (AVC) curve is U-shaped. It slopes downward as long as the marginal cost curve
is below AVC, but it starts to slope upwards when the marginal cost curve crosses it from below. It is because
the AVC is effectively the average of the cumulative marginal cost.
 The marginal cost curve is U-shaped. It initially decreases when marginal product increases, but it starts to
rise as the diminishing returns set in.
 AVC is equal to MC at the output level at which AVC intersects MC.
 The average total cost (ATC) curve is the vertical sum of the average fixed cost (AFC) curve and average
variable cost (AVC) curve.

 When the firm’s production process exhibit constant returns to scale, output can be doubled by doubling
all inputs. Since the cost of inputs is unchanged, it would result in a flat long-run average total cost (LAC)
curve i.e. long-run average total cost shall be same at all output levels.
 However, if the firm has increasing returns to scale, it would be able to produce double output at a less
than double inputs. This should cause a decrease in LAC. SLOPE DOWNWARD
 Alternatively, if the firm experiences decreasing returns to scale, doubling output would require more than
double inputs and this would cause the long-run average total cost (LAC) curve to slope upwards.

Since long-run marginal cost (LMC) is the slope of the long-run average total cost,

MCQ

, LAC curve is U-shaped. It slopes downward as long as the long-run marginal cost curve lies below it but it
starts to slope upwards as soon as LMC crosses it from below.

1. A linear cost function is such that exponent of quantity is 1. It is appropriate only for cost structures in which
marginal cost is constant.
2. A quadratic cost function, on the other hand, has 2 as exponent of output. It represents a cost structure
where average variable cost is U-shaped.
3. A cubic cost function allows for a U-shaped marginal cost curve. The cost function in the example below is
a cubic cost function.

Average total cost curve is typically U-shaped i.e. it decreases, bottoms out and then rises.

The marginal cost curve is generally U-shaped.

  As long as the marginal cost curve lies below the average cost curve, the average cost decreases and
the average cost curve declines, but as soon as the marginal cost curve crosses the AVC curve, average
cost starts to rise.
 Marginal cost is equal to the average variable cost when the average variable cost is at its minimum.
It means that MC curve crosses AVC curve at its minimum point.

It is feasible to operate only when the marginal revenue is higher than average variable cost.

 If the marginal cost curve is below the average variable cost curve, average variable cost should
decline. It is because AVC is the average marginal cost and a marginal cost lower than AVC causes it
to decline.
 On the other hand, if the marginal cost curve is above the average variable cost curve, the average
variable cost increases.
 The marginal cost equals average variable cost when the average variable cost is at its minimum.

Chapter 05
monopolies have significant market power which enables them to dictate a price which is significantly higher than
their marginal cost. Due to extensive barriers to entry, a monopolist can earn positive economic profit even in the
long-run

Since a monopolist is the sole producer, its demand curve is the market demand curve i.e. a downward-sloping
demand curve. As shown in the graph below, a monopolist’s marginal revenue is less than its price.

Natural Monopoly
Natural monopoly is a monopoly that exists as a result of a market situation in which a single monopolistic firm can
supply a particular product or service to the entire market at a lower unit cost than what could be achieved by a
number of competing firms. Natural monopolies typically exist when production of a product or service requires
large and extremely costly infrastructure. Pure cases of natural monopoly are rare in real world but they do exit in
markets of public utilities such as power, water, telephone, railways etc.

A monopolist can maximize its profit by producing at an output level at which its marginal revenue is equal to its
marginal cost.

A monopolist faces a downward-sloping demand curve which means that he must reduce its price in order to sell
more units. Marginal cost curve of the monopolist is typically U-shaped,

Monopoly profit is maximized at a point at which the monopoly’s marginal revenue is equal to its marginal
cost.

Monopoly power (also called market power) refers to a firm’s ability to charge a price higher than its marginal
cost. Monopoly power typically exists where the there is low elasticity of demand and significant barriers to
entry.

Why is it that a firm in perfect competition is a price-taker while a monopoly can set any price it deems fit? The
answer lies in the nature of the demand curve facing each firm. In a perfect competition, no firm has any market
power because they face a horizontal demand curve. They must supply at the prevailing market price or sell
nothing.
A monopoly, on the other hand, need not worry about any competition. Since a monopolist is the only firm in the
market, if the elasticity of demand for its product is low, he determines the market price. In other words, a
monopolist has infinite monopoly power.

Lerner Index
Lerner Index is a measure of monopoly power which equals the markup over marginal cost as percentage of
price. Its value ranges from 0, in case of a perfect competition, to 1, in case of a pure monopoly.

A perfectly-competitive firm can’t afford to set its price higher than its marginal cost. It is because it faces a
horizontal demand curve which means that if it attempts to charge a price higher than its marginal cost, it will have
zero revenue because all its customers will switch to its competitors.

A monopolist on the other hand faces a downward-sloping demand curve which means that it can charge a price
higher than its marginal cost. One way of finding out the extent of monopoly power is to work out the difference
between price and marginal cost of the monopolist. This is exactly what the Lerner Index does.

The higher the price elasticity of demand of a firm’s product, the lower its Lerner Index.

It is because a high elasticity of demand means that any increase in the price of the product will cause customers to
switch to substitute goods. This reduces the monopolist’s ability to sell its products at a higher markup.

There is an inverse relationship between Lerner Index and elasticity of demand as given by the equation
below:

Price Discrimination
Price discrimination is the practice of charging different prices for the same product or service to different customers
instead of selling it at a uniform price to all of them. Monopolistic businesses widely use price discrimination to
maximize their sales.

Price discrimination allows a seller to divide consumers on the basis of their price elasticity of demand. By charging
higher price to consumers having low price elasticity of demand and lower price to consumer having higher
price elasticity of demand, the seller achieves total sales higher than what could be achieved with uniform price for
all customers.

 First degree price discrimination, (perfect price disrimination) in which the seller charges the maximum
price a consumer is willing to pay.
 Second degree price discrimination, (non linear)in which the seller charges higher price for the first unit
and reduces price for each successive unit sold (commonly known as bulk discounts).
 Third degree price discrimination, (group price discrimination) in which the seller segregates customers
into different classes by location, age etc. and charges different price to each class of consumers. A firm's
pricing strategy may combine multiple types of price discrimination.

Chapter 06
Consumption Function
Consumption function is an equation that shows how personal consumption expenditure changes in response to
changes in disposable income, wealth, interest rate, etc. Generally, consumption equals autonomous consumption
plus the product of marginal propensity to consume and disposable income.

Consumption is the largest component of a country’s gross domestic product (GDP). It includes non-commercial
expenditure which people incur on final goods and services such as food, clothing, education, entertainment,
furniture, cars, computers, etc.

The most popular consumption function is the Keynesian consumption function which shows that consumption (C)
depends on autonomous spending (c0), marginal propensity to consume (MPC) and disposable income (Y D).

Average Propensity to Consume (APC)

Average propensity to consume, the ratio of total consumption to total disposable income, can be worked out by
dividing consumption with total income as follows:

Law of Diminishing Marginal Utility

Law of diminishing marginal utility states that as we consume more and more of a good, the contribution of each
additional unit to our total utility is less than the contribution of the unit consumed before it.

Utility is a central concept in economics that refers to the satisfaction or value that we obtain from consumption of a
product. It is an abstract quantification of benefits and its (hypothetical) unit is util. Marginal utility is the
increase in total utility that results from consumption of each additional unit. Marginal utility of the nth unit (MUn)
equals total utility derived from consumption of n units (Un) minus total utility derived from consumption of n – 1
units (Un-1) as show below:

Equimarginal Principle
The equimarginal principle states that consumers allocate their money such that the marginal utility per dollar
of each good is the same because this is how they maximize their total utility.

Marginal utility is the additional satisfaction derived by a consumer by consuming one additional unit of a good.
The law of diminishing marginal utility dictates that the marginal utility decreases with each additional unit consumed.
Because different goods have different prices, their marginal utilities can’t be compared directly. This is where the
concept of marginal utility of income becomes relevant. Marginal utility of income is the marginal utility of a
good per dollar.

Budget Line (Budget Constraints)

Budget line (also known as budget constraint) is a schedule or a graph that shows a series of various
combinations of two products that can be consumed at a given income and prices.
Budget line is to consumers what a production possibilities curve is to producers.

Attainable combination is any combination of two products which may be purchased using the given income. All
points on or below the budget line are attainable, for example, 20 songs and 4 games.

Unttainable combination is any combination of two products which is impossible to purchase using the given
income. All points above the budget line are un-attainable, for example, 30 songs and 6 games.

Consumer Behavior
Consumer behavior is a field of study in economics which tries to explain consumer choices and their decisions in the
context of limited income and the perceived benefit they derive from various goods and services.

Shifts in Budget Line

A budget line shows the maximum consumption of a consumer at a given income level. It shifts parallelly
when there is a change in income but rotates when the relative prices change.

A budget line is also called a budget constraint because it limits total consumption possibility of a consumer. Total
consumption in dollars at all points on the budget line equals total income. If Product A is plotted on y-axis and
Product B on x-axis, the budge line touches y-axis at a point at which all budget is spent on Product A and it touches
x-axis at a point at which only Product B is consumed. At any point in between these two extreme cases, a
combination of Product A and B are consumed.

Change in Income: Parallel Shift

If there is a change in income of a consumer but there is no change in relative prices of the two goods, the
budget line shifts parallelly i.e. the location of the new budget line is parallel to the initial one.

Change in Relative Prices: Rotation

When there is a change in relative prices i.e. when price of only one good increase or when the price of one
good increases by a larger percentage than the other, the budget line rotates i.e. it shifts but not parallelly.

The unparallel shift in budget line due to change in relative prices occurs because an unequal change in price causes a
change in the slope of the budget line i.e. the ratio of prices.

Indifference Curve
An indifference curve is a graph of different combinations of two products to which a consumer is indifferent i.e. he
likes both combinations equally likely.
  The indifference curves do not slope upwards. It is because an indifference curve shows trade-off
between two goods i.e. one must decrease if the other increases. If we have an upward-sloping indifference
curve, it would mean that consumption of both goods can simultaneously increase.
 The outermost indifference curve is most preferred by a consumer and the ranking decreases as we
move inwards i.e. towards left.
 Indifference curves do not intersect. It is because different indifference curves represent different
affluence level and an intersection would mean that the consumer is indifference between product
combinations represented by the two indifference curves.

Marginal rate of substitution is the rate at which a consumer is willing to replace one good with
another. For small changes, the marginal rate of substitution equals the slope of the indifference
curve.
An indifference curve is a plot of different bundles of two goods to which a consumer is indifferent i.e. he
has no preference for one bundle over the other. If we decrease units of one good, we must compensate the
consumer with more units of the other goods in order to maintain the indifference condition. Marginal rate
of substitution is the rate at which a decrease in one good must be compensated with an increase in the
other good.

Income effect and substitution effect are the components of price effect (i.e. the decrease in quantity
demanded due to increase in price of a product). Income effect arises because a price change changes a
consumer’s real income and substitution effect occurs when consumers opt for the product's substitutes.

In case of a normal good i.e. a good whose quantity demanded increases with increase in income, the substitution
effect and the income effect reinforce each other i.e. they work in the same direction. The example discussed above
is a normal good and hence the substitution effect and income effect work in tandem.

In case of an inferior goods (also called Giffen good), the income effect and substitution effect work in opposite
directions i.e. the net effect equal the difference between substitution effect and income effect. It is because an
inferior good reacts differently to a change in income. Its demand increases with decrease in income and vice versa.

Price-consumption curve is a graph that shows how a consumer’s consumption choices change when price of
one of the goods changes. It is plotted by connecting the points at which budget line touches the relevant
maximum-utility indifference curve.

Income-Consumption Curve
Income-consumption curve is a graph of combinations of two goods that maximize a consumer’s satisfaction at
different income levels. It is plotted by connecting the points at which budget line corresponding to each income
level touches the relevant highest indifference curve.

The interplay of a consumer’s budget constraint and his indifference curves determine his utility-maximizing
combination of goods. The point at which his budget constraint (which is derived from his income and prices of
the relevant goods) is tangent to the highest indifference curve is the point at which a consumer’s utility is
maximized.

Consumer Surplus
Consumer surplus represents the difference between total utility of a good and its market cost. It equals the
cumulative difference between the amount consumers are willing to pay for a good and the amount they pay in the
market.

Consumer surplus can be worked out by adding up the price consumers are willing to pay for first, second, third and
nth unit of a good and subtracting the n times the market price of the good. It can be mathematically expressed as
follows:

Engel Curve
An Engel curve is a graph which shows the relationship between demand for a good (on x-axis) and income
level (on y-axis). If the slope of curve is positive, the good is a normal good but if it is negative, the good is an
inferior good.

One of the determinants of demand is consumer income. A change in income can cause a shift in demand curve. In
case of a normal good, an increase in income increases demand and causes an outwards (right-ward) shift in the
demand curve. But in case of an inferior good, an increase in income decreases demand and shifts the demand curve
inwards (left-ward). This is how an Engel curve shows whether a good is a normal good or inferior good.

Since in case of a normal good, quantity demand increases with increase in income, it causes the Engel curve to have
a positive slope. On the other hand, in case of an inferior good, the Engel curve has negative slope.

Engel curves are also related to the income elasticity of demand: where the income elasticity of demand is positive,
Engel curves slope upwards and where the income elasticity of demand is negative, Engel curve slopes downwards.

There are two types of externalities: positive and negative. Positive externalities refer to the benefits enjoyed by
people outside the marketplace due to a firm’s actions but for which they do not pay any amount. On the other hand,
negative externalities are the negative consequences faced by outsiders due a firm’s actions for which it is not
charged anything by the market.

There are two types of positive externalities:

(a) positive production externalities i.e. the positive unpriced benefits that arise from production process and

(b) positive consumption externalities, i.e. the positive external benefits that arise from the consumption activities.

1. Negative production externalities arise from production activities and

2. negative consumption externalities are negative unpriced consequences of consumption process.

Chapter 07

Market structure refers to structural variables such as number of firms, barriers to entry and exit, product
differentiation, etc. which determine the level of competition in a market.

Basic market structures are

1. monopoly,
2. oligopoly,
3. monopolistic competition and
4. perfect competition.
 1. Monopoly has only one firm,
2. duopoly only two,
3. oligopoly is characterized by a few firms,
4. monopolistic competition has significant number of firms and
5. perfect competition has the largest number of firms each of which is so small that it can’t affect
the market in any way.

 A monopoly has highest degree of concentration, followed by an oligopoly.

 Monopolistic competition and perfect competition both have low degree of concentration
 but in perfect competition, a single firm's market share is negligible.

 Firms in perfect competition have completely standardized product with multiple substitutes,
 a firm which has a monopoly has a product with few substitutes
 but firms in oligopoly and monopolistic competition are characterized by differentiated products.

1. A firm which has a monopoly in a product faces a down-ward sloping demand curve and the product
typically has very low elasticity of demand.
2. In case of an oligopoly, even though the industry demand curve slopes downward and the market
elasticity of demand is low, each individual firm has a demand curve and elasticity of demand which are less
steep than the overall market.
3. Firms in perfect competition, on the other hand, face a horizontal demand curve and hence theoretically
infinite price elasticity of demand.

Perfect competition
Market= downward sloping
Firm= horizontal demand curve
Marginal Revenue = Current Market price (maximum profit)

It follows that even though the market demand curve is downward-sloping, the demand curve faced by each
individual firm is a horizontal.

For each firm, marginal revenue, the additional revenue obtained from selling one additional unit, is equal to the
current market price.

marginal revenue= current market price

it ensures that no firm earns positive economic profit in the long-run. If the market is profitable in the short-
run, new firms will enter the market, and this would return the market to zero economic profit. Similarly, if
existing firms are incurring loses, some of them will exit the market and the remaining firms would start
earning zero economic profit.

Monopolistic Competition(Imperfect
Competition)
Monopolistic competition is a type of imperfect competition market structure in which a large number of
firms produce differentiated products and there are no barriers to entry.

Monopolistic competition is monopolistic in the sense that due to product differentiation each firm has some
market power because due to its differentiated products even if it increases its price, its competitors can’t
capture all of its market share.

But monopolistic competition is also competitive because there are no barriers to entry and if the existing
firms earn positive economic profits, new firms can enter the market easily thereby decreasing the market power of
existing firms.

Market= downward sloping

Firm= faltter demand curve
Marginal Revenue = Marginal cost (maximum
profit)
The demand curve facing a individual firm in monopolistic competition is downward-sloping. It is because due
to the differentiated nature of products, they are not perfect substitutes for each other. This gives each firm some
ability to set its own price.

The demand curve relevant to each firm in a monopolistic competition is called residual demand curve, a demand
curve which shows the demand for product of one particular firm. A residual demand curve is flatter than the market
demand curve because individual firm demand is more elastic than market demand. Residual demand curve is
also to the left of market demand curve because individual demand is lower than the market demand.

A firm in monopolistic competition can maximize its profit by producing an

output at which its marginal revenue is equal to its marginal cost.

Monopolistic Competition vs Oligopoly

1. An oligopoly can have a homogeneous product or a differentiated product, but a monopolistic
competition always has a differentiated product.
2. Further, there are no barriers to entry in monopolistic competition but strong barriers in case of an
oligopoly.

Monopolistic Competition vs Monopoly

1. First, there are no barriers to entry in monopolistic competition but high barriers in a monopoly.
2. Second, there are many differentiated products in a monopolistic competition but only a single product in
a monopoly.
3. Third, even though firms in monopolistic competition have certain market power, it is very low when
compared to monopoly power.
Oligopoly
An oligopoly is a market structure in which a few firms have each such a large market share that any change in
output by one firm changes market price and profit of other firms. A member of an oligopoly is called an
oligopolist.

Real life examples of oligopolies include microprocessors, personal computers, airlines, tobacco,
pharmaceuticals, soft drinks, operating systems, etc.

1. An oligopoly of only two firm is called a duopoly, for example Intel and AMD in case of microprocessors.
2. Similarly, an oligopoly of three firm is called a triopoly, for example Microsoft, Nintendo and Sony in case of
game consoles.

Significant barriers to entry exist such as high investment requirement because of a high minimum
efficient scale (due to increasing returns to scale), control of critical natural resource (such as oil, mercury),
etc.

The product they sell might be differentiated (for example in automobiles) or standardized (such as steel,
crude oil, copper).

There is an incentive for firms to because they know that a price war is zero-sum game and that
cartelization can increase the oligopoly profits to monopoly level.

There is price-rigidity because firms fear that any price change will trigger price war.

Pure/Perfect Oligopoly vs Differentiated/Imperfect Oligopoly

1. A pure oligopoly (perfect) is one in which there is a homogeneous product, for example OPEC is a
pure/perfect oligopoly. Same is the case of oligopolies of other commodities such as mercury, copper, etc.
2. A differentiated oligopoly (imperfect), on the other hand, is one in which the product of different firms
is perceived to be different, for example automobile and smartphone industries are differentiated
oligopolies.

Collusive Oligopoly vs Non-Collusive Oligopoly

1. A collusive oligopoly is one in which the member firms engage in price-fixing and cartelization, for
example OPEC.
2. A non-collusive oligopoly in one in which there is no tacit understanding between the member firms
regarding pricing and output. Since price-fixing and cartelization is illegal in most developed countries,
most of oligopolies in US and Europe, etc. are non-collusive oligopolies.

Partial Oligopoly vs Full Oligopoly

1. A partial oligopoly is characterized by one large producer which leads other firms in the oligopoly in
pricing and output decision. It is called partial oligopoly because the output and pricing decisions are
sequential.
2. A full oligopoly, on the other hand, is a market in which firms have to decide about their pricing and
output decisions simultaneously.
Tight Oligopoly vs Loose Oligopoly
1. A tight oligopoly occurs when the four-firm concentration ration is higher than 60.
2. A loose oligopoly, on the other hand, is one in which the four-firm concentration is in the range of 40-
60

Oligopoly Models
Cartelization
An oligopoly can maximize its profits by colluding and forming a cartel. When they do so, they are effectively
a monopoly and they can maximize the industry profits by producing at an output level at which the
industry marginal revenue is equal to industry marginal cost.

Despite the significant advantage of cartelization, cartels are rarely successful. First, because collusion and price-fixing
are illegal in most jurisdictions. Second, individual firms have an incentive to cheat the cartel. Since every individual
firm can be better off if they cheat the cartel, a cartel is inherently unstable.

Cournot Model
The Cournot model of oligopoly applies where

1. the firms produce homogeneous goods

2. they compete simultaneously on output and market share, and
3. they expect their rivals to not change their output in response to any change that they make.

Cournot equilibrium is the output level at which each firm in the oligopoly maximizes its profit given the
output level of all other firms. No firm can gain from changing its output level away from Cournot equilibrium
because the response of other firms will wipe out any additional profit. Cournot equilibrium is the point of
intersection of the best-response curves (also called reaction curves) of the firms. If there are two firms, Reach
and Dorne, the reaction curve of Dorne plots Dorne’s profit-maximizing output given different output levels of Reach
and vice versa. As shown in the graph below, the Cournot equilibrium is the point of intersection of both reaction

Stackelberg Model
A Stackelberg oligopoly is one in which one firm is a leader and other firms are followers. This model applies
where: (a) the firms sell homogeneous products, (b) competition is based on output, and (c) firms choose their
output sequentially and not simultaneously.

The leader is typically a first-mover who chooses its output before other firms can do it. Since other firms must set
their output decision given the leader’s output decision, the leader in a Stackelberg oligopoly typically has a bigger
market share and higher profit than other firms in the oligopoly.

Bertrand Model
There are two versions of Bertrand model depending on whether the products are homogeneous or differentiated.
 1. The homogeneous-products Bertrand model of oligopoly applies when firms in the oligopoly produce
standardized products at same marginal cost. When the marginal cost is same, it is in the best interest of
each firm in oligopoly to undercut its rival (i.e. beat its price), because the other firms are also trying to beat
it. This price war leads to a situation at which market price is equal to the marginal cost. The output and
price level in a Bertrand oligopoly is the same as in perfect competition.

2. The differentiated-products Bertrand model contends that when an oligopoly produces differentiated
products, price competition doesn’t necessarily lead to a competitive outcome. It is because when each firm
produces a differentiated product, its demand doesn’t become zero when it raises its price. In fact, the
Bertrand model concludes that if one firm increases it price, the other firms in a differentiated oligopoly
should also increase theirs because this will increase its profit.

Contestable Market Theory

Contestable market theory posits that when the initial investment required in an oligopoly is not a sunk cost i.e.
where most of the investment can be recovered if a firm decides to leave the market, the industry functions
more like a perfect competition. It is because the recoverability of the investment encourages new firms to get a go
at the industry and this eliminates any positive economic profit.

Kinked Demand Curve Model

The kinked-demand curve model (also called Sweezy model) posits that price rigidity exists in an oligopoly
because an oligopolistic firm faces a kinked demand curve, a demand curve in which the segment above the
market price is relatively more elastic than the segment below it.

An oligopoly is a market structure in which there are a small number of large firms and high barriers to entry. In such
an environment, each firm has significant market power. Hence, firms must consider possible actions of their
competitors in taking their pricing decisions.

The kinked demand model postulates that when a firm increases it price, its competitors do not change their prices.
This causes the demand for goods produced by the firm attempting the price increase to fall. In other words, the firm
faces a very flat demand curve above the market price. On the other hand, when the firm decreases its price, its
competitors follow suit. Since all firms reduce their prices, there is no gain in market share for any firm. The increase in
sales is restricted only to the increase in quantity demanded due to lower market price. This is illustrated by a steeper
demand curve below the market price.

Kinked Demand Curve and Price Rigidity

A kinked demand curve is composed effectively of two demand curves which meet at the prevailing market price. At a
price higher than the prevailing market price, a firm faces a more elastic demand curve but at a price below the
prevailing market price, the demand curve is relatively less elastic. This introduces the disconnect i.e. a kink in the
demand curve at the current market price.

As explained by the kinked demand model, any increase in price is bound to result in drop in market share of the firm
and any decrease in price is not going to result in any gain in market share. Further, firms fear that any downward
revision in price may trigger a price war. This results in significant price rigidity in an oligopoly.

Concentration Ratio
Concentration ratio (also called n-firm concentration ratio) measures the market share of top n firms in an industry.
Four-firm concentration ratio which is the sum of market share of top four firms, is the most common concentration
ratio. It is close to 0 in case of perfect competition and close to 1 in monopoly or oligopoly.

The degree of concentration in an industry is a source of market power, the ability of firms in a market to set their
prices above their marginal cost. For example, in a monopoly where there is only one producer, a firm can charge
whatever price it deems fit without worrying about any competition. Similarly, in an oligopoly where there are only a
few firms, the equilibrium output is lower and the price is higher than in perfect competition.

A reaction curve (or best-response curve) is a graph which shows profit-maximizing output of one firm in a duopoly
given the output of the other firm.

Profit maximization rule (also called optimal output rule) specifies that a firm can maximize its economic
profit by producing at an output level at which its marginal revenue is equal to its marginal cost.

Why MR = MC is Profit-Maximizing?
It means that the rate of change of profit equals the difference between the rate of change of revenue and
rate of change of cost.

Now, at the profit-maximizing output, rate of change of profit should be 0 because we have reached the
peak of the profit curve. The rate of change in profit was positive till we reached the peak and it would turn negative if
we move over it. Hence, it follows that profit maximization is possible if ∆π/∆q is 0.

Chapter 08

National income accounting represents the process of working out measures of a country’s income and production
such as gross domestic product (GDP), gross national income (GNI), net national product (NNP), disposable
personal income, etc.

(GDP), which is the market value of all final goods and services produced within geographical boundaries of a
country. GDP is a measure of total production that takes place inside the border of a country. It also a measure of
total expenses incurred on final goods and services

1. nominal GDP which is value of production based on current prices and

2. Real GDP is the inflation-adjusted measure of GDP.

Gross National Product

Gross national product (also called gross national income) is the total income earned by the residents of a
country. It equals gross domestic product (GDP) plus income earned by a country’s residents abroad
(R) minus income earned by foreigners in a country (P):
GNP = GDP+ R- P

Net National Product

Income generated by a country is achieved on the back of significant investment in infrastructure i.e. roads,
bridges, etc. which must be maintained. If we are interested in finding out the income generated net of such charge
for periodic maintenance of such infrastructure, we calculate net national product (NNP) which equals gross
national product (GDP) minus depreciation D.
NNP= GNP- D

Disposable Income
Disposable income is the income that is at the disposal of residents of the country i.e. it is the income which
they can consume or save.

Disposable income equals personal income (PI) minus personal income taxes (PIT):

Disposable Income= PI – PIT

Approaches to GDP Estimation

GDP can be calculated in three different ways and each gives us the same answer. These three methods are (a) the
product approach, (b) the expenditure approach, and (c) the income approach.

Nominal GDP vs Real GDP

The GDP compiled by statistical agencies is based on the prices prevailing in the market during the period. This
number is called nominal GDP. In order to compare GDP number across time, it is important to remove the effect of
changes in purchasing power from historical time series. The real GDP is the gross domestic product which is worked
using current year quantities and the base year prices. In a time series of real GDP, GDP numbers for all periods are
restated based on the prices that prevailed in the base year.

GDP measures total production within geographical boundaries of a country achieved during a period while GNI is
a measure of income generated by residents of a country regardless of their geographical location. GDP is certainly
a more popular measure of income, but GNP is useful if we are interested in finding out a country’s tax potential, its
residents’ affluence i.e. disposable income, etc.

GDP: Expenditure Approach

Gross domestic product (GDP) represents the value of all final goods produced and services delivered within the
geographical boundaries of a region (city, state, country) in a period (most commonly a year).

Nominal GDP vs Real GDP

Nominal GDP tells about the current market value of final goods and services produced in an economy. Real GDP,
on the other hand, is a measure of total production at constant prices. Change in real GDP over the period is a
measure of growth.

Nominal GDP data series represents the combined effect of changes in quantities of goods and services and their
associated price changes,

but the real GDP keeps the prices constant and measure only changes in quantities of goods and services. Since
the real GDP removes the effect of price changes, it is a better measure of an economy’s growth rate.
  Nominal GDP includes the effect of both changes in prices and changes in total production while real
GDP accounts only for changes in quantities produced.

GDP Deflator
GDP deflator (also called implicit price deflator for GDP) is a measure of price level of domestically-produced goods
and services in an economy. It is calculated by dividing nominal GDP by real GDP multiplied by 100.

Absolute Advantage
An entity has absolute advantage over another when it is more efficient than the other in the production of all the
goods or services which both produce. It means that the entity yielding absolute advantage has higher output per
unit of resource in all the products and services.

The principle of absolute advantage is applied to countries in the study of international trade, though it also relevant
to individuals and businesses.

Circular Flow Diagram

Circular flow diagram shows how income flows in an economy between households, firms and government in product
markets, factors of production markets and financial markets.

Efficiency Factor
Achieving high output to input ratio is the result of efficiency. Efficiency includes both productive and allocative
efficiency. High efficiency increases growth rate when it is coupled with full employment. To achieve maximum
growth rate, an economy must use its available resources in the least costly way to produce the optimum mix of
goods and services and it must use its resources to the maximum extent possible.

CHAPTER 11
Fiscal Policy
Fiscal policy is a form of economic policy that involves changing government spending and taxes in order to achieve
growth while keeping inflation in check. It is also termed as discretionary fiscal policy.

Together with monetary policy, fiscal policy tools are used to keep the economy steady and save it, as much as
possible, from ups and downs. While monetary policy is implemented by the central bank, fiscal policy is
implemented by the government. Since fiscal policy is based on legislation, it typically takes lot more time in
affecting the economy as compared to monetary policy.

When the economy is in facing recessionary pressures, the government provides stimulus to the economy by either
decreasing taxes or increasing its expenditures or taking both the steps simultaneously.
On the other hand, if the economy is facing inflationary pressures, the government attempts to reduce inflation by
either increasing taxes or decreasing its expenditures or doing both.

IS Curve
IS curve is a schedule/curve that shows the equilibrium output level that occurs in the market for goods and services
at different levels of interest. The IS curve is one part of the IS-LM model and it is plotted with interest on y-axis
and output on x-axis.

Marginal Propensity to Consume

Marginal propensity to consume (MPC) is the proportion of an individual’s additional income which he spends. It is the
ratio of change in consumption to change income. It can also be defined as the slope of the consumption function.

Automatic Stabilizers
Automatic stabilizers are economic phenomena which moderate the effect of economic expansions and slow
downs. In periods of economic booms, such factors restrict the growth and in periods of slowdown they partially
mitigate the drop in aggregate output.

Transfer payments
Transfer payments i.e. social security expenses such as unemployment insurance or any other such benefits which are
payable to unemployed people comes into play in economic recessions. When there is an economic slowdown,
companies lay off people thereby reducing the overall employment level. High unemployment rate means more and
more people are eligible for government’s social security benefits which in turn increases the government expenditure
component of the GDP and partially reduces the magnitude of decline in GDP due to slowdown.

Tax Multiplier
Tax multiplier represents the multiple by which gross domestic product (GDP) increases
(decreases) in response to a decrease (increase) in taxes. There are two versions of the tax
multiplier: the simple tax multiplier and the complex tax multiplier, depending on whether the
change in taxes affects only the consumption component of GDP or it affects all the components
of GDP.

Flat Tax
A flat tax (also called proportional tax) is a tax structure in which the tax rate stays constant regardless of the level of
income. It means the rich and the poor pay the same or nearly same proportion of their total income as taxes.

A flat tax is either (a) true flat tax or (b) marginal flat tax. In a true flat tax, no deductions are allowed; while in
marginal flat tax, some deductions are allowed such as on account of charitable donations, etc. A marginal flat
tax is progressive at lower level of income and turns flat as income increases.

Regressive Tax
A regressive tax is a tax structure in which the effective tax rate decreases as the total income of the tax payer
increases. The rich might pay a higher amount of tax, they pay less relative to their total income.
Progressive Tax
A progressive tax regime is a tax structure in which the tax rate increases with an increase in taxable income. It means
that the tax rate applied to a higher slab of income is higher than the tax rate applied to a lower slab of income.

Tax Incidence
Tax incidence is the degree to which a given tax is paid or borne by a particular economic unit such as consumers,
producers, employers, employees etc. When we say that the tax incidence of a given tax falls on A, it means A
ultimately pays or bears the burden of tax in greater proportion.

Statutory incidence or nominal incidence of a given tax is the degree to which the tax is actually paid by an
economic unit in the form of cash, check etc. (Tax may be collected and deposited in government's treasury by
someone else). Statutory incidence is stated in tax law. For example, at the time or writing, US tax laws require that tax
on salary income of an employee must be borne 50% by employer and 50% by employee. In this case, statutory
incidence of tax equally falls on employer and employee.

Economic incidence of a given tax is the degree to which the burden of the tax is borne by an economic unit in the
form of reduced resources. Economic incidence of a tax does not necessarily fall on the same economic unit on which
its statutory incidence falls. Rather it depends on the elasticity of demand and supply. When demand is inelastic and
supply elastic, tax burden is mainly on the consumer; in case of inelastic supply and elastic demand, tax incidence falls
mainly on producer. When both demand and supply are moderately elastic the tax incidence is distributed between
producers and consumers.

Ability-to-Pay Principle
Ability-to-Pay principle is principle of taxation which asserts that the amount of tax levied on an economic entity
should be directly proportional to the ability of the entity to pay taxes. Therefore, a person having high income and
wealth should be taxed more and less tax should be levied on those having low income and wealth provided other
things remain constant.

Benefits-Received Principle
A principle of taxation which states that the burden of tax on an economic entity should be directly
proportional to amount of benefits it receives from the use of public goods or services provided by
government. In other words, consumers and businesses should pay to the government, the value of the public goods
and services they have benefited from as if they were buying those goods and services. This means, for example, that
people who travel by road more should pay more of the taxes used to construct and repair those roads and those
who use roads less should pay small portion of the taxes to be spent on the roads.

1. Expansionary fiscal policy is a form of fiscal policy that involves decreasing taxes, increasing
government expenditures or both, in order to fight recessionary pressures.

Contractionary Fiscal Policy

Contractionary fiscal policy is a form of fiscal policy that involves increasing taxes, decreasing
government expenditures or both in order to fight inflationary pressures.

CHAPTER 12
Monetary Policy
Monetary policy is a form of economic policy that involves changing money supply in order to change cost of

borrowing which in turn changes inflation rate, growth rate and unemployment rate

Liquidity Trap
Liquidity trap (also called zero lower bound) is a situation in which nominal interest rates is already close to zero
and any further increase in money supply does not have any expansionary effect.

LM Curve
LM curve is a graph that plots equilibrium output dictated by the financial market at different interest levels. It slopes
upward because high output/GDP is associated with high interest rate due to high demand for money and vice versa.

IS curve and LM curve are the two components of IS-LM model, a model of combined equilibrium in the goods
market and the financial market.

Quantity Theory of Money

The quantity theory of money states that the price level that prevails in an economy is the direct consequence of the
money supply. If the velocity of money is constant, any increase in money supply causes a proportionate increase in
price level.

Velocity of Money
The quantity theory of money assumes that the circulation of money in an economy is constant. The circulation of
money in measured by its velocity. Velocity of money is the average turnover of a dollar i.e. it is the number of times a
dollar is used in a transaction over a period of time.

The quantity theory of money can be defined using the definition of velocity i.e. velocity must equal the value of
economy’s output measured in today’s dollars divided by number of dollars in the economy:

Expansionary Monetary Policy

Expansionary monetary policy is a form of economic policy that involves increasing the money supply so as to
decrease the cost of borrowing which in turn increases growth rate and reduces unemployment rate. Expansionary
monetary policy is used to fight off recessionary pressures.

Contractionary Monetary Policy

Contractionary monetary policy is a form of economic policy used to fight inflation which involves decreasing the
money supply in order to increase the cost of borrowing which in turn decreases GDP and dampens inflation.

When the economy is under inflationary pressures, the central bank (in US, the Federal Reserve) decreases the money
supply by either increase in the discount rate or sale of government bonds or increase in the required reserve ratio or
by carrying out all the changes simultaneously.

Contractionary monetary policy has some side effects too. It results in an increase in the unemployment rate and a
decrease in the growth rate of the GDP

Fisher Effect
Fisher effect is the concept that the real interest rate equals nominal interest rate minus expected inflation rate.
It is based on the premise that the real interest rate in an economy is constant and any changes in nominal interest
rates stem from changes in expected inflation rate.

Open Market Operation

Open market operation is a monetary policy tool used by central banks to increase or decrease money supply by
buying and selling government bonds in the open market.

Bank Reserves
Bank reserves is the amount of cash which a bank has not yet advanced as loans or invested elsewhere. It equals the
cash physically available with the bank plus the amount it has deposited with the central bank.

CHAPTER 14
Structural Unemployment
Structural unemployment is the unemployment that exists when wages do not adjust to equilibrium such that the
number of job-seekers exceed the number of available jobs even in an economic boom.

As shown in the graph below, the labor demand curve slopes downward. It means that as the wages fall, firms are
willing to hire more workers and vice versa. It is due to diminishing marginal product of labor. As we add more and
more workers while keeping capital constant, they are increasing less and less productive. The labor supply curve is
upward sloping. It means that more workers are willing to work at higher wages.

Cyclical Unemployment
Cyclical unemployment refers to the increase in total unemployment that occurs when an economy is in recession. It is
represented by difference between the unemployment rate and the natural rate of unemployment.
Natural Rate of Unemployment
Natural rate of unemployment is the long-run unemployment rate around which the actual employment rate
oscillates. It is the combined effect of frictional unemployment and structural unemployment.

unemployment.

Frictional Unemployment
Frictional unemployment is the unemployment that results from the time it takes workers in finding jobs. The level of
frictional unemployment depends on the rate of job separations and the average time of job finding.

Labor Force Participation Rate

Labor force participation rate is the percentage of working age population that is part of the labor force. It is a
measure of what proportion of a country's population is employed or actively looking for employment. Higher the
labor force participation rate, more of the country's population is interested in working.